VALUATION OF BONDS (DURATION, CONVEXITY &

CASH FLOW MATCHING)

DURATION OF BOND

Macaulay’s duration is a weighted average of period generating incomes from holding bond. The
weights are present value of incomes divided by present value of present value of bond.
Duration is measured in years, which means, that value of duration changes over time with next
cash flows (coupon payments).

The formula for Macaulay’s duration is:

i
tm M∗k
m 4.6
MD=∑ ¿¿
k=1
¿¿

For zero-coupon bond MD=t

For coupon bond MD<t

t is a period till maturity date.

EXAMPLE 1

Calculate duration of 7-year zero-coupon bond with nominal 250, if YTM is 17%.

Solution:

We can either calculate it using formula 4.6 (remembering that i=0 ) or remember the rule for
zero-coupon bond MD=t

To be sure, we will calculate it using formula:

250∗7
( 1+0.17 )7
MD= /1=7
250
7
( 1+0.17 )

EXAMPLE 2

Calculate duration of 2-year bond with nominal 100, interest 10% and coupons paid semi-
annually, if YTM is 4%.

Solution:

We use formula 4.6:

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 2∗2

∑ 0.1
2
∗100∗k∗MWO0.04 / 2∨¿k +100∗2∗2∗MWO0.04 /2∨¿ 2∗2
5∗1∗MWO 0.02∨¿ 1+5∗2∗MWO0.02∨¿2 +5
k=1
MD= / m=
0.1 111
∗100∗MWOR0.04 / 2∨¿2∗2 +100∗MWO 0.04 /2∨¿2∗2
2

Duration can be also calculated for a moment between a coupons payments. Then in formula 4.6
t should reflect time till maturity (in years) and k should reflect actual periods till the next
coupon payments. It is worth to mention that in case of valuation at a moment between coupon
payments PVB t is a dirty price calculated using theoretical method (with r equaling YTM).

EXAMPLE 3

Calculate duration of 2-year bond with nominal 100, interest 10%, coupons paid quarterly, if
YTM equals 4%, and there is one year and 3 months left till maturity date.

Solution:

Similar to Example 2 we use formula 4.6, but this time remembering that the period till
maturity is 1.25 year and period till payment of next coupons are {0.25; 0.50; 0.75; 1; 1.25
year}.1

0.1 0.1
1.25∗4 ∗100∗k ∗100∗1.25∗4
2 2
∑ 0.04
k
+
0.04
1.25∗4
k=0.25∗4
(1+ ) (1+ )
2 2
MD= /4
PVB 1.25

Duration can be also calculated for any cash flows series CF. Then formula 4.6 would be:
tm
CF k∗k
MD=∑ ¿¿ 4.6.a
k=1
¿¿

So far we have calculated duration for 1 bond. Yet there is no problem with calculating duration
for a portfolio of different bonds. We can calculate it based on all the incomes generated by each
bond from a portfolio. If we know the share of each bond in the whole portfolio [ w i]2, then an
approximation of duration for whole portfolio will be weighted average of each bond duration 3.
Formula is written as follows:

1
[Advice] Drawing a timeline with coupon payments might be helpful.
[Instructor’s comment] This won’t be taught during our class. If you are interested in topic, write me an
email (I’ll provide you with a theoretical material).
2
[Explanation] The share of a bond is fraction of its present value to the sum of present values of all
bonds in portfolio.
3
[Explanation] Weights are the share of each bond mentioned previously.

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 n

∑ MDi∗PV i n
MD port . = i=1 n
=∑ MDi∗wi 4.6.b
∑ PV i i=1

i=1

CONVEXITY

Convexity is a measure of sensitivity to YTM changes. It is expressed in squared years. For bonds
that have the same present value assuming the same YTM, bond with a higher convexity is less
sensitive (more robust) to the increases of YTM 4 and higher sensitivity (lower robust) to
decreases of YTM5. Formula for convexity is the following:

i
tm M∗k∗(k +1)
m 4.7
CON =∑ ¿¿
k=1
¿¿

SENSITIVITY OF PVB TO YTM CHANGES

Obviously, a present value of bond depends on yield to maturity (YTM). We know that the
relation is inverse. In order to calculate how would the present value change under an influence
of YTM change we can:

 calculate percentage change between present value of bond with YTM before the change
and with YTM after the change,
 use an approximation with a duration,
 use a better approximation with a duration and convexity.

