Bond Portfolio Management

Maturity YTM Forward Rate Price (for parts c, d)

1 year 10%
$1,000/1.10 =
$909.09
2 years 11% (1.11
2
/1.10) 1 =
12.01%
$1,000/1.11
2
=
$811.62
3 years 12% (1.12
3
/1.11
2
) 1 =
14.03%
$1,000/1.12
3
=
$711.78
Maturity Price YTM
1 year $1,000/1.1201 = $892.78 12.01%
2 years $1,000/(1.1201 1.1403) = $782.93 13.02%
(a)
(b)
% 00 . 10 1 1000 . 1 1
62 . 811 $
78 . 892 $
= =
% 00 . 10 1 1000 . 1 1
78 . 711 $
93 . 782 $
= =
Next year, the 2-year zero will be a 1-year zero, and will therefore
sell at a price of: $1,000/1.1201 = $892.78.

Similarly, the current 3-year zero will be a 2-year zero and
will sell for: $782.93. Expected total rate of return:

2-year bond:
3-year bond:
Change in Bond Price as a Function of Change
in Yield to Maturity
1. Bond prices and yields are inversely related.
2. An increase in a bonds yield to maturity results in a
smaller price change than a decrease of equal
magnitude.
3. Long-term bonds tend to be more price sensitive than
short-term bonds.
Bond Pricing Relationships
4. As maturity increases, price sensitivity increases at a
decreasing rate.
5. Interest rate risk is inversely related to the bonds
coupon rate.
6. Price sensitivity is inversely related to the yield to
maturity at which the bond is selling.
Bond Pricing Relationships
Prices of 8% Coupon Bond (Coupons Paid
Semiannually)
Prices of Zero-Coupon Bond (Semiannual
Compounding)
A measure of the effective 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
Duration is shorter than maturity for all bonds except zero
coupon bonds.
Duration is equal to maturity for zero coupon bonds.
Duration
| | Price ) 1 ( y
CF w
t
t t
+ =
t w t D
T
t

=
=
1
Duration: Calculation

CF
t
=cash flow at time t
A bond of face value Rs.100, coupon rate 12% (payable
annually) for a maturity of 6 years is trading at a yield of 14%.

Compute the Duration of the bond.
0 1 2 3 4 5 6
12 12 12 12 12 112
Pv of
inflow 10.52 9.23 8.099 7.104 6.232 51.02
6 * 02 . 51 5 * 23 . 6 4 * 1 . 7 3 * 09 . 8 2 * 23 . 9 1 * 52 . 10 ) , ( * *
1
+ + + + + =

=
n
t
t
t r PVIF C t
22 . 92 = PV
D=4.54 yrs
Price change is proportional to duration
and not to maturity



D
*
= modified duration

Duration/Price Relationship
(1 )
1
P y
Dx
P y
( A A +
=
(
+

*
P
D y
P
A
= A
Duration
Consider a zero coupon bond having maturity of 4.54years
and the bond in the previous example.

What is the % change in Price if YTM increases by 0.1% for
both of the bonds.
Price

55.16
New Price

54.94
% change -0.40%
Price 92.22
New Price 91.86
% change -0.40%
Coupon Bond
Zero Coupon Bond
Bond Duration versus
Bond Maturity
Rules for Duration
Rule 1 The duration of a zero-coupon bond equals its time to
maturity

Rule 2 Holding maturity constant, a bonds duration is higher
when the coupon rate is lower

Rule 3 Holding the coupon rate constant, a bonds duration
generally increases with its time to maturity


Rules for Duration
Rule 4 Holding other factors constant, the duration of a
coupon bond is higher when the bonds yield to
maturity is lower

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


Convexity
The relationship between bond prices and yields is
not linear.

Duration rule is a good approximation for only small
changes in bond yields.

Bonds with greater convexity have more curvature in
the price-yield relationship.
Bond Price Convexity: 30-Year Maturity, 8%
Coupon; Initial YTM = 8%
A bond of face value Rs.100, coupon rate 12% for a maturity
of 6 years is trading at a yield of 14%.
Compute the % change in price (for a 1% decrease/increase in
YTM) using the duration rule.
Compute the actual % change in price if YTM increases by
1%? What if the YTM decreases by 1%?
YTM 13% 15%
Old Price

92.22

92.22
New Price

96.00

88.65
% change 4.10% -3.88%
% 98 . 3 % 1 *
%) 14 1 (
54 . 4
% =
+

= change
As per Duration rule
Actual Change
Convexity

=
(

+
+ +
=
n
t
t
t
t t
y
CF
y P
Convexity
1
2
2
) (
) 1 ( ) 1 (
1
Correction for Convexity:
2
1
[ ( ) ]
2
P
D y Convexity y
P
A
= -A + A
A bond of face value Rs.100, coupon rate 12% for a maturity
of 6 years is trading at a yield of 14%. Given the duration of
bond is 4.54 years while its convexity is 22.075
Compute the % change in price (after correcting for
convexity) if YTM decreases by 1% and if it increase by 1%?
% 87 . 3 2 %)^ 1 ( * 075 . 22 * 5 . 0 % 1 *
%) 14 1 (
54 . 4
) ( %
% 09 . 4 2 %)^ 1 ( * 075 . 22 * 5 . 0 % 1 *
%) 14 1 (
54 . 4
) ( %
= +
+

=
= +
+
=
increase for change
decrease for change
% Change in Price after correcting for Convexity
Convexity of Two Bonds
Why do Investors Like Convexity?
Bonds with greater curvature gain more in price when yields
fall than they lose when yields rise.
The more volatile interest rates, the more attractive this
asymmetry.
Bonds with greater convexity tend to have higher prices
and/or lower yields, all else equal.

Callable Bonds
As rates fall, there is a ceiling on the bonds market
price, which cannot rise above the call price.
Negative convexity
Use effective duration:

/
Effective Duration =
P P
r
A
A
Price Yield Curve for a Callable Bond
Mortgage-Backed Securities
The number of outstanding callable corporate bonds
has declined, but the MBS market has grown rapidly.
MBS are based on a portfolio of callable amortizing
loans.
Homeowners have the right to repay their loans at
any time.
MBS have negative convexity.

Mortgage-Backed Securities
Often sell for more than their principal balance.
Homeowners do not refinance as soon as rates drop, so
implicit call price is not a firm ceiling on MBS value.
Tranches the underlying mortgage pool is divided into a set
of derivative securities
Price-Yield Curve for a Mortgage-Backed
Security