1.

3 Interest Rates and Price

Vola4lity
 1.3 Interest rates and price vola3lity
1.3.1 Various interest rate measures
1.3.2 Factors affec4ng security prices & price
vola4lity
1.3.2.1 Interest rate
1.3.2.2 Maturity
1.3.2.3 Coupon rate
1.3.2.4 Dura4on (Macaulay, PorEolio, Modified and Effec4ve)
1.3.2.5 Convexity
 Various Interest Rate Measures
!  Coupon rate
!  periodic cash flow a bond issuer contractually promises to pay a
bond holder
!  Required rate of return (r)
!  Interest rate an investor should receive on a security given its risk
!  rates used by individual market par4cipants to calculate fair
present values (PV)
!  Expected rate of return or E(r)
!  Interest rate an investor expects to receive on a security if he or
she buys the security at current market price ( ), receives all
expected payments, and sells the security at the end of his or her
investment horizon
!  Realized rate of return (r )
!  interest rate actually earned on investments
 Required Rate of Return
!  Is an ex ante (before the fact) measure of interest rate on a
security
!  The appropriate return to compensate investors for the risks
!  Calculated using (RFR + risk premiums) or CAPM
!  The fair present value (PV) of a security is determined using
the required rate of return (r) as the discount rate

CFt = cash flow projected in period t (t = 1, …, n)

n = number of periods in the investment horizon
!  Then the PV is compared with current market price to determine whether
the security is fairly/over/under-valued.
 Expected Rate of Return
!  also an ex ante measure of interest rate
!  Rate that equates the future cash flow of the security with
its current market price
!  The current market price ( ) of a security is determined
using the expected rate of return or E(r) as the discount
rate

CF1 = cash flow in period t (t = 1, …, n)

n = number of periods in the investment horizon
!  Current market price is a perceived value of investors which might
not properly account for all the risk of the security
 Rela4on between Required return
and Expected return
E(r) > r Projected cash flows received on the Security is Buy
security are greater than to those undervalued,
required to compensate for the risk < PV
incurred from inves4ng in the security

E(r) < r Projected cash flows received on the Security is Sell

security are less than is required to overvalued,
compensate for the risk incurred from > PV
inves4ng in the security
E(r) = r Projected cash flows received on the Security is fairly Neutral
security are equal to that required to valued, or Hold
compensate for the risk incurred from = PV
inves4ng in the security

If markets are efficient, required return is the same as expected return

 Realized Rate of Return
!  Ex-post (aber the fact) measure of interest rate
!  The realized rate of return ( ) is the discount rate that
just equates the actual purchase price ( ) to the present
value of the realized cash flows (RCFt) t (t = 1, …, n)

= price actually paid for the security

RCFt= Realized cash flow in period t (t = 1, …, n)
n = number of periods in the investment horizon
 Various interest rate measures
A2Z Corpora4on has outstanding 12-year P1,000 par value
bond with a coupon of 10% that is paid annually. Real risk-
free rate is expected to be 3% and expected infla4on
premium is 2% annually for the next 10 years. The default
risk and liquidity premium on the bond is 2.40% and
1.70%, respec4vely; while, maturity risk premium on an
10-year security 1.50%. You purchased the bond two years
ago for P895 and sold it at its current market price of P920
today.
Calculate the required return, expected return (upon
issuance and today) and realized return if beta of the
security is 0.80 while market return is currently at 12%.
 Factors that affect Security Prices
and Price Vola4lity
Price vola4lity- is the degree of varia4on in prices. It is measured
by the percentage change in prices.

Factors Prices Price Vola3lity

Interest rate As interest rate increases, The higher the ini4al interest
(ini4al and price decreases rate, the less vola4le the
change) price is
Time to As the security’s maturity The longer the 4me to
maturity approaches, the closer the maturity, the more vola4le
price is to its face value. (Pull the price is.
to par effect)
Coupon rate The higher the coupon rate, The higher the coupon rate,
the higher the price is at a the less vola4le the price is
given interest rate
 Rela4on between Interest Rates and Price
Price

