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8/1/12

Exhibit 4-1

Required Yield (%)

6.00 7.00 8.00 8.50 8.90 8.99 9.00 9.01 9.10 9.50 10.00 11.00 12.00 8/1/12

**Price–Yield Relationship for Six Hypothetical Bonds Price at Required Yield (coupon/maturity in years)
**

9% / 5 9% / 25 112.7953 138.5946 108.3166 123.4556 104.0554 110.7410 102.0027 105.1482 100.3966 100.9961 100.0395 100.0988 100.0000 99.9604 99.6053 98.0459 96.1391 92.4624 88.9599 100.0000 99.9013 99.0199 95.2539 90.8720 83.0685 76.3572 6% / 5 100.0000 95.8417 91.8891 89.9864 88.4983 88.1676 88.1309 88.0943 87.7654 86.3214 84.5565 81.1559 77.9197 6% / 25 100.0000 88.2722 78.5178 74.2587 71.1105 70.4318 70.3570 70.2824 69.6164 66.7773 63.4881 57.6712 52.7144 0% / 5 74.4094 70.8919 67.5564 65.9537 64.7017 64.4236 64.3928 64.3620 64.0855 62.8723 61.3913 58.5431 55.8395 24-2 0% / 25 22.8107 17.9053 14.0713 12.4795 11.3391 11.0975 11.0710 11.0445 10.8093 9.8242 8.7204 6.8767 5.4288

Copyright © 2010

Exhibit 4-2

Shape of Price-Yield Relationship for an Option-Free Bond Maximum Price

Price

Yield

8/1/12 Copyright © 2010 34-3

**Price Volatility Characteristics of Option-Free Bonds
**

There are four properties concerning the price volatility of an option-free bond: (i) Although the prices of all option-free bonds move in the opposite direction from the change in yield required, the percentage price change is not the same for all bonds. (ii) For very small changes in the yield required, the percentage price change for a given bond is roughly the same, whether the yield required increases or decreases.

v

8/1/12

Copyright © 2010

44-4

(i)

For large changes in the required yield, the percentage price change is not the same for an increase in the required yield as it is for a decrease in the required yield. For a given large change in basis points, the percentage price increase is greater than the percentage price decrease. An explanation for these four properties of bond price volatility lies in the convex shape of the price-yield relationship.

(ii)

(v)

8/1/12

Characteristics of a Bond that Affect its Price Volatility There are two characteristics of an option-free bond that determine its price volatility: coupon and term to maturity. 1) First, for a given term to maturity and initial yield, the price volatility of a bond is greater, the lower the coupon rate. ü) This characteristic can be seen by comparing the 9%, 6%, and zero-coupon bonds with the same maturity.

v

8/1/12

2)

Second, for a given coupon rate and initial yield, the longer the term to maturity, the greater the price volatility. This can be seen in Exhibit 4-3 by comparing the five-year bonds with the 25-year bonds with the same coupon.

ü)

8/1/12

EXHIBIT 4-3

Instantaneous Percentage Price Change for Six Hypothetical Bonds

**Six hypothetical bonds, priced initially to yield 9%:
**

9% coupon, 5 years to maturity, price = 100.0000 9% coupon, 25 years to maturity, price = 100.000 6% coupon, 5 years to maturity, price = 88.1309 Yield (%) Change to: 6.00 7.00 8.00 8.50 8.90 8.99 9.01 9.10 9.50 10.00 11.00 12.00 8/1/12 Change in Basis Points -300 -200 -100 -50 -10 -1 1 10 50 100 200 300 6% coupon, 25 years to maturity, price = 70.3570 0% coupon, 5 years to maturity, price = 64.3928 0% coupon, 25 years to maturity, price = 11.0710