If we want to calculate percentage change we should start with a formula for percentage change:

X ' −X
∆ %=
X

Substituting PVBs into above formula we can calculate the percentage change of present values
due to the change of YTM to YTM’
'
PVB (YT M )−PVB (YTM ) ∆ PVB
∆ %= = 4.8.a
PVB (YTM ) PVB(YTM )

When we know a duration before the change we can use an approximation, which is burdened
with a slight mistake:

4
[Explanation] An increase of YTM leads to decrease of PVB. Bond with a higher convexity loses less of
present value than an alternative bond with a lower convexity.
5
Explanation] A decrease of YTM leads to increase of PVB. Bond with a higher convexity earns more of
present value than an alternative bond with a lower convexity.

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 ∆ PVB MD
≈− ∗∆ YTM
PVB (YTM ) YTM 4.8.b
1+
m

If we additionally know a convexity before the change, then our approximation will be
considerably better:

∆ PVB MD 1
≈− ∗∆ YTM + ∗CON∗( ∆ YTM )2
PVB (YTM ) YTM 2 4.8.c
1+
m

INVESTMENT IN BONDS STRATEGIES

Apart from standard investment in bonds, bonds can be used as a form of hedging future
liabilities (payments to be done). Our goal is to receive incomes from holding a bond that will
cover future payments (expenses) that we have to do. What is extremely important is that we
have to match the amounts and the moments when we receive payments and make
expenditures.

In order to hedge liabilities we can use among several strategies:

 cash flow matching strategy

 portfolio immunization strategy6

CASH FLOW MATCHING

Cash flows matching strategy is to construct such a bond portfolio so that every positive cash
flow (coupons and nominal) covers every negative cash flow (liabilities).

In order to construct such a portfolio we have to start from the end i.e.. last liability that is due to
pay. Then we are looking for such a bond that generates cash flows when the liability is due to
payment. Then we calculate what is an actual cash flow generated by this bond (coupons or
coupons with nominal) at the moment of due payment and we buy such amount of bond to be
able to cover whole or most of the liability. Then we check second to last liability. At this stage
we have to correct our second to last liability by a cash flows generated at the moment of
second-to-last due payment date by bonds bought in previous step. When we corrected our
liability we look for a bond that will generate such incomes that will cover corrected liability.
Now we have to determine how many bonds should be buy and we repeat our procedure till the
present moment. It seems a little bit complicated but it will be more clearly with an example

EXAMPLE 4

He have to pay following liabilities:

 after a year – 20.000

 after 2 years – 30.000
 after 3 years – 10.000

6
[Explanation] PVB(YTM) is a function of YTM for present value of bond

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 There are following bonds available on the market each with a nominal of 100 and coupons
paid annually:

 one-year zero-coupon bond

 2-year bond with interest 10%
 3-year bond with interest 15%
 4-year zero-coupon bond

Hedge liabilities using cash flow matching strategy.

Solution:

Let’s examine what positive cash flows we might receive each year from bonds available on the
market. Please remember that we are looking at the actual future cash flows not the present
values. We are not interested what is the present value of cash flows generated after 3 years. For
example, in 3rd year we will receive nominal from 3-year zero-coupon bond and we will have to
pau liability. Those two cash flows happened at the same moment so calculating present values
is unnecessary and might cause you more problems.

Bond Cash flows

Year I Year II Year III Year IV
1-year + 100 0 0 0
2-year 0,1 * 100 = + 10 10 + 100 = + 110 0 0
3-year 0,15 * 100 = + 15 + 15 15 + 100 = + 115 0
4-year 0 0 0 + 100

We have added to the table cash flows connected with liabilities.

