Rates, Yields, Bond Math 23

much the price changes as the yields change is known as the price sensitiv-
ity or price risk, and can be answered by calculating the derivatives of the
pricing formula.

2.5.1 PV01, PVBP

The main driver for bond prices is the general level of market interest rates.
When market rates rise, the bond’s fixed coupon rate becomes less attrac-
tive relative to new market rates, and the bond value drops accordingly.
Alternatively, when market yields drop, then a bond’s coupon becomes more
attractive and the bond value increases. The sensitivity of a bond price to
changes in interest rates, known as the market risk, is the primary source of
risk to a bond holder. Other risks include credit risk, liquidity risk, inflation
risk, re-investment, and prepayment risk.
It is the standard to consider price changes due to 1 basis point (bp,
0.0001 = 1% of 1%) move in yields/rates, giving rise to PV01: the change
in Present Value of the bond due to 1 basis point change in implied yields:

dP
PV01 = × 0.0001
dy

where dP∕dy is the first derivative of the bond price formula with respect
to yield.
Starting with the bond price-yield formula, P(C, y, N, m), we calculate
( )
dP C 1 N C∕y − 1
= 2 − 1 + (2.9)
dy y (1 + y∕m)N m (1 + y∕m)N+1

The relative or percentage change in price is known as the Modified

Duration
1 dP
Modified Duration = ,
P dy

and has a unit of years. In bond markets, PV01 and modified duration are
usually defined using −dP∕dy instead of dP∕dy. This is to ensure that a pos-
itive amount signifies a long position, i.e., owning a bond. We will ignore
this market practice.
A similar but not identical concept to PV01, is PVBP : Present Value of
1 bp. This is the change in price due to changing the coupon rate by 1 bp

dP
PVBP = × 0.0001
dC