Percentage Price Change (coupon/maturity in years) 9% / 5 9% / 25 12.80 38.59 8.32 23.46 4.06 2.00 0.40 0.04 -0.04 -0.39 -1.95 -3.86 -7.54 -11.04 10.74 5.15 1.00 0.10 -0.10 -0.98 -4.75 -9.13 -16.93 -23.64 6% / 5 13.47 8.75 4.26 2.11 0.42 0.04 -0.04 -0.41 -2.05 -4.06 -7.91 -11.59 6% / 25 42.13 25.46 11.60 5.55 1.07 0.11 -0.11 -1.05 -5.09 -9.76 -18.03 -25.08 84-8 0% / 5 15.56 10.09 4.91 2.42 0.48 0.05 -0.05 -0.48 -2.36 -4.66 -9.08 -13.28 0% / 25 106.04 61.73 27.10 12.72 2.42 0.24 -0.24 -2.36 -11.26 -21.23 -37.89 -50.96

**Price Volatility Characteristics of Option-Free Bonds (continued)
**

v

Effects of Yield to Maturity

Ø

Ø

§

ü

We cannot ignore the fact that credit considerations cause different bonds to trade at different yields, even if they have the same coupon and maturity. Holding other factors constant, the higher the yield to maturity at which a bond trades, the lower the price volatility. To see this, compare the 9% 25-year bond trading at various yield levels in Exhibit 4-4 The 1st column of Exhibit 4-4 shows the yield level the bond is trading at, and the 2nd column gives the initial price.

94-9

8/1/12

ü

The 3rd column of Exhibit 4-4 indicates the bond’s price if yields change by 100 basis points. The 4th and 5th columns of Exhibit 4-4 show the dollar price decline and the percentage price decline. The 4th and 5th columns of Exhibit 4-4 also show: higher the initial yield, the lower the price volatility. An implication of this is that for a given change in yields, price volatility is greater (lower) when yield levels in the market are low (high).

ü

ü

ü

8/1/12

EXHIBIT 4-4 Price Change for a 100-Basis-Point Change in Yield for a 9% 25Year Bond Trading at Different Yield Levels Initial Price New Price a

Yield Level (%)

Price Decline

Percent Decline

7 8 9 10 11 12 13 14 8

$123.46 110.74 100.00 90.87 83.07 76.36 70.55 65.50 110.74

$110.74 100.00 90.87 83.07 76.36 70.55 65.50 61.08 100.00

$12.72 10.74 9.13 7.80 6.71 5.81 5.05 4.42 10.74

10.30 9.70 9.13 8.58 8.08 7.61 7.16 6.75 9.70

a As a result of a 100-basis-point increase in yield.

8/1/12

Copyright © 2010

114-11

**Measures of Bond Price Volatility
**

v

Money managers, arbitrageurs, and traders need to have a way to measure a bond’s price volatility to implement hedging and trading strategies. Three measures that are commonly employed: price value of a basis point yield value of a price change duration

v

1) 2) 3)

8/1/12

Copyright © 2010

124-12

**Measures of Bond Price Volatility (continued)
**

Price Value of a Basis Point Ø The price value of a basis point, also referred to as the dollar value of an 01, is the change in the price of the bond if the required yield changes by 1 basis point. Ø Note that this measure of price volatility indicates dollar price volatility as opposed to percentage price volatility (price change as a percent of the initial price).

v

8/1/12

Copyright © 2010 Pearson Copyright Inc. Publishing as Education, © 2010

134-13

4-13

Typically, the price value of a basis point is expressed as the absolute value of the change in price. Ø Price volatility is the same for an increase or a decrease of 1 basis point in required yield. Ø Because this measure of price volatility is in terms of dollar price change, dividing the price value of a basis point by the initial price gives the percentage price change for a 1-basis-point change in yield.

Ø

8/1/12

**Measures of Bond Price Volatility (continued)
**

Yield Value of a Price Change Ø Another measure of the price volatility of a bond used by investors is the change in the yield for a specified price change. Ø This is estimated by first calculating the bond’s yield to maturity if the bond’s price is decreased by, say, X dollars. Ø Then the difference between the initial yield and the new yield is the yield value of an X dollar price change.

v

8/1/12

Copyright © 2010 Pearson Copyright Inc. Publishing as Education, © 2010

154-15

4-15

Price volatility is the same for an increase or a decrease of 1 basis point in required yield. Ø The smaller this value, the greater the dollar price volatility, because it would take a smaller change in yield to produce a price change of X dollars.

