SAPM 1 (2019-2020)

FIXED INCOME SECURITIES

1
 CONTENTS: PART A
• Intrinsic value vs market value
• Intrinsic value: how measured
• Market value
• What are bonds
• Inputs for determining intrinsic value
• Intrinsic value of discount bond
• Intrinsic value of level coupon bond
• Coupon Rate vs Market Interest Rate: Par, Premium
& Discount Bonds
• Sources of Return
• Measures of Yield
• Shortcomings of CY
• Interpretation of YTM
• Proxy for market interest rates
• Spot Rates & YTM
• Average of term structure
• Implied assumptions of YTM
• Reinvestment rate equals YTM
• Issues with YTM
• Misleading for long maturity bonds
• Portfolio YTM does not equal weighted YTM of
constituents
• For premium bonds
• Coupon rate >CY>YTM
• Bond equivalent yield
• Bond equivalent yield & effective yield
• Holding period yield or realized yield
• Always lies between r and YTM
• T bill yield or discount yield
• T bill yield & effective yield
• Limitations of T bill yield
• Yield to call/ put
• Semi annual coupons
• Adjustment for accrued interest
• Dirty vs clean price
• Interest rate risk & reinvestment rate risk
• Factors affecting reinvestment risk
• Interest rate risk
• Price-yield relationship
• Price vs yield curve
• Convexity of price-yield curve
• Consequences of convexity
• Consequences of convexity
• Measures of interest rate risk
• Dollar value per bp
• Duration and convexity
• Macauley’s and modified duration
• Interest rate elasticity
• Immunization
• The caveat
• Duration and immunization
• Significance of duration
• Duration of zeros
• Duration: important properties
• Duration and coupon rates
• Duration and coupon rates
• Duration and maturity
• Price sensitivity and maturity
• Bond price and maturity
• Duration gap
• Limitations of duration gap analysis
• Maturity and bond price sensitivity: problem no 20
 SOME TERMINOLOGY
• Face value
• Coupon rate, frequency
• Maturity/term to maturity
• Premium/par/discount bonds
• Premium/discount on redemption
 WHAT IS “INTRINSIC VALUE”?
• Intrinsic value of a financial security is the
present value of all future cash flows
attributable to that security discounted at the
rate that is representative of the risk profile of
these cash flows T
C
V0 =  i

1 + r 
i
I=1
i-1,i
 DEFINITION OF A BOND
• A bond is a legally binding agreement between a
borrower (bond issuer) and a lender (bondholder):
• Specifies the principal amount of the loan.
• Specifies the size and timing of the cash flows:
• In dollar terms (fixed-rate borrowing)
• As a formula (adjustable-rate borrowing)
 CLASSIFICATION OF FI SECURITIES:
TERM TO MATURITY BASIS

• Money market instruments: maturity less than

one year
• Notes: maturity upto ten years
• Bonds: maturity exceeding ten years
 VALUATION OF BONDS
• First Principles: Value of financial securities = PV of
expected future cash flows To value bonds and
stocks we need to:
• Estimate future cash flows:
• Size (how much) and Timing (when)
Discount future cash flows at an appropriate rate:
• The rate should be appropriate to the risk
presented by the security.
 BOND VALUE & MARKET INTEREST RATES:
BOND PRICES
• Intrinsic value is investor specific hence, for intrinsic
value, we use the discount rate that encapsulates
the investor’s own risk perception of the security.
• Similarly, if we use the interest rates appropriate to
the market’s risk perception of the bond’s
cashflows, we shall obtain the market price of the
bond although the converse is more common since
price is determined by demand and supply
 VALUE OF A DISCOUNT BOND
• A discount bond is a bond that is issued/sold at a
discount to face value and redeemed at face
value on maturity. There is no other cash flow
i.e. no interest payments. F
V0 =
1 + S 
T
0 ,T
 VALUE OF A LEVEL COUPON BOND
T T
Ci cF F
V0 =  = +
1 + S0i  1 + r 
1 + r 
i i T
I=1 I=1

 1 + r  - 1 
T
T
1 F F
= cF  + = cF  +
I=1  1 + r  1 + r   r 1 + r   1 + r 
i T T T

cF F  c  c  1 
= + 1 -  = F + F 1 -   - 1
1 + r   r  r   1 + r 
T T
r 
 SPOT RATES
• Spot interest rates are the YTMs on bonds that
pay only one cash flow to the investor. Such a
bond is called a pure discount bond or zero
coupon bond.
• Spot rates are usually calculated and quoted for
6 monthly intervals and then annualized by
doubling the 6-monthly rate.
 PRICES VS INTEREST RATES
• Bond prices and the corresponding interest rates
are inversely related
• If market interest rates exceed the coupon rate
the bond will be priced below par value
(discount bond) and vice versa
 SOURCES OF RETURN
• Coupon income
• Interest on reinvested coupons
• Capital gains
 MEASURES OF YIELD
• Nominal yield (coupon rate)
• Current yield
• Yield to maturity
• Realized yield
• Discount yield (t-bill yield)
• Yield to call
• Yield to put
• Cash flow yield
 CURRENT YIELD
• CURRENT YIELD

