Fixed-Income Risk and Return (Duration+Convexity)

FIXED-INCOME RISK AND RETURN
(DURATION + CONVEXITY)
Reference: Chapter 5 (PET) + Other notes
Presented By:
M. EMRUL HASAN, CFA, FRM, PhD
Lecturer, Beedie School of Business,
Simon Fraser University
Lecturer, Vancouver School of
Economics, UBC
Director of Learning, FinanceTraining.ca
1
1. INTRODUCTION
• Any analysis of fixed-rate securities starts with an
understanding of their risk and return characteristics.
• The yield-to-maturity, or internal rate of return on future
cash flows, is of particular focus.
• The return on a fixed-rate bond is affected by many factors,
such as credit risk (potential default on payments) and
interest rate risk (varying coupon reinvestment rate and
sale price).
Copyright: CFA Institute and FinanceTraining.ca 2

2. SOURCES OF RETURN
A fixed-rate bond has three sources of return:
Receipt of the promised coupon and principal payments
1. on the scheduled dates
Reinvestment of coupon payments
2.
Potential capital gains or losses on the sale of the bond
3. prior to maturity
• the internal rate of return between the

A horizon yield total return for the investment horizon
and the purchase price of the bond
• the purchase price plus (minus) the

amortized amount of the discount
A carrying value (premium) if the bond is purchased at a
price below (above) par value
SOURCES OF RETURN
Example: An investor purchases a 10-year, 8% annual coupon bond at
$85.503075 per $100 of par value and holds it to maturity. The bond’s
yield to maturity is 10.40% (also the reinvestment rate). Show the
sources of return:
Bondholder receives 1) Coupon payments 10 × $8 = $80; 2) Par value at
maturity $100; 3) Reinvestment income from coupons (at 10.40%).
8× 1.1040 ! + 8× 1.1040 " + 8× 1.1040 # + 8× 1.1040 $ +[8×
1.1040 % ]+ 8× 1.1040 & + 8× 1.1040 ' + 8× 1.1040 ( +[8×
1.1040 ) ] + 8 = $𝟏𝟐𝟗. 𝟗𝟕𝟎𝟔𝟕𝟖
$129.970678 = Future value of the coupons on the bond’s maturity date
$49.970678 = Interest on reinvested coupons ($129.970678 – $80)
$229.970678 = Total return ($129.970678 + $100)
!⁄
((!.!#+$#" !"
Realized rate of return: 𝑟 = − 1 = 𝟎. 𝟏𝟎𝟒𝟎 or 𝟏𝟎. 𝟒𝟎%.
"%.%+'+#%
SOURCES OF RETURN
Example: An investor purchases a 10-year, 8% annual coupon bond at
$85.503075 and sells it in four years. The bond’s yield-to-maturity goes
up from 10.40% to 11.40% straight after the purchase. Show the sources
of return:
Bondholder receives 1) Coupon payments 4 × $8 = $32; 2) Sale price (at
11.40% YTM) $85.780408; 3) Reinvestment income from coupons (at
11.40%).
8× 1.1140 ' + 8× 1.1140 ( + 8× 1.1140 ) + 8 = $𝟑𝟕. 𝟖𝟗𝟗𝟕𝟐𝟒
$37.899724 = Future value of the reinvested coupons

$5.899724 = Interest on reinvested coupons ($37.899724 – $32)
$123.680132 = Total return ($37.899724 + $85.780408)
!⁄
)('.$"+)'( #
Realized rate of return: 𝑟 = − 1 = 𝟎. 𝟎𝟗𝟔𝟕 or 𝟗. 𝟔𝟕%.
"%.%+'+#%

INVESTMENT HORIZON AND
INTEREST RATE RISK
A few important points about fixed-rate bonds:

• The investment horizon is at the heart of understanding
interest rate risk and return.
Coupon
reinvestment
There are two risk
offsetting types of
interest rate risk
Market price
risk

COUPON REINVESTMENT RISK AND
MARKET PRICE RISK
The future value of reinvested coupon payments
(and in a portfolio, the principal on bonds that
mature before the horizon date) increases when
interest rates go up and decreases when rates go
down.
The sale price on a bond that matures after the

horizon date (and thus needs to be sold) decreases
when interest rates go up and increases when rates
go down.
Coupon reinvestment risk matters more when the

investor has a long-term horizon relative to the time-
to-maturity of the bond.

3. INTEREST RATE RISK ON FIXED-RATE BONDS
The duration of a bond measures the sensitivity of the
bond’s full price (including accrued interest) to changes in
the bond’s yield-to-maturity or, more generally, to changes in
benchmark interest rates.
There are several types of bond duration. In general, these

can be divided into yield duration and curve duration.
Curve duration is the
Yield duration is the sensitivity sensitivity of the bond price (or
of the bond price with respect more generally, the market
to the bond’s own yield-to- value of a financial asset or
maturity. liability) with respect to a
benchmark yield curve.

