Financial Institutions Management,
By Anthony Saunders
Price Sensitivity and Maturity
The longer the term to maturity, the greater the
sensitivity to interest rate changes.
Example: Suppose the zero coupon yield curve is flat
at 12%. Bond A pays $1762.34 in five years. Bond B pays
$3105.85 in ten years, and both are currently priced at
$1000.
Example continued...
Bond A: P = $1000 = $1762.34/(1.12)5
Bond B: P = $1000 = $3105.84/(1.12)10
Now suppose the interest rate increases by 1%.
Bond A: P = $1762.34/(1.13)5 = $956.53
Bond B: P = $3105.84/(1.13)10 = $914.94
The longer maturity bond has the greater drop in
price.
Coupon Effect
Bonds with identical maturities will respond
differently to interest rate changes when the coupons
differ. This is more readily understood by recognizing
that coupon bonds consist of a bundle of “zero-
coupon” bonds. With higher coupons, more of the
bond’s value is generated by cash flows which take
place sooner in time.
Price Sensitivity of 6% Coupon Bond
r 8% 6% 4% Range
n
40 $802 $1,000 $1,273 $471
20 $864 $1,000 $1,163 $299
10 $919 $1,000 $1,089 $170
2 $981 $1,000 $1,019 $37
Price Sensitivity of 8% Coupon Bond
r 10% 8% 6% Range
n
40 $828 $1,000 $1,231 $403
20 $875 $1,000 $1,149 $274
10 $923 $1,000 $1,085 $162
2 $981 $1,000 $1,019 $38
Remarks on Preceding Slides
The longer maturity bonds experience greater price
changes in response to any change in the discount rate.
The range of prices is greater when the coupon is
lower.
The 6% bond shows greater changes in price in response
to a 2% change than the 8% bond. The first bond is
riskier.
Duration
Duration
Combines the effects of differences in coupon rates and
differences in maturity.
Based on elasticity of bond price with respect to interest
rate.
Duration
Duration
Duration
D = nt=1[Ct• t/(1+r)t]/ nt=1 [Ct/(1+r)t]
Where
D = duration
t = number of periods in the future
Ct = cash flow to be delivered in t periods
n= term-to-maturity & r = yield to maturity.
Duration
Duration
Weighted sum of the number of periods in the future of
each cash flow, (weighted by respective fraction of the
PV of the bond as a whole).
For a zero coupon bond, duration equals maturity since
100% of its present value is generated by the payment of
the face value, at maturity.
Duration as Index of Interest Rate Risk:
The greater the duration, the greater the price
sensitivity and the greater the risk. Higher duration
indicates that it takes a longer time to recover the PV
of the bond. This agrees with intuition once we realize
that ONLY a zero-coupon bond has duration equal to
maturity. ALL other bonds will have duration LESS
than maturity.
An example:
Eurobonds pay coupons annually. Suppose the annual coupon is 8
percent (6 year maturity ) , the face value of the bond is $1,000, and the
current yield to maturity (R) is also 8 percent. We show the calculation
of its duration.
An example:
The Duration of a Two-Year U.S. Treasury Bond with 8 Percent Coupon
(6 month) and 12 Percent Yield.
Limits to Duration Measure
Duration relationship may not hold if the bond has a
call or prepayment provision.
Convexity.
Negative Convexity.
Special Case and an Adjustment
Maturity of a consol: M = .
Duration of a consol: D= 1 + 1/R
Special Case and an Adjustment
Consol bond: A bond that pays a fixed coupon each year forever.
Suppose that the yield curve implies R = 5 percent annually; then the
duration of the consol bond would be:
