Lecture Note Three:

Bond Price Volatility

FINA3323 Fixed Income Securities

HKU Business School
University of Hong Kong

Dr. Huiyan Qiu

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 Outline
Price-Yield relationship
Factors that affect bond price volatility
Yield level, coupon rate, term to maturity
Measures of bond price volatility
• PVBP / DV01, duration
Convexity
Bond price approximation

Reference: Fabozzi’s chapter 4 and Tuckman’s chapter 4

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 Bond Valuation
The price of an option-free T-year bond with par value
M, coupon C per year, and required yield y per year
(assuming m periods per year) is:

• Bond price is linear in coupon payment.

• Bond price moves opposite to the required yield.
• Bond price approaches par value as it approaches maturity

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 Price vs. Yield
Price-yield curve is not only downward sloping but
also convex: the rate of bond price decrease is faster for
low yield than it is for high yield.

In other words, bond price is more sensitive to change in

yield – price volatility of bond is higher – at low yield
level.

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 Example: Price vs. Yield
Example: The price of a 10-year zero-coupon bond,
with par value $100 and required yields ranging from
1%-10%
Required Yield 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10
Bond Price 90.53 82.03 74.41 67.56 61.39 55.84 50.83 46.32 42.24 38.55
100

80
Bond Price

60

40

20
0 0.02 0.04 0.06 0.08 0.1 0.12
Required Yield 3-5
 Example: Price vs. Yield
Starting from 5% required yield, the price of bond goes
up more due to a 1% decrease than it will go down due
to 1% increase in yield.
• from 4% to 5%:
• (61.39 – 67.56) = – $6.17
• from 5% to 6%:
• (55.84 – 61.39) = – $5.55

At low yield level, bond price is more sensitive to

change in yield.
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 Factors Affecting Price Volatility
Question: Besides the level of yield, what other
characteristics of a coupon bond affect the sensitivity of
bond price to change in required yield?
Answer:
• (1) Longer term to maturity (TTM)
• (2) Smaller coupon Rate
Both make the bond price more sensitive to change in
required yield, i.e., price volatility of the bond higher.
Intuitively, why is this so?

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 Effect of TTM on Price Volatility
Example: Consider a zero coupon bond with TTM = 1
day. If the required yield is 1%, the bond price is:
• 100/(1.01)(1/365) = 99.997
• If the required yield jumps to 20%, the bond price would
drop to: 100/(1.20 )(1/365) = 99.950

This enormous change in rates makes only a tiny

difference in bond price because the time over which
this discount rate is applied is small.

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 Effect of TTM on Price Volatility
Another example: Consider a zero coupon bond with
TTM = 10 years. If the required yield is 1%, the bond
price is:
• 100/(1.01)10 = 90.5287
• If the required yield jumps to 2%, the bond price would
drop to: 100/(1.02 )10 = 82.0348

For large TTM’s, 1% change in the required yield makes

a much larger impact on the discounting of future cash
flows.

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Effect of Coupon on Price Volatility
Question: How does coupon rate affect a bond’s
sensitivity to change in required yield?
• A coupon bond should be thought of a portfolio of zero-
coupon bonds, each with different maturity.
• For a given maturity, the smaller the coupon rate, the
more ‘weight’ a portfolio has of zero coupon bonds with
long maturity.
• It follows that a smaller coupon rate translates into higher
volatility
• Zero-coupon bonds have highest volatility for a given
maturity
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 Example: Bond Price Volatility
YTM T = 1 year T = 10 years T = 20 years
8% Coupon Bond
8% $100.00 $100.00 $100.00
9% $99.06 $93.50 $90.80
% change in price 0.94% 6.50% 9.20%
Zero Coupon Bond
8% $92.46 $45.64 $20.83
9% $91.57 $41.46 $17.19
% change in price 0.95% 9.15% 17.46%

Longer TTM or smaller coupon rate

 higher bond price volatility
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 Bond Price Volatility
Rank the following bonds in terms of how sensitive their
prices are to changes in yields.
A. $100 face value, 10 year, 8% coupon bond
B. $1000 face value, 2 year, 8% coupon bond
C. $100 face value, 10 year, 0 coupon bond
D. $10,000 face value, 2 year, 0 coupon bond
 B is the least volatile
 C is the most volatile
Question: Can you determine the rankings of the other
two?
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 Measures of Bond Price Volatility
Money managers, arbitrageurs, and traders need to have
a way to measure a bond’s price volatility to implement
hedging and trading strategies

