Fundamentals of

Investments
Management
INV2601

Bond Fundamentals

College of Economic and Management

Sciences
Education is the most powerful weapon which
you can use to change the world. Mandela
 How is your studying
At the moment on an average day, how much time do you
dedicate to studying?
A. 30 minutes or less
B. More than 30 minutes, but less than an hour
C. 1 – 2 hours
D. More than 2 hours

2
Bond Duration
 What is Bond Duration

• Bond duration is a way of measuring how much bond prices are likely to
change if and when interest rates move.
• In more technical terms, bond duration is measurement of interest rate
risk.
• Understanding bond duration can help investors determine how bonds
fit in to a broader investment portfolio..
• Macaulay duration estimates how many years it will take for an investor
to be repaid the bond’s price by its total cash flows.

4
 Duration Formulae
• Duration = 𝑉−−𝑉+ൗ2𝑉 (Δ𝑦)
0

• Where:
• Δ𝑦 = change in interest rates in decimal form
• V0 = current bond price
• V- = estimate bond price if interest rate decrease
• V+ = estimate bond price if interest rate increase

5
 What is Bond Duration

Bond duration is …
A. A measure of how much bond prices change if interest rates move.
B. Measure of bond risk.
C. Returns you earn for investing in bonds
D. All the above

6
 Duration Calculation
• Duration = 𝑉−−𝑉+ൗ2𝑉 (Δ𝑦)
0
A 10% per annum coupon 10-year bond, with face value of R1,000.00 is trading at R887.00, as
yield is 12%. Suppose the yield is changed by 50 basis points. What is the duration?
• Thus, Δy = 0.005 and V0 = R887.00
Duration = 913.48−861.59Τ2𝑋 887.00𝑋 0.005
Description Symbol V- V0 V+
= 51.89Τ8.87
Periods n 10 10 10
= 5.85056
Yield to Maturity i 11.5% 12% 12.5%
Interpretation: The bond price changes
Coupon PMT 100 100 100 by about 5.8506% for a 50 basis points
Maturity Value FV 1000 1000 1000 change in interest
Price PV 913.48 887.00 861.59
Your Question
Calculate the effective duration of an 18%, R1000 par bond maturing in 15 years if the yield to
maturity is 7% and interest is paid semi-annually. The yield to maturity changes by 1%
7
 Solution: Duration
Calculate the effective duration of an 18%, R1000 par bond maturing in 15 years if the yield
to maturity is 7% and interest is paid semi-annually. The yield to maturity changes by 1%

Step 1 Step 2
Draw the table

FV 1000 1000 1000

PMT 90 90 [(1000 × 90
0.18)÷2]
I/YR 3 [(7-1)÷2] 3.5 [7÷2] 4 [(7+1)÷2]
N 30 30 30

PV 2176.0265 2011.5625 1864.6017

8
 QUESTION: DURATION

A 6 years annual bond with a par value of R100 has an 8.5% yield to
maturity and a coupon rate of 6%.
If there is a 100 basis points change in the interest rate.
Calculate the effective duration.
1. 3.65
2. 4.76
3. 8.48
4. 9.47

9
 SOLUTION: Duration
A 6 years annual bond with a par value of R100 has an 8.5% yield to maturity and a
coupon rate of 6%. If there is a 100 basis points change in the interest rate.
Calculate the effective duration.

1. 3.65 2. 4.76 3. 8.48 4. 9.47

Step 1 V- V0 V+
FV 100 100 100
PMT 6 6 6
I/Y 7.5 8.5 9.5
N 6 6 6
PV 92.9592 88.6160 84.5306
10
Bond Convexity
 CONVEXITY

• Duration and convexity are positively correlated.

• Convexity means the price change to rising interest rates is smaller than
the price change to falling interest rates.
• Convexity, is calculated in the same way as duration.
• However you substitute into the convexity formula

12
 EXAMPLE: CONVEXITY
A 20 year, 10% semi-annual coupon bond (R1 000 par value) is priced at a yield to maturity of 8%. The yield to
maturity changes by 1%. Calculate the convexity of the bond.
Options
1. 68.78 2. 137.55 3. 68.78 4. 137.55
STEP 1 V- V0 V+
STEP 2
FV 1000 1000 1000
PMT 50 50 50

I/YR 3.5 [(8-1)÷2] 4 (8÷2) 4.5 [(8+1)÷2]

N 40 40 (20×2) 40
PV R1 320.3261 R1 197.9277 R1 092.0079

Your Question
A 6 years annual bond with a par value of R100 has an 8.5% yield to maturity and a coupon rate of 6%. If there
is a 100 basis points change in the interest rate. Calculate the effective convexity.
Options>>1. 12.50 2. 14.57 3. 20.00 4. 25.00
13
 SOLUTION: CONVEXITY

A 6 years annual bond with a par value of R100 has an 8.5% yield to maturity and a
coupon rate of 6%. If there is a 100 basis points change in the interest rate.
Calculate the effective convexity.
1. 12.50 2. 14.57 3. 20.00 4. 25.00
Step 2
Step 1 V- V0 V+
FV 100 100 100
PMT 6 6 6
I/Y 7.5 8.5 9.5
N 6 6 6
PV 92.9592 88.6160 84.5306

