BF (2 and Quiz)

Bond
Bond Fundamentals
Fundamentals
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Bond term sheet
As of May 31, 2009
Issuer Company ABC
Face Value $100
Maturity 10 years
Coupon 8%
Coupon payment Frequency Quarterly
Day count 30/360

Other important terms
► Seniority
► Secured or unsecured
► Covenants and events of default
► But these do not affect cash flows in ordinary course of

business

Bond cash flows
$100
$2 (bullet)
$2 $2 $2
Interest Interest
period period
40 coupons
Price

Coupon reinvestment and effective yield
x1.02 x1.02 x1.02
x1.02 x1.02
$2
x1.02
$2
$2
$2
Beginning End
of year of Year

Calculating effective yield
► By end of one year, aggregate amount received by investor is
3 2
($2 x 1.02 ) + ($2 x 1.02 ) + ($2 x 1.02) + $2 = $8.2432
► This is equivalent to a 8.24% effective annual yield
► Compare this to a bond with nominal annual coupon of 8.05%, but

paid semi-annually
► Equation above becomes

($4.025 x 1.04025) + $4.025 = $8.2120
► This is equivalent to a 8.21% effective annual yield

Converting nominal yield into effective yield
Nominal Effective
Coupon Frequency Yield
Bond 1 8% 4 8.24%
Bond 2 8.05% 2 8.21%
Bond 3 7.95% 12 8.24%

Interest accrual
► Last coupon was paid May 31, 2009
► Today is June 30, 2009; how much interest has “accrued”?
► Approximate answer is 1/3rd of $2, so $0.6667
► This is correct under 30/360 convention, which treats each month as

exactly 1/12th of one year, and the year as having exactly 360 days
► More specifically, accrued interest is calculated as

30
$100 × 8% × = $0.0667
360
► On July 31, 2009, accrued interest would reach
60
$100 × 8% × = $1.3333
360
Interest accrual (actual/actual)
► Applicable to US government bonds, among others; these make semi-annual

payments, so 8% coupon becomes $4 per $100
► Now assume last coupon was paid May 31, 2009, how much interest has accrued
as of August 31, 2009?
► Actual days elapsed has been 92 (June + July + August = 30 + 31 + 31). What do
we write in the denominator below:
92
$ 100 × 4 % ×
?
► 365 or 366 would clearly understate severely amount of interest accrual
► Correct answer under this convention is

92
$100 × 4% × = $2.0109
183
► Peculiarity: daily rate of interest accrual never the same in successive semi-annual
periods

Interest accrual (actual/360)
► Applies to USD Libor and some other money-market instruments
► Assume coupon is Libor flat, and Libor reset at 6% as of May 31. How
much interest has accrued as of July 31?
61
► Answer is: $100 × 6% × = $1.0167
360
► Note that with 12-month Libor, coupon paid at end of non-leap year is
365
$ 100 × 6 % × = $ 6 .0833
360
and for leap year
366
$ 100 × 6 % × = $ 6 . 1000
360
► In both cases this is more than $6
Interest accrual generally
► Many important money-markets, such as Sterling Libor, use actual/365
► Importance of daycount convention should be very clear
► Comprehensive discussion of most conventions can be found at

http://en.wikipedia.org/wiki/Day_count_convention

Clean price v. dirty price
► Suppose bond is trading at 100 if we ignore accrued interest, but that

accrued interest is $1.75
► We quote a clean price of 100, and a dirty price of 101.75
► Normal convention is to quote only clean price, with interest accrual being
understood as additional payment from buyer to seller
► Convention applies whether or not bond is trading at par: so if bond would

trade at 96 absent any accrued interest,
● Clean price (the one typically quoted) would be 96, and
● Dirty price would be 97.75

Current yield
► Definition: Annualized Coupon/ Price in percentage
► Gives more accurate reflection of investor’s return from coupon payments for bond
trading above or below par
► Example: 8% bond trading at 80 really represents 10% return via its coupons
► Example: 8% bond trading at 133.33 really represents 6% return via its coupons
► Following relationships always hold
Price above par Current Yield < Coupon
Price at par Current Yield = Coupon
Price below par Current Yield > Coupon