How can the price volatility of bonds having different

maturities and coupon rates be meaningfully compared?
• Price Value of a Basis Point
• Yield Value of a Price Change
• Duration

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 Price Value of a Basis Point
The price value of a basis point (PVBP or PV01) is the
change in price of a bond if the required yield decreases
by 1 basis point
• This measure of price volatility indicates dollar price
volatility as opposed to percentage price volatility.
• This measure is also referred to as the dollar value of an
01 (DV01)
• DV01 is positive most of time: all fixed coupon bonds
and most other fixed income securities do rise in price
when rates decline.

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 PVBP / DV01
Let ΔP and Δy denote the change in price and rate,
respectively, and note that the change in rate measured
in basis points is 10,000×Δy. Then the dollar value of an
01 is

Given price-yield curve, the slope of the tangent line at a

particular yield level is called derivative in calculus and
is denoted dP/dy. In terms of the derivative, .

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 PVBP / DV01
Given
The price value of a basis point is:

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 PVBP / DV01: Example
Example: 25-year Treasury bond with coupon rate of
6%, now selling at PAR. Price = 100.
• YTM changes to 6.01%  Price = 99.871473
• YTM changes to 5.99%  Price = 100.128771

• Although small, the difference between the change in

bond price when the required yield increases by 0.01%
and when the required yield decreased by 0.01% is not
zero. (0.128527 vs. 0.128771).

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 PVBP / DV01: Example (cont’d)
Using derivative,
M = 100, C = 6, y = 6%, m = 2, T = 25.

For every $100 face value of this bond, a 1 basis point

change in yield leads to 12.86 cents change in the bond
price.

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 Yield Value of a Price Change
The yield value of a price change is the change in yield
for a specified price change
• A bond’s yield to maturity is calculated when the bond’s
price is decreased by, say, X dollars – then the difference
between the initial yield and the new yield is the yield
value of an X dollar price change. Low value, high price
volatility.
• In the Treasury market investors compute the yield value
of a 32nd
• In the corporate and municipal bond markets investors
compute the yield value of an 8th
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 Yield Value of a Price Change: Example
Assume 6% required yield.
Coupon TTM Initial Price Initial Price Yield at New Yield Value
minus a 32nd Price of a 32nd
0% 5 $74.4094 $74.3781 6.0087% 0.0087%
4% 5 $91.4698 $91.4385 6.0077% 0.0077%
6% 5 $100.0000 $99.9688 6.0073% 0.0073%
8% 5 $108.5302 $108.4990 6.0070% 0.0070%
0% 25 $22.8107 $22.7795 6.0056% 0.0056%
4% 25 $74.2702 $74.2390 6.0030% 0.0030%
6% 25 $100.0000 $99.9688 6.0024% 0.0024%
8% 25 $125.7298 $125.6985 6.0020% 0.0020%

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 Yield Value of a Price Change: Example
Assume 6% required yield and use percentage change in
price.
Coupon TTM Initial Price Initial Price Yield at New Yield Value
minus 0.1% Price of 0.1%
0% 5 $74.4094 $74.3350 6.0206% 0.0206%
4% 5 $91.4698 $91.3783 6.0226% 0.0226%
6% 5 $100.0000 $99.9000 6.0235% 0.0235%
8% 5 $108.5302 $108.4217 6.0242% 0.0242%
0% 25 $22.8107 $22.7879 6.0041% 0.0041%
4% 25 $74.2702 $74.1960 6.0071% 0.0071%
6% 25 $100.0000 $99.9000 6.0078% 0.0078%
8% 25 $125.7298 $125.6040 6.0082% 0.0082%
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 Duration
While price value of a basis point measures the dollar
price volatility, duration measures the percentage price
volatility.
Modified duration measures the percentage change of
bond price for a unit change in the required yield.

In terms of the derivative, .

