Bond Duration & Volatility

Prof(Dr.) Harsh Vardhan

27/10/2023
 Objective
 Duration
 Yield & Duration
 Modified Duration
 Duration & Volatility
 Volatility of Bond
 Properties of Duration
 Callable Bond

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 Duration
 Duration[Macaulay Duration] is a measure of weighted average of life
of a Bond which considers the size and timing of each cash flow .
 The weights assigned to each time period is the Present Value of cash
flow paid at that time as proportion of price of the bond.
𝑃𝑉 𝐶1 ∗1:𝑃𝑉 𝐶2 ∗2:𝑃𝑉 𝐶3 ∗3:𝑃𝑉 𝐶4 ∗4:..…:𝑃𝑉 𝐶𝑛 ∗𝑛
 Duration =
𝑃0
 Where PV(Ct)= Present Value of cash flows receivable at the end of
year t (t=1,2,….n),
 P0 is current value of Bond, P0 = 𝑛𝑡=1 PV(Ct)
 YTM or IRR is used to discount

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 Duration
 Duration is a measure of the average life of a debt instrument.
 It is defined as the weighted average time to full recovery of principal
and interest payments.
𝑛 𝐶𝑡∗𝑡
𝑡=1(1+𝑟)𝑡
 It is defined by D = 𝑛 𝐶𝑡 …..(1)
𝑡=1(1+𝑟)𝑡
𝒏 𝒏
𝒕=𝟏 𝑷𝑽𝒕∗𝒕 𝒕=𝟏 𝑷𝑽𝒕∗𝒕
D= 𝒏 𝑷𝑽 = ……(2)
𝒕=𝟏 𝒕
𝑷𝟎
 D = Duration
 t = Time period in which the Coupon / Principal payment occurs
 Ct = Interest & / or Principal at time t
 r = Market Yield on the Bond.

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 The Duration (Macaulay) is the break-even point in the sense when
we liquidate the Bond position ,the unrealized capital gain/loss from
the bond exactly offsets the loss/gain of reinvestment interest
payment.
𝑃1𝑡1:𝑃2𝑡2:𝑃3𝑡3:𝑃4𝑡4:⋯:𝑃𝑛𝑡𝑛
 Duration = ;
𝑃
where P1,P2 ….. Pn are Present Value at t0 of payments made at t0,t1…,tn
respectively and
 P= P1+P2+P3….Pn is NPV or Price of Bond at t=t0
𝑤𝑖𝑥𝑖
 [Wi =PVi =Pi ,Weightage average with weights PVi ( )]
𝑤𝑖

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 Duration is measure (in years) of Bond’s price volatility with respect
to change in the Bond yield r
 Each year of Duration represents the change of 1% gain or loss of
principal for every 1% change in interest rate i.e.
 It measures the Interest Rate Risk of a Bond.

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 Problem 4

 Suppose you decide to buy 10% annual Bond maturity after 5 years with
face value ₹ 100 and interest rate available is 19%.
 Find Duration of the Bond.

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Duration-Excel

https://indianexpress.com/article/explained/indian-economy-recovery-
growth-explained-7491224/
CF/MDI/Harsh/5 8
 Problem 5

 Consider a 8% Bond with settlement date 1st Nov 2019 and having
maturity after 3 years.
 The Bond is selling at 9% yield .
 The Face value of Bond is ₹100 and coupon payment are semi- annual.
 Find the Duration of the Bond.

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Duration
Year Payment PV PV*t
0.5 4 3.83 1.92
1 4 3.67 3.67
1.5 4 3.51 5.27
2 4 3.37 6.73
2.5 4 3.22 8.06
3 104 80.31 240.92
Sum 97.91 266.57
Duration 2.72
Interest 9%

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 Duration - Exercise

 Calculate Duration of Bond A.