Yield-to-maturity
► Return to 8% bond trading at 80; assume matures in 10 years
► Current yield of 10% is in a sense supplemented by capital gain at

maturity of $20
► Can approximate this additional return by visualizing it as $2 extra per

annum, i.e. as 2.5% extra in terms of yield; under this approximation
bond’s all-in return is around 12.5%
► Inaccuracy was to treat $20 extra gain in 10 years as the same as $2 per
annum, ignoring time value of money, so has overstated the result
► RATE function in Excel performs the correct calculation

Calculating Bond Yield-to-Maturity
Number of periods 10
Coupon 8%
Price 80
Face Value 100
YTM 11.46%
YTM (s.a.) 11.40%
Effective YTM (s.a) 11.73%

Calculating Bond Yield-to-Maturity
Sett Date 7/31/2009

Mat date 5/31/2019
Coupon 8%
Price 80
Face Value 100
Frequency 2
YTM 11.44%

Comparing two bonds via their YTM
Bond A Bond B
Tenor in years 10 10
Price 105 96
Face value 100 100
Coupon 5% 4%
Frequency 2 2
YTM 4.38% 4.50%

Yield-to-maturity – formal definition
► Reminder: each cash flow under a bond has present value equal to its size,
discounted at appropriate discount rate
► For our 8% bond trading at 80, we can write
80 = 8 /(1 + y ) + 8 /(1 + y ) 2 + 8 /(1 + y ) 3 + .... + 8 /(1 + y ) 9 + 108 /(1 + y )10
► Yield-to-maturity is single value of y that satisfies this equation
► If coupon is paid semi-annually, equation becomes
y y y y y
80 = 4 /(1 + )+ 4 /(1 + ) 2 + 4 /(1 + ) 3 + .... + 4 /(1 + )19 + 104 /(1 + ) 20
2 2 2 2 2
► Excel operator RATE solves for entire term y/2, hence need to multiply by 2 at
the end.
Yield-to-maturity – generalized formula
► For bond having a maturity of n years, a payment frequency of f, a coupon

of C dollars per $100 of face value, and a price of Pr
C C C C 100 + C
Pr = + + + .... + +
y y y y y
1+ (1 + ) 2 (1 + ) 3 (1 + ) ( fn −1) (1 + ) fn
f f f f f
► From this we can observe:
● For a given bond and a given coupon, as the bond’s price rises,
its YTM falls, and vice versa
● If a bond is trading above par, its YTM is lower than its coupon,
and vice versa if it is trading at a discount to par
● If two bonds are trading at the same discount to par and have the
same coupon and payment frequency, the one with the longer
maturity will have the lower YTM; and vice versa if the two bonds
are trading at a premium to par
YTM v. current yield v. coupon
► It turns out our earlier table can be expanded as follows:
Price above par YTM < Current yield < Coupon
Price at par YTM = Current yield = Coupon
Price below par YTM > Current yield > Coupon

Yield-to-maturity – Limitations
► Price-yield equation assumes single value of y for all cash flows, which
suggests a flat yield curve
C C C C 100 + C
Pr = + + + .... + +
y y 2 y 3 y y
1+ (1 + ) (1 + ) (1 + ) ( fn −1 ) (1 + ) fn
f f f f f
► Better approach would be to use gradually increasing values for y when

curve is upward sloping and gradually declining values when curve is
inverted
► But this leads to single equation with several unknown, so would have
infinite number of solutions
► More advanced approach is to use individualized risk-free rate for each

cash flow, and then add to that constant credit spread for all cash flows,
such that sum of cash flow PVs equals bond’s price
Yield-to-call
► Return to 8% 10-year bond trading at 80, but now assume bond may be
called at the end of year 5
► Exercise of call would boost investor’s yield substantially since discount of

20 would have been earned faster
► Yield-to-call is defined as yield-to-maturity assuming maturity date is in

fact call date
► Note that call price may be different from par
► Note also that some bonds have several call dates, so can speak of yield-
to-first-call, yield-to-second-call, etc, and yield-to-worst for outcome with
lowest return for investor