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 Modified Duration
Example: 25-year Treasury bond with coupon rate of
6%, now selling at PAR. Price = 100.
• YTM changes to 6.01%  Price = 99.871473
• YTM changes to 5.99%  Price = 100.128771

Interpretation: the percentage change in price is –

12.8649 times the change in the yield.
• One basis point decrease  0.128649% increase in price
 $0.128649 increase (DV01)
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Modified Duration: Example (cont’d)
Note: if YTM changes from 6% to 7%, bond price is
PV(rate=7%/2, nper=50, pmt=3, fv=100, type=0) = –
$88.272191.

Changing yield by 0.01% or by 1% results in very

different duration measure. The precise measure should
be calculated using the formula in terms of the
derivative.

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 Duration of a Portfolio
The duration of a portfolio is the weighted average
duration of the bonds in the portfolio
• The duration of each bond is weighted by its percentage
within the portfolio (on a market value basis)

• For the portfolio, the duration is given by

DP = wA DA + wB DB
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 Macaulay Duration
Another duration measure of bond price risk is
Macaulay Duration.

Macaulay duration is the weighted average of the

maturities of bond cash flows.

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 Macaulay Duration
Note: Macaulay duration is well-defined even if the
discount rate yt for time-t cash flow is different for
different t.

Define the weights as , the Macaulay duration is

where the are the time to receive each cash flow.

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Macaulay Duration and Modified Duration

As a weighted average of the time (number of years)

until the bond payments occur, with weight being the
percentage of the bond price accounted for by each
payment, Macaulay duration is linearly related to the
Modified duration.

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Macaulay Duration and Modified Duration

Bond price function:

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 Macaulay Duration: Zero-Coupon
Zero-coupon bond has one single payment, the maturity
payment, at the maturity date. Hence, the Macaulay
duration of zero-coupon bond is the term to maturity of
the bond.
Example: A 3-year zero-coupon bond with a yield to
maturity of 7%. The bond price per $100 of maturity
value is $100/1.073 = $81.629788
• At a yield of 7.01%, one basis point higher, the bond price
is $100/1.0713 = $81.606905
• DV01 = $0.022883

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 Macaulay Duration: Zero-Coupon
Example (cont’d):

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 Macaulay Duration: Coupon Bond
Consider a 3-year par coupon bond with coupon rate 7%
and annual payment. For the par bond, the yield to
maturity is the coupon rate 7%.
Macaulay duration is

• On average, the bond investor has to wait for 2.808 years

before recovering his investment.
It is intuitive that higher Macaulay duration, higher
interest rate risk of the bond.
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 Macaulay Duration: Perpetual Bond
Perpetual bond is bond that pays coupon indefinitely.
For perpetual bond with no maturity date, the average
waiting time to recover investment is finite.
Assuming annual coupon payment, the bond price is

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 Macaulay Duration
General Characteristics:
Macaulay Duration of a zero coupon bond with maturity
T is T.
Macaulay Duration of a coupon bond with maturity T is
less than T since some payments are received before T.
For a given maturity T, the higher the coupon rate, the
lower the Macaulay duration.
• Zero-coupon bonds have the largest duration for a given
maturity

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 Excel Application
Excel has functions for calculating duration measures.

Bond 1 Bond 2 Bond 3 Bond 4

Settlement 1/1/2012 1/1/2012 1/1/2012 1/1/2012
Maturity 1/1/2015 1/1/2015 1/1/2015 1/1/2015
Coupon 0% 5% 7% 8%
Yield 7% 7% 7% 7%
Price 81.6298 94.7514 100.0000 102.6243

Modified Duration
by Excel 2.8037 2.6685 2.6243 2.6039

Macaulay Duration
by Excel 3.0000 2.8553 2.8080 2.7862
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 Duration Approximation
Recall , where is the slope of the tangent line at a
particular yield level given price-yield curve.
• Per dollar invested, the modified duration of the bond is
determined by the slope.
Alternatively, modified duration can be used to estimate
the curved relationship between price and yield with a
straight line (the tangent line).
or

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 Tangent Line
Price P(y)
𝑄 − 𝑃 ( 𝑦∗ ) 𝑑𝑃
Actual Price Curve =
𝑦−𝑦
∗
𝑑𝑦

Q
P(y*)

Tangent Line at
y*

y y* Yield y

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 Duration Approximation
If we draw a vertical line from any yield y, the distance
between the horizontal axis and the tangent line
represents the price P(y) approximated by using duration
starting with the initial yield y*.

