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Bond A B C Z

Coupon 6 6 10 0

Maturity(yrs) 10 20 20 20

• Higher the maturity of the bond, greater is the change in price in

response to change in yield.

• Price of a zero-coupon bond is more sensitive to yield changes than

a coupon bond.

• A bond with higher coupon is less sensitive than a bond with lower

coupon. [As bond with higher coupon gets the cash flows earlier

than the bond with lower coupon, assuming both bonds have same

maturity period]

• We have established the following:

– Giv en equ al coup on s, lo nger m atu rity bon ds are m ore

sens itiv e to yield chan ges.

– Giv en equ al matu rities, h igh er cou pon bonds ar e less

sens itiv e to yield chan ges.

• Expectation of Portfolio Manager based on interest rate movement –

– In a declining interest rate scenario portfolio manager will prefer

• Longer Maturity bonds

• Lower coupon bonds

– But if bonds differ by both maturity and coupon – and the impacts of the

two on price sensitivity are in opposite directions, as is the case with

bonds A and C – a judgment about relative price sensitivities is more

difficult. This is where Duration comes in.

Duration

• Duration measures the average maturity of a bond’s total cash flows

– coupon as well as principal.

• The average is weighted by the present value dollars paid in each

period.

• Thus, duration encompasses all the parameters of a bond –

maturity, coupon and yield.

• Duration is the tool we are looking for: the one measure of bond

price sensitivity to yield changes.

Duration Parameters

• Duration rises with maturity

• Higher coupon means lower Duration [Duration of a zero-coupon

bond is equal to its maturity as it has only one cash flow]

• Duration is inversely related to yield

• Higher duration bond is more sensitive to interest rate movements.

duration as a measure of price sensitivity to yield changes. Small

changes in yield hardly change the bond’s duration.

Duration…

• Absolute Price Change

∆P Dur For semi-annual coupon bonds

--- = - ------- X P divide y by 2, for quarterly

coupon bonds divide y by 4.

∆y (1+y)

∆P /P Dur

--- = - -------

∆y (1+y)

• Duration

Macaulay Duration

• 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.

Modified Duration …

• - Duration = ∆P (1+y) / (P * ∆y)

• The presence of the 1+y term (or 1+y/2 for semi-annual bonds) in

the denominators makes comparison difficult

• To address this we have Modified Duration

Mod. Duration = Duration/(1+y) [or Mac.Duration/(1+y)]

∆P/P = − Mod.Dur x ∆y

Mod. Duration = - ∆P/(P x ∆y)

• Armed with the modified durations of all the bonds currently in the

portfolio or with the potential to be there, a trader can easily and

quickly estimate the impacts of expected yield changes on bond

prices.

• For example, a half-percent increase in yield to maturity on the bond

(duration=5½ years) results in a 2.75% drop in its price. If a bond’s

duration is 12 years, a ten basis point drop in yield produces a 1.2%

increase in price

Portfolio Duration

• Duration of portfolio is calculated by assigning weights to bonds.

• Using portfolio duration as a measure of price sensitivity is only

relevant when the assumed interest rate change is the same (or

nearly the same) for all the bonds in the portfolio.

• If, for Bond1 (maturity 4 yrs) the four-year yield rises by half a

percent and for Bond2 (maturity 10 yrs) the ten-year by one and a

half percent, even though the average increase is one percent, the

resulting price change of the portfolio will be quite different.

• In other words, portfolio duration as a measure of price sensitivity is

only accurate for a parallel shift in the yield curve.

Zero Duration

• Duration reflects the degree of sensitivity of a bond – or a portfolio

of bonds – to interest rate changes. A zero duration means no

sensitivity.

• Why is there no sensitivity? Because the effect of a change in

interest rates on the bond owned should be matched – in the

opposite direction – by its effect on the bond sold short.

• Hedging, therefore, represents a situation where a portfolio is

insulated from interest rate shifts in the market.