1,152.47

1,000
Inverse
874.50 relationship is
curvilinear

Interest rates
8% 10% 12%

As interest rate increases, price decreases at a decreasing rate*

* % change in price to a given change in interest return is smaller
when ini4al interest rates are higher
Pull to par effect-prices approach their par values as
4me to maturity declines towards zero
 Maturity and Security Price Vola4lity
to Changes in Interest rates
Absolute Value of
Percent Change in a
Price for a Given
Change in Interest
Rates

Time to Maturity
Price vola4lity for a given increase in interest rates
increases with maturity but at a decreasing rate.
Maturity and Security Price Vola4lity
to Changes in Interest rates
*when interest
rates increase from
7% to 7.5% for
1,000 bonds with a
6% coupon and
different maturi4es

Note that price

volatility
increases at a
decreasing rate
Coupon Rates, Security Price and Security
Price Vola4lity

Price
High-Coupon Bond
higher
coupon line
is flatter than
low coupon
Low-Coupon Bond

Interest Rate
The higher the coupon, the higher its price at a given
interest rate and the smaller the price changes for a
given change in interest rates
Coupon and Security Price Vola4lity

*when interest rates

decrease from 7% to
6.5% for 10 year bonds
with differing coupon

Note that
price
volatility
decreases at
a decreasing
rate
 Dura3on
!  Dura3on is the weighted-average life ( in years to maturity) of a
financial security using the rela4ve present values of the cash
flows as weights
- incorporates the 4me of arrival of all cash flows along the
security’s maturity date
-captures the coupon and maturity effects on vola4lity
- measures the vola4lity (or elas4city) of a security’s price to
small (up to 100 basis points) interest rate changes

!  Types of Dura4on: Macaulay, PorEolio, Modified and

Effec4ve
 Macaulay Dura3on
!  Dura3on (D) for any fixed-income security can be calculated as
follows:

t = 1 to N, the period in which a cash flow is received
N = the number of periods to maturity
CFt = cash flow received at end of period t
r = yield to maturity or required rate of return on the investment
m = number of 4mes per year interest is paid
 Macaulay Dura4on
Compute for Dura4on for the following bonds
1.  6% Coupon, 4 year maturity annual payment bond with a 5% ytm
2.  6% coupon, 4 year maturity annual payment bond with an 8% ytm
3.  3% Coupon, 4 year maturity annual payment bond with a 5% ytm
4.  6% Coupon, 6 year maturity annual payment bond with a 5% ytm

Time CF PV of CF PV of CF x PV of CF Weights x t
(t) t weights
1/2 xxx xxx xxx OR x% xxx
1 xxx xxx xxx x% xxx
Sum A Sum B Sum C
D= Sum B/ Sum A OR Sum C
 Dura4on and Vola4lity
6% Coupon, 4 year maturity annual payment bond with a 5% ytm

Duration = 3.6793 years

This bond has approximately the same price vola4lity as a zero

coupon bond that matures in 3.679 years
 Dura4on and Vola4lity: YTM difference
6% Coupon, 6 year maturity annual payment bond with an 8% ytm

Duration = 3.6603 years

No4ce that with higher YTM, this bond has a shorter dura4on and
hence lower price vola4lity.
 Dura4on and Vola4lity: coupon difference
3% Coupon, 4 year maturity annual payment bond with a 5% ytm

Duration = 3.8213 years

No4ce that with a lower coupon this bond has a bigger dura4on and
hence larger price vola4lity. With the lower coupon, a lower
percentage of the investment is returned in the early years. This
makes the bond more price vola4le.
 Dura4on and Vola4lity: maturity difference
6% Coupon, 6 year maturity annual payment bond with a 5% ytm

Duration = 5.2342 years

No4ce that with the longer maturity this bond has a bigger dura4on
and hence larger price vola4lity. Maturity is the predominant effect
of the three on dura4on.
Proper4es of Dura4on
!  Dura3on and rate of return/ yield to maturity
!  the higher the rate of return or yield to maturity, the shorter its
dura4on
!  Dura3on and coupon interest
!  the higher the coupon payment, the lower the bond’s dura4on
!  Dura3on and maturity
!  Dura4on is always equal or less than the security’s maturity
!  Longer the maturity, the larger the discrepancy between maturity
and dura4on; and
!  dura4on increases with maturity (but at a decreasing rate)
Dura4on and Elas4city
!  Elas4city- percentage change in the price of an asset or
liability for a given change in interest rates
!  Given an interest rate change, the es4mated percentage
change in price for securi4es can be computed as follows:

where 1 + rb is the yield for the applicable period (annual,

semi-annual, etc.);
D and Δrb should be for the same period as (annual or semi-
annual)

