BUS424: Fixed Income Security Analysis

CHAPTER 4: BOND PRICE VOLATILITY

I.

Price-Yield Relationship for Option-Free Bonds

The price of a bond changes in opposite direction to change in the required yield. Required Yield Price , v.v.

II. Price-Volatility Characteristics of Option-Free Bonds

PROPERTY 1:
PROPERTY 2:
PROPERTY 3:
PROPERTY 4:

Although prices of option-free bonds move in opposite direction of the change in required yield,
the percentage price change is not the same for all bonds
For very small changes in the yield required, the percentage price change for a given bond is
roughly the same, whether the required yield increases or decreases
For large changes in the required yield, the percentage price change is not the same for an
increase in the required yield as it is for a decrease in the required yield
For a given large change in basis points, the percentage price increase is the greater than the
percentage price decrease. This implies that the capital gain if required yield decreases will be
greater than the capital loss from a rise in required yield.

A. Characteristics of a Bond that affect Price Volatility

1. For a given term to maturity and initial yield, the lower the coupon rate, the greater the price volatility
2. For a given coupon rate and initial yield, the longer the term to maturity, the greater the price volatility
B. Effects of Yield to Maturity the higher the yield to maturity at which a bond trades, the lower the price volatility
III. Measures of Bond Price Volatility
A. Price value of a basis point (aka, dollar value of an 01, or DV01) the change in the price of a bond if the required
yield changes by 1 basis point
Indicates dollar price volatility (not percentage price volatility)
Typically expressed as absolute value of the change in price
B. Yield value of a price change another measure of price volatility is the change in yield for a particular price
change
C. Duration
1. Macaulay duration

1C
2C
nC
nM
+
+ +
+
2
n
1+ y ( 1+ y )
(1+ y ) (1+ y )n
Macaulay duration=
P
2. Modified duration

modified duration=

Macaulay duration
1+ y

dP 1
=modified duration
dy P

3. Spread duration measure of how a non-Treasury bonds price will change if the spread sought by the market
changes

a. Fixed-rate bonds approximate change in the price of a fixed-rate bond for a 100-basis-point change in
the spread
b. Floating-rate bonds the price sensitivity will depend on whether the spread the market wants changes
o The spread is reflected in quoted margin in the coupon rest formula
4. Portfolio duration the weighted average duration of the bonds in the portfolios
o Portfolio managers look at interest rate exposure to a certain issue in terms of contribution to portfolio
duration
'

contribution portfolio duration=weight of issue issu e s duration

5. Analytical vs. empirical duration the risk associated with a bond is composed of two elements: interest rate
risk and equity risk
o For corporate bonds with a high credit rating the interest-rate risk is the dominant risk
o For corporate bonds with a low credit rate, the equity risk is more likely to be dominant the duration
measure as calculated by formula may not be a good measure of interest-rate risk
D. Measuring convexity
1. Dollar convexity measure

dollar convexity measure=

d2 P
d y2

2. Convexity measure

convexity measure=

d2 P 1
d y2 P

3. Convexity measure in years

convexity measure years=

convexity measurem periods per year

2
m

4. Measures of bond price volatility and their relationship to one another

By definition

D=

Close approximation for small

D
1+

P
: D P
y

y
m

To close approximation

D P
PVBP
10,000

Close approx.:

for small
D: Macaulay duration
y: yield to maturity (decimal)
m: number of coupons per yr

PVBP=

y :

P
slope of price yield curve
Y

For bonds at or near par

Close approximation for small

D
100

D =

D*: modified duration

Y: yield to maturity (percent)

P
Y

PVBP: price val of basis point

P: price of bond

E. Properties of convexity
1. As the required yield increases (decreases), the convexity of a bond decreases (increases) positive
convexity
o Implies that the duration of an option-free bond moves in the right direction as market yields change
if yields rise, price falls, and the price decline is slowed down by a decline in the duration of the
bond as market yields rise
2. For a given yield and maturity, the lower the coupon, the greater the convexity of a bond
3. For a given yield and modified duration, the lower the coupon, the smaller the convexity
o Implies that zero-coupons have lowest convexity for a given modified duration
F. Duration is not a measure of time duration is the approximate percentage change in price for a small change in
interest rates the approx. percentage change in price for a 100 bps change in interest rates
EX: If a bond has a duration of 40, it means that for a 100 basis point change in yield, the bonds price will
change by 40%
G. Approximating a bonds duration and convexity measure
1. Increase the yield on the bond by a small number of basis points and determine the new price at this higher
yield level, denoted P+
2. Decrease the yield on the bond by the same number of basis points and calculate the new price, denoted P 3. Use the following formula:

P+
2( P0)( y)
P
duration=

NOTE: Duration is a by-product of a pricing model poor pricing model = poor duration estimate

4. Approximate convexity measure

++

P2 P

P0 ( y )
P
convexity=
IV.

Measuring a Bond Portfolios Responsiveness to Nonparallel Changes in Interest Rates a shortcoming of

duration is that it could be inadequate in measuring how a securitys price or a portfolios value will change
when interest rates do not change in a parallel manner
A. Yield curve reshaping duration - this approach concentrates on sensitivity of a portfolio to changes in the
slope of the yield curve focus on three maturity points on the yield curve, 2-yr, 10-yr, and 30-yr