Bond A
Face value ₹100
Coupon (interest rate) 15 % payable annually
Years to maturity 6
Redemption value ₹ 100
Current market price ₹ 89.50
Yield to Maturity 18 %

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 Calculation of Duration

BOND A : 15 PERCENT COUPON

YEAR CASH FLOW PRESENT VALUE PROPORTION OF PROPORTION OF THE

AT 18 PER CENT THE BOND'S VALUE BOND'S VALUE TIME

1 15 12.71 0.142 0.142

2 15 10.77 0.120 0.241
3 15 9.13 0.102 0.306
4 15 7.74 0.086 0.346
5 15 6.56 0.073 0.366
6 115 42.60 0.476 2.856

DURATION 4.257 YEARS

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 Yield & Duration by Excel
1. The Face Value of 6 years ₹ 100 Bond with Coupon payable annually
@15% is selling at ₹ 89.50. Find it’s Yield .
2. The settlement date of above 6 years Bond is 1/1/2015 & maturity
is 12/31/2020 .The interest is paid semi-annually. Find the Duration
of the Bond. In case interest is paid annually what will be the
Duration? How do you interpret the outcome??

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Yield & Duration by Excel

Basis 3 represents the day count convention: actual

number of days/365 days in interest calculation
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Question
 Does Duration changes for semi-annual and annual coupon rate?
Or
 Will Duration be shorter or longer for a bond that makes semi-annual
coupon payments rather than annual coupon payments?

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This implies that the Duration for annual Bond is larger than that
for the Bond having semi annual payment of Coupon.
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 Duration
 Does the Duration change, with payments of coupon on different
timing (like semi - annually or annually)??
 Face Value =100
 Coupon = 10%
 Maturity =12 years
 YTM=8%
 Coupon Payment for Bond A annual and for Bond B semi annual .

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Duration gets reduced from 7.81 to 7.58 years if payments
of coupon changes from annually to semi annually .
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 Shorter way for Calculation
A B
Settlement 01-01-2011 01-01-2011
Maturity 31-12-2022 31-12-2022
Coupon 10% 10%
Yield 8% 8%
frquency 1 2
Basis 3 3
Duration 7.80 7.58
DURATION(B2,B3,B4,B5,B6,B7)

Duration for Bond A = 7.80 years >Duration for Bond B=7.58 years
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 Duration & Volatility
 Let D is Macaulay Duration
 P =Price of Bond
 C is semi annual Coupon interest
 y= one half the yield to maturity or required yield
 n= number of semi annual periods
 M= Maturity Value
𝐶 𝐶 𝐶 𝐶 𝐶 𝑀
 P= + + + ……. + + ….1
(1:𝑦) (1:𝑦)2 (1:𝑦)3 (1:𝑦)4 (1:𝑦)𝑛 (1:𝑦)𝑛

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 After differentiation P with respect to y
dP 1 1
 * =- x D ….(2) , where D is Macaulay Duration
dy P (1:y)
dP 1
 * = -D∗ ….(3)
dy P
1
 xD is known as Modified Duration=𝐷∗
(1:𝑦)
𝑀𝑎𝑐𝑎𝑢𝑙𝑎𝑦 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
 Modified Duration =
(1:𝑦)
𝑑𝑃
 Rearrange equation 3 ; ≃ - 𝐷∗ dy ….(4)
𝑃
 The Modified Duration is related to the approximate % change in price for a
given change in yield
 Modified Durations for all option free bond are positive.
 Equation 4 implies that there exists an inverse relationship between Modified
Duration and approximate % change in price for a given yield change
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 Bond Volatility
 Bond Volatility V can be defined by absolute value of % change in
Bond Price associated with specified change in yield y
𝑑𝑃 𝑀𝑎𝑐𝑢𝑙𝑎𝑦 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 𝐷
 V= 𝑃
= −𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 ≃ ≃
𝑑𝑦 (1:𝑦) (1:𝑦)
𝐷
 Thus V ≃
(1:𝑦)

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 Example-4
 The Face Value of 6 years ₹ 100 Bond with Coupon payable annually
@15% is selling at ₹ 89.50. Find it’s Yield .
 The settlement date of above 6 years Bond is 1/1/2015 & maturity is
12/31/2020 . If the interest is paid annually what will be the Duration?
 Ans Duration or Macaulay Duration=D= 4.257