Bond & liability Cash flows

Year I Year II Year III Year IV
1-year + 100 0 0 0
2-year 0,1 * 100 = + 10 10 + 100 = + 110 0 0
3-year 0,15 * 100 = + 15 + 15 15 + 100 = + 115 0
4-year 0 0 0 + 100
Liabilities - 20.000 - 30.000 - 10.000 0

We are not interested in 4-year bonds, because their income will be distributed only at the end
of 4th year, so after all our liabilities were paid. Even if it was non zero-coupon bond, buying
such bond won’t be an effective choice, because the only income from this bond that will be able
to cover liabilities is coupon payment which in fact is a small fraction of nominal (bond main
cash flow).

Therefore we are looking for 3-year bond. We can notice that our 3-year bond will provide 115
at the end of 3rd year. We have to cover 10.000 so we need 86,95 bonds. Regrettably, we cannot
buy a fraction of bond.

In such situation we have to make an assumption. If we do not have to cover all liability from
bond payments, because we are sure we will have additional savings, then we can round it
down. If we want to cover whole liability then we round it up. For the need of this example we
will assume we do not have to cover whole liability. Thus we buy 86 3-year bonds and our
mismatch in 3rd year is = 10000 – 86 * 115 = 110.

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 Bond & liability Cash flow
Year I Year II Year III
Liability (before income) - 20.000 - 30.000 - 10.000
3-year bonds - - 10.000 / 115 = 86
Income from 3-year bonds 86 * 15 = 1.290 86 * 15 = 1.290 86 * 115 = + 9.890

At the end of 2nd year we have to cover lability of 30000. We remember that at the end of 2nd
year we will also receive coupons from 86 3-year bonds. So our liability still uncovered is 30000
– 86*15 = 28710.

Bond & liability Cash flow

Year I Year II Year III
Liability (before income) - 20.000 - 30.000 - 10.000
3-year bonds - - 10.000 / 115 = 86
Income from 3-year bonds 86 * 15 = 1.290 86 * 15 = 1.290 86 * 115 = + 9.890
Liability (after I cash flows) - 18.710 - 28.710 - 110

This time we will choose 2-year bond in order to cover our liability. We have to buy 28710 / 110
= 261 of such bonds. Therefore our liability will be fully covered, so our mismatch in 2nd year is
0.

Bond & liability Cash flow

Year I Year II Year III
Liability (before income) - 20.000 - 30.000 - 10.000
3-year bonds - - 10.000 / 115 = 86
Income from 3-year bonds 86 * 15 = 1.290 86 * 15 = 1.290 86 * 115 = + 9.890
Liability (after I cash flows) - 18.710 - 28.710 - 110
2-year bonds - 28.710 / 110 = 261 -
Income from 2-year bonds 10 * 261 = + 2.610 110 * 261 = + 28.710 0

There is only liability at the end of 1 st year remaining in amount of 20000. Similar like in 2 nd year
we will receive at the end of 1 st year coupon from 3-year bond and coupon from 2-year bond.
Thus our uncovered liability is 20000 – 15*86 – 10*261 = 16100, which means that in order to
cover it we need 161 1-year bonds.

Bond & liability Cash flow

Year I Year II Year III
Liability (before income) - 20.000 - 30.000 - 10.000
3-year bonds - - 10.000 / 115 = 86
Income from 3-year bonds 86 * 15 = 1.290 86 * 15 = 1.290 86 * 115 = + 9.890
Liability (after I cash flows) - 18.710 - 28.710 - 110
2-year bonds - 28.710 / 110 = 261 -
Income from 2-year bonds 10 * 261 = + 2.610 110 * 261 = + 28.710 0
Liability (after II cash flows) - 16.100 0 - 110
1-year bonds 16.100 / 100 = 161 - -
Income from 1-year bonds 161 * 100 = 16.100 0 0
Liability (after III cash flows) 0 0 - 110
Mismatch 0 0 110

Obviously, this method has many flaws. Foremost it is hard to find such bonds that will generate
payments at a specific moment of time (e.g. we have a due payment on 13 of February, while

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bond might pay coupons at 31st of March). Secondly it is hard to cover liabilities perfectly
because bonds are indivisible.

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