Course Title Bond and Equity Portfolio Management

Strategies (MFB511)
Program MSc in Finance and Banking

Surname Chinhoro

First Name Milton Tendai

Reg Number R199952X

Question Compare and contrast Duration and Convexity

and how they relate to Bond portfolio
management strategies with references to a
financial institution of your choice in or outside
Zimbabwe.

Due Date: 5 May 2023

Lecturer Mr. Petros Jecheche

Introduction
A bond is an instrument of indebtedness that obliges the bond issuer (borrower) to repay the
lender (creditor) the borrowed assets plus the interest within a certain period of time invested
(Fabozzi, 2000, p. 1). Duration and convexity are two tools used to manage the risk exposure
of fixed-income investments. Duration measures the bond's sensitivity to interest rate
changes. Convexity relates to the interaction between a bond's price and its yield as it
experiences changes in interest rates. Maturity of the bond gives information only on the date
of the final payment, but not on the size and date of coupon payments prior to the last
payment of coupon and principal. The longer the period to maturity and the higher the
coupon rate and yield to maturity, the more important coupon payments become when
compared to payments upon the maturity of the bond. Maturity of the bond, therefore, is not
an adequate indicator of the time required to make investment in bonds worthwhile. Thus, the
concept of bond duration and convexity has been developed.

Definition of Key Terms

Duration is a measure of the (weighted) average of time one has to wait to receive coupon
payments, as defined by Reilly & Brown (2003).

Convexity is an approximation of the change in the bond’s duration resulting from interest
rate change (Petrasek 2012).

Bond is a debt instrument, the issuer (debtor) agrees with the investor (creditor) to pay the
amount borrowed plus interest at a specified time (Fabozzi, 2000).

In 1938, Canadian economist Frederick Robertson Macaulay dubbed the effective-maturity

concept the “duration” of the bond. In doing so, he suggested that this duration be computed
as the weighted average of the times to maturity of each coupon, or principal payment, made
by the bond using what is known as Macaulay's duration formula.

Duration is critical to managing fixed-income portfolios, for the following reasons:

1. It’s a simple summary statistic of the effective average maturity of a portfolio.

2. It’s an essential tool in immunizing portfolios from interest rate risk.
3. It estimates the interest rate sensitivity of a portfolio.
The duration metric carries the following properties:

 The duration of a zero-coupon bond equals time to maturity.

 Holding maturity constant, a bond's duration is lower when the coupon rate is higher,
because of the impact of early higher coupon payments.
 Holding the coupon rate constant, a bond's duration generally increases with time to
maturity. But there are exceptions, as with instruments such as deep-discount bonds,
where the duration may fall with increases in maturity timetables.
 Holding other factors constant, the duration of coupon bonds is higher when the
bonds’ yields to maturity are lower. However, for zero-coupon bonds, duration equals
time to maturity, regardless of the yield to maturity.

Many international banks such as Citibank exhibit mismatches between asset and liability
maturities. Bank liabilities, which are primarily the deposits owed to customers, are generally
short-term in nature, with low duration statistics. By contrast, a bank's assets mainly comprise
outstanding commercial and consumer loans or mortgages. These assets tend to be of longer
duration, and their values are more sensitive to interest rate fluctuations. In periods when
interest rates spike unexpectedly, banks may suffer drastic decreases in net worth, if their
assets drop further in value than their liabilities.

CitiBank employs a technique called gap management is a widely used risk management tool

where it attempts to limit the "gap" between asset and liability durations. Gap management
heavily relies on adjustable-rate mortgages (ARMs), as key components in reducing the
duration of bank-asset portfolios. Unlike conventional mortgages, ARMs don’t decline in
value when market rates increase, because the rates they pay are tied to the current interest
rate.

On the other side of the balance sheet, the introduction of longer-term bank certificates of

deposit (CDs) with fixed terms to maturity, serve to lengthen the duration of bank liabilities,
likewise contributing to the reduction of the duration gap.
CitiBank employ gap management to equate the durations of assets and liabilities, effectively
immunizing their overall position from interest rate movements. In theory, a bank’s assets
and liabilities are roughly equal in size. Therefore, if their durations are also equal, any
change in interest rates will affect the value of assets and liabilities to the same degree, and
interest rate changes would consequently have little or no final effect on net worth. Therefore,
net worth immunization requires a portfolio duration, or gap, of zero.