= ANNUAL COUPON PAYMENTS

CURRENT MARKET PRICE
 CURRENT YIELD:LIMITATIONS
• The current yield considers only the coupon
interest and no other source for an investor’s
return.
• No consideration is given to the capital gain an
investor will realize when a bond purchased at a
discount is held to maturity.
• No consideration is given to reinvestment income.
 WHAT IS YTM???
• YTM is the discount rate that equates the
present value of future cash flows from the
instrument to its current market price.
T
Ct
P0  
1  y 
t
t 1

F F
For a zero coupon bond P0  
1  y  1  S0T 
T T

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 SPOT RATE: DEFINITION
Spot interest rates of a particular maturity are
the YTMs on zero coupon bonds of bonds of the
same maturity.

F F
P0    y  S 0T
1  y  1  S0T 
T T
 EXAMPLE 1
• Consider three bonds A,B and C. Face value of each bond
is 1,000 and maturity is two years.
• Bond A is a zero coupon bond redeemable at face value
• Bond B is a par bond with annual coupons.
• Bond C is an annuity with two equal payments at the end
of each of two years, quoting at par.
• The annual spot rates are S01 = 10% and S02=15%
• Calculate the YTM of each bond.
TIMELINE YTM 0 1 2
SPOT RATE (P.A.) 10% 15%
DISCOUNT FACTOR 0.90909 0.75614
BOND A 0.15 -756.14367 0 1000
BOND B 0.14644 -1000.0006 146.44 1146.44
BOND C 0.131324 -1000 600.516 600.516
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 WHY YTM???
MATURITY YTM 1 2
COUPON 15% 15%
SPOT RATE 8% 12%
DISC RATE 0.9259 0.79719
A 0.117187 -1056 150 1150
B 0.104216 -1060 650 575
 YTM: AN INTERPRETATION
• The YTM may also be interpreted as a proxy/
average for the market interest rates. Why???
• Captures the term structure in one single
interest rate.
For annual coupons,
T T T
Ci Ci Ci
P0 =  = 
i=1  1 + S 0i  i=1 1  y 
 1 + f 
i i i
i=1
j-1,j
J=1
 SPOT RATES, YTM & PRICE
• A given spectrum of spot rates and pattern of cash
flows uniquely determine the price and, therefore,
the YTM.
• There is 1-1 correspondence between price and
YTM of a given bond.
• A given YTM and pattern of cash flows uniquely
determine the price. Does this information uniquely
determine the spectrum of spot rates? “NO”.
MATURITY YTM 1 2
SPOT RATE 0.08 0.12
DISC RATE 0.92593 0.79719
BOND PRICE 0.1042 -1060 650 575
NEW SPOT RATE -1060 0.0829 0.11803
P0  a1 1  a2 2  a1  1  a2  2

 
1 1

a2
a1
  2
  2

Since there is only one eq with
two unknowns, we have one dof
that can be set arbitrarily.
Hence, we have infinite no of
solutions.
 YTM AND BOND PRICE
$1400
When the YTM < coupon, the bond trades at a

Bond Value
1300
premium.

If YTM=coupon, the bond trades at par.

1200 P
1100
Q
1000

800
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
6 Discount Rate
When the YTM > coupon, the bond trades at a discount. 3/8
 IMPLIED ASSUMPTIONS OF YTM
• THE REINVESTMENT RATE EQUALS THE YTM
• THE INVESTOR PLANS TO HOLD THE BOND TO
MATURITY
 SO WHAT IS RE-INVESTMENT RATE?
• The rate at which intermediate coupon
payments may be re-invested by the investor.

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 REINVESTMENT RATE EQUALS YTM
• Consider two bonds A & B, both of maturity 2 years priced at
916.77 with YTM of 12%. Bond A has a cashflow of 1150 at t=2
while B has a cashflow of 1026.8 at t=1. Calculate reinvestment
rate r12.
MATURITY 1 2

