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Duration
Learning outcomes
By the end of this lecture you should:
Be comfortable with the concept of duration and
know how to calculate it and what affects it
Be able to use duration to measure and think
about interest rate risk in bond portfolios
Be familiar with the concept of convexity and
know why its an interesting characteristic of a
bond
Be able to immunize a liability by constructing an
appropriate bond portfolio
s
T
PV ( CFt )
Example
Consider a five-year, 10%-coupon bond with a
face value of $100 and a 10% YTM
Weights of cash flows
80
100%
90%
70
80%
60
70%
Year 5
50
60%
Year 4
40
50%
Year 3
30
40%
Year 2
30%
Year 1
20
20%
10
10%
0%
1
Example
Lets calculate the weights
Since YTM = C, we know that the bond trades
at par
10
Lets calculate the weights:
w =
100 = 9.09%
1
wt =
PV (CFt )
CFt
=
P
t
PV (CFt ) (1 + y )
t
1.1
10
w2 = 2
1.1
10
w3 = 3
1.1
10
w4 = 4
1.1
110
w5 = 5
1 .1
100 = 8.26%
100 = 7.51%
100 = 6.83%
100 = 68.30%
Example
How long is our average weight for a (present
value) dollar?
D = 0.0909 1 + 0.0826 2 + 0.0751 3 + 0.0683 4 + 0.6830 5 = 4.16
50
40
30
20
10
0
1
Coupon rate
A higher coupon rate means larger close cash flows.
When the coupon rate is zero, i.e. for a zero-coupon
bond, the entire price is made up of the face value
and duration equals maturity.
Time to maturity
The further away in time our final cash flows are, the
longer is the average maturity. This is almost trivial.
80
$
60
40
20
0
1
100
80
$
60
40
20
0
1
100
80
$
60
40
20
0
1
Modified duration
We are interested in how much the price of a
bond changes when the interest changes
Recall that the price of a bond is the sum of
the present values of its future cash flows:
T
P=
t =1
CFt
(1 + y )t
t
y y t =1 (1 + y )t y t =1
Modified duration
We recall that the derivative of a sum is the
sum of the derivatives:
T
P T
1
CFt
= CFt ( t )
=
t +1
t +1
y t =1
(1 + y )
t =1 (1 + y )
t
P
= D
t
(
)
1
+
y
t =1
(1 + y ) P = T
P
Modified duration
Since we are interested in the (percentage)
change in the bond price, lets keep that on
the LHS:
P
D
*
P
(1 + y )
y = D y
Modified duration
The relationship is only true for very small
changes in the yield
If we consider non-trivial changes in the yield
we are in effect making a first-order Taylor
approximation:
P
D *y
P
Duration approximation
Convexity
We always underestimate the price, since we ignore
the second derivative and the price-yield relationship is
convex
In principle, we could get a better estimate with a
second (or higher) order Taylor approximation
The severity of the error depends on where we are on
the Price-Yield curve
Recall that the YTM is specific to each bond
Convexity gives rise to a favorable asymmetry in the
price effects of yield changes
Since investors value this asymmetry, convexity is
priced
Portfolio duration
We can think of coupon bonds as a portfolio of
zero coupon bonds
In the end we only care about the cash flows
By the same logic, we may add up the cash flows
from a bond portfolio and think of it as one bond
Our pricing and duration formulas still apply
Specifically, the duration of our portfolio will be a
weighted average of the durations of its
components
PV CFt P
DP =
t
PP
t =1
T
1
DP =
PA + PB
1
DP =
PA + PB
PA
DP =
PA + PB
t =1
T
t =1
T
PV CFt
PA
t =1
DP = A DA + B DB
1
t +
PA + PB
PV (CF ) t
)t +
PV CFt B
t
P
t =1
B
PV (CF )
A
PB
PA + PB
t =1
T
Asset-liability matching
When we buy a bond we are in effect
postponing cash flows (saving)
We may want to do this if we know that we
have some future liabilities, such as tax debts
or foreseeable investments, that we must
meet
If we buy a zero-coupon bond whose maturity
matches that of the liability, we dont have to
worry about reinvestment or liquidity risks
Immunization
What if there is no such bond?
We would be exposed to changes in the yield
Higher yields are beneficial if we have taken on
reinvestment risk, since we can reinvest our
coupons at better interests
Lower yields are beneficial if we have taken on
liquidity risk, since we can sell our bonds at a
higher price if the discount rate is lower
We can construct a bond portfolio that balances
these effects against each other to match our
liabilities
Immunization
Recall that we can think of duration as a
measure of the sensitivity of our bonds to
changes in their yields
If we set the duration of our bond portfolio
equal to the duration of our liabilities, price
changes resulting from (parallel) yield
movements will cancel out
This process is known as immunization
Immunization
Given a liability with duration DL and two
bonds with durations DA and DB chose
portfolio weights XA and (1 - XA) such that:
DP = X A DA + (1 X A )DB = DL
XA =
DL DB
DA DB
Example
Suppose we have a liability of $1000 at t = 5
There are only two bonds on the market: A 3-year, 10 %
coupon bond and a 10-year zero-coupon bond. They both
have a FV of $100. Lets assume a flat term structure with y =
5%. The price of Bond A is $61.39.
T=5
L
-1000
T = 10
Bond A
100
T=3
Bond B
10
10
110
Example
Bond A carries liquidity risk since we have to sell
it at t = 5
Bond B carries reinvestment risk since we have to
reinvest the coupons and FV
Strategy: Calculate the durations of the liability
and bonds and choose portfolio weights so that
the durations of our assets and liabilities are
equal
The liquidity and reinvestment risks will cancel
out
Example
The durations of the liability and bond A are trivially 5
respectively 10 years
We calculate the duration of Bond B as above:
PB =
10
1 100
1
+
= 113.62
0.05 1.053 1.053
10 / 1.05
10 / 1.052
110 / 1.053
DB =
1 +
2+
3 = 2.75
113.62
113.62
113.62
Example
Choose X so that the durations (yield
sensitivities) are equal:
DP = X A D A + (1 X A )DB = DL
X A D A + DB X A DB = DL
XA =
DL DB
5 2.75
=
= 0.31
DA DB 10 2.75
Example
We want to invest enough money in our bond
portfolio to meet the liability
That means the present value of our portfolio
has to be equal to the present value of our
liability
The PV of the liability is straight forward to
calculate:
PV (L ) =
1000
= 783.53
5
1.05
Example
Rebalancing
The portfolio are chosen to equalize the
durations given the yield and maturities that
we see today
These parameters will change constantly
To keep the portfolio immune we must
constantly recalculate the appropriate weights
and adjust our portfolio accordingly