The Duration Measure

• Since price volatility of a bond varies

inversely with its coupon and directly with
its term to maturity, it is necessary to
determine the best combination of these two
variables to achieve your objective
• A composite measure considering both
coupon and maturity would be beneficial
 The Duration Measure
n n
C t (t )
t 1 (1  i )
t  t  PV (C ) t
D n  t 1
Ct

price
t 1 (1  i )
t

Developed by Frederick R. Macaulay, 1938

Where:
t = time period in which the coupon or principal payment occurs
Ct = interest or principal payment that occurs in period t
i = yield to maturity on the bond
 Macaulay Duration
• the weighted average term to
maturity of the cash flows from
a bond.
• a measure of bond price
volatility with respect to interest
rates.
Characteristics of Macaulay
Duration
• Duration of a bond with coupons is always less
than its term to maturity because duration gives
weight to these interim payments
– A zero-coupon bond’s duration equals its maturity
• There is an inverse relationship between duration
and coupon
• There is a positive relationship between term to
maturity and duration, but duration increases at a
decreasing rate with maturity
• There is an inverse relationship between YTM and
duration
• Sinking funds and call provisions can have a
dramatic effect on a bond’s duration
Modified Duration and Bond Price
Volatility
An adjusted measure of duration can be used
to approximate the price volatility of an
option-free (straight) bond
Macaulay duration
modified duration 
YTM
1
Where: m
m = number of payments a year
YTM = nominal YTM
Modified Duration and Bond Price
Volatility
• Bond price movements will vary proportionally with
modified duration for small changes in yields
• An estimate of the percentage change in bond prices equals
the change in yield time modified duration
P
 100   Dmod  i
Where: P
P = change in price for the bond
P = beginning price for the bond
Dmod = the modified duration of the bond
i = yield change in basis points divided by 100
 Trading Strategies Using Modified
Duration
• Longest-duration security provides the maximum price
variation
• If you expect a decline in interest rates, increase the average
modified duration of your bond portfolio to experience
maximum price volatility
• If you expect an increase in interest rates, reduce the average
modified duration to minimize your price decline
• Note that the modified duration of your portfolio is the market-
value-weighted average of the modified durations of the
individual bonds in the portfolio
 Sample Problem
• Talmart Corporation bonds have a $1,000
face value and will mature in 4 years. The
bonds have a 7% coupon rate. Interest is
paid annually and the required rate of return
is 6 percent for these bonds.
1. Bond Price
2. Macaulay Duration
3. Modified Duration
Bond Price
Macaulay Duration
Modified Duration

Mod :
3.64 / 1.06

= 3.43
 Bond Convexity
• Modified duration is a linear approximation
of bond price change for small changes in
market yields
P
 100   Dmod  i
P

• However, price changes are not linear, but a

curvilinear (convex) function
Price-Yield Relationship for Bonds
• The graph of prices relative to yields is not a
straight line, but a curvilinear relationship
• This can be applied to a single bond, a portfolio of
bonds, or any stream of future cash flows
• The convex price-yield relationship will differ
among bonds or other cash flow streams
depending on the coupon and maturity
• The convexity of the price-yield relationship
declines slower as the yield increases
• Modified duration is the percentage change in
price for a nominal change in yield
 Modified Duration
dP
Dmod  di
P
For small changes this will give a good
estimate, but this is a linear estimate on the
tangent line
 Determinants of Convexity
The convexity is the measure of the curvature
and is the second derivative of price with
resect to yield (d2P/di2) divided by price
Convexity is the percentage change in dP/di
for a given change in yield
2
d P
2
Convexity  di
P
 Determinants of Convexity
• Inverse relationship between coupon and convexity
• Direct relationship between maturity and convexity
• Inverse relationship between yield and convexity
Modified Duration-Convexity Effects

• Changes in a bond’s price resulting from a

change in yield are due to:
– Bond’s modified duration
– Bond’s convexity
• Relative effect of these two factors depends
on the characteristics of the bond (its
convexity) and the size of the yield change
• Convexity is desirable
 Duration and Convexity
for Callable Bonds
• Issuer has option to call bond and pay off with
proceeds from a new issue sold at a lower yield
• Embedded option
• Difference in duration to maturity and duration to
first call
• Combination of a noncallable bond plus a call
option that was sold to the issuer
• Any increase in value of the call option reduces
the value of the callable bond
 Option Adjusted Duration
• Based on the probability that the issuing
firm will exercise its call option
– Duration of the non-callable bond
– Duration of the call option
 Convexity of Callable Bonds
• Noncallable bond has positive convexity
• Callable bond has negative convexity
 Limitations of Macaulay and
Modified Duration
• Percentage change estimates using modified
duration only are good for small-yield
changes
• Difficult to determine the interest-rate
sensitivity of a portfolio of bonds when
there is a change in interest rates and the
yield curve experiences a nonparallel shift
• Initial assumption that cash flows from the
bond are not affected by yield changes
 Bond Price Change in Duration
and Convexity
• Est. of ∆Price from Duration
= D*(∆ in YLD/100)