Ø

8/1/12

Duration

•

A measure of the effective average maturity of a bond. The weighted average of the times until each payment is received, with the weights proportional to the present value of the payment. – Macaulay Duration Duration is shorter than maturity for all bonds except zero coupon bonds. Duration is equal to maturity for zero coupon bonds.

•

•

•

Duration

•

Duration is calculated as:

So, Macaulay’s duration is a weighted average of the time to receive the present value of the cash flows • The weights are the present values of 8/1/12 the bond’s cash flows as a proportion

•

**Measures of Bond Price v Duration Volatility (continued)
**

Ø

The Macaulay duration is one measure of the approximate change in price for a small change in yield:

1C M a c a u la y d u r a t i o n =

( 1+ y)

1

+

2C

(

1 )+ y

2

+ . . .+

(

+ 1 y (+ )

n

nC

nM

)1

n

y

P

where P = price of the bond C = semiannual coupon interest (in dollars) y = one-half the yield to maturity or required yield n = number of semiannual periods (number of years times 2) M = maturity value (in dollars)

8/1/12

Copyright © 2010 Pearson Education, Inc. Publishing as

194-19

4-19

Calculating Duration

•

**Consider a 2 year bond with a YTM of 5% per six-months:
**

964. 0 54 4 0 1 4 0 2 4 0 3 1,0 4 00 0 4

•

Note that this is 3.77 six-month periods, which is about 1.89 years 8/1/12

**Duration Calculation: Spreadsheet
**

8 Bo % nd Ti yea me rs . 5 1 1 . 5 2 . 0 Payme nt 4 0 4 0 4 0 10 40 su m PV of (10 CF %) 38.0 95 36.2 81 34.5 53 855.6 11 964.5 40 Weig ht . 039 5 . 037 6 . 035 .8 88 71 1.0 00 C1 C X 4 . 019 7 . 037 6 . 053 7.77 1 42 1.88 52

**Rules for Duration
**

Rule 1 The duration of a zero-coupon bond equals its time to maturity. Rule 2 Holding maturity constant, a bond’s duration is higher when the coupon rate is lower. Rule 3 Holding the coupon rate constant, a bond’s duration generally increases with its time to maturity. Rule 4 Holding other factors constant, the duration of a coupon bond is higher when the bond’s yield to maturity is lower.

8/1/12

**Rules for Duration (cont’d)
**

Rules 5 The duration of a level perpetuity is equal to: (1 +y)

y

**Rule 6 The duration of a level annuity is equal to: 1 + y T
**

y − (1 + y ) T − 1

8/1/12

**Rules for Duration (cont’d)
**

Rule 7 The duration for a coupon bond is equal to:

1 + y (1 + y ) + T (c − y ) − T y c[(1 + y ) − 1] + y

8/1/12

v

Ø

Duration

Investors refer to the ratio of Macaulay duration to 1 + y as the modified duration. The equation is:

**where y = one-half the yield to maturity or required yield.
**

Ø

The modified duration is related to the approximate percentage change in price for a given change in yield as given by:

dP 1 = −m o d i f i e d d u r a t i o n dy P

**where dP = change in price, dy = change in yield, P = price of the bond.
**

8/1/12

Copyright © 2010 Pearson Copyright Inc. Publishing as Education, © 2010

254-25

4-25

Ø

There is a consistency between the properties of bond price volatility and the properties of modified duration. For example, a property of modified duration is that, ceteris paribus, a bond with a longer maturity will have a greater modified duration. Generally, a lower coupon rate implies a greater modified duration and a greater price volatility.

§

§

8/1/12

**Measures of Bond Price Volatility (continued)
**

v

Ø

**Approximating the Percentage Price Change
**

The below equation can be used to approximate the percentage price change for a given change in required yield: dP = −(m o d i f i e d d u r a t i o n ) )d y ( P Suppose that the yield on any bond changes by 100 basis points. Then, substituting 100 basis points (0.01) for dy into the above equation, we get: dP = −(m o d i f i e d d u r a t i o n ) 0 .)0 1 (= o d i f i e d d u r a (t i o n ) 1 % m− ( ) P Thus, modified duration can be interpreted as the approximate percentage change in price for a 100-basis-point change in yield.

