Fixed Income Markets - Part 2

Duration and convexity

FIN 509: Foundations of Asset Valuation
Class session 2
Professor Jonathan M. Karpoff
FIN 509 Class session 2 2
Sleeping Beauty bond case - Central points
Bond prices are sensitive to changes in interest rates
This sensitivity tends to be greater for longer term bonds
But duration is a better measure of term than maturity
Duration for 100-year bond = 14.24
Duration for 30-year zero = 30
Duration for 30-year coupon = 12.64
Sleeping beauty bond has longer maturity but less sensitivity to interest rates
than the 30-year zero bond
30-year coupon and zero bonds have the same maturity but 30-year zero is
more sensitive than the 30-year coupon bond
FIN 509 Class session 2 3
Duration and convexity: Outline
I. Macaulay duration
II. Modified duration
III. Examples
IV. The uses and limits of duration
V. Duration intuition
VI. Convexity
VII. Examples with both duration and convexity
VIII. Takeaways
FIN 509 Class session 2 4
I. (Macauly) duration
Weighted average term to maturity
Measure of average maturity of the bonds promised cash flows
Duration formula:


where:




t is measured in years
P
) 1 /(
) ( PV
) ( PV
t
t t
t
y CF
Bond
CF
w
+
= =
D
m
= t w
t
( )
t =1
T

w
t
=1
t =1
q

FIN 509 Class session 2 5

Duration - The expanded equation








Duration is shorter than maturity for all bonds except zero
coupon bonds
Duration of a zero-coupon bond is equal to its maturity

D
m
= t w
t
t =1
T

= t
PV(C
t
)
PV(Bond)



(

(
t =1
T

=
1
C
1
(1 + y)
1



(

(
+ 2
C
2
(1+ y)
2



(

(
+ . .. + N
C
N
(1+ y)
N



(

(
C
1
(1+ y)
1
+
C
2
(1 + y)
2
+. .. +
C
N
(1+ y)
N
FIN 509 Class session 2 6
II. Modified duration (D*
m
)




Direct measure of price sensitivity to interest rate changes
Can be used to estimate percentage price volatility of a bond
y
D
D
m
m
+
=
1
*
AP
P
= D
m
*
Ay
FIN 509 Class session 2 7
Derivation of modified duration







So D*
m
measures the sensitivity of the % change in bond price
to changes in yield

y
D
D
m
m
+
=
1
*
P =
C
t
(1+ y)
t
t =1
N

cP
cy
=
1
1 + y
t
C
t
(1 + y)
t
|
\

|
.
t =1
N

cP
cy
=
D
m
1 + y
P = D
m
*
P
1
P
cP
cy
= D
m
*
FIN 509 Class session 2 8
III. An example
Compare the price sensitivities of:
Two-year 8% coupon bond with duration of 1.8853 years
Zero-coupon bond with maturity AND duration of 1.8853 years
Semiannual yield = 5%
Suppose yield increases by 1 basis point to 5.01%





Upshot: Equal duration assets are equally sensitive to interest rate
movements
Original Price New Price % Change
Coupon bond 964.54 964.19 -.0189
Zero bond 831.96 831.61 -.0189
FIN 509 Class session 2 9
Another example
Consider a 3-year 10% coupon bond selling at $107.87 to yield 7%.
Coupon payments are made annually.
87 . 107 79 . 89 73 . 8 35 . 9 bond of Price
79 . 89
) 07 . 1 (
110
) (
73 . 8
) 07 . 1 (
10
) (
35 . 9
) 07 . 1 (
10
) (
3
3
2
2
1
= + + =
= =
= =
= =
CF PV
CF PV
CF PV
Duration (D
m
) = 1*
9.35
107.87
|
\
|
.
+ 2 *
8.73
107.87
|
\
|
.
+ 3 *
89.79
107.87
|
\
|
.
= 2.7458
FIN 509 Class session 2 10
Another example page 2
Modified duration of this bond:



If yields increase to 7.10%, how does the bond price change?
The percentage price change of this bond is given by:



= 2.5661 .0010 100
= .2566

5661 . 2
07 . 1
7458 . 2
*
= =
m
D
AP
P
100 = D
m
*
Ay 100
FIN 509 Class session 2 11
Another example page 3

What is the predicted change in dollar terms?