A 0.12 -916.8 0 1150

B 0.12 -916.8 1026.8 0
0.12002
 ISSUES WITH YTM: REINVESTMENT RATE
• THE YTM MEASURE FOR LONG-TERM MATURITY
COUPON BONDS TELLS LITTLE ABOUT THE
POTENTIAL RETURN THAT AN INVESTOR MAY
REALIZE IF THE BOND IS HELD TO MATURITY.
 ISSUES WITH YTM CONTD…
• Which is better if the reinvestment rate is 9% pa?
Bond A Bond B
Coupon 10% 3%
Face Value 100 100
Price 138.90 70.22
Maturity 15 years 15 years
Frequency of payment Annual Annual
Yield to maturity 6% 6.1%
 A B
REINVESTMENT RATE 6.66% 6.66%
REINVESTED COUPONS 243.6823 73.1047
RED VALUE 100.12223 100.321
TOTAL 343.80453 173.426
PRICE 138.9 70.22
RETURN 1.062284 1.06213
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PRICE A 138.9 B 70.22
INTT RATE TOTAL CASH FLOW TCF/PRICE RETURN
A B A B A B
0.06 332.88 170.15 2.39654 2.4231 0.06 0.0608
0.061 334.66 170.68 2.40936 2.43065 0.0604 0.061
0.065 341.94 172.87 2.46177 2.46183 0.0619 0.0619
0.066 343.805 173.4261 2.47519 2.46975 0.0622 0.06212
0.07 351.41 175.71 2.52995 2.50228 0.0638 0.0631
We illustrate the calculations for Bond A
Step 1 : Calculate Redemption Value  RV  from given ytm :
  1 + y n - 1  RV
The ytm eq. is P0 = cF   +
   
n n

 y 1 + y 
 1 + y
  1 + 0.06  - 1 
15
RV
138.90 = 10   +
   
15 15

 0.06 1 + 0.06 
 1 + 0.06
Step 2 : Calculate the total terminal value from the bond :
Total terminal from the bond
TV = Total proceeds on maturity
n

 cF  1 + r 
n-i
= + RV
i=1
15

 10  1 + 0.09 
15-i
= + RV
i=1
Step 3 : Calculate return per annum
1 15
 15 
  10  1 + 0.09 
15-i
+ RV 
ry =  i=1  -1
 138.90 

 

 ISSUES WITH YTM CONTD.

• THE YTM OF A PORTFOLIO IS NOT EQUAL TO THE

WEIGHTED AVERAGE YTM OF ITS CONSTITUENTS
• A portfolio is made of equal proportions (by value)
of two securities A and B. The current price of A is
100 and its respective cashflows over the next
three years is 15, 15 and 115. The price of B is 100
and the cash flows are 6,106 and 0. Calculate the
YTM of A,B and the portfolio as well.
PORTFOLIO 0 1 2 3
A 0.15 -100 15 15 115
B 0.06 -100 6 106 0
PORTFOLIO 0.11289 -200 21 121 115
 PROPERTIES OF YTM
• Bond prices and YTM are inversely related:
• The value of a bond would be equal to its face value only
when the coupon interest rate and YTM are equal.
• The value of a bond would be higher (lower) than its face
value when the coupon interest rate is higher (lower)
than YTM.
• The value of a bond would decrease (increase) as it
approaches maturity, if it is a premium (discount) bond
 REALIZED YIELD/ HOLDING PERIOD YIELD
• Realized yield is the yield actually earned by the
investor on his investment, and depends on the
reinvestment rate available to him, and the holding
period chosen by him.
• The realized yield (ry)is given by the eq
P0 1 + ry  = TOTAL CASH FLOWS AT
n

END OF HOLDING PERIOD

= PROCEEDS FROM REINVESTED COUPONS
+ SALE PRICE
 PROPERTIES OF REALIZED YIELD
• The realized yield will always lie between the
YTM and the reinvestment rate.
• For bonds with longer term to maturity realized
yield will be closer to the reinvestment rate. for
bonds with shorter term to maturity, realized
yield will be closer to the YTM.
 COUPON RATE, CURRENT YIELD AND
YTM
• Bond selling at par
• coupon rate = current yield = ytm
• Bond selling at discount
• coupon rate < current yield < ytm
• Bond selling at premium
• coupon rate > current yield > ytm
Consider a premium bond, so that P0 > F and c > y
cF cF
Then, Coupon Rate = c = > = Current yield
F P0
Current yield cF cF
Now, = =
ytm yP0  T cF F 
y + T 
 i=1 1 + y  1 + y  
i
 
c 1 + y 
T
cF
= = >1
  1 + y  - 1  F  c 1 + y  - c + y
T T

y cF  T 
+ T
  y 1 + y   1 + y  
 SPOT RATES AND YTM
For annual coupons,
T T T
Ci Ci Ci
P0 =  = 
1 + S0i   1 + f  1  y 
i i i
i=1 i=1 i=1
j-1,j
J=1

• It follows that ytm is some kind of an averaging,

maybe not in the conventional sense, of the spot
rates over the life of the bond for, we must have
• SMIN < Y< SMAX
THE CASE OF ZERO COUPONS
F F
P0 = = OR S0T = y
1 + S0T  1 + y 
T T
 THE CASE OF PAR BONDS
T T
cF F cF F
F= + = + but c = y
1 + S 0i  1 + S 0T  1 + y  1 + y 
i T i T
i=1 i=1