**where dP = change in price, P = price of the bond and dy = change in yield.
**

Ø

Ø

8/1/12

274-27

4-27

**Measures of Bond Price Volatility (continued)
**

v

Approximating the Dollar Price Change

Modified duration is a proxy for the percentage change in price. Investors also like to know the dollar price volatility of a bond. Ø For small changes in the required yield, the below equation does a good job in estimating the change in price yield: dP = (dollar duration)(dy) where dP = change in price and dy = change in yield.

Ø

8/1/12

Copyright © 2010 Pearson Copyright Inc. Publishing as Education, © 2010

284-28

4-28

v

Ø

Portfolio Duration

Thus far we have looked at the duration of an individual bond. Ø The duration of a portfolio is simply the weighted average duration of the bonds in the portfolios. Ø Portfolio managers look at their interest rate exposure to a particular issue in terms of its contribution to portfolio duration.

§

This measure is found by multiplying the weight of the issue in the portfolio by the duration of the individual issue.

8/1/12

**Measures of Bond Price Volatility and Their Relationships to One Another
**

Notation:

D = Macaulay duration D* = modified duration PVBP = price value of a basis point y = yield to maturity in decimal form Y = yield to maturity in percentage terms ( Y = 100 × y) P = price of bond m= number of coupons per year

8/1/12

Copyright © 2010

304-30

**Exhibit 4-11 Measures of Bond Price Volatility and Their Relationships to One Another (continued) Relationships:
**

D D* = → by definition 1+ y m ∆P P ≈ D → to a close approximation for a small y ∆ ∆y ∆ P ∆Y ≈ slope of price-yield curve →to a close approximation for a small∆ y D* × P PVBP ≈ → to a close approximation 10, 000

For Bonds at or near par :

**PVBP = D* 100 → to a close approximation D* = ∆ P ∆ Y → to a close approximation for a small y ∆
**

8/1/12 Copyright © 2010 314-31

**Why is Duration Better than Term?
**

Earlier, it was noted that duration is a better measure than term to maturity. To see why, look at the following example: • Suppose that you are comparing two five-year bonds, and are expecting a drop in yields of 1% almost immediately. Bond 1 has a 6% coupon and bond 2 has a 12% coupon. Which would provide you with the highest potential gain if your 8/1/12

•

**Why is Duration Better than Term? (cont.)
**

•

Both bonds have equal maturity, so a superficial investigation would suggest that they will both have the same gain. However, as we’ll see bond 2 would 60 1000 gain more. actually

D1 =

∑ 1.08 ( t ) + 1.08 ( 5)

t =1 t 5

5

920.15

= 4.44

D Mod ,1 = 4.30

5

1.08

= 3.98

5

D2 =

120 1000 ∑ 1.08 ( t ) + 1.08 ( 5)

t =1 t

1159.71

= 4.11

D Mod , 2 = 4.11 = 3.81 1.08

8/1/12

**Why is Duration Better than Term? (cont.)
**

•

Note that the modified duration of bond 1 is longer than that of bond two, so you would expect bond 1 to gain more if rates actually drop.

–

Pbond 1, 8%= 920.15; Pbond 1, 7%= 959.00; gain = 38.85 Pbond 2, 8%= 1159.71; Pbond 2, 7%= 1205.01; gain = 45.30

–

•

Bond 1 has actually changed by less than bond 2. What happened? Well, if we figure the percentage change, we find that bond 1 actually gained by more than bond 2. %∆bond 1 = 4.22%; %∆bond 2 = 3.91% so your 8/1/12 is actually 31 basis points higher with bond 1. gain

•

**Why is Duration Better than Term? (cont.)
**

•

Bond price volatility is proportionally related to the modified duration, as shown previously. Another way to look at this is by looking at how many of each bond you can purchase. For example, if we assume that you have $100,000 to invest, you could buy about 108.68 units of bond 1 and only 86.23 units of bond 2. Therefore, your dollar gain on bond 1 is $4,222.14 vs. $3,906.15 on bond 2. The net advantage to buying bond 1 is $315.99. Obviously, bond 1 is the way to go.