3-24
 PorOolio Dura3on
!  Dura3on of a porOolio of assets instead of just a
single asset
!  Two methods:
1. Weighted average of 3me of receipt of the
aggregate cash flows (theore3cally correct but
difficult to implement)
•  If not given, compute YTM of porOolio using aggregate
cashflows
•  Use YTM computed and apply Macaulay’s Dura3on
equa3on
 PorOolio Dura3on
!  Two methods:
2. Weighted average of all individual asset dura3on
comprising the porOolio (commonly used)
 PorEolio Dura4on
Compute for porEolio Dura4on comprising of the following bonds:

50,000 of 6% Coupon, 4 year maturity annual payment bond with a 5%

ytm

30,000 of 3% Coupon, 4 year maturity annual payment bond with a 5%

ytm

20,000 of 6% Coupon, 6 year maturity annual payment bond with a 5%

ytm
Modified Dura4on

!  Modified dura4on (MD) is a more direct measure of price

sensi4vity. Calculated by:
Dannual/(1+rb)
where rb is the beg yield for the period
!  Using modified dura4on to predict price changes, the dura4on
equa4on can be rearranged as follow:

where Δrb is the change in annual yield

 Dura4on and Vola4lity
6% Coupon, 4 year maturity annual payment bond with a 5% YTM

Duration = 3.67927054 years

Now assume that YTM increases by 20 basis points (20/100 of 1

percent). Compute for the (a) modified dura4on, (b) predicted
percentage or value change in the bond’s price
 Effec4ve Dura4on
!  Is a dura4on calcula4on for bonds that have embedded op4ons
!  takes into account the fact that expected cash flows will
fluctuate as interest rates change.
!  The longer the maturity of a bond, the larger its effec4ve
dura4on.
!  Calculated as:
Effec3ve dura3on = (P(1) - P(2)) / (2 x P(0) x Y)
where: P(0) = the bond's original price
P(1) = the price of the bond if the yield were to decrease by Y percent
P(2) = the price of the bond if the yield were to increase by Y percent
Y = the es4mated change in yield used to calculate P(1) and P(2)
 Effec4ve Dura4on example
If an investor purchases a bond for 10,000 and
that the bond is currently yielding 8%. A yield
decrease of 0.5% would result to a bond price
of P10,980. A yield increase by 50 basis points
would result to a bond price of P9,850. Given
this informa4on, Calculate effec4ve dura4on.

Effec3ve dura3on = (P(1) - P(2)) / (2 x P(0) x Y)

Dura4on Based Predic4on Errors

Dura4on assumes linear rela4onship hence overpredicts

price fall and underpredicts price increase
Features of Convexity
!  Convexity is desirable
!  The greater convexity of a security, the more insurance or interest
rate protec4on against rate increases and greater poten4al gains
if interest rate falls
!  Convexity diminishes the error in dura3on as an
investment criterion
!  Larger interest rate changes, the more convex, greater error in
using just dura4on to immunize exposure to interest rate shocks
!  All fixed-income securi3es are convex
!  As interest rates change, prices change at a nonconstant rate
Convexity
!  Convexity (CX) is the degree of curvature of the price-
interest rate curve around some interest rate level
!  measures the change in slope of the price-yield curve
(capital gain effect larger than capital loss effect)
!  Convexity can be computed as follows:

ΔP-/P - Capital loss from a one basis point increase in rates

ΔP+/P - Capital gain from a one basis point decrease in rates
 Convexity and Vola4lity
!  Convexity can be inserted into the price predic3on
equa3on with a convexity adjustment as follows:
 Dura4on, Convexity and Vola4lity
A 5 –year P1,000 bond that pays interest semiannually has a 6%
coupon and a 7% quoted YTM. Annual interest rates increase 50 basis
points.