PRICE VOLATILITY CHARACTERISTICS
OF OPTION-FREE BONDS (REF. FABOZZI)
• There are four properties concerning the price volatility of an
option-free bond:
1) Although the prices of all option-free bonds move in the
opposite direction from the change in yield required, the
percentage price change is not the same for all bonds.
2) For very small changes in the yield required, the percentage
price change for a given bond is roughly the same, whether the
yield required increases or decreases.
3) For large changes in the required yield, the percentage price
change is not the same for an increase in the required yield as
it is for a decrease in the required yield.
4) For a given large change in basis points, the percentage price
increase is greater than the percentage price decrease.
• An explanation for these four properties of bond price volatility
lies in the convex shape of the price-yield relationship.
Copyright: CFA Institute and FinanceTraining.ca 4-9

PRICE VOLATILITY CHARACTERISTICS
OF OPTION-FREE BONDS (REF. FABOZZI)
Characteristics of a Bond that Affect its Price

Volatility
There are two characteristics of an option-free bond that
determine its price volatility: coupon and term to maturity.
1) First, for a given term to maturity and initial yield, the

price volatility of a bond is greater, the lower the
coupon rate.
2) Second, for a given coupon rate and initial yield, the

longer the term to maturity, the greater the price
volatility.

YIELD DURATION STATISTICS
Yield duration • Macaulay duration
statistics used in • Modified duration
fixed-income • Money duration
analysis include • Price value of a basis point (PVBP)
The Macaulay duration (D) formula (for the period)
$ $ $
("#%)×()* (.#%)×()* (/#%)×(()*+01)
- -⋯-
("+,)"#$/% ("+,).#$/% ("+,)/#$/%
𝐷= ()* ()* ()*+01
- -⋯-
("+,)"#$/% ("+,).#$/% ("+,)/#$/%
where t is the number of days from the last coupon payment to the
settlement date; T is the number of days in the coupon period; PMT is
the coupon payment per period; FV is par value; r is YTM/discount rate
per period; and N is the number of coupon periods to maturity.

MACAULAY DURATION
Another way to calculate Macaulay duration is by using the
following formula:
1 + 𝑟 1 + 𝑟 + 𝑁× 𝑐 − 𝑟 𝑡
𝐷= − ! −
𝑟 𝑐× 1 + 𝑟 − 1 + 𝑟 𝑇
where c is the coupon rate per period.
MacDur is calculated in terms of the underlying periodicity of

the cash flows.

EX 1: CALCULATING THE MACAULAY DURATION
Example: A 6% annual payment bond matures on 14 February 2025
and is purchased for settlement on 11 July 2019. The YTM is 4.00%.
Calculate the bond’s Macaulay duration (actual/actual convention):
Period Time to Cash Present Weight Time x

Receipt Flow Value Weight
1 0.5973 6 5.8611 0.0522 0.0312
2 1.5973 6 5.6357 0.0502 0.0802
3 2.5973 6 5.4189 0.0483 0.1254
4 3.5973 6 5.2105 0.0464 0.1670
5 4.5973 6 5.0101 0.0446 0.2052
6 5.5973 106 85.1071 0.7582 4.2441
112.2433 1.0000 4.8530
The Macaulay duration is 4.8530 years.
13
CALCULATING THE MACAULAY DURATION
WITH THE ALTERNATIVE FORMULA
Using the alternative formula, the calculation is as

follows:
1 + 0.04 1 + 0.04 + 6× 0.06 − 0.04 147

MacDur = − " −
0.04 0.06 × 1 + 0.04 − 1 + 0.04 365
= 𝟒. 𝟖𝟓𝟑𝟎 years
14
EX. 2: CALCULATING THE MACAULAY DURATION
and is purchased for settlement on 11 April 2014. The YTM is 4%.
Calculate the bond’s Macaulay duration (actual/actual convention):
Period Time to Receipt CF (cash PV of CF Time-Weighted PV
flow) of CF
1 309/365 = 0.8466 6 6/(1 + 0.04)^0.8466 = 0.8466 × 5.80 = 4.91
5.80
2 1.8466 6 5.58 10.31
3 2.8466 6 5.37 15.28
4 3.8466 6 5.16 19.85
5 4.8466 6 4.96 24.05
6 5.8466 106 84.28 492.74
111.15 567.13
D = 567.13/111.15 = 5.1 years
CALCULATING THE MACAULAY DURATION
WITH THE ALTERNATIVE FORMULA
Using the alternative formula, the calculation is as

follows:
1 + 0.04 1 + 0.04 + 6× 0.06 − 0.04 56

𝐷= − !
−
0.04 0.06× 1 + 0.04 − 1 + 0.04 365
= 𝟓. 𝟏𝟎 𝐲𝐞𝐚𝐫𝐬.