 1 1  1 1
y  -  + =
1 + y  1 + S 0i   1 + y  1 + S 0T 
i i T T

 1 + y T - 1  1 1 1
y  - y  + =
 y 1 + y   1 + S 0i  1 + y  1 + S 0T 
T i T T

1
1-
 1 + S 0T 
T

y=
1
 1 + S  i
0i
 BOND EQUIVALENT YIELD
• The convention developed in the bond market to
move from a semiannual yield to an annual yield is
to simply double the semiannual yield. This is
called the bond-equivalent yield.
• In general, when one doubles a semiannual yield
(or a semiannual return) to obtain an annual
measure, one is said to be computing the measure
on a bond-equivalent basis.
BOND EQUIVALENT YIELD VS
EFFECTIVE ANNUAL YIELD
• (1+ye) = (1+0.5ybey)2
• Consider a bond that pays a semi annual coupon
of 50 over the next two years. It is being quoted
at 1075 (FV=1000). Calculate the bond
equivalent yield and effective annual yield.
The bond equivalent yield by can be
obtained by solving the equation
4
1 1000
1075  50 i
 4
j 1 yb   yb 
1   1  
 2  2
The effective yield & ytm are then obtained by
2
 yb 
ie  y  1    1
 2
 REALIZED YIELD
• Realised yield is the yield actually earned by the
investor on his investment, and depends on the
reinvestment rate available to him, and the holding
period chosen by him.
• The realized yield (ry)is given by the eq
P0 1 + ry  = TOTAL CASH FLOWS AT
n

END OF HOLDING PERIOD

= PROCEEDS FROM REINVESTED COUPONS
+ SALE PRICE
 PROBLEM 2
• A portfolio manager of an insurance company has a known
liability that will occur at the end of six years. He can either
purchase a 13% GOI bond due in 6 years or a 13% GOI bond
due in 10 years that would be sold at the end of 6 years. Both
bonds have a face value of Rs. 1000 and are quoted at par. The
interest rates are expected to make a single downward change
at the end of year 4 and the market yield would dip from 13
per cent and remain at 10 per cent through year 10.
a. Calculate the realized returns on the two bonds.
b. If the objective of the insurance company is to minimize
interest rate risk which bond will you recommend? Why?
Total proceeds from Bond A at the end of 6 years
( A)  130 1.131.13 1.13 1.10 1.10  
130 1.131.131.10 1.10   130 1.13 1.10 1.10 
130 1.10 1.10   130 1.10   130  1000
Since the bonds are quoted at par , we have
1000 1  ry   A whence ry will be calculated .
6

In the sec ond case, the sale price of the bond at the
end of year 6 will be :
( B )  130 1.10   130 1.10   130 1.10   1130 1.10 
1 2 3 4

so instead of 1000 you will substitute ( B ) and solve the

above equation
 PROPERTIES OF REALIZED YIELD
• The realized yield will always lie between the
ytm and the reinvestment rate.
• For bonds with longer term to maturity realized
yield will be closer to the reinvestment rate. For
bonds with shorter term to maturity, realized
yield will be closer to the ytm.
We have (r = reinvestment rate)
P0 1 + ry  = cF 1 + r 
T T-1
+ .... + cF + F
P0 1 + y  = cF 1 + y 
T T-1
+ .... + cF + F
so that

P0 1 + ry  - 1 + y   = cF  1 + r  - 1 + y  
T-1
T T i i

  i=1
 
Let r > y, then RHS is positive so that ry > y

1 + ry 
T
T
1 F
P0 = cF  +
1 + r  1 + r  1 + r 
T i T
i=1

Since it is assumed that r > y, the RHS is less than P0

Hence, ry < r whence r > ry > y
The reverse inequality will hold if r < y
 TREASURY BILL YIELD/DISCOUNT YIELD
• Treasury bills are zero-coupon instruments with
a maturity of one year or less. The yield on T
bills is quoted on a discount basis.
 P1 - P0   360   360 
d=    1 - p   
 P1  NSM   NSM 
By definition of T  bill yield
1
P1  P0 360 P1  dN SM 
d   so that  1  
P1 N SM P0  360 
Now, effective return
365 N SM
 P1  P0 
ie  1  r   1  1  1
365 N SM

 P0 
365 N SM
 dN SM  
1
365 N SM
 P1 
   1   1    1
 P0  
 360  
 EXAMPLE 2
• Consider a treasury bill of face value 100 and a
tenure of 60 days presently being quoted at 99.
Calculate the discount yield, effective annual
yield and bond equivalent yield.
 P1  P0 360
1. The discount yield is given by d  
P1 N
365 N
 P1 
2. The effective yield is ie    1
 P0 