Calculating Bond Yield-to-Call
Coupon 8%
Price 80
Face Value 100
Number of periods 10
Periods until Call 5
YTC 13.80%

Bond price volatility – Generally
► Many factors affect bond price, including changes in credit quality,

regulation, shifts in demand/supply dynamics, etc
► Here we focus only on price changes due to changes in interest rates
► In our standard formula, reproduced here

C C C C 100 + C
Pr = + + + .... + +
y y 2 y 3 y y
1+ (1 + ) (1 + ) (1 + ) ( fn −1 ) (1 + ) fn
f f f f f
● yield increases lead to increase in denominators so drop in price
● yield declines lead to decrease in denominators so gain in price
► Argument applies only to fixed rate bonds with no embedded options; not
to floating rate notes, inverse floaters, callable or puttable bonds, etc

Bond Price-Yield Relationship
Coupon 8%
Tenor in Yrs 10
Face Value 100
Percentage Percentage
Marginal Total
YTM Price Marginal Total
Gain/(Loss) Gain/(Loss)
4% $132.44 $9.28 7.53% $32.44 32.44%

5% $123.17 $8.45 7.36% $23.17 23.17%
6% $114.72 $7.70 7.19% $14.72 14.72%
7% $107.02 $7.02 7.02% $7.02 7.02%
8% $100.00 - - - -
9% $93.58 ($6.42) -6.42% ($6.42) -6.42%
10% $87.71 ($5.87) -6.27% ($12.29) -12.29%
11% $82.33 ($5.38) -6.13% ($17.67) -17.67%
12% $77.40 ($4.93) -5.99% ($22.60) -22.60%

Decomposing the bond
$100
$8
10 cash flows
Original 8% bond
$100
$7
+ $1
10 cash flows 10 cash flows

7% bond 10-year annuity
Price - Yield
$135.00
$125.00
$115.00
$105.00
$95.00
$85.00
$75.00
4% 6% 8% 10% 12%

Decomposing the bond
$100
20-year bond
$100
20-year bond $7
$
$8 20 cash flows 10 cash flows

for years 1-10
PV = $7.02
$1 +
20 cash flows
20 cash flows
$
20-year annuity
10 cash flows
for years 11-20
PV < $7.02
Bond Price-Yield Relationship
Coupon 8%
Tenor in Yrs 10
Face Value 100
Marginal Total
4% $132.44 $9.28 7.53% $32.44 32.44%

5% $123.17 $8.45 7.36% $23.17 23.17%
6% $114.72 $7.70 7.19% $14.72 14.72%
7% $107.02 $7.02 7.02% $7.02 7.02%
8% $100.00 - - - -
9% $93.58 $5.87 -6.42% ($6.42) -6.42%
10% $87.71 ($5.87) -6.27% ($12.29) -12.29%
11% $82.33 ($5.38) -6.13% ($17.67) -17.67%
12% $77.40 ($4.93) -5.99% ($22.60) -22.60%
Coupon 6%
Tenor in Yrs 10
Face Value 100
Marginal Total
4% $116.22 $8.50 7.89% $29.64 34.24%

5% $107.72 $7.72 7.72% $21.14 24.42%
6% $100.00 $7.02 7.55% $13.42 15.50%
7% $92.98 $6.40 7.39% $6.40 7.39%
8% $86.58 - - - -
9% $80.75 ($5.83) -6.74% ($5.83) -6.74%
10% $75.42 ($5.33) -6.60% ($11.16) -12.89%
11% $70.55 ($4.87) -6.45% ($16.03) -18.51%
12% $66.10 ($4.46) -6.31% ($20.48) -23.66%

Price to Yield (Bond 8% v. 6%)
$140.00
$120.00
$100.00 Price
(8%)
$80.00 Price
(6%)
$60.00
$40.00
$20.00
$0.00
4% 5% 6% 7% 8% 9% 10% 11% 12%

Duration – Definition
fn
(t )( PVCF t )
Duration (in years) =∑
t =1 ( f )( PVTCF )
n = number of years
f = compounding periods per year