14
Duration Effect
 Duration Effect
Estimates the impact that change in yield will have on price
Formulae
%ΔP = - Deffective X Δy
Where:
%Δ𝑃 = percentage change in bond price
Δ𝑦 = yield change in (basis points/ 100)

16
 Duration Effect
Past Exam Question (May 2010, Q25)
A 12% coupon bond that pays interest semi annually has an effective duration of 1.71. If the yield to
maturity increases by 100 basis points (1%), what would be the approximate change in price due to
duration (duration effect)
1. -1.71% 2. -0.20% 3. 0.12%4. 1.71%

Answer
Duration effect = - duration × % change in yield to maturity
%ΔP = - Deffective X Δy
= -1.71 × 1%
= -1.71%

17
 Duration Effect
Past Mock Exam Question (2021, Q23)
Calculate the change in price due to duration (duration effect), if the yield to maturity
decreases by 2% and the duration is 5.9.
1. -5.90%
2. -17.70%
3. 2.95%
4. 11.80%
Duration effect: %Δ𝑃= −𝐷(Δ𝑦)

18
 Duration Effect
Past Mock Exam Question (2021, Q23)
Calculate the change in price due to duration (duration effect), if the yield to maturity
decreases by 2% and the duration is 5.9.
1. -5.90% 2. -17.70% 3. 2.95% 4. 11.80%

Duration effect:
%Δ𝑃=−𝐷(Δ𝑦)
=−5.90(−2)
=11.80%

19
Convexity Effect
 Convexity Effect
The price of the bond change of the bond is smaller to rising rates in
comparison to falling rates: that depends on the convexity of the bond.

Formulae
%Δ𝑃=Convexity(Δ𝑦)2

Where:
%Δ𝑃 = percentage change in bond price
Δ𝑦 = yield change in decimal form

21
 Convexity Effect Calculation
Past Exam Question (Oct 2010 Q 27)
Calculate the convexity effect, if the effective convexity is 93.85 and the yield to maturity
change by 150 basis points.

1) 0.0094 2) 0.0211 3) 1.4078 4) 14.0775

Answer
Convexity effect = C(Δy/100)²
= 93.85 × (1.5/100)²
= 93.85 × 0.0002
= 0.0211

22
 Convexity Effect Calculation
Past Exam Question (June 2015 Q 27)
A bond has a convexity of 58.00. It is expected to have a change in yield of 25 basis
points. The convexity effect is closest to

1) 0.04 2) 1.45 3) 2.60 4) 5.80

Formulae
Convexity effect = C(Δy/100)²

23
 Convexity Effect Calculation
Past Exam Question (June 2015 Q 27)
A bond has a convexity of 58.00. It is expected to have a change in yield of 25 basis points. The convexity
effect is closest to

1) 0.04 2) 1.45 3) 2.60 4) 5.80

Answer
Convexity effect = C(Δy/100)²
= 58.00 × (0.25/100)²
= 58.00 × 0.0002
= 0.03625

24
Total Effect
 COMBINED OR TOTAL EFFECT
• Combined effect take into account Duration and convexity into account.
• By combining the the duration effect and convexit, you get a more
accurate result in price change taking both factors into account.
• %ΔP = Duration effect + Convexity effect
• %ΔP = - Deffective (Δy) + Convexity(Δ𝑦)2

26
 Convexity Effect Calculation
Past Exam Question (June 2015 Q 28)
An economist expects that future bond yields will decline by 200 basis points. As an analyst,
you are requested to estimate the price change of a bond that has an effective duration of 10.5
and convexity of 97.3. The estimated percentage change in price is closest to:

1) 17.11% 2) 19.05% 3) 22.95% 4) 24.89%

Formulae
%ΔP = - Deffective (Δy) + Convexity(Δ𝑦)2

27
 Total Effect Calculation
Past Exam Question (June 2015 Q 28)
An economist expects that future bond yields will decline by 200 basis points. As an analyst, you are
requested to estimate the price change of a bond that has an effective duration of 10.5 and convexity of
97.3. The estimated percentage change in price is closest to:

1) 17.11% 2) 19.05% 3) 22.95% 4) 24.89%

Formulae
%ΔP = - Deffective (Δy) + Convexity(Δ𝑦)2
%ΔP = (-10.5 X -0.02) + (97.3 X -0.022)
= 0.2100 + 0.0389
= 24.89%

28
Horizon Yield
 Horizon Yield
• YtM assumes coupons are reinvested at same rate throughout the life of the
bond
• Interest rates change often
• Coupons can only be re-invested at prevailing interest rate
• Horizon yield or realised compound yield captures that reality

30
 Horizon Yield
Example
You purchase a 3-year annual paying R1,000 par value bond, with an 8% coupon and a yield to
maturity of 7.5%. The market price of the bond is R1,013. After you purchase the bond, one year
interest rates are as follows, year 1 = 12%, years 2 = 10%, year 3 = 8%. Calculate the realized
compound yield, if you hold the bond to maturity and interest is paid annually