MODIFIED DURATION
Modified duration (MD) is a
Modified duration provides a
direct measure of the interest
linear estimate of the
rate sensitivity of a bond. It
percentage price change for a
assumes that yield changes
do not change the expected bond given a change in its
yield-to-maturity.
cash flows.
𝐷
MD = %∆PV/011 ≈ −MD×∆Yield(%)
1+𝑟
where r is the yield per period.
- Note: MD is expressed in annual terms. MD is related to the approximate percentage change in

price for a given change in yield as given by:
dP 1
= -modified duration
dy P
- To get the % change in bond price, the % change must be multiplied by the original bond price.
- ModDur and MacDur are expressed in periodic terms. They can be annualized by dividing by the
number of periods in the year (the periodicity) to get AnnMacDur and AnnModDur.

APPROXIMATE MODIFIED DURATION
An alternative approach is to estimate the approximate modified
duration (AMD) directly:
PV2 − (PV-)
AMD =
2×(∆Yield)×(PV+ )
where PV0 is the price of the bond at the current yield, PV+ is the price of
the bond if the yield increases (by ΔYield), and PV– is the price of the
bond if the yield decreases (by ΔYield).
Example: Consider a 6% semiannual coupon paying bond with 4 years

to maturity currently priced at par (YTM = 6%).
If the YTM increases/decreases by annualized 20 bps, the price
raises/decreases to 99.301 and 100.705, respectively:
)++.#+% 2(!!.'+))
AMD = = 𝟑. 𝟓𝟏 𝐲𝐞𝐚𝐫𝐬.
(×(+.++()×()++)
APPROXIMATE MODIFIED DURATION
Price
The approximate
modified duration is a
linear approximation of
the price/yield curve. The
difference is due to the
convexity of the bond.
Tangent line
Yield

APPROXIMATE MACAULAY DURATION
The approximate Macaulay duration (ApproxMacDur)

is calculated from the approximate modified duration
(ApproxModDur).
ApproxMacDur = ApproxModDur × (1 + 𝑟)
In the example from slide 15:
ApproxMacDur = 3.51 × 1 + 0.03 = 𝟑. 𝟔𝟏𝟓

The given yield-to-maturity of 6% is quoted on a
semiannual bond basis. The yield per period is 3%.
20
EFFECTIVE DURATION
• Another approach to assess the interest rate risk of a bond
is to estimate the percentage change in price given a
change in a benchmark yield curve—for example, the
government par curve.
• This estimate, which is very similar to the formula for
approximate modified duration, is called the “effective
duration”:
PV# − (PV$)
EffDur =
2×(∆Curve)×(PV%)
where ΔCurve is a parallel shift in the benchmark curve.

WHEN TO USE EFFECTIVE DURATION
A callable/putable
bond does not have
a well-defined
Effective duration is internal rate of return
essential to the (yield-to-maturity).
measurement of the Therefore, yield
interest rate risk of a duration statistics,
complex bond, such such as modified and
as a bond with an Macaulay durations,
embedded option. do not apply.
Effective duration is
the appropriate
duration measure.

PROPERTIES OF BOND DURATION
Bond duration is the basic measure of interest rate risk on a

fixed-rate bond.
• Coupon rate or payment per

period
The duration for a • Yield-to-maturity per period
fixed-rate bond is • Time-to-maturity (as of the
a function of beginning of the period)
these input • Fraction of the period that has
variables. gone by
• Presence and nature of
embedded options

COUPON RATE AND YIELD-TO-MATURITY
RELATION TO MACAULAY DURATION
The coupon rate is inversely The yield-to-maturity is
related to the Macaulay inversely related to the
duration. Macaulay duration.
• A lower-coupon bond has a • A higher yield-to-maturity

higher duration and more reduces the weighted average
interest rate risk than a of the time to receipt of cash
higher-coupon bond. flow.
• The Macaulay duration of a

zero-coupon bond is equal to
its time-to-maturity.

TIME-TO-MATURITY AND FRACTION OF THE
PERIOD RELATION TO MACAULAY DURATION
From the equation before, it

Time-to-maturity is typically is clear that the fraction of
directly related to the the period that has gone by
Macaulay duration. (t/T) is inversely related to
the Macaulay duration.
• This pattern always holds for • Macaulay duration

bonds trading at par value or decreases smoothly as t
at a premium above par. goes from t = 0 to t = T and
• The exception is deep- then jumps upward after the
discount bonds, where the coupon is paid.
relationship does not hold for
a long time-to-maturity.

BONDS WITH EMBEDDED OPTIONS
• Bonds with embedded options (e.g., callable, putable)

require the use of effective duration because Macaulay and
modified yield duration statistics are not relevant.
The yield-to-maturity for callable and putable bonds is not

well defined because future cash flows are uncertain.
• When benchmark yields are high (low), the effective

durations of the callable (putable) and non-callable (non-
putable) bonds are very similar. There is a large
discrepancy in durations for callable (putable) and non-
callable (non-putable) bonds when yields are low (high).
• In summary, the presence of an embedded option reduces
the sensitivity of the bond price to changes in the
benchmark yield curve (lower duration), assuming no
change in credit risk.