The approximation will always understate the actual

price.

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 Duration Approximation
Actual Price

Price Error in Estimating Price

Based only on Duration

Error in Estimating Price

Based only on Duration
p*
Tangent Line at y*
(estimated price)
y1 y2 y* y3 y4 Yield
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 Limitations of Using Duration
This type of linear approximation is only good for very
small changes in the yield.
When the yield decreases, the duration approximation
will underestimate the increase in price.
When the yield increases, the duration approximation
will overestimate the decrease in price
Can the duration measure be improved upon? Yes! Use
higher degree derivatives!

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 Taylor Series
A fundamental property in math (calculus) is that an
infinitely differentiable function can be approximated by
a Taylor series (a polynomial function).
Generalized Taylor series formula

Using more terms will result in a better approximation.

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 Taylor Series and Interpretations


(Duration approximation)

where .

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 Using Duration and Convexity
Thus, we can use both the duration and the convexity to
approximate the new bond price or the percentage price
change

• Convexity is positive for option-free bond. Hence, the

adjustment on price change based on convexity is always
positive no matter whether the yield increases or
decreases.

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 Using Duration and Convexity
For increases in interest rates (y1), the
Price
duration plus convexity approximation
gives a higher estimate of the bond price
For decreases in interest rates (y2), the
duration plus convexity approximation
gives a lower estimate of the bond price
P0 First
a
deriv nd seco
ative nd
s
Fi
d e rs t Price
ri v
at
ive
Yield
y2 y0 y1
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 Approximate Price Change
Example: Consider a 3-year coupon bond with coupon
rate 7%, annual payment. Suppose the required yield is
5% and par value $100.
a) What is the bond price?
b) What is the modified duration of the bond?
c) What is the convexity of the bond?
d) If the required yield increases to 5.5%, what is the new
bond price? What is change in bond price approximated
by duration only? By both duration and convexity?
e) Answer question (d) for yield decreasing to 4.5%.
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 Duration Hedging
Duration and convexity measure how sensitive bond
price is with respect to the change in interest rate. In
other words, they measure the interest rate risk in a fixed
income security.
To hedge interest rate risk in fixed income security, one
can find another security (or a portfolio) with
appropriate duration and convexity so that the hedged
portfolio (initial portfolio together with the hedging
portfolio) is insensitive to the change in the interest rate.

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 Duration Hedging
Example: consider the following portfolio and available
hedging instruments. Assume yields are approximately
the same

Modified
Portfolio Price Convexity
Duration
Initial Portfolio $32,863.5 6.76 85.329
Hedging
$97.962 8.813 99.081
Instrument 1
Hedging
$108.039 2.704 10.168
Instrument 2

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 Duration Hedging
Create the hedging portfolio consisting of instrument 1
and 2 so that the duration and convexity are matched.
• Let x and y denote the value weight of instrument 1 and 2
in the hedged portfolio. Then, the value weight of the
original portfolio in the hedged portfolio is 1 – x – y.

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 Duration Hedging
Solving the two equations, we have

The amount of investment in the original investment is

$32,863.5. Thus the investment amount in instrument 1
and 2 are and , respectively.

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 Duration Hedging
The hedged portfolio has both duration and convexity
zero  insensitive to the change in the interest rate.
Duration hedging is very simple. However, it has
limitations: working well only for small changes in
interest rate, assuming one interest rate factor; assuming
parallel shifts of all interest rates…
Still very valuable in practice.

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 Discussion Question
Consider two bond portfolios with the same price and
same duration, but with different convexity, say
portfolio(1) having larger convexity than portfolio(2).
Portfolio(1) seems to be a better portfolio because for
any change in yield Δy, the return on portfolio(1) is
higher based on

Arbitrage opportunities?

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 Discussion (cont’d)
Consider purchasing $100 worth of portfolio(1), and
shorting $100 worth of portfolio(2). Hence, the net
value of this portfolio is zero. No matter what value of
Δy occurs, the combined portfolio seems to make a
profit.

There appears to be an arbitrage opportunity.

Question: Is there an arbitrage opportunity? If not,

where is the flaw in the argument?

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End of the Notes!

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