CFt
PVCFt = PV of cash flow in periodt =
y
(1 + )t
f
PVTCF = Total PV of the cash flow on the bond; i.e. the price

Programming duration formula in Excel
Period Cash Flow DF PVCF t x PVCF Face Value 100

Coupon Rate 8%
1 4 0.9615 3.8462 3.8462 Yield 8%
2 4 0.9246 3.6982 7.3964 Frequency 2
3 4 0.8890 3.5560 10.6680
4 4 0.8548 3.4192 13.6769
5 4 0.8219 3.2877 16.4385
6 4 0.7903 3.1613 18.9675
7 4 0.7599 3.0397 21.2777
8 4 0.7307 2.9228 23.3821
9 4 0.7026 2.8103 25.2931
10 4 0.6756 2.7023 27.0226
11 4 0.6496 2.5983 28.5816
20 104 0.4564 47.4642 949.2848
Price 100.000 1,413.39

Duration 7.067
fn
Duration (in years) = ∑ (t) (PVCFt )/(f)(PVTCF)
t=1

Duration/modified duration -- generally
► Can be viewed as the average time it takes for a bondholder to receive, in PV

terms, the investment made initially
► Does not differentiate between cash flows of coupon and principal
► Real use is that it leads us to its cousin, modified duration
► Formula for this is simply
Modified duration = duration/(1 + y/f)
► Terminology: regular duration is often called “Macauley duration”, to distinguish it

from modified duration
► Unfortunately many people simply say “duration” when they really mean “modified
duration”

Programming duration formula in Excel
Period Cash Flow DF PVCF t x PVCF Face Value 100

Coupon Rate 8%
1 4 0.9615 3.8462 3.8462 Yield 8%
2 4 0.9246 3.6982 7.3964 Frequency 2
3 4 0.8890 3.5560 10.6680
4 4 0.8548 3.4192 13.6769
5 4 0.8219 3.2877 16.4385 fn
6 4 0.7903 3.1613 18.9675 Duration (in years) = ∑ (t) (PVCFt )/(f)(PVTCF)
7 4 0.7599 3.0397 21.2777 t=1
8 4 0.7307 2.9228 23.3821
9 4 0.7026 2.8103 25.2931
10 4 0.6756 2.7023 27.0226 Modifed Duration = Duration/(1+y/f)
11 4 0.6496 2.5983 28.5816
20 104 0.4564 47.4642 949.2848
Price 100.000 1,413.39

Duration 7.067
Modifed Duration 6.795

Using modified duration
► First order approximation of the percentage price change of a bond given

a defined movement in its yield
► So if 8% Bond has modified duration of 6.8:

● 1 bp change in yield causes a 0.068% change in its price; and
● 10 bps change in yield causes a 0.68% change in its price
► More generally we write
Percentage change in price = – Modified duration x Change in yield

Estimating price change with modified duration
Est % Price Actual

Est Price Actual % Price
Change Price using
YTM Using Mod Change using
Using Mod PV
Dur PV function
Dur function
Face Value 100
6.00% 13.5903% $113.59 $114.88 14.8775% Coupon Rate 8%
7.00% 6.7952% $106.80 $107.11 7.1062% Yield 8%
7.90% 0.6795% $100.68 $100.68 0.6825% Frequency 2
7.99% 0.0680% $100.07 $100.07 0.0680% Tenor 10
8.00% 0.0000% $100.00 $100.00 0.0000%
8.01% -0.0680% $99.93 $99.93 -0.0679% Modified Duration 6.7952
8.10% -0.6795% $99.32 $99.32 -0.6765%
9.00% -6.7952% $93.20 $93.50 -6.5040%
10.00% -13.5903% $86.41 $87.54 -12.4622%

Estimating price change with modified duration
Est % Price Actual Price Actual % Price