MONEY DURATION
The money duration of a bond is a measure of the price
change in units of the currency in which the bond is
denominated.
- The money duration can be stated per 100 of par value or in
terms of the actual position size of the bond in the portfolio.
Money duration (MoneyDur) is calculated as follows:
MoneyDur = AnnModDur × PV&'((
The estimated change in the bond price in currency units is

calculated by the following:
∆PV"#$$ ≈ −MoneyDur × ∆Yield
27
MONEY DURATION CALCULATION
Example: Consider a 6% semiannual coupon bond with a
current full price of KES100.940423 per 100 of par value and
an annual modified duration of 6.1268. Suppose a life
insurance company has a position in the bond of KES100
million, and the market value of the investment is
KES100,940,423. Calculate the money duration and change
in value of position as a result of a 100 bps decline in YTM.
• Money duration (MoneyDur) is calculated as
MoneyDur = 6.1268 × KES 100,940,423 = 𝐊𝐄𝐒 𝟔𝟏𝟖, 𝟒𝟒𝟏, 𝟕𝟖𝟒.
• The estimated change in the bond price in KES is

∆PV&'(( ≈ −KES 618,441,785 × (−0.0100) = 𝐊𝐄𝐒 𝟔, 𝟏𝟖𝟒, 𝟒𝟏𝟖.
28
MEASURES OF BOND PRICE VOLATILITY (REF.
FABOZZI)
Spread Duration
Market participants compute a measure called spread
duration.
• This measure is used in two ways: for fixed bonds and
floating-rate bonds.
• A spread duration for a fixed-rate security is
interpreted as the approximate change in the price of
a fixed-rate bond for a 100-basis-point change in the
spread of the bond.

4-29
CALCULATING THE DURATION OF A
BOND PORTFOLIO
Bonds are typically held in a portfolio.
The weighted This method is

average of time to the theoretically
receipt of the correct approach,
aggregate cash but it is difficult to
There are two flows use in practice.
ways to
calculate the
duration of a The weighted
This method is
bond portfolio. commonly used
average of the
by fixed-income
individual bond
portfolio
durations that managers, but it
comprise the
has its own
portfolio
limitations.

BOND PORTFOLIO (REF. FABOZZI)
Portfolio Duration
Portfolio managers look at their interest rate exposure to a
particular issue in terms of its contribution to portfolio duration.
• This measure is found by multiplying the weight of the issue
in the portfolio by the duration of the individual issue given
as:
Contribution to portfolio duration = weight of issue in portfolio
× duration of issue.
• For the four-bond portfolio in next slide, the contribution to
portfolio duration for each issue is shown in following slide.

4-31
Ref. Fabozzi Four Bond Portfolio
Portfolio
Bond Market Value Duration
Weight
A $10 Million 0.10 4
B $40 Million 0.40 7
C $30 Million 0.30 6
D $20 Million 0.20 2

Ref. Fabozzi Calculation of Contribution to
Portfolio Duration for Four-Bond
Portfolio
Weight Contribution to
Market
in Portfolio
Bond Value Duration
Portfolio Duration
A $10,000,000 0.10 4 0.40
B $40,000,000 0.40 7 2.80
C $30,000,000 0.30 6 1.80
D $20,000,000 0.20 2 0.40
Total $100,000,000 1.00 5.40

Portfolio Duration
• Portfolio managers look at portfolio duration for sectors of the
bond market.
• The procedure is the same for computing the contribution to
portfolio duration of a sector as it is for computing the
contribution to portfolio duration of an individual issue.
• A spread duration for a portfolio of fixed-rate bonds can also be
computed.
• In this case, the portfolio duration is divided into two durations.
- The first is the duration of the portfolio with respect to
changes in the level of Treasury rates.
- The second is the spread duration.
Copyright: CFA Institute and FinanceTraining.ca

4-34
Portfolio Duration
• Next slide shows the four sectors in which the portfolio manager
has invested.
• Shown in the second column of the table is the allocation to each
sector in the portfolio.
- The duration of each sector is shown in the third column.
- The last row in the contribution to portfolio duration column shows
the duration of the portfolio.
• The following slide shows the index weight for Barclays Capital
U.S. Aggregate Index benchmark and the contribution to index
duration by sector (the second and third columns, respectively).
- The benchmark for the portfolio is shown in the last row of the 3rd
column.
Copyright: CFA Institute and FinanceTraining.ca

4-35
Ref. Fabozzi Sector Distribution and Contribution to
Duration for a Portfolio
Portfolio Sector Contribution to

Sector Weight Duration Portfolio Duration
Treasury 0.295 7.25 2.14

Government
0.036 1.94 0.07
Related
Corporates 0.139 4.85 1.84
Agency MBS 0.290 5.17 1.50
Total 1.000 5.55

Ref. Fabozzi Sector Distribution and Contribution to
Duration for the Barclays Capital U.S.
Aggregate Index
Sector Contribution to
Sector Index Weight Duration Portfolio Duration
Treasury 0.333 5.32 1.77

