Q1

c.

The price-yield curve of a bond is a convex one as shown above. And the bonds duration at a
specific yield level is the slope of the curve at that interest rate (i.e. the slope of the tangent line
to the curve at that interest rate level).
When interest rate increases, the curve becomes flatter, and hence the duration becomes smaller.
So when you use the duration rule to calculate price changes: P/P ~= -Dy/(1+y), the duration
is that at the original interest rate (6%) which is bigger than the actual durations (which keeps
changing, become smaller and smaller) over the course of interest rate increase. And thus the
estimated (negative) price change is too big in magnitude.
So it is clear from the discussion above that the approximation error is due to convex price-yield
curve and thus negative duration-yield relationship.
Now for your own exercise, please assume interest rate decreases from 6% to 5%, and redo a)
and b). What do you find? And please follow my arguments above to explain the findings.
d. P/P ~= -Dy/(1+y) + 0.5convexity(y)2
I assume everyone can do this calculation.
e. From c we know that the approximation error of duration rule is due to the convex price-yield
curve and the change in duration when interest rate changes. You can easily see from the priceyield curve above that the curve becomes flatter when interest rate is higher the curve is closer
to a linear line (it becomes almost a flat line when interest rate is very high). And the flatter (or
less convex) the curve is, the smaller the change in duration due to change in interest rate, and
hence the smaller the approximation error if we use duration to estimate price change.

Q4
P/P ~= -Dy/(1+y). so the percentage price change depends on the duration.
This question essentially tests the determinants of bond duration. We know from the lecture that,
everything else equal, the bond duration: i) increases with maturity, but at a decreasing rate; ii)
decreases with coupon rate; iii) decreases with interest rate (or more specifically yield).
a) Bonds A, B and C have the same time-to-maturity. The coupon rate is 0% for bond A, 6% for
bond B and 7% for bond C. Further bonds A and B have the same YTM of 6%, while bond C has
a YTM of 7%.
So based on the relationship between duration and coupon rate, we know that DA > DB > DC, if
everything else equal. And actually bond C even has a higher YTM, which makes it even more
obvious that its duration should be lowest.
So the percentage price change should be largest for bond A, and lowest for bond C. Please
verify this with your calculation.
b) this is no-brainer the only difference between these two bonds is that bond D has a longer
maturity, and thus a higher duration.
c) everything else equal, duration increases with maturity at a decreasing rate.
So DE > DD > DC, but DE - DD < DD - DC
Hence the difference in percentage price change should be between bonds C and D. again, please
verify it.
d) the only difference between bonds E and F is the YTM bond F has a higher YTM (its YTM >
7%, where YTM of bend E = 7%).
The answer is clear based on the relationship btw duration and YTM.

Selected end-of-chapter questions

BKM16: 1-4, 7, 8a, 9, 12, 15, 22(a, b and c)
1.

While it is true that short-term rates are more volatile than long-term rates, the longer duration of
the longer-term bonds makes their prices and their rates of return more volatile. The higher duration
magnifies the sensitivity to interest-rate changes.

2.

Duration can be thought of as a weighted average of the maturities of the cash flows paid to holders
of the perpetuity, where the weight for each cash flow is equal to the present value of that cash flow
divided by the total present value of all cash flows. For cash flows in the distant future, present
value approaches zero (i.e., the weight becomes very small) so that these distant cash flows have
little impact and, eventually, virtually no impact on the weighted average.

3.

The percentage change in the bonds price is:

4.

a.

D
7.194
y =
0.005 = 0.0327 = 3.27%, or a 3.27% decline
1+ y
1.10

YTM = 6%

(1)
Time until
Payment
(Years)
1
2
3

(2)

(3)

(4)

(5)

Weight

Column (1)
Column (4)

53.40

0.0566
0.0534

0.0566
0.1068

890.00

0.8900

2.6700

$1,000.00

1.0000

2.8334

PV of CF
(Discount
Rate = 6%)
Cash Flow

60.00
60.00

1,060.00
Column sums

Duration = 2.833 years

56.60

b.

YTM = 10%

(1)
Time until
Payment
(Years)
1
2
3

(2)

(3)

(4)

(5)

Weight

Column (1)
Column (4)
0.0606
0.1102

PV of CF
(Discount
Rate = 10%)
Cash Flow

60.00

$ 54.55

60.00

49.59

0.0606
0.0551

796.39

0.8844

2.6532

$900.53

1.0000

2.8240

1,060.00
Column sums

Duration = 2.824 years, which is less than the duration at the YTM of 6%.
7.

Bond d. Investors tend to purchase longer term bonds when they expect yields to fall so they can
capture significant capital gains, and the lack of a coupon payment ensures the capital gain will be
even greater.

8.

a.

9.

a.

Bond B has a higher yield to maturity than bond A since its coupon payments and maturity
are equal to those of A, while its price is lower. (Perhaps the yield is higher because of
differences in credit risk.) Therefore, the duration of Bond B must be shorter.

(1)
Time until
Payment
(Years)
1
5

(2)

(3)

(4)

(5)

Weight

Column (1)
Column (4)

2.48 million

0.7857
0.2143

0.7857
1.0715

$11.57 million

1.0000

1.8572

PV of CF (Discount
Rate = 10%)
Cash Flow

$10 million
4 million
Column sums

$ 9.09 million

D = 1.8572 years = required maturity of zero coupon bond.

b.