3. The bond eq yield is given by yb  2 1  ie  1 
63
 ISSUES WITH T BILL YIELD
• The quoted yield on a discount basis is not a meaningful
measure of the return from holding a treasury bill for two
reasons.
• First, the measure is based on a maturity value investment
rather than on the actual dollar amount invested.
• Second, the yield is annualized according to a 360-day year
rather than a 365-day year, making it difficult to compare
yields the use of 360 days for a year is a convention for
money market instruments. despite its shortcomings as a
measure of return,
 YIELD TO CALL
• When a bond is callable, the practice has been to
calculate a yield to call as well as a yield to maturity. A
callable bond may have a call schedule. The yield to call
assumes the issuer will call a bond on some assumed call
date and that the call price is the price specified in the
call schedule. Typically, investors calculate a yield to first
call or yield to next call.
• The yield to first call is computed for an issue that is not
currently callable, while the yield to next call is computed
for an issue that is currently callable.
• The procedure for calculating any yield to call
measure is the same as for any yield to maturity
calculation: determine the interest rate that will
make the present value of the expected cash
flows equal to the price plus accrued interest. In
the case of yield to first call, the expected cash
flows are the coupon payments to the first call
date and the call price etc.
 YIELD TO PUT
• When a bond is puttable, the yield to the first
put date is calculated. The yield to put is the
interest rate that will make the present value of
the cash flows to the first put date equal to the
price plus accrued interest.
 SEMIANNUAL COUPONS
• Adjust the coupon payments by dividing the
annual coupon payment by 2
• Adjust the discount rate by dividing the annual
discount rate by 2
• The time period t in the present value formula is
treated in terms of 6-month periods rather than
years
VALUING A BOND BETWEEN COUPON
PAYMENTS
• IN THIS CASE, ONE OF THE CASH FLOWS, THE
VERY NEXT CASH FLOW, ENCOMPASSES TWO
COMPONENTS AS SHOWN BELOW:
• INTEREST EARNED BY THE SELLER
• INTEREST EARNED BY THE BUYER
 ADJUSTMENT IN PRICE FOR ACCRUED
INTEREST
• The interest earned by the seller is the interest
that has accrued between the last coupon
payment date and the settlement date. This
interest is called accrued interest.
• At the time of purchase, the buyer must
compensate the seller for the accrued interest.
• The buyer recovers the accrued interest when the
next coupon payment is received.
 DIRTY VS CLEAN PRICE
• WHEN THE PRICE OF A BOND IS COMPUTED USING THE
PRESENT VALUE CALCULATIONS DESCRIBED EARLIER, IT
IS COMPUTED WITH ACCRUED INTEREST EMBEDDED IN
THE PRICE. THIS PRICE IS REFERRED TO AS THE FULL
PRICE. (DIRTY PRICE) IT IS THE FULL PRICE THAT THE
BUYER PAYS THE SELLER.
• FROM THE FULL PRICE, THE ACCRUED INTEREST MUST
BE DEDUCTED TO DETERMINE THE PRICE OF THE BOND,
THE CLEAN PRICE.
INTEREST RATE RISK
 INTEREST RATE RISK
• Since the price of a bond fluctuates with market
interest rates, the risk that an investor faces
when investing in a long bond portfolio is that
the price of a bond held in a portfolio will
decline if market interest rates rise
UNANTICIPATEDLY. This risk is referred to as
interest rate risk.
 YTM AND BOND PRICE
$1400

Bond Value
1300
YIELD PRICE CURVE
1200 P
1100
Q
1000

800
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
6 Discount Rate
When the YTM > coupon, the bond trades at a discount. 3/8
CONVEXITY OF PRICE-YIELD CURVE
First derivative is negative.
N
Ct
P0 =  SO THAT Second derivative is positive.
t =1  1 + y 
t
Slope is negative, θ is in
dP0 1 N
tCt second quadrant.
dy
=- 
1 + y  t =1 1 + y  t
 0;
θ is decreasing in magnitude.
d 2 P0 1 N t  t + 1 Ct
= +  >0
dy 2 1 + y  1 + y 
2 t
t =1

THEREBY ESTABLISHING THE CONVEXITY

OF THE PRICE / YIELD CURVE
 YTM AND BOND PRICE
$1400
Negative first derivative:

Bond Value
Price and YTM are 1300
inversely related. YIELD PRICE CURVE
Positive 2nd derivative: 1200 P
Slope increases with
YTM. 1100
These two together imply Q
that the magnitude of 1000

the slope is decreasing

with YTM thereby 800
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
establishing convexity. 6 Discount Rate
3/8
Impact of convexity:
For a given decrease in
yield, the percentage
price increase is
greater than the
percentage price
decrease for an equal
increase in yield.
 MEASURES OF INTEREST RATE RISK
• DOLLAR VALUE PER BASIS POINT (DV01)
• MACAULAY’S DURATION & CONVEXITY
• MODIFIED DURATION
• INTEREST RATE ELASTICITY
 DOLLAR VALUE PER BP
• DOLLAR VALUE PER BASIS POINT (DV01) IS THE
CHANGE IN BOND PRICE CORRESPONDING TO A
CHANGE OF ONE BASIS POINT IN THE YIELD
• It is given by the negative slope of the
price/yield curve:
dP  y 
DV 01  
dy
 N
Ct
DURATION P0 =  ; P0 = P  y 0  ; P0 + dP = P  y 0 + dy 
1+ y 0 
t
t=1