Government
0.068 5.88 0.40
Related
Corporates 0.266 6.50 1.73
Agency MBS 0.333 4.53 1.51
Total 1.000 − 5.41

MEASURES OF BOND PRICE VOLATILITY
(REF. FABOZZI)
Analytical Versus Empirical Duration

• The purpose of calculating duration is to estimate a bond’s
interest-rate risk.
• However, a more general way to think about the risk
associated with a bond is that it is comprised of two elements:
an equity risk and an interest-rate risk.
• For corporate bonds that have a high credit rating (i.e.,
investment-grade bonds), the interest-rate risk is the dominant
risk. In contrast, for corporate bonds with a low credit rating
(i.e., non-investment-grade or high-yield corporate bonds), the
equity risk is more likely to be dominant.
• Hence, the duration measure as calculated by formula may
not be a good measure of interest-rate risk for such bonds.

PRICE VALUE OF A BASIS POINT (PVBP)
• The price value of a basis point (PVBP) is an estimate of
the change in the full price given a 1 bp change in the
yield-to-maturity.
The PVBP is calculated as follows:
(PV#) − (PV$)
PVBP =
2
Example: Assume a T-note is priced at 99.561006 and

yields 0.723368%. An increase and decrease in 1 bp results
in the price changing to 99.512707 and 99.609333,
respectively. Calculate the PVBP:
))."%)+++#)).,-./%/
PVBP = .
= 𝟎. 𝟎𝟒𝟖𝟑𝟏.
THE MATH. RELATIONSHIPS OF DURATION
MEASURES (REF. FABOZZI)
Notation:
D = Macaulay duration
D* = modified duration
PVBP = price value of a basis point
y = yield to maturity in decimal form
Y = yield to maturity in percentage terms ( Y = 100 × y)
P = price of bond
m= number of coupons per year
(this continues on next page)

THE MATH. RELATIONSHIPS OF DURATION
MEASURES (REF. FABOZZI)
Relationships:
D
D* = ® by definition
1+ y m
DP P
» D ® to a close approximation for a small D y
Dy
D P D Y » slope of price-yield curve ® to a close approximation for a small Dy
D* ´ P
PVBP » ® to a close approximation
10, 000
For B onds at or near par :
PVBP = D * 100 ® to a close approximation
D* = D P D Y ® to a close approximation for a small D y

CONVEXITY (REF. FABOZZI)
• Because all the duration measures are only
approximations for small changes in yield, they do not
capture the effect of the convexity of a bond on its price
performance when yields change by more than a small
amount.
• The duration measure can be supplemented with an
additional measure to capture the curvature or
convexity of a bond.
• In next slide, a tangent line is drawn to the price–yield
relationship at yield y*.
- The tangent shows the rate of change of price with
respect to a change in interest rates at that point (yield
level).

LINE TANGENT TO THE PRICE-YIELD
RELATIONSHIP (REF. FABOZZI)
Price
Actual Price
p* Tangent Line at y*
(estimated price)
y* Yield
• If we draw a vertical line from any yield (on the horizontal axis),
as in the previous slide, the distance between the horizontal
axis and the tangent line represents the price approximated by
using duration starting with the initial yield y*.
• The approximation will always understate the actual price.
• This agrees with what we demonstrated earlier about the
relationship between duration (and the tangent line) and the
approximate price change.
• When yields decrease, the estimated price change will be
less than the actual price change, thereby underestimating
the actual price.
• On the other hand, when yields increase, the estimated
price change will be greater than the actual price change,
resulting in an underestimate of the actual price.

PRICE APPROXIMATION USING DURATION (REF.
FABOZZI)
Actual Price
Price Error in Estimating Price

Based only on Duration
Error in Estimating Price

Based only on Duration
p*
Tangent Line at y*
(estimated price)
y1 y2 y* y3 y4 Yield
Measuring Convexity
• Duration (modified or dollar) attempts to estimate a convex
relationship with a straight line (the tangent line).
- The dollar convexity measure of the bond: 2
d P
dollar convexity measure = 2
dy
- The approximate change in price due to convexity is:
2
dP = ( dollar convexity measure )( dy )
- The percentage change in the price of the bond due to convexity
or the convexity measure is: 2
d P 1
convexity measure = 2
dy P
- The percentage price change due to convexity is:
dP 1 2
= ( convexity measure )( dy )
P 2

4-46
CONVEXITY STATISTIC
• The true relationship between the bond price and the yield-
to-maturity is the curved (convex) line, which shows the
actual bond price given its market discount rate.
The linear approximation of estimated price change

offered by duration is good for small yield-to-maturity
changes. But for larger changes, the difference becomes
significant.
• The convexity statistic for the bond is used to improve

the estimate of the percentage price change provided by
modified duration alone:
&'((
1
%∆PV ≈ −AMD×∆Yield + ×Conv×(∆Yield).
2
APPROXIMATE, MONEY, AND
EFFECTIVE CONVEXITY
Like modified duration, convexity can be accurately approximated.
• The approximate convexity is calculated by the following:
(PV2 ) + (PV3 ) − 2 × PV4

