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portfolio….

BOAR D

SFFAS 1 – Accounting for Selected Assets and

Liabilities

in Market-based and marketable Treasury

securities, the market valuation should be

disclosed.

From the FedInvest system you can select Prior Days

Prices which takes you to a listing of price files. You can

choose the price file for the particular day you wish to

value your portfolio.

Once you choose the price file you use the End

of Day price to calculate your market value.

Duration

• We know:

– An increase in interest rates causes

bond prices to fall, and a decrease in

interest rates causes bond prices to

rise.

securities tend to be more volatile in

price.

– For a given change in interest rates, the

price of a longer term bond generally

changes more than the price of a shorter

term bond.

• Two bonds with the same term to

maturity do not have the same

interest-rate risk.

– A 10 year zero coupon bond makes all

of its payments at the end of the

term.

– A 10 year coupon bond makes

payments before the maturity date.

• When interest rates rise, the prices

of low coupon securities tend to fall

faster than the prices of high

coupon securities.

• Similarly, when interest rates

decline, the prices of low coupon

rate securities tend to rise faster

than the prices of high coupon rate

securities.

• Knowledge of the impact of

varying coupon rates on security

price volatility led to the

development of a new index of

maturity other than straight

• calendar

The new time.

measure permits analysts

to construct a linear relationship

between term to maturity and

security price volatility, regardless

of differing coupon rates.

Duration…

is the measure of the price sensitivity of

a fixed-income security to an interest

rate change of 100 basis points. The

calculation is based on the weighted

average of the present values for all

cash flows.

Duration is measured in years; however,

do not confuse it with a bond’s maturity.

For all bonds, duration is shorter than

maturity except zero coupon bonds,

whose duration is equal to maturity. This

is because all cash flows are received at

maturity.

The term “duration,” having a special meaning in the context of bonds, is

a measurement of how long in years it takes for the price of a bond to be

repaid by its internal cash flows. It is an important measure for investors

to consider, as bonds with higher durations are more risky and have

higher price volatility than bonds with lower durations.

For each of the two basic types of bonds the duration is the following:

1. Zero-coupon bond – Duration is equal to its time to maturity.

2. Straight bond – Duration will always be less than its time to

maturity.

Here are some visual models that demonstrate the properties of duration

for a zero-coupon bond and a straight bond.

Duration of a Zero-Coupon Bond

The red lever above represents the four-year time period it takes for a zero

coupon to mature. The money bag balancing on the far right represents the

future value of the bond, the amount that will be paid to the bondholder at

maturity. The fulcrum, or the point holding the lever, represents duration,

which must be positioned where the red lever is balanced. The fulcrum

balances the red lever at the point on the time line when the amount paid

for the bond and the cash flow received from the bond are equal. Since the

entire cash flow of a zero-coupon bond occurs at maturity, the fulcrum is

located directly below this one payment.

Duration of a Straight Bond

Consider a straight bond that pays coupons annually and matures in five years.

Its cash flows consist of five annual coupon payments and the last payment

includes the face value of the bond.

The moneybags represent the cash flows you will receive over the five-year period.

To balance the red lever (at the point where total cash flows equal the amount

paid for the bond), the fulcrum must be further to the left, at a point before

maturity. Unlike the zero-coupon bond, the straight bond pays coupon payments

throughout its life and therefore repays the full amount paid for the bond sooner.

Factors Affecting Duration

It is important to note, however, that duration changes as the coupons are

paid to the bondholder. As the bondholder receives a coupon payment, the

amount of the cash flow is no longer on the timeline, which means it is no

longer counted as a future cash flow that goes towards repaying the

bondholder. Our model of the fulcrum demonstrates this: as the first

coupon payment is removed from the red lever (paid to the bondholder), the

lever is no longer in balance (because the coupon payment is no longer

counted as a future cash flow).

The fulcrum must now move to the right in order to balance the

lever again:

the life of the bond, the duration is continually decreasing as time to the

bond’s maturity decreases. The movement of time is represented above as

the shortening of the red lever: notice how the first duration had five payment

periods and the above diagram has only four. This shortening of the timeline,

however, occurs gradually, and as it does, duration continually decreases. So,

in summary, duration is decreasing as time moves closer to maturity, but

duration also increases momentarily on the day a coupon is paid and removed

from the series of future cash flows – all this occurs until duration, as it does

for a zero-coupon bond, eventually converges with the bond’s maturity.

Duartion – Other factors:

Coupon rate and Yield also affect the bond’s duration. Bonds with high

coupon rates and in turn high yields will tend to have a lower duration

than bonds that pay low coupon rates, or offer a low yield. This makes

sense, since when a bond pays a higher coupon rate the holder of the

security received repayment for the security at a faster rate. The

diagram below summarizes how duration changes with coupon rate and

yield.

Macaulay

Duration

The formula usually used to calculate a bond’s basic duration is the

Macaulay duration, which was created by Frederick Macaulay in 1938 but

not commonly used until the 1970s.

Macaulay duration is calculated by adding the results of multiplying the present

value of each cash flow by the time it is received, and dividing by the total price

of the security. The formula for Macaulay duration is as follows:

t = time to maturity

C = cash flow

i = yield to maturity

M = maturity par value

If you hold a five-year bond with a par value of $1,000 and a coupon rate of 5%.

For simplicity, assume that the bond is paid annually and that interest rates are

3% (yield).

n = number of cash flows

t = time to maturity

C = cash flow

i = yield to maturity

M = maturity par value

Fortunately if you are seeking the Macaulay duration of a zero-coupon bond, the

duration would be equal to the bond’s maturity, so there is no calculation

required.

Therefore…the lower the coupon rate, the

higher the duration of the bond.

Coupon Bonds: duration is shorter than

maturity

Discount bonds (yield is greater than

coupon): duration increases at a decreasing

rate up to a point, after which it declines

maturity.

duration increases throughout but at a lesser

rate than with a par value bond.

Duration depends on yield-to-maturity.

duration, other things being equal.

In Treasury bonds, the only source of

risk stems from interest rate

changes.

Duration is a measure of this source

of risk.

maturities and coupon rates to be

directly compared.

@DURATION(settlement;maturity;coupon;yield;[frequency];[

basis]) calculates the annual duration for a security that

pays periodic interest.

Example

A security has a July 1, 1993, settlement date and a

December 1, 1998, maturity date. The semiannual coupon

rate is 5.50% and the annual yield is 5.61%. The bond has a

30/360 day-count basis.

To determine the security's annual duration:

@DURATION(@DATE(93;7;1);@DATE(98;12;1);0.055;0.0561;

2;0) = 4.734591

DURATION(settlement,maturity,coupon

yld,frequency,basis)

Example

A bond has the following terms:

January 1, 1998, settlement date

January 1, 2006, maturity date

8 percent coupon

9.0 percent yield

Frequency is semiannual

Actual/actual basis

The duration (in the 1900 date system) is:

DURATION("1/1/1998","1/1/2006",0.08,0.09,2,1)

equals 5.993775

http://www.investopedia.com/calculator/MDuration.aspx

Email Fedinvestor@bpd.treas.gov if you would

like to receive either or both of the reports.

Duration) you would like to receive, the

Account Fund Symbol(s), and a date for which

you want the information.

Questions?

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