Debt Markets

MODULE 2
 Debt Markets

MODULE 2

LEARNING OBJECTIVE :

BOND PRICE VOLATILITY

REFERENCE : CHAPTER 4 OF FRANK J FABOZZI’S BOOK ON

BOND MARKETS, ANALYSIS AND STRATEGIES
 Duration

What is duration ?

∆P / P = - D * ∆r

Percent change in debenture price =

- 1 * duration of debenture * change in interest rate

Duration of a debenture is equal to

% change in debenture price for 1% change in
interest rate
 Duration - examples

When interest rates dropped by 0.25% p.a. , the

price of a bond went up by 3%? What is the duration
of the debenture?
D = - 1 * 3% / (-0.25%) = 12
• Duration of a mutual fund portfolio is 4.2, interest
rates are expected to go down by 0.1% p.a. ? What is
the expected increase/decrease in the value of the
fund portfolio?
-1 * 4.2 * (-0.1%) = 0.42% ie the value of the fund
portfolio will go up by 0.42%
 Calculating duration

How to calculate duration for a debenture ?

 Calculate change in price for a very small change in

interest rate
 Change in price is not symmetrical, price up is
usually higher than price down
 Hence calculate change in price in both directions
 Duration = (Phigh - Plow)/(2 * Po * ∆r)
 Illustrating calculation of duration
year cash flow
0
1 10
2 10
3 110

discount rate 10% 10.01% 9.99%

₹ 100.00 ₹
price ₹ 99.98 100.02
Duration 2.49
=(P high - P low)/( 2 * P * change in interest rate)
=(100.02487 - 99.97514)/( 2 * 100 * 0.01%)

npv (discount rate,cash flows)

 Duration vs tenor

What is the difference between duration of a

debenture and its tenor ?
Longer the tenor, higher the duration
 Illustration for
Longer the tenor, higher the duration

Year         Year        
0     0    
1 8   1 8  
2 8   2 8  
3 8   3 8  
4 108   4 8  
    5 108  
Discount Discount
rate   10% 10.01% 9.99% rate   10% 10.01% 9.99%
₹ ₹ ₹
Price   ₹ 93.66 93.6299 ₹ 93.6906 Price   ₹ 92.42 92.3825 92.4544
Duration       3.24 Duration       3.89
 Duration vs coupon rate

What is the relationship between coupon rate and

duration?

 Lower the coupon, higher the duration

 Zero coupon bonds have higher duration than

coupon bearing bonds with same tenor
 Illustration of
Duration vs Coupon rate

Year         Year        
0   0  
1 8   1 0  
2 8   2 0  
3 8   3 0  
4 108   4 108  
       
Discount
Discount rate 10% 10.01% 9.99% rate 10% 10.01% 9.99%
₹ ₹ ₹
Price ₹ 93.66 ₹ 93.6299 93.6906 Price ₹ 73.77 73.7386 73.7923
Duration       3.24 Duration       3.64
 Duration with varying cash flows at varying intervals

Cash Discounting Discount Discount rates

Date flow rate PV   rates + .01% PV   - .01% PV
25-07-
2017  
15-09-
2017 90 6.50% ₹ 89.20 6.51% ₹ 89.19 6.49% ₹ 89.20
16-09-
2018 90 7.10% ₹ 83.20 7.11% ₹ 83.19 7.09% ₹ 83.21
14-09-
2019 1100 7.30% ₹ 946.06 7.31% ₹ 945.87 7.29% ₹ 946.25

   
₹ ₹
Price ₹ 1,118.45 1,118.2560 1,118.6535

   

Duration                 1.78
 Macaulay ‘s duration

What is Macaulay’s duration?

 Average tenor weighing each year with PV of the cash
flow in that year.

• What is the relationship between Duration defined in

earlier slides and Macaulay’s duration?
 Duration as defined in the earlier slides =
Macaulay’s duration / ( 1 + r)
 Duration defined in the earlier slide is also called
Modified duration
 Illustration for
calculation of Macaulay duration

Macaulay Duration
Disc
ounti
ng
rate- PV *
-> 9% PV Year PV * Year / Price
Year  
0 ($100.0)
1 9 $8.26 $8.26
2 9 $7.58 $15.15
3 9 $6.95 $20.85
4 9 $6.38 $25.50
5 9 $5.85 $29.25
6 9 $5.37 $32.20
7 9 $4.92 $34.46
8 9 $4.52 $36.13
9 9 $4.14 $37.29
10 109 $46.04 $460.43 7.00
Modified duration calculations compared

Modified duration calculated using the formula shown earlier

Discount rate   9% 9.01% 8.99%

Price ₹ 100.00 ₹ 99.9359 ₹ 100.0642
Duration
(years)       6.42

Modified duration calculated using Macaulay

duration

Modified duration = Macaulay duration / ( 1+ r)

=7/1.09
6.42
 Macaulay duration for zero coupon bond

Macaulay duration for zero coupon bond = maturity

period of the bond
 Hence modified duration of zero coupon bond =
maturity period / ( 1 + discounting rate of the bond)
 Duration for a portfolio

Sr No Value of Debenture in Rs cr Duration

1 100 1.3
2 250 0.7
3 1090 2.5
4 450 1.8
5 110 0.1
  Portfolio duration 1.93
  (weighted average)  
 Price vs interest rate chart

Chart Title Year cash flow

₹128.00 0
1 4.5
₹118.00 2 4.5
3 4.5
₹108.00
4 4.5
₹98.00 5 4.5
6 4.5
₹88.00
7 4.5
₹78.00 8 4.5
9 4.5
₹68.00
10 104.5
₹58.00

₹48.00

₹38.00

₹28.00
2% 7% 12% 17% 22% 27%
 Upmove and downmove in price are not symmetric

Note that
 the magnitude of up move in price,(when interest rate declines) is
higher than
 the magnitude of the down move in price, (when interest rate goes
up by the same value)
To illustrate,
 interest rate goes down by 1%, price of a bond changes from
100 to 102 ( increase of Rs 2)
 Interest rate goes up by 1%, price of a bond changes from 100 to
98.5 ( decrease of Rs 1.5)

This is due to the convexity of the price yield curve

 Convexity measure

Convexity measure is used to find a more accurate

change in bond price for a given change in interest
rate
 More accurate than computing price change by using duration
only
∆P/P = - D * ∆r + 1/2 * C * (∆r)^2
where ∆P change in bond price
P original bond price
D duration of the bond
∆r change in interest rate
C convexity
(∆r)^2 square of change in interest rate

Note that the estimation for change in price using this formula is more accurate for
smaller change in interest rates.
 Computing convexity

Convexity measure can be computed using the

following formula

convexity = ( P high + P low - 2 * P)/( P * ∆r * ∆r)

Where P high and P low are the new bond prices due to a
small change, ∆r; in the interest rate down and up. P is
the original bond price