Institutions with future fixed obligations, such as pension funds and insurance companies,

differ from banks in that they operate with an eye towards future commitments. For example,
pension funds are obligated to maintain sufficient funds to provide workers with a flow of
income upon retirement. As interest rates fluctuate, so do the value of the assets held by the
fund and the rate at which those assets generate income. Therefore, portfolio managers may
wish to protect (immunize) the future accumulated value of the fund at some target date,
against interest rate movements. In other words, immunization safeguards duration-matched
assets and liabilities, so a bank can meet its obligations, regardless of interest rate
movements.

Consequently, duration has several simple properties namely duration is proportional to

the maturity of the bond, since the principal repayment is the largest cash flow of the
bond and it is received at maturity. duration is inversely related to the coupon rate, since
 there will be a larger difference between the present values for the earlier payments over
the lesser value for the principal repayment. duration decreases with increasing payment
frequency, since half of the present value of the cash flows is received earlier than with
less frequent payments, which is why coupon bonds always have a shorter duration than
zeros with the same maturity.

Critics of the concept of duration argue that although it is only a good indicator of percentage
change in price only for small changes in yield. With large changes in yield, the duration is a
wrong measure since it shows overestimated/ underestimated approximation of the price
change in relation to real change in bond price. For small changes in yield, the percentage
change in price is almost the same, regardless of the rise or drop in yield, while for the great
changes in yield the percentage change in price is not the same when it comes to rise or drop
in yield. The reason for this is the convex shape of the price-yield curve. The greater the
convexity, the less accurate the use of concept of duration only will be.

In finance, bond convexity is a measure of the non-linear relationship of bond prices to

changes in interest rates, the second derivative of the price of the bond with respect to interest
rates (duration is the first derivative). In general, the higher the duration, the more sensitive
the bond price is to the change in interest rates. Bond convexity is one of the most basic and
widely used forms of convexity in finance. Convexity was based on the work of Hon-Fei Lai
and popularized by Stanley Diller. Convexity is a measure of the curvature, or the degree of
the curve, in the relationship between bond prices and bond yields. Convexity is a risk-
management tool, used to measure and manage a portfolio's exposure to market risk.
Convexity is a measure of the curvature in the relationship between bond prices and bond
yields. Convexity demonstrates how the duration of a bond changes as the interest rate
changes. If a bond's duration increases as yields increase, the bond is said to have negative
convexity. If a bond's duration rises and yields fall, the bond is said to have positive
convexity.

Convexity is the rate that the duration changes along the price-yield curve, and, thus, is the
1s t  derivative to the equation for the duration and the 2n d  derivative to the equation for the
price-yield function. Convexity is always positive for vanilla bonds. Furthermore, the
price-yield curve flattens out at higher interest rates, so convexity is usually greater on the
upside than on the downside, so the absolute change in price for a given change in yield
will be slightly greater when yields decline rather than increase. Consequently, bonds with
higher convexity will have greater capital gains for a given decrease in yields than the
corresponding capital losses that would occur when yields increase by the same amount. 

Convexity is usually a positive term regardless of whether the yield is rising or falling, hence,
it is positive convexity. However, sometimes the convexity term is negative, such as occurs
when a callable bond is nearing its call price. Below the call price, the price-yield curve
follows the same positive convexity as an option-free bond, but as the yield falls and the bond
price rises to near the call price, the positive convexity becomes negative convexity, where
the bond price is limited at the top by the call price. Hence, like the terms for modified and
effective duration, there is also modified convexity, which is the measured convexity when
there is no expected change in future cash flows, and effective convexity, which is the
convexity measure for a bond for which future cash flows are expected to change. Convexity,
a measure of the curvature of the changes in the price of a bond, in relation to changes in
interest rates, addresses this error, by measuring the change in duration, as interest rates
fluctuate.

In general, the higher the coupon, the lower the convexity, because a 5% bond is more
sensitive to interest rate changes than a 10% bond. Due to the call feature, callable bonds will
display negative convexity if yields fall too low, meaning the duration will decrease when
yields decrease. Zero-coupon bonds have the highest convexity, where relationships are only
valid when the compared bonds have the same duration and yields to maturity. Pointedly: a
high convexity bond is more sensitive to changes in interest rates and should consequently
witness larger fluctuations in price when interest rates move. The opposite is true of low
convexity bonds, whose prices don't fluctuate as much when interest rates change. When
graphed on a two-dimensional plot, this relationship should generate a long-sloping U shape
(hence, the term "convex").