EXPANDING P  y 0 + dy  AS A TAYLOR SERIES AROUND y 0 , WE HAVE

P  y 0 + dy  - P  y 0  P'  y 0  1 P''  y 0 
2
dP dy  dy 
 dy  + .... = -D
2

1 + y 0   1 + y 0 
= = dy + + C
P y0 ,P0 P y0  P y0  2 P y0 
N
tCt N
t  t +1 Ct
 1+ y 
1 + y 0  P'  y 0  = t=1  0  1 + y 0  P''  y 0  = t=1 1 + y 0 
t 2 t

where Duration D = - , Convexity C =

P  y0  P  y0  2P  y 0  2P  y 0 
IF WE IGNORE CONVEXITY, THEN
P  y0 
dP  P'  y 0  dy; P'  y 0  = -D ;
1 + y 0 
N
tCt
P  y0 
 1+ y
 
t

dy  dy  for given y 0  ; D =
t=1 0
dP = -D is fixed for given y 0 ;
1 + y 0  P y0 
dP
or = constantshowing that "duration" is a linear
dy y0
approximation of the yield - price curve around the point of reference.
 s Q
Y Curvature measures
CURVATURE P
θ θ’ the rate at which the
X tangent line turns as
δθ dθ dθ dx d tan dy dx  dx we move along the
-1

 = lim = = =
δs 0 δs ds ds dx ds dx curve.
d 1 d2y
tan -1  dy dx   = ds   dy 
2 12

dx  
dy
2
dx 2
 1 +   
1+  dx   dx  
 dx 
-3/ 2
  dy  2
 d2y Since (dy/dx) is simply the slope of the straight line
κ = 1 +    approximation at the point under reference, it is the
  dx   dx 2
second derivative that captures the curvature effect.
 IMPORTANT
• Higher the curvature (convexity) of a bond,
greater will be the deviation of its actual price
shift due to a shift in interest rates from the
shift calculated using the “duration” formula.
• In other words, greater the convexity, higher
will be the error by using the “only duration”
formula.
 EXAMPLE 1
• Consider a 12% coupon bond with an yield to maturity of
18% and 5 years remaining to maturity.
a. What is the bonds current price, assuming annual coupons?
b. What is the bond’s Duration? Convexity?
c. What percentage price change might you expect if the yield
to maturity suddenly increased to 25%? Calculate using
Duration alone and then using both Duration & Convexity.
d. What would be the exact percentage price change?
TIMELINE 0 1 2 3 4 5
YTM 0.18 0.18 0.18 0.18 0.18
DISC FACTOR 0.84745763 0.71818 0.60863 0.5157889 0.4371
CASH FLOW 12 12 12 12 112
DCF 81.23697 10.1694915 8.61821 7.30357 6.1894665 48.956
tC(t) 12 24 36 48 560
DISC tC(t) 318.8557 10.1694915 17.2364 21.9107 24.757866 244.78
DURATION 3.925007
t(t+1)C(t) 24 72 144 240 3360
DISC t(t+1)C(t) 1752.167 20.3389831 51.7093 87.6428 123.78933 1468.7
CONVEXITY 10.7843
85
ACTUAL REVISED PRICE
TIMELINE 0 1 2 3 4 5
YTM 0.25 0.25 0.25 0.25 0.25
DISC FACTOR 0.8 0.64 0.512 0.4096 0.3277
CASH FLOW 12 12 12 12 112
DCF 65.03936 9.6 7.68 6.144 4.9152 36.7
ORIGINAL PRICE 81.23697
ACTUAL % CHANGE -0.199387
GIVEN CHANGE IN YTM 0.07
% CHANGE IN PRICE USING DURATION -0.232839
CONVEXITY CORRECTION 0.037951
NET % CHANGE IN PRICE -0.194888
86
 MACAULEY’S AND MODIFIED DURATION
1 T iCi
P'  y 0 

