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Macaulay duration
The duration of a fixed income instrument is a weighted
average of the times that payments (cash flows) are made.
The weighting coefficients are the present value of the
individual cash flows.
D
where PV(t) denotes the present value of the cash flow that
occurs at time t.
If the present value calculations are based on the bonds
yield, then it is called the Macaulay duration.
Now, P
2
n
n
1 y
(1 y )
1 dP
1 1
then
P d
1 y m
(1 y )
(1 y )
~
~
~
1 C
2C
nC
nF 1
2
n
n
1 y (1 y )
(1 y )
(1 y ) P
1 dP
modified duration =
P d
1
Macaulay duration =
m
nF
(1 y ) n
k 1
~
kC
(1 y ) k
1 dP
The negativity of
indicates that bond price drops as yield
P d
increases.
Prices of bonds with longer maturities drop more steeply with
increase of yield.
This is because bonds of longer maturity have longer Macaulay
duration:
DMac
P
.
P
1 y
Example
Consider a 7% bond with 3 years to maturity. Assume that the bond
is selling at 8% yield.
A
B
C
D
E
Year
0.5
1.0
1.5
2.0
2.5
3.0
Sum
Payment
3.5
3.5
3.5
3.5
3.5
103.5
~
Here, = 0.08, m = 2, y = 0.04, n = 6, C = 3.5, F = 100.
1%
2%
5%
10%
0.997
1.984
4.875
9.416
20.164
26.666
22.572
20.500
0.995
1.969
4.763
8.950
17.715
22.284
21.200
20.500
0.988
1.928
4.485
7.989
14.536
18.765
20.363
20.500
0.977
1.868
4.156
7.107
12.754
17.384
20.067
20.500
D
P
1 y
i.e.
Properties of duration
1. Duration of a coupon paying bond is always less than its
maturity. Duration decreases with the increase of coupon
rate. Duration equals bond maturity for non-coupon
paying bond.
2. As the time to maturity increases to infinity, the duration
does not increase to infinity but tends to a finite limit
independent of the coupon rate.
1 m
Actually, D where is the yield per annum, and
Duration of a portfolio
Suppose there are m fixed income securities with prices
and durations of Pi and Di, i = 1,2,, m, all computed at
a common yield. The portfolio value and portfolio
duration are then given by
P = P1 + P2 + + Pm
D = W1D1 + W2D2 + + WmDm
Pi
,
where Wi
P1 P2 Pm
i 1,2,, m.
Example
Bond Market value Portfolio weight
A
B
C
D
$10 million
$40 million
$30 million
$20 million
0.10
0.40
0.30
0.20
Duration
4
7
6
2
Immunization
bond
Example
Suppose Company A has an obligation to pay
$1 million in 10 years. How to invest in bonds
now so as to meet the future obligation?
An obvious solution is the purchase of a
simple zero-coupon bond with maturity 10
years.
Suppose only the following bonds are available for its choice.
Bond 1
Bond 2
Bond 3
coupon rate
6%
11%
9%
maturity
30 yr
10 yr
20 yr
price
69.04
113.01
100.00
yield
9%
9%
9%
duration
11.44
6.54
9.61
V = $121,854.78.
Yield
9.0
Bond 1
Price
Shares
Value
8.0
10.0
69.04
77.38
62.14
4241
4241
4241
292798.64 328168.58 263535.74
Bond 2
Price
113.01
120.39
106.23
Shares
1078
1078
1078
Value
121824.78 129780.42 114515.94
Obligation
value
414642.86 456386.95 376889.48
Surplus
-19.44
1562.05 1162.20
Observation
At different yields (8% and 10%), the value of the portfolio
almost agrees with that of the obligation.
Convexity measure
Taylor series expansion
dP
1 d 2P
2
P
(
)
higher order terms.
2
d
2 d
1 dP
To first order approximation, the modified duration P d
measures the percentage price change due to change in yield
.
Zero convexity
This occurs only when the price yield curve is a straight line.
price
error in estimating price
based only on duration
yield
2
1
d
P captures the percentage price change
The convexity measure
P d2
due to the convexity of the price yield curve.
Example
Consider a 9% 20-year bond selling to yield 6%. Suppose =0.002,
V+ = 131.8439, V = 137.5888, V0 = 134.6722.
Convexity V V 22V0
V0 ( )
Value of convexity
price
Bond B
Bond A
yield