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 Example-4
 Macaulay Duration D= 4.257
1
 Modified Duration=𝐷 ∗ = xD
(1:𝑦)

∗ D 4.257
 Modified Duration 𝐷 = = =3.608
(1:𝑦) 1.18
dP 1
 * ≃ -D∗ ….(3)
dy P
dP
 ≃ -D∗ dy
P
 Using the Bond for which the Modified Duration is D* = 3.608 and assuming a
change of yield 0.2%( 20 Basis point) ,The % change in Price of Bond can be
calculated :
 D* = 3.608
 dy = 0.2 percent
dP
 ≃ – 3.608 x 0.2 = – 0.722 %
P CF/MDI/Harsh/5 24
 Volatility of Bond
 The Volatility ( or interest rate sensitivity ) of a Bond is approximately
related to its Duration
Duration
 Volatility ≃
[1:Yield]

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Duration & Volatility

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 Inference
 It is seen that :
 Duration of Bond A <Duration of Bond B
Duration
 Volatility(Interest rate sensitivity) of Bond is defined by =
(1+Yield)
 Volatility of Bond A= 3.61 < Volatility of Bond B =3.86
 Thus 1% increase(decrease) in the required yield will result in 3.61% fall(rise)
in price of Bond A and 3.86% fall (rise) in the price of Bond B

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 The Duration of a Perpetuity
(1 + Yield) (1 + Y)
 The Duration of a Perpetuity is: =
Yield Y
 Example:
 What will be Duration of Perpetuity that pays Rs 100 per year for ever
at 9% yield?
(1:𝑦) 1:0.09
 Ans Duration of a Perpetuity = = = 12.11
𝑦 0.09
 It is clear that maturity and duration can be substantially different
,while the maturity of perpetuity is infinite ,the duration of the Bond
at 9% yield is 12.11 years

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 Q
 What happens to Duration when you change the Coupon rate of a bond?
And also YTM?

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 Duration by Spread Sheet

As the coupon rate decreases(15% to 8% ,YTM declines(18% to 10%) consequently

Duration increases from 4.25 to 4.92

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 Duration-insight
 The Duration(Macaulay) is the break-even point in the sense when we
liquidate the bond position, the unrealized capital gains/ loss from the bond
exactly offset the loss/ gains of the reinvestment interest payments.
 Duration is a measure (in years) of bond’s price volatility with respect to
change in the bond yield r.
 Each year of duration represents the change of a 1% gain or loss of principal
for every 1% change in interest rates i.e it measures the interest rate risk of
a bond.

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 Properties of Duration
 A Bond’s Duration is influenced by its Maturity, Coupon and Yield.
 Duration of a Bond with Coupons is always less than its term to maturity
because duration gives weight to these interim payments.
 The longer the Maturity ,the greater the Duration,
 The higher the level of Coupon, the shorter the Duration
 The greater the Yield to Maturity ,the Shorter the Duration
 Higher the Interest (Coupon rate) ,the shorter the Duration
 For a Zero Coupon Bond[ZCB] ,the Duration=Maturity of bond
 The Bond’s Yield to Maturity is reflective of the market rate of interest for
bond of a given type and represents the assumed reinvestment rate in
duration calculation.
 The Duration of a Zero Coupon Bond is its Maturity; as ZCB does not pay a
coupon and so there is no reinvestment rate risk associated with coupons.
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 Properties of Duration
1. The Duration of a Zero Coupon Bond is the same as its Maturity.
2. For a given maturity, a Bond’s Duration is higher when its coupon rate is lower.
3. For a given Coupon rate, a Bond’s Duration generally increases with maturity.
4. Other things being equal, the duration of a coupon bond varies inversely with its
yield to maturity.
(1 + Yield) (1 + Y)
5. The Duration of a Perpetuity is: =
Yield Y
For example ,at 9% yield, the Duration of a Perpetuity that pays ₹100 per year forever
1.09
will be = =12.11 years
.09
From this rule it is clear that Maturity and Duration can be substantially different. While
Maturity of Perpetuity is infinite, the Duration of the Bond at 9% yield is only 12.11
years CF/MDI/Harsh/5 33
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Thanks!!

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