8/1/12

•

•

Ø

When there are large movements in the required yield, dollar duration or modified duration is not adequate to approximate the price reaction. Duration will overestimate the price change when the required yield rises, thereby underestimating the new price. When the required yield falls, duration will underestimate the price change and thereby underestimate the new price.

Ø

Ø

8/1/12

Convexity

v

v

v

Ø

Because all the duration measures are only approximations for small changes in yield, they do not capture the effect of the convexity of a bond on its price performance when yields change by more than a small amount. The duration measure can be supplemented with an additional measure to capture the curvature or convexity of a bond. In Exhibit 4-12 (see below), a tangent line is drawn to the price–yield relationship at yield y*. The tangent shows the rate of change of price with respect to a change in interest rates at that point (yield level).

8/1/12

Copyright © 2010

374-37

**Exhibit 4-12 Line Tangent to the Price-Yield Relationship
**

Price Actual Price

p*

Tangent Line at y* (estimated price)

y*

8/1/12 Copyright © 2010

Yield

384-38

Convexity (continued)

v

v

v

If we draw a vertical line from any yield (on the horizontal axis), as in Exhibit 4-13 (see Overhead 4-36), the distance between the horizontal axis and the tangent line represents the price approximated by using duration starting with the initial yield y*. The approximation will always understate the actual price. This agrees with what we demonstrated earlier about the relationship between duration (and the tangent line) and the approximate price change.

8/1/12

Copyright © 2010

394-39

v

v

When yields decrease, the estimated price change will be less than the actual price change, thereby underestimating the actual price. On the other hand, when yields increase, the estimated price change will be greater than the actual price change, resulting in an underestimate of the actual price.

8/1/12

**Exhibit 4-13. Price Approximation Using Duration
**

Actual Price Price

Error in Estimating Price Based only on Duration Error in Estimating Price Based only on Duration Tangent Line at y* (estimated price)

p*

y 1

8/1/12

y 2

y* y 3

y 4

Yield

414-41

Copyright © 2010

•

DURATION REPRESENTS THE FIRST DERIVATIVE (dP/dy) of the price yield relationshi. Convexity is the 2nd derivative d²P/dy² and its effect on price for a change in yield is given by +1/2 C dy²

•

•

8/1/12

v

Ø

Measuring Convexity

Convexity (continued)

**Duration (modified or dollar) attempts to estimate a convex relationship with a straight line (the tangent line).
**

The dollar convexity measure of the bond:

2 d P d o l la r c o n v e xi ty m e a s u r e = 2 dy The approximate change in price due to convexity is:

§

§

§

**The percentage change in the price of the bond due to convexity or the convexity measure is: 2
**

§

dP =

( dolla r

convexity m easure( dy ) )

2

d P 1 2 dy P The percentage price change due to convexity is: co nvexity m easure =

dP 1 2 = ( convexity measure) ( dy ) P 2

8/1/12

Copyright © 2010 Pearson Copyright Inc. Publishing as Education, © 2010

434-43

4-43

Calculating Convexity

•

Convexity can be calculated with the following formula:

•

For the example bond, the convexity (per period) is:

8/1/12

•

The convexity per year would be 16.758/4 = 4.139

•

8/1/12

**Calculating Bond Price Changes
**

•

We can approximate the change in a bond’s price for a given change in yield by using duration and convexity: If yields rise by 1% per period, then the price of the example bond will fall by 33.84, but the approximation is:

8/1/12

•

EXHIBIT 4-14

Calculation of Convexity Measure and Dollar Convexity Measure for Five-Year 9% Bond Selling to Yield 9%