YTM Change Using using PV Change using
Mod Dur function PV function
Face Value 100
6.00% 14.34% $100.00 15.73% Coupon Rate 6%
7.00% 7.17% $92.89 7.50% Yield 8%
7.90% 0.72% $87.03 0.72% Frequency 2
7.99% 0.07% $86.47 0.07% Tenor 10
8.00% 0.00% $86.41 0.00%
8.01% -0.07% $86.35 -0.07% Modified Duration 7.1675
8.10% -0.72% $85.79 -0.71%
9.00% -7.17% $80.49 -6.85%
10.00% -14.34% $75.08 -13.12%

Modified duration as percentage change
Zero-coupon 10-
8% 10-year Bond year Bond
Initial price $100.00 $45.64
New @ 7.9% $100.68 $46.08

Absolute gain $0.68 $0.44
Percentage gain 0.68% 0.97%
New at 7% $107.11 $50.26

Absolute gain $7.11 $4.62
Percentage gain 7.11% 10.12%

Limitations of modified duration
► Modified duration as a risk measure suffers from similar limitation to

concept of yield-to-maturity
► It speaks of “yield movement”, without specifying which point of the curve

is moving
► In essence it assumes the entire curve is moving in a parallel shift
► If curve pivots and becomes steeper or flatter, modified duration does a

poor job of measuring a bond’s price change
► More advanced concepts exist which measure the sensitivity of the bond’s
price to movements in any one point of the curve

Dollar Value of Basis Point (“DV01”)
► Closely tied to modified duration, but differs from it in that

● (i) it assumes a yield shift of exactly one basis point; and
● (ii) it incorporates the size of the position, in dollar terms, and therefore
produces a result also in dollar terms
► So “8% bond trading at par has modified duration of 6.8”

is essentially equivalent to
“$100MM position in 8% bond trading at par has DV01 of $68,000”
► Advantages of DV01:
● Perhaps easier to visualize potential gain or loss expressed in currency
units
● Additive for several positions without need to worry about their relative
size
● This contrasts with modified duration, for which weights of each position
must be factored into the calculation of aggregate modified duration

Additivity of DV01 and modified duration
8% Bond 6% Bond Portfolio

@8% yield
Face amount $100,000,000 $100,000,000 $200,000,000
Market value $100,000,000 $86,409,674 $186,409,674
Weight within portfolio 53.65% 46.35% 100.00%
Modified duration 6.7952 7.1675 6.9678
DV01 $ 67,951.63 $ 61,934.56 $ 129,886.20
@7.9% yield
Face amount $100,000,000 $100,000,000 $200,000,000
Market value $100,682,535 $87,031,839 $187,714,374
Correct price change (using PV) $ 1,304,700

Estimated price change (using Mod Dur) $ 1,298,862
Estimated price change (using DV01) $ 1,298,862
www.dnatrainingconsulting.net (c) DNA Training & Consulting

Excel Duration
Settlement date 6/15/2009

Maturity date 6/15/2019
Coupon 8%
Yield 8%
Frequency 2
Basis 0
Duration 7.0670
Mod Duration 6.7952

Duration v. Tenor
Settlement date 6/15/2009 6/15/2009 6/15/2009 6/15/2009 6/15/2009 6/15/2009 6/15/2009 6/15/2009
Maturity date 6/15/2010 6/15/2012 6/15/2014 6/15/2019 6/15/2039 6/15/2059 6/15/2109 6/15/3009
Tenor (yrs) 1 3 5 10 30 50 100 1,000

Coupon 8% 8% 8% 8% 8% 8% 8% 8%
Yield 8% 8% 8% 8% 8% 8% 8% 8%
Frequency 2 2 2 2 2 2 2 2
Basis 0 0 0 0 0 0 0 0
Duration 0.9808 2.7259 4.2177 7.0670 11.7642 12.7426 12.9949 13.0000

Mod Duration 0.9430 2.6211 4.0554 6.7952 11.3117 12.2525 12.4951 12.5000
Duration and Mod. Duration v. Tenor
14.00
Duration
12.00
10.00
8.00
6.00
Mod
Duration
4.00
2.00
0.00
- 5 10 15 20 25 30 35 40 45 50