1. 7.23% 2. 7.47% 3. 7.59% 4. 7.86%

Illustration

31
 Example
You purchase a 3-year annual paying R1,000 par value bond, with an 8% coupon and a yield to
maturity of 7.5%. The market price of the bond is R1,013. After you purchase the bond, one year
interest rates are as follows, year 1 = 12%, years 2 = 10%, year 3 = 8%. Calculate the realized
compound yield, if you hold the bond to maturity and interest is paid annually

1. 7.23% 2. 7.47% 3. 7.59% 4. 7.86%

Answer
Step 1: Calculate the future value of reinvested coupons
=R80(1.10)(1.08) + R80(1.08) + R80
=R88.00 + R86.40 + R80 =R261.44
Step 2: Calculate the total future value
= Future value of reinvested coupons + par value of bond
= R254.40 +R1 000 =R1 261.44
Step 3: Calculate the realized compound or horizon yield
FV R1 261.44 PV -R1 013 N 3
COMP I/YR 7.59%
32
 Horizon Yield
Q X Practice Question
You purchase a 4-year annual paying R1,000 par value bond, with an 10% coupon and a yield to
maturity of 16%. The market price of the bond is R832.11. After you purchase the bond, one year
interest rates are as follows, year 1 = 10%, years 2 = 15%, year 3 = 10%, year 4 = 5%. Calculate the
realized compound yield or horizon yield, if you hold the bond to maturity and interest is paid annually

1. 4.70% 2. 8.92% 3. 14.96% 4. 16.12%

33
 Horizon Yield
Q X Practice Question
You purchase a 4-year annual paying R1,000 par value bond, with an 10% coupon and a yield to
maturity of 16%. The market price of the bond is R832.11. After you purchase the bond, one year
interest rates are as follows, year 1 = 10%, years 2 = 15%, year 3 = 10%, year 4 = 5%. Calculate the
realized compound yield or horizon yield, if you hold the bond to maturity and interest is paid annually

1. 4.70% 2. 8.92% 3. 14.96% 4. 16.12%

Illustration

34
 Horizon Yield
Q X Practice Question
You purchase a 4-year annual paying R1,000 par value bond, with an 10% coupon and a yield to
maturity of 16%. The market price of the bond is R832.11. After you purchase the bond, one year
interest rates are as follows, year 1 = 10%, years 2 = 15%, year 3 = 10%, year 4 = 5%. Calculate the
realized compound yield or horizon yield, if you hold the bond to maturity and interest is paid annually

1. 4.70% 2. 8.92% 3. 14.96% 4. 16.12%

Answer
Step 1: Calculate the future value of reinvested coupons
=R100x1.15x1.1x1.05 + R100x1.1x1.05 + R100x1.05 + R100
=R132.83 + R115.50 + 105.00 +R100 =R453.33
Step 2: Calculate the total future value
= Future value of reinvested coupons + par value of bond
= R453.33 +R1 000 =R1 453.33
Step 3: Calculate the realized compound or horizon yield
FV R1 453.33 PV -R832.11 N 4
COMP I/YR 14.96%
35
Horizon Yield
 Forward Rates
• Given bond yields or spot rates imply a certain interest rate in the future
• Spot rates are rates you would expect if there are no cashflows
• Rate of borrowing or lending at some future date
• This implied rate called the forward rate
• You can therefore calculate the forward rate if you know the future spot rate

Forward Rate 1 Forward Rate 2

Period 1 Period 2 … Period 3
Today

Bond Price
>Interest
Interest Interest
>Face Value
Spot Rate 1
Spot Rate 2 Spot Rate n

37
 Forward Rates
Bond Maturity Zero Coupon YTM
A 1 year 8.300%
B 2 years 9.247%
C 3 years 9.787%

Calculate the forward rate for Bond A where par value is R100.00
F = 1+ 𝑌𝑇𝑀2ൗ(1+𝑌𝑇𝑀1)-1
(1+0.09247)2
A= ൗ(1+0.083)- 1
A = 10.2%

38
 Forward Rates
Bond Maturity Zero Coupon YTM
A 1 year 8.300%
B 2 years 9.247%
C 3 years 9.787%

Calculate 1 year forward rate in 2 years

F = 1+ 𝑌𝑇𝑀3ൗ(1+𝑌𝑇𝑀2)-1
3
1+0.0987
= ൗ 1+0.09247 2- 1
= 10.88%

39
 Practice Question
Suppose the current 4 year spot rate is 18% and the current 3 year spot rate is 17%.
What is the one year forward rate in three years?
1. 14.05%
2. 17.50%
3. 21.05%
4. 23.10%

40
 Practice Question
Suppose the current 4 year spot rate is 18% and the current 3 year spot rate is 17%.
What is the one year forward rate in three years?

Calculation
FR = 1+𝑆𝑅4ൗ(1+𝑆𝑅3)-1
1+0.18 4
= ൗ 1+0.17 3- 1
= 21.05%

1. 14.05%
2. 17.50%
3. 21.05%
4. 23.10%

41
 THANK YOU

Yumna Gutta & Dr John Nyamunda

Yumnagutta@gmail.com

Website