1+ y 0  i=1 1+ y 0  i
DMAC
MOD DURATION  DMOD  =  = =
P  y0  P y0  1+ y 0 
dP
= -DMODdy
P
 INTEREST RATE ELASTICITY
• In close proximity of a given yield i.e. for small
dy we can assume the yield-price relationship
to be linear, whence
P  y 0 + dy  - P  y 0  P'  y 0   dy  P y0 
= dy = -D   since P'  y 0  = -D
P  y0  P  y0   1 + y0  1 + y 0 
dP P0 P'  y 0   y0 
OR IE y = = y 0  -D    -DMod y 0
0
dy y 0 P  y 0   1 + y0 
 A RECAP
T
1 iCi
P'  y 0  1 + y 0  
i=1  1 + y 0
i
DMAC
DMOD =  = =
P y0  P y0  1 + y 0 
dP D
DV01 = - = DMOD × P = MAC × P
dy 1+ y
2 2
P dy  dy   dy 
= -DMAC + C   -DMod dy + C  
P y 0 ,P0  1 + y 0  1 + y 0   1 + y 0 
dP P0  y0 
IE = = -DMAC    -DMod y 0
dy y 0  1 + y0 
 IMMUNIZATION
Consider a case when the interest rates increase
immediately after a bond issue. Obviously, the income
from reinvested coupons will increase due to this increase
in interest (reinvestment) rates.
However, the anticipated price at the end of the holding
period will decrease and hence, the expected capital gains
would decrease. Thus, the reinvestment income and the
capital gains move in opposite directions due to a change in
interest rate and hence, annul the effect of each other to
some extent.
Nevertheless, the extent to which these effects would
cancel each other also depends on the holding period of the
investor. The longer the holding period, the greater would
be the effect on reinvested income of an interest rate
change and smaller would be the effect on price since the
bond would be closer to maturity and hence, fewer coupons
would be available for discounting.
In fact, there exists a holding period at which both these
effects exactly annul each other. This holding period turns
out to be the Macaulay’s duration as derived below:
 N
Ct
WE HAVE P0 = 
1 + y 
t
t=1

LET T BE THE HOLDING PERIOD OF THE INVESTOR

THEN, TOTAL CASH FLOWS TO THE INVESTOR
AT THE END OF THE HOLDING PERIOD
TCF = PROCEEDS OF REINVESTED COUPONS + SALE PRICE
T
=  Ct  1 + y 
T-t
+ PT
t=1
 N-T CT+j N
Ck N
BUT PT =    C 1 + y 
T-t
= =
1 + y  1 + y 
j k-T t
j=1 k=T+1 t=T+1

N
dTCF N
HENCE, TCF =  Ct 1 + y   =   T - t  C t 1 + y 
T-t T-t-1

t=1 dy t=1
N N

 tC 1 + y   tC 1 + y 
-t -t
i i
dTCF
THUS, = 0  T y = t=1
N
 t=1
=D
 C 1 + y 
dy -t P0
t
t=1
93
• Thus, given any rate (y), if an investor adopts a
holding period T(y) given by N

 tC 1 + y 
-t
t
Ty = t=1
N

 C 1 + y 
-t
t
t=1

• then his total cashflows from the investment are

immunized against changes in the interest rate.
 THE CAVEAT
• The immunization of the cash flows extends over an
infinitesimally small range y-dy to y+dy of interest. This
is because Newtonian differentiation assumes a straight
line structure around the neighborhood of the point at
which the curve is differentiated.
• Because, the price/yield curve is non-linear, the
immunization will not extend over a large variation in y.
• Furthermore, it is also assumed that the value of y is the
same for all maturities i.e. the term structure is flat.
 T

 C 1 + y 
n-i
We have TCF = i so that
i=1
T
dTCF
 Ci  n - i 1 + y 
n-i-1
= and
dy i=1

d 2 TCF T

 Ci  n - i  n - i - 11 + y 
n-i-2
=
dy 2 i=1

d 2 TCF
Now, if 2
< 0, we must have
dy
either (i) n > i and n < i + 1 or (ii) n < i and n > i + 1
Now, (i) cannot hold because n must be a positive integer and
thereis no integer between i and i + 1.
(ii) is obviously impossible, since all quantities must be positive
d 2 TCF
However , > 0 can hold .
dy 2
• Relationship between duration and the total cash flows for different
reinvestment rates if the bond is held for its duration.
• I have considered a 12% bond with a maturity of 25 years. At a YTM of
16.65%, the Macaulay duration works out to exactly 7 years. Hence, I
have fixed the holding period at 7 years and worked out the Total Cash
Flows at 7 years for different reinvestment rates: The results are as
follows: R (%) TCF R(%) TCF
11 2251 16 2137
12 2210 16.65 2135.63
13 2180 17 2135.94
14 2158 18 2141
15 2144 19 2150
• There are two things worth noting here:
• The YTM yields the minimum total cash flows
for the holding period equal to the duration.
Please note that this is the way it should be
because duration constitutes the minimum risk
holding period also.
• That for interest rates close to the YTM e.g. 16%
and 17% the variation in cash flows is very small
if the bond is held for its duration.
 DURATION WITH CONTINUOUS
COMPOUNDING
P y = C e t
-yt

