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: