INTEREST RATE RISK

F 504 Fixed Income Securities

 Bond Pricing Relationships
16-2

1. Bond prices and yields are inversely

related.
2. An increase in a bond’s 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
16-3

4. As maturity increases, price sensitivity

increases at a decreasing rate.
5. Interest rate risk is inversely related to
the bond’s coupon rate.
6. Price sensitivity is inversely related to
the yield to maturity at which the bond
is selling.
Interest Rate Risk : Full Valuation Approach

Full Valuation Approach        

Coupon
Rate 9%  
Maturity 20  
Price $ 134.67  
Yield to
Maturity 6%  
Par Value $ 10,000,000.00 100,000  
Market
Value $ 13,467,220.00  
   
New New Market % change in Market
Scenario Yield Change (bp) Yield New Price Value Value
1 50 6.5% 127.76054 12,776,054.15 -5.13%
2 100 7% 121.35507 12,135,507.23 -9.89%
3 200 8% 109.89639 10,989,638.69 -18.40%
Price Yield Volatilities: Properties
 Property 1:
Although the price moves in the opposite direction
from the change in yield the percentage price
change is not the same for all bonds.
 Property 2:
For small changes in the yield, the percentage price
change for a given bond is roughly the same,
whether the yield increases or decreases.
Price Yield Volatilities: Properties
 Property 3:
For large changes in yield, the percentage price
change is not the same for an increase in yield as it
is for a decrease in yield.
 Property 4:
For a given large change in yield, the percentage
price increase is greater than the percentage price
decrease.
 Duration
16-7

 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
16-8

 Duration is a measure of the approximate

price sensitivity of a bond to interest rate
changes. More specifically, it is the
approximate percentage change in price for
a 100 basis point change in rates.
 The Dollar Duration is the dollar change

in price for a small change in the yield.

 “Duration" generally means Macaulay’s

Duration.
 Duration: Calculation
16-9

 t
wt  CF t (1  y ) Price 
T
D   t wt
t 1

CFt=cash flow at time t

 Duration/Price Relationship
16-10

Price change is proportional to duration and not to

maturity

P  (1  y ) 
  Dx  
P  1 y 
D* = modified duration

P
  D * y
P
Macaulay Duration
 For small interest rate changes, duration is the
approximate percentage change in the value of the
bond for a 1% increase in market interest rates.
T
PV (CFt )t
D
1 Vb
 The time-weighted average present value term to
payment of the cash flows on a bond.
Macaulay Duration
 The proportional change in a bond’s
price is proportional to duration through
the yield-to-maturity

V   (1  r ) 
 D  
V  (1  r ) 
Macaulay Duration
 A 10-year bond with a duration of 7 would fall
approximately 7% in value if interests rates increased
by 1%.
 The higher the coupon rate of a bond, the shorter the
duration.
 Duration is always less than or equal to the overall life
(to maturity) of the bond.
 A zero coupon bond will have duration equal to the
maturity.
Dollar Duration
 Duration x Bond Price: the change in price in
dollars, not in percentage, and has units of
Dollar-Years (Dollars times Years).
 The dollar variation in a bond's price for small
variations in the yield.
 For small interest rate changes, duration is the
approximate percentage change in the value of the
bond for a 1% increase in market interest rates.
Dollar Duration
 Dollar Duration =
𝜕𝑃 −1 × 𝐶 −2 × 𝐶 −𝑁 × 𝐶 −𝑁 × 100
= + …….+ +⋯+
𝜕𝑦 ሺ1 + 𝑦ሻ ሺ1 + 𝑦ሻ
2 3 ሺ1 + 𝑦ሻ𝑁+1 ሺ1 + 𝑦ሻ𝑁+1

or
1 𝐶 −2 × 𝐶 −𝑁 × 𝐶 −𝑁 × 100
− ൜ + … … . + + ⋯ + ൠ
1 + 𝑦 ሺ1 + 𝑦ሻ ሺ1 + 𝑦ሻ
1 2 ሺ1 + 𝑦ሻ𝑁 ሺ1 + 𝑦ሻ𝑁
Modified Duration
 Modified Duration – where n=cash flows per year.
1 𝐶 2×𝐶 𝑁×𝐶 𝑁 × 100 1
൜ + …….+ + ⋯+ ൠ∗
ሺ1 + 𝑦ሻ ሺ1 + 𝑦ሻ ሺ1 + 𝑦ሻ
1 2 ሺ1 + 𝑦ሻ𝑁 ሺ1 + 𝑦ሻ 𝑃
𝑁

Macaulay Duration
D* 
1 r
and

V
  D * r
V
 Modified Duration
V
  D * r
V
V   D * r  V
What will happen to the price of a 30 year 8% bond priced to yield 9% (i.e. $897.27)
with D* of 11.37 - if interest rates increase to 9.1%?

11.37
 0.001$897.26  $9.36
1.09
Macaulay Duration
 Macaulay Duration = (1+y)x Modified Duration

𝐶 2×𝐶 𝑁×𝐶 𝑁 × 100 1

൜ + …….+ +⋯+ ൠ∗
ሺ1 + 𝑦ሻ ሺ1 + 𝑦ሻ
1 2 ሺ1 + 𝑦ሻ𝑁 ሺ1 + 𝑦ሻ 𝑃
𝑁
Duration: Summary
 The Price Value of a Basis Point (PVBP) is the
change in price of the asset when its yield changes
by 1 basis point (100 bp = 1%).
 PVBP = Dollar Duration/10,000
 Modified Duration, D* = Macaulay Duration/(1+y)
 Dollar Duration = -P x Modified Duration
T
PV (CFt )t
 Macaulay Duration = D  
1 Vb
Duration: Concept Check
 Determine the durations of 10% coupon and
zero-coupon bonds, both with 2 years to
maturity. The yield to maturity is 15% p.a.

Bond
Coupon Rate 10%
Par Value 100
Years Mat 2
YTM 15%

PV of Cash Macaulay Duration (4)

Time (1) Cash Flow (2)
Flows = (1)x(3)/Price
1 Coupon 10 8.69565 0.094650
Bond A Coupon +
2 Principal 110 83.17580 1.810700
        91.87146 1.905350
Bond B 2 Principal 100 75.61437 2
 Change in Bond Price
Δp = Δy x (4)
Modified
Macaulay Dollar
Bond Duration
Duration Duration
(1) (3) =
(2) (4) = -P*(3) Δy = .005 Δy = .01
(2)/(1+y)

A 1.9053 1.6568 -152.2150 -0.7611 -1.5222

B 2.0000 1.7391 -131.5032 -0.6575 -1.3150

In the case of the Bond B, the dollar duration implies:

• If yield increases from 15% to 15.5% then the price of the bond will drop to
(75.61437- 0.6575) = 74.95687.
•If yield increases from 15% to 16% then the price of the bond will drop to (75.61437-
1.3150) = 74.299937.
Note:
• Prices at different levels of yield are close to but higher than the prices computed
using dollar duration.
• Bond price is a convex function of yield. The duration is the slope of the curve at y =
10%. When we approximate the changes in the price of a bond using duration we move
along tangent. As can be seen from the graph, the actual price of the bond at different
levels of yield will always be greater than the tangent.
• The tangent approximates the price curve for small changes in yield.
 The yield curve is flat at 10%. The Macaulay duration of
a coupon bond is 5 years and its current price is $100. If
there is a parallel shift in the curve to 11% then the price
of this bond:
1. Will be more than $104.55
2. Will be less than or equal to $104.55 but more than
$100.
3. Will be more than $95.45.
4. Will be less than or equal to $95.45.
5. None of the above.
 Rules for Duration
16-23

Rule 1 The duration of a zero-coupon bond equals its

time to maturity, N.

Rule 2 Holding maturity constant, a bond’s duration is

higher when the coupon rate is lower

Rule 3 Holding the coupon rate constant, a bond’s

duration generally increases with its time to maturity

Rule 4 Holding other factors constant, the duration of

a coupon bond is higher when the bond’s yield to
maturity is lower
 Rules for Duration
16-24

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

y

Rules 6 The Macaulay duration of a portfolio of bonds is the

weighted average of the Macaulay durations of the
underlying bonds.

Rules 7 The Modified duration of a portfolio of bonds is the

weighted average of the Modified durations of the
underlying bonds.

Rule 8 The Dollar duration of a portfolio of bonds is the sum

of the Dollar durations of the underlying bonds.