Low-coupon and zero-coupon bonds, which tend to have lower yields, show the highest
interest rate volatility. In technical terms, this means that the modified duration of the bond
requires a larger adjustment to keep pace with the higher change in price after interest rate
moves. Lower coupon rates lead to lower yields, and lower yields lead to higher degrees of
convexity.

Ever-changing interest rates introduce uncertainty in fixed-income investing. Duration and

convexity let investors quantify this uncertainty, helping them manage their fixed-income
portfolios. With coupon bonds, investors rely on a metric known as “duration” to measure a
bond's price sensitivity to changes in interest rates.

 Using a gap management tool, Citibank has been able to equate the durations of assets
and liabilities, effectively immunizing their overall position from interest rate
movements.

 Another method which Citibank has used to measure interest rate risk, which is less
computationally intensive, is by calculating the duration of a bond, which is the
weighted average of the present value of the bond's payments. Consequently,
duration is also called the average maturity or the effective maturity. The longer the
duration, the longer is the average maturity, and, therefore, the greater the
sensitivity to interest rate changes. Graphically, the duration of a bond can be
envisioned as a seesaw where the fulcrum is placed so as to balance the weights of
the present values of the payments and the principal payment. Mathematically,
duration is the 1s t  derivative of the price-yield curve, which is a line tangent to the
curve at the current price-yield point.
  Although the effective duration is measured in years, it is more useful to interpret
duration as a means of comparing the interest rate risks of different securities.
Securities with the same duration have the same interest rate risk exposure. For
instance, since zero-coupon bonds only pay the face value at maturity, the duration
of a zero is equal to its maturity. It also follows that any bond of a certain duration
will have an interest rate sensitivity equal to a zero-coupon bond with a maturity
equal to the bond's duration.

Convexity in Fixed Income Management employed by Citibank

Unfortunately, duration has limitations when used as a measure of interest rate sensitivity.
While the statistic calculates a linear relationship between price and yield changes in bonds,
in reality, the relationship between the changes in price and yield is convex. The price
sensitivity to parallel changes in the term structure of interest rates is highest with a zero-
coupon bond and lowest with an amortizing bond (where the payments are front-loaded).
Although the amortizing bond and the zero-coupon bond have different sensitivities at the
same maturity, if their final maturities differ so that they have identical bond durations then
they will have identical sensitivities. That is, their prices will be affected equally by small,
first-order, (and parallel) yield curve shifts. They will, however, start to change by different
amounts with each further incremental parallel rate shift due to their differing payment dates
and amounts.

For two bonds with the same par value, coupon, and maturity, convexity may differ
depending on what point on the price yield curve they are located. Suppose both of them have
at present the same price yield (p-y) combination; also you have to take into consideration the
profile, rating, etc. of the issuers: let us suppose they are issued by different entities. Though
both bonds have the same p-y combination, bond A may be located on a more elastic segment
of the p-y curve compared to bond B. This means if yield increases further, the price of bond
A may fall drastically while the price of bond B won’t change; i.e. bond B holders are
expecting a price rise any moment and are therefore reluctant to sell it off, while bond A
holders are expecting further price-fall and are ready to dispose of it. So the higher the rating
or credibility of the issuer, the lower the convexity and the lower the gain from risk-return
game or strategies. Less convexity means less price-volatility or risk; less risk means less
return.
Duration and convexity are two tools used to manage the risk exposure of fixed-income
investments. With coupon bonds, investors rely on a metric known as duration to measure a
bond's price sensitivity to changes in interest rates. Because a coupon bond makes a series of
payments over its lifetime, fixed-income investors need ways to measure the average
maturity of a bond's promised cash flow, to serve as a summary statistic of the bond’s
effective maturity. The duration accomplishes this, letting fixed-income investors more
effectively gauge uncertainty when managing their portfolios.

Convexity and duration are both risk management metrics, used similarly to the
way 'gamma' is used in derivatives risks management; it is a number used to manage
the market risk a bond portfolio is exposed to. If the combined convexity and duration of a
trading book is high, so is the risk. However, if the combined convexity and duration are low,
the book is hedged, and little money will be lost even if fairly substantial interest movements
occur.

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