The market value of the zero must be $11.57 million, the same as the market value of the
obligations. Therefore, the face value must be:
$11.57 million (1.10)1.8572 = $13.81 million

12.

a.

PV of the obligation = $10,000 Annuity factor (8%, 2) = $17,832.65

(1)
Time until
Payment
(Years)
1
2

(2)

(3)

(4)

(5)

Weight

Column (1)
Column (4)

0.51923
0.48077

0.51923
0.96154

1.00000

1.48077

PV of CF
(Discount
Rate = 8%)
Cash Flow

$10,000.00

$ 9,259.259

10,000.00

8,573.388

Column sums $17,832.647

D = 1.4808 years
b.

A zero-coupon bond maturing in 1.4808 years would immunize the obligation. Since the
present value of the zero-coupon bond must be $17,832.65, the face value (i.e., the future
redemption value) must be
$17,832.65 1.081.4808 = $19,985.26

c.

If the interest rate increases to 9%, the zero-coupon bond would decrease in value to

$19,985.26
= $17,590.92
1.091.4808
The present value of the tuition obligation would decrease to $17,591.11
The net position decreases in value by $0.19
If the interest rate decreases to 7%, the zero-coupon bond would increase in value to

$19,985.26
= $18,079.99
1.071.4808
The present value of the tuition obligation would increase to $18,080.18
The net position decreases in value by $0.19
The reason the net position changes at all is that, as the interest rate changes, so does the
duration of the stream of tuition payments.

15.

a.

The duration of the annuity if it were to start in one year would be

(1)
Time until
Payment
(Years)

(2)

(3)

(4)

(5)

Weight

Column (1)
Column (4)

PV of CF
(Discount
Rate = 10%)
Cash Flow

1
2

8,264.463

0.14795
0.13450

0.14795
0.26900

7,513.148

0.12227

0.36682

6,830.135

0.11116

0.44463

0.10105

0.50526

5,644.739

0.09187

0.55119

5,131.581

0.08351

0.58460

4,665.074

0.07592

0.60738

$10,000

$ 9,090.909

10,000

10,000

10,000

10,000

10,000

10,000

10,000

6,209.213

10,000

4,240.976

0.06902

0.62118

10

10,000

3,855.433

0.06275

0.62745

Column sums $61,445.671

1.00000

4.72546

D = 4.7255 years
Because the payment stream starts in five years, instead of one year, we add four years to the
duration, so the duration is 8.7255 years.

b.

The present value of the deferred annuity is

10,000 Annuity factor (10%,10)

= $41,968
1.10 4
Alternatively, CF 0 = 0; CF 1 = 0; N = 4; CF 2 = $10,000; N = 10; I = 10; Solve for NPV =
$41,968.
Call w the weight of the portfolio invested in the five-year zero. Then
(w 5) + [(1 w) 20] = 8.7255 w = 0.7516
The investment in the five-year zero is equal to
0.7516 $41,968 = $31,543
The investment in the 20-year zeros is equal to
0.2484 $41,968 = $10,423
These are the present or market values of each investment. The face values are equal to the
respective future values of the investments. The face value of the five-year zeros is
$31,543 (1.10)5 = $50,801
Therefore, between 50 and 51 zero-coupon bonds, each of par value $1,000, would be purchased.
Similarly, the face value of the 20-year zeros is
$10,425 (1.10)20 = $70,123

22.

a.

The price of the zero-coupon bond ($1,000 face value) selling at a yield to maturity of 8% is
$374.84 and the price of the coupon bond is $774.84.
At a YTM of 9%, the actual price of the zero-coupon bond is $333.28 and the actual price of
the coupon bond is $691.79.
Zero-coupon bond:
Actual % loss =

$333.28 $374.84
= 0.1109 = 11.09% loss
$374.84

The percentage loss predicted by the duration-with-convexity rule is:

Predicted % loss = [(11.81) 0.01] + 0.5 150.3 0.012 = 0.1106 = 11.06% loss
Coupon bond:
Actual % loss =

$691.79 $774.84
= 0.1072, or10.72% loss
$774.84

The percentage loss predicted by the duration-with-convexity rule is:

Predicted % loss =
0.1063, or10.63% loss
[(11.79) 0.01] + 0.5 231.2 0.012 =

b.

Now assume yield to maturity falls to 7%. The price of the zero increases to $422.04, and the
price of the coupon bond increases to $875.91.
Zero-coupon bond:

Actual % gain
=

$422.04 $374.84
= 0.1259, or12.59% gain
$374.84

The percentage gain predicted by the duration-with-convexity rule is:

Predicted % gain =

[(11.81) (0.01)] + 0.5 150.3 0.012 =

0.1256, or12.56% gain

Coupon bond:
Actual % gain
=

$875.91 $774.84
= 0.1304, or13.04% gain
$774.84

The percentage gain predicted by the duration-with-convexity rule is:

Predicted % gain =

c.

[(11.79) (0.01)] + 0.5 231.2 0.012 =

0.1295, or 12.95% gain

The 6% coupon bond, which has higher convexity, outperforms the zero regardless of
whether rates rise or fall. This can be seen to be a general property using the duration-withconvexity formula: the duration effects on the two bonds due to any change in rates are equal
(since the respective durations are virtually equal), but the convexity effect, which is always
positive, always favors the higher convexity bond. Thus, if the yields on the bonds change by
equal amounts, as we assumed in this example, the higher convexity bond outperforms a
lower convexity bond with the same duration and initial yield to maturity.