Compute for the:

(a) dura4on
(b) modified dura4on
(c) predicted percentage or peso value change in the bond’s price
using dura4on
(d) convexity
(e) predicted percentage or peso value change in the bond’s price
using dura4on with convexity adjustment
 Answers to CX sample Prob
(a) dura4on: 4.3774 years
(b) modified dura4on: 4.2294 years
(c) predicted percentage or peso value change in the bond’s price
using dura4on: -2.1147% or P20.27 decrease (predicted price:
P938.15)
(d) convexity: 21.4572 ( no rounding-off)
(e) predicted percentage or peso value change in the bond’s price
using dura4on with convexity adjustment
If CX is 21.4572: -2.0879% or P20.01 decrease (predicted price:
P938.41)
 1.3 Interest rates and price vola3lity
1.3.1 Various interest rate measures
1.3.2 Factors affec4ng security prices & price
vola4lity
1.3.2.1 Interest rate
1.3.2.2 Maturity
1.3.2.3 Coupon rate
1.3.2.4 Dura4on (Macaulay, PorEolio, Modified and Effec4ve)
1.3.2.5 Convexity
End of 1.3
Ques4ons?
Knowledge Check
KC #1
Johnson Motor’s bonds have 10 years remaining to
maturity. Interest is paid annually, the bonds have
P1,000 par value, and the coupon rate is 8%. The
bonds have a yield to maturity of 9%. What is the
current market price of the bonds?
KC #2
You have just been offered a bond for P863.73. The
coupon rate is 8% payable annually, and the yield to
maturity on new issues with the same degree of risk
are 10%. You want to know how many more interest
payments you will receive , but the party selling the
bond cannot remember. If the par value is P1,000,
how many interest payments remain?
KC #3
Paychex Inc. (PAYX) recently paid a P0.84 dividend. The
dividend is expected to grow at a 15% rate. At a
current stock price of P40.11, what return are
shareholders expec4ng?
 KC #4
An insurance company is analyzing the following three bonds, each with five
years to maturity, and is using dura4on as its measure of interest rate risk:
a)  P10,000 par value, coupon rate = 8%, rb = 0.10
b)  P10,000 par value, coupon rate = 10%, rb = 0.10
c)  P10,000 par value, coupon rate = 12%, rb = 0.10
Compute for the following for all the three bonds:
Dura4on
Modified Dura4on
PorEolio Dura4on if the company bought 25 bond A, 50 bond B and 25 bond C.
Predicted price ( if interest decrease by 1.5%)
Predicted price (if interest increase 1.5%)
Effec4ve Dura4on (using predicted prices above)
Convexity
Predicted price with CX adjustment ( if interest decrease by 1.5%)
Predicted price with CX adjustment (if interest increase 1.5%)
 Notes and A2Z Answers
!  If problem is silent, the rate given is in annual terms
!  Take note if compute rate would be for period (semi-annual)
only or for the year (annual) already
!  Required return= fair values; expected return= market price
!  Realized return – computed similarly to HPY

!  Required using RFR: 3% + 2% + 2.4% + 1.7% + 1.5% = 10.60%

!  Required using CAPM: 5% + 0.80 (12%-5%) = 10.60%
!  Expected upon issuance: 895= (100xPVIFA12,?) + (1000 x
PVIF12,?) = 11.67%
!  Expected today: 920 = (100xPVIFA10,?) + (1000 x PVIF10,?) =
11.38%
!  Realized return: 895 = (100xPVIFA2,?) + (920 x PVIF2,?) = 12.49%
 Factors that affect Security Prices
and Price Vola4lity/ Sensi4vity
!  The four variables that affect vola4lity are coupon and maturity (which
are captured by dura4on), change in ytm or r and the star4ng ytm or r.
(r = ytm)