Duration v. Coupon
Settlement date 6/15/2009 6/15/2009 6/15/2009 6/15/2009 6/15/2009 6/15/2009 6/15/2009 6/15/2009
Maturity date 6/15/2019 6/15/2019 6/15/2019 6/15/2019 6/15/2019 6/15/2019 6/15/2019 6/15/2019
Coupon 0% 2% 4% 6% 8% 10% 12% 15%

Yield 8% 8% 8% 8% 8% 8% 8% 8%
Frequency 2 2 2 2 2 2 2 2
Basis 0 0 0 0 0 0 0 0
Duration 10.0000 8.7620 7.9861 7.4543 7.0670 6.7724 6.5407 6.2732

Mod Duration 9.6154 8.4250 7.6789 7.1675 6.7952 6.5119 6.2891 6.0320
Duration & Mod Duration v. Coupon
12.00
10.00
8.00
Duration
6.00
4.00 Mod
Duration
2.00
0.00
0% 2% 4% 6% 8% 10% 12% 14% 16%

Duration v. Yield
Settlement date 6/15/2009 6/15/2009 6/15/2009 6/15/2009 6/15/2009 6/15/2009 6/15/2009 6/15/2009
Maturity date 6/15/2019 6/15/2019 6/15/2019 6/15/2019 6/15/2019 6/15/2019 6/15/2019 6/15/2019
Coupon 8% 8% 8% 8% 8% 8% 8% 8%
Yield 0% 2% 4% 6% 8% 10% 12% 1000%
Frequency 2 2 2 2 2 2 2 2
Basis 0 0 0 0 0 0 0 0
Duration 7.8889 7.6982 7.4970 7.2863 7.0670 6.8404 6.6079 0.6000

Mod Duration 7.8889 7.6219 7.3500 7.0740 6.7952 6.5146 6.2339 0.1000
Duration & Mod. Duration v. Yield

9.00
8.00
7.00
Duration
6.00
5.00
4.00 Mod
Duration
3.00
2.00
1.00
0.00
-200% 0% 200% 400% 600% 800% 1000% 1200%

Drivers of duration measures
Effect on duration/
modified duration
Tenor increases Increases
Tenor decreases Decreases
Coupon increases Decreases
Coupon decreases Increases
Yield increases Decreases
Yield decreases Increases

Convexity
► Strict mathematical definition is
1 fn
( PVCFt )(t )(t + 1)
Convexity =
y 2 ∑
t =1 ( PVTCF )( f )
2
[1 + ( )]
f
► Convexity is derived by differentiating the formula for modified duration with respect
to y; i.e. it is the second derivative of the price function with respect to yield
► It is not possible to understand such a number intuitively, unlike duration where the
number derived from the formula can be thought of either in terms of the average
time it takes to receive in PV terms the amount of your initial investment, or as a
sort of multiplier that converts yield movements into percentage price changes.
► The greater the convexity number, the more you should expect the correct graph for
the bond’s price-yield relationship to deviate away from the straight line
representing the linear approximation involving modified duration.

Convexity
Period Cash FlDF PVCF t x PVCF t x (t+1) x PVCF
1 4 0.9479 3.7915 3.7915 7.5829

2 4 0.8985 3.5938 7.1876 21.5629
3 4 0.8516 3.4065 10.2194 40.8775
4 4 0.8072 3.2289 12.9155 64.5773
5 4 0.7651 3.0605 15.3027 91.8161
6 4 0.7252 2.9010 17.4059 121.8413
7 4 0.6874 2.7497 19.2482 153.9858
8 4 0.6516 2.6064 20.8512 187.6605
19 4 0.3616 1.4463 27.4800 549.6002
20 104 0.3427 35.6438 712.8762 14970.4011
Price 82.0744 1103.8633 19977.3571

Duration 6.7248
Modifed Duration 6.3742
Convexity 54.6720
fn
Convexity = 1/[1+(y/f)]2 ∑ [(PVCFt )(t)(t+1)]/[(PVTCF)f2]
t=1

Using convexity
► Can use convexity to improve our estimate of percentage price changes given a
certain yield movement
% change in price = - Modified duration x Change in yield

