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Pricing and Duration

Content

Time value of money

Pricing a bond, dirty price, accrued interest and clean price

Duration

Convexity

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The price of financial assets

All financial assets, in particular securities, should have a value that is the present
value of future cash flows
Where possible, cash flows need to be forecast into the future, and discounted
back to today
This concept is the time value of money, where values can be moved between
present values (PV) and future values (FV)
PV =
Effect of interest

PV FV

Present values in more detail

So given a future cash flow, like a coupon or a redemption payment, we can
calculate how much it is worth now, and add together all the cashflows of a bond
and thus calculate the value of a bond
PV =

Here, we include a compounding factor where the bond might pay coupons on a
more frequent basis than annually and therefore a different compound frequency
must be used
‘r’ is the yield of the bond
Rates for bonds are always expressed annually, and we will see there are various
terminologies and conventions for the different returns for a bond

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Discount factors
A discount factor is a calculated factor to multiply a future value by to get the
present value
From the previous equation PV = the equation can be simplified to
PV = ∑ FV ∗ DF
Where the DF =
So for a rate of 5% for three years, the discount factor is 0.8638

Yield
To describe a bonds return we use the word yield
It works better than ‘interest’ as a bonds return is made up of several factors:
 The coupons received
 The gain or loss made in holding the bond
 The length of time holding the bond - precisely when the monies are received
There are different measures of yield:
 Current or simple yield
 Yield to maturity
 Japanese Yield
 True Yield
The yield is the rate at which we will discount the bonds cashflows by to get the
price of the bond

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Valuing a bond
So a bonds price must be the present value of all of it’s cashflows into the future
PV = ∑ FV ∗ DF
b = + +…+

Applying the discount factors

Now adding a discount factor column, using DF =
Then multiply out to get the present value

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Different bonds have different cashflows

In practice many bonds pay more frequently than annual, so lets take that into
account
Note that the convention in bond markets with yields is to just halve the yield for
a 6 monthly pay bond

Price and yield

Mathematically it should be obvious that there in an inverse relationship
between price and yield
As price goes up, the implied yield must be going down, and the opposite true if
price is going down
If the yield is above the coupon, the bond must be trading under par value (100%
in this case) – this is called a discount bond
If the yield is below the coupon the bond will be trading above par value – this
bond is trading at a premium
If the yield equals the coupon the bond is trading at par – this is why many bonds
are issued with coupons near their expected yield

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Reinvestment yield
The yield to maturity assumes that all coupons are reinvested at the same yield,
which is normally an unrealistic assumption – it assumes the yield curve is flat
Prove this by calculating the future value of the cashflows and prove the
difference between the PV and FV of the cashflows is the yield!
So 101.5103 * (1+0.026/2) ^ (4*2) = 112.5604

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Problem
Obviously this pricing sheet only works well if the next bond’s coupon is perfectly
1 period away, in reality the bond was issued on a specific date, like 31st August,
and needs to be valued taking into account what the current date is, so we need
a more robust spreadsheet
We are working up to using the Excel functions PRICE, YIELD and ACCRINT, but it
might be fun to build the sheet ourselves, to prove those functions work
We are going to need more inputs, see on the next page

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Building inputs
So we need the inputs to the right for our calculation
Settlement: The day we take ownership of the bond, not
the day or purchase – Government bonds tend to be
T+1, corporate bonds can be T+3
 Previous coupon and next coupon will be needed for
calculations, the previous coupon might just be the issue
date
Maturity (and the other numbers above) needs to be an
actual date

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More inputs
Basis and frequency of coupon will be needed
Use these data tables to the right and set up a VLOOKUP or
something to get the input number for equations
We’ve seen frequency before, just the number of coupons
per year
Basis is the day count convention used for bonds
Treasuries use Actual/Actual, corporate bonds are either of
the 30/360’s depending on where they are and the other two
are normally day counts for money markets

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A Treasury

Source: Bloomberg

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A Treasury continued

Source: Bloomberg

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Input into the sheet

All the inputs as per the right
Remember the fractional pricing of US Treasuries
Their price is in 32ths, so 99-29 and an 1/8th is
99+29.125/32

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Dates
Forecast out the dates from the
prev/settlement/next coupon dates
Use EDATE or EOMONTH for this
Then calculate the time period to the
next coupon
Then each time period beyond that
just add 1 (for six months)

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Coupons and discount factors

Just like before, forecast down the coupons as a percentage of the par value and
the final cash flow should get the principal back as well
Then forecast down the discount factors
Then multiply out to get the PV