!  Interest rate- there is a nega4ve rela4on between interest rate changes

and price changes on financial securi4es. As interest rates increase, the
prices (present values) decrease at a decreasing rate
!  Time remaining to maturity- the longer the 4me to maturity for a
security, the farther the price is to the face value of the security. The
higher the 4me to maturty, the larger the price change (at a decreasing
rate) for a given in interest rate change.
!  Coupon rate- The higher the coupon, the higher its price at a given
interest rate; the higher the security’s coupon rate, the smaller the price
change on the security for a given change in interest rates
 Notes and Answers
!  Interest rates and Prices
!  Inverse rela4onship is curvilinear, (not linear); % change in
bond value to a given change in required return is smaller when
interest rates are higher
!  Pull to par- This is true regardless whether it is a premium,
discount or par bond; 4me value effect is reduced as maturity
approaches
!  Higher coupon, larger por4on of required return is paid in the
form of coupon payments; a security that returns a greater
propor4on of investment sooner is more valuable and less price
vola4le
 Notes: Dura4on
!  Note that if the security makes semiannual or monthly
payments then the cash flow, the interest rate and the number
of periods must be adjusted to reflect the payment frequency.
Denominator is simply the current market price
!  Important to reflect 4me as it is (e.g semi-annual = ½, unlike
before that we simply mul4ply period by the number of
compounding)
!  Weight-% of its cost in PV recovered that year
!  If you have zero coupon bond, dura4on is simply its maturity;
bonds that pay some cash flows prior to maturity, its dura4on
will always be less than its maturity
 Notes
!  Higher ytm- more investor earned on reinvested
coupon, recoup investment faster
!  Nega4ve sign of D indicates inverse rela4onship
between interest changes and price changes
!  For small changes in interest rates, bond prices move
in an inversely propor4onal manner according to the
size of D,
!  long dura4on would suffer a larger capital loss or
receive larger capital gain if interest rates rise or fall
than do short dura4on securi4es
Answers:
PorEolio dura4on= (50% x 3.6793) + (30% x
3.8213) + (20% x 5.2342) =4.0329

!  Modified dura4on- More intui4ve form of dura4on, same with dura4on,

applicable to small interest rate changes
3.5041 (3.67927054/ 1.05)
!  Price change= -0.7008% or -7.2566 (3.5041 x 0.2%)
Vs. Using PV equa4on, change in bond price is -0.6976% or -7.2232

Effec4ve Dura4on: bond's price would be expected to change by the

effec4ve dura4on x change in rate (same as modified dura4on)
(10,980-9,850)/ (2 x 10,000 x 0.005) = 11.3
 Notes
!  Dura4on is an accurate predictor of price changes only
for very small interest rate changes (one or few basis
points). For day to day fluctua4ons dura4on works
quite well
!  but when interest rates move significantly, such as
when the Fed makes an announcement of a rate
change, the predicted pricing errors can become
significant.
!  The predic4on errors arise because bond prices are
not linear with respect to interest rates.
!  Also note that capital loss effect (due to large interest
rate increases) tends to be smaller than do capital gain
effect due to bond price-interest rate rela4onship
exhibi4ng a property called convexity
 Notes and answers
!  Convexity Rela4onship = Higher level of interest rates, the
smaller the bonds price sensi4vity to interest rate changes
!  In effect is similar to buying par4al interest rate risk insurance
(capital gain effect more than offsets for capital loss effect)
!  Using the convexity adjustment reduces the error between the
predicted value and true value to just a few basis points
 D=4.3774 years

Using Modified Duration

Predicted Price Change Using Modified Duration

Predicted Price Change Using Convexity

CX = 108 [-0.042283%+0.042304%] = 21.4572
Price change= -2.1147% + ½(21.4572*0.0052) = -2.0879% or –P20.0105
Using 4me value, new price is P938.40, price change is -20.0129 or -2.0881%
 KC#1-3 Answers:
!  1.) P935.82
!  2.) 12 years
!  3.) 17.41%
KC#4 Answer:
 KC Answers
#1.) Vb = 1,000(0.08) {[1 - (1/(1 + 0.09)10)]/0.09} + 1,000(1 + 0.09)10 = P935.82
Or, on a financial calculator: N = 10, I = 9, PMT = 80, FV = 1,000, => PV = P935.82

#2.) 863.73 = 1,000(0.08) {[1 - (1/(1 + 0.10)n)]/0.10} + 1,000/(1 + 0.10)n => n =

12 years
Or, on a financial calculator: I = 10, PV = -963.73, PMT = 80, FV = 1,000, => n =
12 years

#3.) E(rs) = 0.84(1 + 0.15) + 0.15 = 17.41%

40.11
KC#4 Answers
KC#4 Answers