New predicted price: $107.87 .2768 = $107.5932

Actual dollar price (using PV equation): $107.5966
AP =
.2566
100
P
=
.2566
100
$107.87
= $.2768
Good
approximation!
FIN 509 Class session 2 12
Summary: Steps for finding the predicted
price change
Step 1: Find Macaulay duration of bond.
Step 2: Find modified duration of bond.
Step 3: Recall that when interest rates change, the change in a bonds
price can be related to the change in yield according to the rule:




Find percentage price change of bond
Find predicted dollar price change in bond
Add predicted dollar price change to original price of bond
Predicted new price of bond
AP
P
100 = D
m
*
Ay 100
FIN 509 Class session 2 13
IV. Why is duration a big deal?
Simple summary statistic of effective average maturity

Measures sensitivity of bond price to interest rate changes
Measure of bond price volatility
Measure of interest-rate risk

Useful in the management of risk
You can match the duration of assets and liabilities
Or hedge the interest rate sensitivity of an investment

FIN 509 Class session 2 14
Qualifiers
First-order approximation

Accurate for small changes in yield

Limitation: Depends on parallel shifts in a flat yield curve
Multifactor duration models try to address this

Strictly applicable only to option-free (e.g., non-convertible)
bonds
FIN 509 Class session 2 15
An aside: Corporate bonds and default risk
Most corporate bonds are either callable or convertible
Callable bonds give the firm the right to repurchase these bonds at a pre-
specified price on or after a pre-specified date
Convertible bonds give their holders the right to convert the bonds they
hold into common stock of the firm
Bond Rating: An indicator or assessment of the issuers ability to meet its
interest and principal payments
Moodys: Aaa; Aa; A; Baa; Ba; Caa; Ca; C (1-3)
S&P: AAA; AA; A; BBB; BB; B; CC; C; CI; D (+/-)
FIN 509 Class session 2 16
V. Check your intuition
How does each of these changes affect duration?
1. Having no coupon payments.
2. Decreasing the coupon rate.
3. Increasing the time to maturity.
4. Decreasing the yield-to-maturity.

FIN 509 Class session 2 17
Pictorial look at duration
*
Cash flows of a seven year 12% bond discounted at 12%.
Shaded area of each box is PV of cash flow






Distance (x-axis) is a measure of time
FIN 509 Class session 2 18
Effects of the coupon

Duration is similar to the distance to the fulcrum (5.1 years)








Duration
High C, Lower Duration
Low C, Higher Duration
FIN 509 Class session 2 19
Example of the coupon effect
Consider the durations of a 5-year and 20-year bond with
varying coupon rates (semi-annual coupon payments):







5 year bond 20 year bond
Zero coupon 5 20
6% coupon 4.39 11.90
9% coupon 4.19 10.98
FIN 509 Class session 2 20
Effect of maturity and yield on duration
Duration increases with increased maturity







Effect of yield
| yield, weight on earlier payments |, fulcrum shifts left
+ yield, weight on earlier payments +, fulcrum shifts right
FIN 509 Class session 2 21
VI. A complication
Notice the convex shape of price-yield relationship








Bond 1 is more convex than Bond 2
Price falls at a slower rate as yield increases
A
B
5% 10%
Bond 1
Bond 2
Price
Yield
FIN 509 Class session 2 22
Convexity
Measures how much a bonds price-yield curve deviates from a
straight line
Second derivative of price with respect to yield divided by bond price






Allows us to improve the duration approximation for bond price
changes
c
2
P
c
2
y
=
1
(1 + y)
2
CF
t
(1+ y)
t
(t
2
+ t)



(

(
t =1
N

Convexity =
1
P
c
2
P
c
2
y
FIN 509 Class session 2 23
Predicted percentage price change
Recall approximation using only duration:



The predicted percentage price change accounting for
convexity is:




AP
P
100 = D
m
*
Ay 100
AP
P
100 = D
m
*
Ay 100
( )
+
1
2
Convexity (Ay)
2
100
|
\
|
.
FIN 509 Class session 2 24
VII. Numerical example with convexity
Consider a 20-year 9% coupon bond selling at $134.6722
to yield 6%. Coupon payments are made semiannually.

D
m
= 10.98





The convexity of the bond is 164.106.





66 . 10
) 2 / 06 . 0 ( 1
98 . 10
*
=
+
=
m
D
FIN 509 Class session 2 25
Numerical example - page 2
If yields increase instantaneously from 6% to 8%, the percentage
price change of this bond is given by:
First approximation (Duration):
10.66 .02 100 = 21.32

Second approximation (Convexity)
0.5 164.106 (.02)
2
100 = +3.28

Total predicted % price change: 21.32 + 3.28 = 18.04%
(Actual price change = 18.40%.)
FIN 509 Class session 2 26
Numerical example - page 3
What if yields fall by 2%?
If yields decrease instantaneously from 6% to 4%, the percentage
price change of this bond is given by:
First approximation (Duration):
10.66 .02 100 = 21.32

Second approximation (Convexity)
0.5 164.106 (.02)
2
100 = +3.28

Total predicted price change: 21.32 + 3.28 = 24.60%

Note that predicted change is NOT SYMMETRIC.
FIN 509 Class session 2 27
VIII. Takeaways: Duration and convexity
Price approximation using only duration:

New Bond Price ($) = P + [AP (Duration)]


Price approximation using both duration and convexity:

New Bond Price ($) = P + [AP (Duration)] + [AP (Convexity)]
= P+ P D
m
*
Ay
| |
= P+ P D
m
*
Ay
| |
+ .5 P Convexity (Ay)
2
| |