ApproxCon =
(∆Yield)5 × PV4
•The money convexity of the bond is the annual convexity

multiplied by the full price.
•The effective convexity of a bond is a curve convexity statistic
that measures the secondary effect of a change in a benchmark
yield curve.
(67$ ) - (67% ) 2 ( × 67"

EffCon =
(∆9:;<=)& × 67"
48
CALCULATING APPROXIMATE CONVEXITY
Example: Consider a 6% semiannual coupon payment
bond with 4 years to maturity that is currently priced at par
(YTM = 6.00%) and has an annual modified duration of 3.51.
If the YTM increases/decreases by 20 bps, the price
decreases/increases to 99.301 and 100.705, respectively.
Calculate ApproxCon and the effect of a 50 bps increase in
yield on the bond price:
!"".$"%&''.("!) *×!""
ApproxCon = = 𝟏𝟒. 𝟖𝟏
(".""*"). × !""
1
%∆PV./00 ≈ −3.51×0.0050 + ×14.81× 0.0050 * = −𝟎. 𝟎𝟏𝟕𝟒
2
Modified duration alone estimates the price change to be
− 1.76%, convexity adds 2 bps to give an estimate of − 1.74%.
49
CALCULATING A BOND’S CONVEXITY (OPTIONAL)
and is purchased for settlement on 11 April 2014. The YTM is 4%.
Calculate the bond’s convexity (actual/actual convention):
Period Time to CF PV of CF t^2+t (t^2+t) × PV of CF

Receipt
1 0.8466 6 5.80 1.56 9.07
2 1.8466 6 5.58 5.26 29.34
3 2.8466 6 5.37 10.95 58.76
4 3.8466 6 5.16 18.64 96.19
5 4.8466 6 4.96 28.34 140.58
6 5.8466 106 84.28 40.03 3373.63
111.15 3707.57
Conv = 1/(1 + 0.04)^2 × 3707.57/111.15 = 30.84
Ref. Fabozzi Calculation of Convexity Measure and Dollar
Convexity Measure for Five-Year 9% Bond Selling
to Yield 9% (Optional)
Coupon rate: 9.00%, Term (years): 5, Initial yield: 9.00%, Price: 100
t(t + 1)CF
Period, t Cash Flow 1/(1.045)t+2 t(t + 1)CF
(1.045) t+2
1 4.50 0.876296 9 7.886
2 4.50 0.838561 27 22.641
3 4.50 0.802451 54 43.332
4 4.50 0.767895 90 69.110
5 4.50 0.734828 135 99.201
6 4.50 0.703185 189 132.901
7 4.50 0.672904 252 169.571
8 4.50 0.643927 324 208.632
9 4.50 0.616198 405 249.560
10 104.50 0.589663 11,495 6,778.186
12,980 7,781.020

Ref. Fabozzi Calculation of Convexity Measure and Dollar
Convexity Measure for Five-Year 6% Bond Selling
to Yield 9% (Optional)
Coupon rate: 6.00%, Term (years): 5, Initial yield: 9.00%, Price: 88.13
t(t + 1)CF
Period, t Cash Flow 1/(1.045)t+2 t(t + 1)CF
(1.045) t+2
1 3.00 0.876296 6 5.257
2 3.00 0.838561 18 15.094
3 3.00 0.802451 36 28.888
4 3.00 0.767895 60 46.073
5 3.00 0.734828 90 66.134
6 3.00 0.703185 126 88.601
7 3.00 0.672904 168 113.047
8 3.00 0.643927 216 139.088
9 3.00 0.616198 270 166.373
10 103.00 0.589663 11,330 6,680.891
12,320 7,349.446

EFFECTS OF CONVEXITY ON BONDS
For the same decrease in yield-to-maturity, the more convex

bond appreciates more in price. And for the same increase in
yield-to-maturity, the more convex bond depreciates less in price.
The conclusion is that the more convex bond outperforms the

less convex bond in both bull (rising price) and bear (falling price)
markets.
The negative convexity is
Option-free bonds always have
present in callable bonds but not
positive convexity.
in putable bonds.
PRICE–YIELD RELATIONSHIP
FOR A CALLABLE BOND
Option-free bond
Price
Area of negative
convexity
Callable bond
r* Yield

Approximating Percentage Price Change Using Duration and
Convexity Measures
• Using duration and convexity measures together gives a
better approximation of the actual price change for a large
movement in the required yield.
Some Notes on Convexity
• Three points to know for a bond’s convexity and convexity
measure.
1) Convexity refers to the general shape of the price-yield
relationship, while the convexity measure relates to the
quantification of how the price of the bond will change when
interest rates change.
2) The approximation percentage change in price due to convexity
is the product of three numbers: ½ , convexity measure, and
square of the change in yield.
3) In practice different vendors compute the convexity measure
differently by scaling the measure in dissimilar ways.