• Note again, though, that this assumes a parallel shift in the yield

curve. If the yields on the four and ten-year notes move differently,

the hedge will not remove the interest rate risk.

• The ten-year’s dollar duration is nearly double that of the four-year.

Therefore, only about half of a ten-year needs to be sold for every

one four-year held to achieve zero duration.

Problem with Duration

• When interest rates fall, Duration understates positive effect on

bond’s price.

– For e.g. if interest rates fall by 0.5%, bond price may actually rise

by $2.053, but duration may predict a price rise of $2.033.

• Similarly when interest rates rise, Duration overstates the drop in

bond’s price.

– For e.g. if interest rates rise by 0.5%, bond price may actually fall

by $1.99, but duration may predict a price fall of $2.01.

Convexity

• As yield-to-maturity declines, the rise in the bond’s price becomes

larger and larger.

• Conversely, as the yield increases, each successive fall in price is

smaller than the one before.

• This relationship between yield and price is called its convexity. It

exists because the shape of the price-yield curve is convex [and not

linear].

Convexity …

Why duration is inaccurate in measuring the effect of yield changes on

price?

• Duration and YTM are inversely related.

• As yields rise, duration falls. Thus, the next yield increase has less

of a negative effect on price since duration is lower.

• As yields fall, duration rises. Thus, the next yield decline has more

of a positive effect on price since duration is higher.

• Using the duration method to calculate the new price of a bond

following a yield change – negative or positive – will, therefore, be

inaccurate (and always too low) since the bond’s original duration is

used in the calculation and the duration itself changes.

Convexity …

• In short, duration is only an estimate of the effect of yield-to-maturity

changes on bond price, as it effectively assumes the price-yield

relationship is linear (mathematically, it has a constant slope).

• Since, in fact, it is not linear (the slope declines as yield rises), using

duration will over or understate the effect.

• Convexity is a measure of the difference between what this

estimate of price change is, and the actual price change.

of successive yield declines

Price accelerate and the negative

effects of yield increases

decelerate is obviously an

attractive feature of bonds that

Convexity display convexity.

Duration The more convex a bond, the

more attractive.

Yield

Convexity …

• During times of volatility in rates, investors prefer bonds with higher

convexity.

• Thus, when an increase in volatility is expected, for example, a less

convex bond should be sold along with the purchase of the more

convex security in a combination that produces a zero duration.

• Thus, if volatility is feared, the convexity characteristic makes more

sense. In other words, the more risk averse the investor, combined

with a fear of volatility, the more preferable convexity is to yield.

• Conversely, investors with greater tolerance for risk or less

anxiousness about future volatility will opt for higher yield and not

need the convexity. A more convex portfolio, in a sense, may be

considered a defensive market position.

Negative Convexity

• For a non-callable bond, there is an inverse relationship between

duration and yield

• Negative convexity means that as market yields decrease, duration

decreases as well.

• Since this is an unfavorable characteristic of a bond, investors

demand a higher yield.

• Negatively convex bonds (such as callable corporates and

mortgages) thus yield more than otherwise equivalent non-callable,

or positively convex, bonds.

• Investors expecting stability in yields are attracted to such bonds.

Determinants of Convexity

• Duration: convexity increases with duration, since a higher duration

means more of the bond’s cash flows occur later in time, which

enhances the “curvature” of the yield-price relationship

• Maturity: unlike duration, whose increase will decelerate as maturity

lengthens, convexity tends to accelerate (mathematically, this is

because convexity is related to the second derivative – the “square”

of time)

• Coupon: a higher coupon will reduce convexity, as the importance

of earlier cash flows to the bond’s value increases

• Dispersion of cash flows: for the same duration, a security whose

cash flows are more dispersed around a mean will have greater

convexity since the addition to convexity supplied by the later cash

flows more than offsets the subtraction from convexity due to the

earlier cash flows

• Yield: a higher yield will also reduce convexity, since it shifts the

relative weightings to earlier cash flows

• Any call features attached to the bond.

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