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Dirty and clean prices

Our value is now the full or ‘all in’ cost of the bond, known as the dirty price – but
this doesn’t match the price shown on the screen!
The market price (or clean price) excludes the interest that the seller of the bond
has already earnt of the next coupon, it’s a better price to quote as that is what
the bond buyer is getting – they’ll end up paying a bit more, but get it back when
they get the full next coupon
Calculate the accrued interest for this bond = (Days held/Days in
period)*coupon/2

Accrued Interest = 17/181 This interest the buyer gets 164/181

31st August 20 17th Sept 20 28th Feb 21

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What we have so far…

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Done?? Lets use the Excel functions

So our clean price is close (but not exact!) to the listed price
The reason it’s wrong is we only have the yield down to 6 decimal places, it
wasn’t exactly the yield (and I mean exactly!)
So Excel has a function to calculate the yield, (=YIELD), price (=PRICE) and accrued
interest (=ACCRINT)
But don’t worry, we didn’t waste any time - we’ll see why our sheet helps us later
on
Have a go with those functions.. And think about whether Excel has given you the
clean or dirty price!
Iterate by putting the yield you got back into the yield input cell, and you’ll see it
all perfect!!

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Pricing all finished!!

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Duration
So we have established that if yield goes up, or down, that the price of a bond
goes the other way
We would like to know the amount of this change – would be useful for
evaluating the risk of a portfolio, or estimating the profit/loss from a position
There are different measures of duration, namely
 Macaulay duration – a number in years, which gives the average time to receipt of a bonds
cashflows
 Modified duration – the approximate percentage change in the value of a bond given a 1%
(100bps) change in yield
 DVO1/PVBP – these the dollar value of 1bp, (or price of a basis point) so give the amount the
price moves when rates change by 1 basis point (0.01%)

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Duration of the treasury (risk section)

Source: Bloomberg

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Duration conceptually
Cashflows are ‘riskier’ the further away they are from you
So a choice between a 10 year bond and a 2 year bond – obviously the 10 year
bond has more risk and would move in price by more if rates changed
Two 5 year bonds, one with a 3% coupon and one with a 7% coupon, the lower
coupon bond would be riskier as its payments are relatively further away
But what about a 7 year 3% coupon bond, and a 8 year 6% coupon bond – I cant
just by looking tell which one is riskier – I need to do a calculation!

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Macaulay Duration
Macaulay calculated the weighted average time to the receipt of a bonds
cashflows, weighted by time – thus its measured in years
A zero coupon bond, or any single payment, has a Macaulay duration of its exact
maturity from today
Any coupon paying instrument the ‘average’ time to receipt of the bonds
cashflows reduces the higher the intervening payments
∑ ∑
Macaulay Duration = ∑
or =
Get this number from the spreadsheet!

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Macaulay Duration

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Modified duration
Macaulay duration is great for asset liability managers – who are trying to match
the duration of their assets and liabilities (like pension fund managers) but
doesn’t mean much for anyone else
Modified duration turns Macaulay duration into a usable number – modified
duration is the percentage change in the price of a bond given a 1% (100bp)
change in yields
Modified Duration =

For our bond is

= 4.9250 / (1+0.268271%/2) = 4.9184

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Excel functions
Once again, there is a function in Excel for these
=DURATION and =MDURATION – check them out and see if it gives the same
answers

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DV01
A 1% (100bp) change in yields is fairly large – the markets tend not to move
anywhere near that much
Also modified duration doesn’t take into account how much you own of the
bond, its just a percentage – some investors would like to know their dollar
gain/loss with a projected rate change
DV01 (or PVBP) is the amount of gain/loss per 1 million nominal on a bond
position
DV01 = Modified duration x dirty price of bond
For our bond, is 4.9184 x 99.9219 = $491
You need to be very careful with the magnitude of this number, but it makes
sense here as 0.01% x 1m x 5years is $500, so this is right!

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Convexity
The price yield relationship of a bond is not linear, there is a second derivative
This can be measured as convexity

Price Convexity

Duration

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Convexity
Convexity is also to do with a bonds cashflow dispersion, it’s the second order
derivative of the bonds price change with respect to yield
Convexity is a good thing, it means when yields go down, price starts to go up
faster, and when yields go up, price goes down slower
There is no Excel formula for convexity (which is now why our spreadsheet comes
into it’s own!)
∑ ∑

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Convexity
Convexity in Bloomberg is showen as this number divided by 100

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Corrected price change

To take into account the convexity:
convexity
Change in Price = bond price x (−Modified duration x ∆y + x ∆y 2 )
2

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