Value of Convexity
• Up to this point, we have focused on how taking
convexity into account can improve the approximation of
a bond’s price change for a given yield change.
• The convexity of a bond, however, has another important
investment implication, which is illustrated in next slide.
• The exhibit shows two bonds, A and B. The two bonds
have the same duration and are offering the same yield;
they have different convexities, however, Bond B is more
convex (bowed) than bond A.

COMPARISON OF CONVEXITY OF TWO BONDS
(REF. FABOZZI)
Price Bond B Has Greater

Bond A Convexity Than Bond A
Bond B
Bond B
Bond A
Yield
Value of Convexity
• The market considers a bond’s convexity when pricing it.
• If investors expect that market yields will change by very little,
investors should not be willing to pay much for convexity.
• If the market prices convexity high, investors with
expectations of low interest rate volatility will probably want to
“sell convexity.”
Properties of Convexity
• All option-free bonds have the following convexity properties.
1) As portrayed in next slide, the required yield increases
(decreases), the convexity of a bond decreases (increases).
This property is referred to as positive convexity.
2) For a given yield and maturity, lower coupon rates will have
greater convexity.
3) For a given yield and modified duration, lower coupon rates
will have smaller convexity.
CHANGE IN DURATION AS THE
REQUIRED YIELD CHANGES (REF. FABOZZI)
Price
1
As yield ↓
Slope (duration) ↑
2 As yield ↑
Slope (duration) ↓
Yield
4-59
ADDITIONAL CONCERNS WHEN
USING DURATION (REF. FABOZZI)
• Relying on duration as the sole measure of the
price volatility of a bond may mislead investors.
• There are two other concerns about using duration
that we should point out.
1) First, in the derivation of the relationship between
modified duration and bond price volatility, we
assume that all cash flows for the bond are
discounted at the same discount rate.
2) Second, there is misapplication of duration to bonds
with embedded options.

DON’T THINK OF DURATION AS A
MEASURE OF TIME (REF. FABOZZI)
• Thus, Market participants often confuse the main purpose of duration
by constantly referring to it as some measure of the weighted average
life of a bond.
• Certain CMO bond classes are leveraged instruments whose price
sensitivity or duration, as a result, are a multiple of the underlying
mortgage loans from which they were created.
- a CMO bond class with a duration of 40 does not mean that it
has some type of weighted average life of 40 years.
- Instead, it means that for a 100-basis-point change in yield, that
bond’s price will change by roughly 40%.
• Like a CMO bond class, we interpret the duration of an option
in the same way.

APPROXIMATING A BOND’S DURATION AND
CONVEXITY MEASURE (REF. FABOZZI)
Duration of an Inverse Floater
• The duration of an inverse floater is a multiple of the
duration of the collateral from which it is created.
• Assuming that the duration of the floater is close to zero, it
can be shown that the duration of an inverse floater is as
follows:
duration of an inverse floater =
collateral prices
( 1 + L )( duration of collateral ) ´
inverse prices
where L is the ratio of the par value of the floater to
the par value of the inverse floater.

MEASURING A BOND PORTFOLIO’S
RESPONSIVENESS TO NONPARALLEL CHANGES IN
INTEREST RATES (REF. FABOZZI)
Key Rate Duration

• The most popular measure for estimating the
sensitivity of a security or a portfolio to changes
in the yield curve is key rate duration.
• The basic principle of key rate duration is to
change the yield for a particular maturity of the
yield curve and determine the sensitivity of a
security or portfolio to that change holding all
other yields constant.
• Check Canvas “Extra Notes” for more
details on Key Rate Duration

KEY RATE DURATION
A key rate duration (or

partial duration) is a
measure of a bond’s
sensitivity to a change in In contrast to effective duration,
the benchmark yield key rate durations help identify
curve at a specific “shaping risk” for a bond—that is,
maturity segment. a bond’s sensitivity to changes in
the shape of the benchmark yield
curve (e.g., the yield curve
becoming steeper or flatter).

4. INTEREST RATE RISK AND
THE INVESTMENT HORIZON
• An important aspect in understanding the interest rate risk and
return characteristics of an investment in a fixed-rate bond is the
time horizon.
• Bond duration is the primary measure of risk arising from a

change in the yield-to-maturity; convexity is the secondary risk
measure.
• The common assumption in interest rate risk analysis is a

parallel shift in the yield curve. In reality, the shape of the yield
curve changes based on factors affecting the supply and
demand of shorter-term versus longer-term securities.