• Est. of ∆Price from Convexity

= ½ x PRICE x Convexity x (∆YLD)2
 Illustration (from Book)
Given:
• 18 year bond, 12% coupon, 9%YTM
• Price = 126.50 Dmod = 8.38 Conv =107.70

Required: Find changes in duration, convexity and

the combined effects of a bond which
has a yield change of -100BP.
Solution: For 100bp
Duration Change: -8.38 x (-100/100) = 8.38%
+8.38 x 126.50 = +10.60
Convexity Change:
½ x (126.50) x 107.70 x (0.01)2 = .68

Combined effect:
126.50 + 10.60 + .68 = 137.78
Sample Problem
Given:
• 10 year bond, 10% coupon, 8%YTM
• Price = 150.00 Dmod = 7.35 Conv =102.20

Find changes in duration, convexity and

the combined effects of a bond which
has a yield change of -200BP.
 Effective Duration
• Measure of the interest rate sensitivity of an asset
• Use a pricing model to estimate the market prices
surrounding a change in interest rates

Effective Duration Effective Convexity

P   P  P   P   2 P
2
2 PS PS
P- = the estimated price after a downward shift in interest rates
P+ = the estimated price after a upward shift in interest rates
P = the current price
S = the assumed shift in the term structure
 Effective Duration
• Effective duration greater than maturity
• Negative effective duration
• Empirical duration
Sample Problem
• Stone & Co 9% of 10 are option free
and selling at 106 to yield 8.5%. Let's
change rates by 50 bps. The new price
for the increase in 50 bps would be 104
and the new price for a decrease in
rates would be 109. Compute for the
effective duration.
Solution

= 109 - 104 / 2 *(106) * (.005)

= 5 / 1.06
= 4.717

This means that for a 100 basis point

change, the approximate change would be
4.717%
 Price Change in Effective Duration
• - duration x change in yield x 100

Sample Problem:
With duration of 4.717, effect the
approximate changes:
:small movement in rates = 20 bps inc
: large movement in rates = 250 bps inc
Solution
• small percentage increase of 20bps
• Percentage Price Change
= - 4.717 x (+0.0020) x 100 = -.943%

• large change of 250 bps increase

• Percentage Price Change
= -4.717. (+0.0250) x 100 = -11.79%
 Empirical Duration
• Actual percent change for an asset in
response to a change in yield during a
specified time period
 Portfolio Duration
=equal to the weighted average of the durations
of the bonds in the portfolio. The weight is
proportional to how much of the portfolio
consists of a certain bond.

Portfolio Duration = w1D1 + w2D2 ...+ wkDk

 Sample Problem
Consider the 3 bonds to determine portfolio
duration:

Issuer Market Value Yield Maturity Duration

Stone & Co. 6,000,000 7% 10 5.5

Zack Stores 3,400,000 9% 15 7.8
Yankee Corp. 1,535,000 5% 20 12
 Solution:
• Total market valve of $10,935,000
• Find the weighted average of each bond
Stone & Co. =6,000,000 / 10,935,000 = .548
Zack Stores =3,400,000 / 10,935,000 = .311
Yankee Corp.= 1,535,000 / 10935,000 = .14
• Portfolio duration
.548(5.5) + .311(7.8) + .14 (12) = 7.119
If rates change by 100 bps the portfolio's value will
change by approximately by 7.119%
 Percentage Price Change in
Portfolio Duration
= -duration x change in yield x market value

Sample Problem:
Assume the same portfolio value with 50
bps change yield, how much would be the
dollar change?
 Solution:
• Stone & Co = -5.5 x .005 x 6,000,000 =
165,000
Zack Stores = -7.8 x .005 x 3,400,000 =
132,600
Yankee Corp = -12 x .005 x 1,535,000 =
92,100

• So the dollar change for a 50 bp change would

be equal to approximately $389,700
Yield Spreads With Embedded
Options
• Static Yield Spreads
– Consider the total term structure
• Option-Adjusted Spreads
– Consider changes in the term structure and
alternative estimates of the volatility of interest
rates