**Coupon rate: 9.00% Period, t 1 2 3 4 5 6 7 8 9 10
**

8/1/12

Term (years): 5

Initial yield: 9.00% t(t + 1)CF 9 27 54 90 135 189 252 324 405 11,495 12,980

Price: 100 t(t + 1)CF (1.045) t+2 7.886 22.641 43.332 69.110 99.201 132.901 169.571 208.632 249.560 6,778.186 7,781.020

Cash Flow 4.50 4.50 4.50 4.50 4.50 4.50 4.50 4.50 4.50 104.50 CONVEXITY = 77.81

1/(1.045)t+2 0.876296 0.838561 0.802451 0.767895 0.734828 0.703185 0.672904 0.643927 0.616198 0.589663

Convexity (continued)

Some Notes on Convexity Ø Three points to know for a bond’s convexity and convexity measure. i. Convexity refers to the general shape of the price-yield relationship, while the convexity measure relates to the quantification of how the price of the bond will change when interest rates change. ii. The approximation percentage change in price due to convexity is the product of three numbers: ½ , convexity measure, and square of the change in yield. iii. In practice different vendors compute the convexity measure differently by scaling the measure in dissimilar ways.

v

8/1/12

Copyright © 2010

484-48

Convexity

v

Ø

(continued)

Value of Convexity

Up to this point, we have focused on how taking convexity into account can improve the approximation of a bond’s price change for a given yield change. The convexity of a bond, however, has another important investment implication. The exhibit shows two bonds, A and B. The two bonds have the same duration and are offering the same yield; they have different convexities, however, Bond B is more convex (bowed) than bond A.

Ø

Ø

8/1/12

Copyright © 2010

494-49

**Exhibit 4-16 Comparison of Convexity of Two Bonds
**

Price Bond A Bond B Bond B Has Greater Convexity Than Bond A

**Bond B Bond A Yield
**

8/1/12 Copyright © 2010 504-50

Convexity (continued)

v

Ø Ø

Value of Convexity

Ø

The market considers a bond’s convexity when pricing it. If investors expect that market yields will change by very little, investors should not be willing to pay much for convexity. If the market prices convexity high, investors with expectations of low interest rate volatility will probably want to “sell convexity.”

v

Ø

i.

Properties of Convexity

**All option-free bonds have the following convexity properties.
**

As portrayed in Exhibit 4-17 , AS the required yield increases (decreases), the convexity of a bond decreases (increases). This property is referred to as positive convexity. For a given yield and maturity, lower coupon rates will have greater convexity. For a given yield and modified duration, lower coupon rates will have smaller convexity.

ii.

iii.

8/1/12

Copyright © 2010 Pearson Education, Inc.

514-51

**Exhibit 4-17 Change in Duration as the Required Yield Changes
**

Price 1 As yield ↓ Slope (duration) ↑ 2 3 As yield ↑ Slope (duration) ↓

Yield

8/1/12 Copyright © 2010 Pearson Education, Inc. 524-52

**CONCERNS ABOUT DURATION
**

v

v

i.

ii.

Relying on duration as the sole measure of the price volatility of a bond may mislead investors. There are two other concerns about using duration that we should point out. First, in the derivation of the relationship between modified duration and bond price volatility, we assume that all cash flows for the bond are discounted at the same discount rate. Second, there is misapplication of duration to bonds with embedded options.

8/1/12

**Don’t Think of Duration as a Measure of Time
**

v

v

Market participants often confuse the main purpose of duration by constantly referring to it as some measure of the weighted average life of a bond. Certain CMO bond classes are leveraged instruments whose price sensitivity or duration, as a result, are a multiple of the underlying mortgage loans from which they were created.

8/1/12

Copyright © 2010 Pearson Education, Inc.

544-54

Ø

Ø

v

Thus, a CMO bond class with a duration of 40 does not mean that it has some type of weighted average life of 40 years. Instead, it means that for a 100-basis-point change in yield, that bond’s price will change by roughly 40%. Like a CMO bond class, we interpret the duration of an option in the same way.

8/1/12

PROBLEMS

• •

BODIE CH. 16 3,4,5,6 FABOZZZI CH. 4 ; 2,3,4,5

8/1/12

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