+
0.5 x Convexity x (Change in yield)2
► Note that whether yields move up or down, the squaring of the yield change
ensures that the convexity adjustment is always positive
► Bondholder will still have losses if rates rise; but the greater the bond’s convexity
the more the actual loss will be reduced by virtue of the convexity adjustment
► When rates fall and the bondholder has gains, those gains are magnified further by
the convexity adjustment, with the more convex bonds seeing the greatest
magnification

Convexity Adjustment
Est % Price Est % Price Change

Change Using Mod Dur and Actual % Price
Using Mod Convexity Actual Price using Change using
YTM Dur Adjustment PV function PV function
6.00% 13.5903% 14.6838% $114.88 14.8775%

7.00% 6.7952% 7.0685% $107.11 7.1062%
7.90% 0.6795% 0.6822% $100.68 0.6825%
7.99% 0.0680% 0.0680% $100.07 0.0680%
8.00% 0.0000% 0.0000% $100.00 0.0000%
8.01% -0.0680% -0.0679% $99.93 -0.0679%
8.10% -0.6795% -0.6768% $99.32 -0.6765%
9.00% -6.7952% -6.5218% $93.50 -6.5040%
10.00% -13.5903% -12.4969% $87.54 -12.4622%
Face Value 100

Coupon Rate 8% Mod. Duration 6.7952
Yield 8% Convexity 54.6720
Frequency 2
Tenor 10

Drivers of convexity
Effect on duration / Effect on convexity

modified duration
Tenor increases Increases Increases
Tenor decreases Decreases Decreases
Coupon increases Decreases Decreases
Coupon Increases Increases

decreases
Yield increases Decreases Decreases
Yield decreases Increases Increases

BF (2 and Quiz)

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BF (2 and Quiz)

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Bond

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As of May 31, 2009

Issuer Company ABC

Face Value $100

Coupon payment Frequency Quarterly

Day count 30/360

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► Covenants and events of default

► But these do not affect cash flows in ordinary course of

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x1.02 x1.02 x1.02

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► By end of one year, aggregate amount received by investor is

► This is equivalent to a 8.24% effective annual yield

► Compare this to a bond with nominal annual coupon of 8.05%, but

► Equation above becomes

► This is equivalent to a 8.21% effective annual yield

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► Last coupon was paid May 31, 2009

► Today is June 30, 2009; how much interest has “accrued”?

► Approximate answer is 1/3rd of $2, so $0.6667

► This is correct under 30/360 convention, which treats each month as

► More specifically, accrued interest is calculated as

► Applicable to US government bonds, among others; these make semi-annual

► Correct answer under this convention is

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► Applies to USD Libor and some other money-market instruments

► Many important money-markets, such as Sterling Libor, use actual/365

► Importance of daycount convention should be very clear

► Comprehensive discussion of most conventions can be found at

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► Suppose bond is trading at 100 if we ignore accrued interest, but that

► We quote a clean price of 100, and a dirty price of 101.75

► Convention applies whether or not bond is trading at par: so if bond would

● Clean price (the one typically quoted) would be 96, and

● Dirty price would be 97.75

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► Definition: Annualized Coupon/ Price in percentage

► Following relationships always hold

Price above par Current Yield < Coupon

Price at par Current Yield = Coupon

Price below par Current Yield > Coupon

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► Return to 8% bond trading at 80; assume matures in 10 years

► Current yield of 10% is in a sense supplemented by capital gain at

► Can approximate this additional return by visualizing it as $2 extra per

► RATE function in Excel performs the correct calculation

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YTM (s.a.) 11.40%

Effective YTM (s.a) 11.73%

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Sett Date 7/31/2009

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YTM 4.38% 4.50%

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► For our 8% bond trading at 80, we can write

80 = 8 /(1 + y ) + 8 /(1 + y ) 2 + 8 /(1 + y ) 3 + .... + 8 /(1 + y ) 9 + 108 /(1 + y )10

► Yield-to-maturity is single value of y that satisfies this equation

► If coupon is paid semi-annually, equation becomes

► For bond having a maturity of n years, a payment frequency of f, a coupon