Effective Duration

RAVI

Callable Bonds
A callable bond is a bond that can be redeemed
by theissuerprior to its maturity.
Ifinterest rateshave declined since the
company first issued the bond, the company is
likely to want torefinancethis debt at a lower
rate of interest.
In this case, the company calls its current
bonds and reissues them at a lower rate of
interest.

Advantages of Callable Bonds

A callable bond pays an investor a higher
couponthan a non-callable bond.
The issuer has flexibility in payment
amount and loan length when borrowing
money from an investor.
Issuing a bond lets a corporation borrow at
a lower interest rate than a bank loan,
saving the company money.

Disadvantages of Callable
Bonds
When a company reissues a bond at a lower interest
rate, the bond costs the investor more than when it
was originally issued.
The company can call a bond at a price
below the marketprice.
The bondholder must turn in the bond to get back
the principal; no further interest is paid.
An investor might reinvest at a lower interest rate
and lose potential income.
The price of a callable bond will not be much higher
than itscall price, as lowering interest rates mean
calling the bond is likely.

Disadvantages of Callable
Bonds
An investor must consider the yield-tocall (YTC) and yield-to-maturity (YTM)
when analyzing potential returns for a
callable bond to ensure potential
income matches his objectives.
A callable bond may not appropriate
for an investor seeking regular income
and predictable returns.

Effective Duration
Effective durationis a calculation used to
approximate the actual, modifieddurationof a
callable bond.
It takes into account that future interest rate changes
willaffect the expectedcashflows for a callable bond.
This measure of duration takes into account the fact
that expectedcash flowswill fluctuate as interest rates
change.
Effective duration can be estimated using
modified durationif abondwith embedded options
behaves like an option-free bond.

HOW IT WORKS (EXAMPLE):

Effective Duration = (P-- P+) /
[(2)*(P0)*(Y+- Y-)]
Where:
P0= thebond's initial price per $100 of
par value
P-= the bond's price if itsyieldfalls byx
basis points
P+= the bond's price if its yield rises by x
basis points
(Y+- Y-) = Change in yield in decimal

Example
Let's assume you purchase a
Company XYZ bond at 100% ofpar.
The bond currently has an 8% yield.
If the bond price increases to 101.5
when yields fall 10 basis points and
the price falls to 99.5 when yields
rise by 10 basis points, then using
the formula, we could calculate that
the bonds effective duration is:

 Effective Duration = (P-- P+) / [(2)*(P0)*(Y+Y-)]

(101.5 - 99.5) / [2 *(100) * (.001)]
= (2) / (.2) = 10.00
This bond's effective duration is 10.00.

This means that for every 100basis pointchange in

rates, the bond's pricewillchange by 10.00%.
Effective duration takes into account what
commonly happens to callable bondholders: interest
rates change over time and the bond iscalled away
before it matures.

WHY IT MATTERS:
Clearly, the fact that abondis callable affects its
price at certain times.
The higher acallable bond'scoupon rateis
compared to themarket's prevailingyield, the
more likely it is to be called and, therefore, the
lower the bond's effective duration.
In contrast, a bond with a coupon rate lower than
the prevailing market yield is not likely to be called
andwillthus have an effective duration similar to a
noncallable bond. In turn, the greaterdurationof
the bond, the greater its percentage price volatility.

Problems

Data Provided
Bond Par Amount: $1,000
Bond Coupon: 8%
Coupon Frequency: Annual
Market Discount Rate: 6%
Bond Maturity: 2 years
Calculate Duration, MD, Effective
Duration

Exercise

Question
An investment pays 1000 in three
years and 3000 at the end of the
fourth year.
An investor has purchased it to yield
the annual rate i = 0.075.
Find the duration and the modified
duration.

 The individual and the total present

values of the payments are
1000v 3 = 804.96, 3000v 4 = 2246.40,
1000v 3 + 3000v 4 = 3051.36.
The duration and the modified durations
are
D = 3 * 804.96/ 3051.36 +
4 * 2246.40/ 3051.36 = 3.7362,
DM = D/(1 + i) = 3.4755.

Question
What is the Price and duration of a 4year bond, with face value 10000,
YTM=3%, coupon= 4%.