YIELD VOLATILITY
• The term structure of yield volatility is the relationship

between the volatility of bond yields-to-maturity and times-
to-maturity.
The first factor is

The impact per
The importance duration or the
basis point
of yield volatility combination of
change in the
in measuring duration and
yield-to-maturity convexity.
interest rate
risk is that bond
price changes The number of
The second
are products of basis points in
factor is the yield
two factors. the yield-to-
volatility.
maturity change

GENERAL RELATIONSHIPS AMONG INTEREST RATE
RISK, THE MACAULAY DURATION, AND THE
INVESTMENT HORIZON
> = <
When the
When the investment When the investment horizon
horizon is greater investment is less than the
than the Macaulay horizon is equal to Macaulay duration
duration of a bond, the Macaulay of a bond, market
coupon reinvestment duration of a price risk
risk dominates market bond, coupon dominates coupon
price risk. The reinvestment risk reinvestment risk.
investor’s risk is to offsets market The investor’s risk
lower interest rates. price risk. is to higher interest
rates.
• The difference between the Macaulay duration of a bond and the

investment horizon is called the “duration gap.”
5. CREDIT AND LIQUIDITY RISK
• The yield-to-maturity on a corporate bond is composed of a
government benchmark yield and a spread over that
benchmark. A change in the bond’s yield-to-maturity can
originate in either component or a combination of the two.
A change in the benchmark yield can arise from a change in

either the expected inflation rate or the expected real rate of
interest.
• The inflation duration would indicate the change in the bond

price if expected inflation were to change by a certain amount.
• The real rate duration would indicate the bond price change if
the real rate were to go up or down.

IMPACT OF CHANGES IN YIELD-TO-MATURITY
A change in the spread can arise from a change in the credit

risk of the issuer or in the liquidity of the bond.
• For a bond with a given duration and convexity, the impact

of changes in yield-to-maturity on the bond’s price will
be the same regardless of the source of the yield-to-
maturity change.
• The problem for a fixed-income analyst is that it is rare for
the changes in the components of the overall yield-to-
maturity to occur in isolation.

Fixed-Income Risk and Return (Duration+Convexity)

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FIXED-INCOME RISK AND RETURN

Copyright: CFA Institute and FinanceTraining.ca 2

• the internal rate of return between the

• the purchase price plus (minus) the

8× 1.1140 ' + 8× 1.1140 ( + 8× 1.1140 ) + 8 = $𝟑𝟕. 𝟖𝟗𝟗𝟕𝟐𝟒

$37.899724 = Future value of the reinvested coupons

Copyright: CFA Institute and FinanceTraining.ca 5

A few important points about fixed-rate bonds:

Copyright: CFA Institute and FinanceTraining.ca 6

The sale price on a bond that matures after the

Coupon reinvestment risk matters more when the

Copyright: CFA Institute and FinanceTraining.ca 7

There are several types of bond duration. In general, these

Copyright: CFA Institute and FinanceTraining.ca 8

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Characteristics of a Bond that Affect its Price

1) First, for a given term to maturity and initial yield, the

2) Second, for a given coupon rate and initial yield, the

Copyright: CFA Institute and FinanceTraining.ca 4-10

The Macaulay duration (D) formula (for the period)

Copyright: CFA Institute and FinanceTraining.ca 11

where c is the coupon rate per period.

MacDur is calculated in terms of the underlying periodicity of

Copyright: CFA Institute and FinanceTraining.ca 12

Period Time to Cash Present Weight Time x

The Macaulay duration is 4.8530 years.

Using the alternative formula, the calculation is as

1 + 0.04 1 + 0.04 + 6× 0.06 − 0.04 147

Using the alternative formula, the calculation is as

1 + 0.04 1 + 0.04 + 6× 0.06 − 0.04 56

Copyright: CFA Institute and FinanceTraining.ca 16

- Note: MD is expressed in annual terms. MD is related to the approximate percentage change in

Copyright: CFA Institute and FinanceTraining.ca 17

Example: Consider a 6% semiannual coupon paying bond with 4 years

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The approximate Macaulay duration (ApproxMacDur)

In the example from slide 15:

ApproxMacDur = 3.51 × 1 + 0.03 = 𝟑. 𝟔𝟏𝟓

where ΔCurve is a parallel shift in the benchmark curve.

Copyright: CFA Institute and FinanceTraining.ca 21

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Bond duration is the basic measure of interest rate risk on a

• Coupon rate or payment per

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• A lower-coupon bond has a • A higher yield-to-maturity

• The Macaulay duration of a

Copyright: CFA Institute and FinanceTraining.ca 24

From the equation before, it

• This pattern always holds for • Macaulay duration

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• Bonds with embedded options (e.g., callable, putable)

The yield-to-maturity for callable and putable bonds is not

• When benchmark yields are high (low), the effective

Copyright: CFA Institute and FinanceTraining.ca 26

Money duration (MoneyDur) is calculated as follows:

MoneyDur = AnnModDur × PV&'((

The estimated change in the bond price in currency units is

• The estimated change in the bond price in KES is

Copyright: CFA Institute and FinanceTraining.ca 4-29

The weighted This method is

Copyright: CFA Institute and FinanceTraining.ca 30

Copyright: CFA Institute and FinanceTraining.ca 4-31

A $10 Million 0.10 4