t
P'  y  = -  tC e t
-yt

dP P'  
y  tC e
t
t
-yt

= dy = - dy
P P y P
 t
tC e
t
-yt

= -Ddy where D =
P

99
 DURATION: ALTERNATIVE DEFINITION
dP dy
= -D
P 1+ y
 1 
d  lnP  = -Dd   
ln 1 + y 
 = Dd  ln 
  1 + y 
d  lnP  d  lnP 
D= =
 1  d  lnP1 
d  ln 
  1 + y  
1
P1 = = Current price of a one year zero of face value 1.
1 + y 
 DURATION OF ZEROS
• The Duration Of A Zero Coupon Bond Is Equal To
Its Maturity. Hence, Longer Term Zeros Are
More Price Sensitive Than Short Term Zeros.
• This Makes Intuitive Sense, Since A Change In
Yield For A Long Term Bond Affects Cash Flows
Over A Larger Number Of Discounting Periods.
DURATION OF LEVEL COUPON BOND
P = PC + PA
  1+ y  -1  1 1  F dPF NF NPF
N
N
cF
PC =  = cF  N 
= cF  - N
PF = ; =- = -
t=1 1+ y 
t
 y 1+ y    y 1+ y  
y 1+ y 
N
dy 1+ y 
N+1
1+ y 
dPC cF  -1
= - 2 - cF -Ny 1+ y  - y -2 1+ y  
-N-1 -N 1+ y  dP 1+ y   dPC dPF 

P  dy dy 
dy y   D=- =- +
P dy
cF 1 1
= - 2 + NcF
y y 1+ y 
N+1
+ cF 2
y 1+ y 
N  1+ y   1 Nc NPF 
=- - PC + PF - 
1 1 1  1 P  y y 1+ y  1+ y  
= - cF  - N
+ NcF PC  1  NPF  c 
y  y y 1+ y   y 1+ y 
N+1
=  1+  +
1 Nc P  y P  y  1- 
= - PC + PF
y y 1+ y 

102
 DURATION:IMPORTANT PROPERTIES
• Duration of a perpetuity does not depend on
coupon rates.
• The Macaulay Duration of a zero equals its
maturity.
• Bonds with higher duration have higher price
sensitivity in absolute terms.
 DURATION AND COUPON RATES
• For practically realizable values, duration of all
types of bonds (par, premium and discount)
would decrease with increase in coupon rate.
This is because as coupon increases a greater
proportion of the cashflows are realized by the
investor earlier.
As an illustration, we consider the case of a 5 year Rs 1,000/- bond with a YTM of 20%.
The values of the various measures of interest rate sensitivity are tabulated below:

Coupon Rate (%) DV01(Rs/%) DMod (Years) DMac (Years) Price (Rs)
5 20.03 3.63 4.36 551
10 23.32 3.33 3.99 701
15 26.61 3.13 3.76 850
20 29.90 2.99 3.59 1000
25 33.20 2.89 3.47 1150
30 36.48 2.81 3.37 1299
 DURATION AND MATURITY
• Duration of par and premium bonds always
increases with increasing maturity.
• There would be a critical value of maturity, upto
which duration would increase with maturity. If
maturity exceeds this critical value, then
duration will start decreasing with maturity for
discount bonds.
As an illustration of this phenomenon, we consider a Rs 1,000 face value bond with a
coupon rate of 15% quoting at a YTM of 25%. The above data corresponds to a Tc  11.5
years.

Maturity (Years) DV01(Rs/%) DMod (Years) DMac (Years) D*

3 16.63 2.06 2.58 -6.8
5 21.38 2.92 3.66 -5.2
10 24.86 3.87 4.83 -1.2
20 24.46 4.05 5.06 6.8
25 24.21 4.03 5.03 10.8
50 24.00 4.00 5.00 30.8
 PRICE SENSITIVITY AND MATURITY
THE PRICE SENSITIVITY OF A BOND
dP DMAC
DV01 = - = DMOD × P = ×P
dy 1+ y
• HENCE, TWO EFFECTS INTERACT DUE TO INTEREST RATE
SHIFTS
• DURATION EFFECT
• PRICE EFFECT
• The duration effect of par & premium bonds increases with
maturity.
• The price of a premium (discount) bond increases (decreases)
with maturity while that of a par bond remains constant.
• It follows that price sensitivity of premium and par bonds will
always increase with maturity.
• For short term discount bonds, the duration effect dominates
and sensitivity increases to start with. As maturity increases, the
decrease due to price effect also becomes significant and the
sensitivity starts decreasing gradually until a limiting value
corresponding to a perpetuity is reached.
 MATURITY AND BOND PRICE SENSITIVITY:
• Two bonds X and Y are both 12% annual coupon
bonds of the face value of 1,000. They are
redeemed at par after two years and ten years
respectively. Calculate the percentage change in
price of each bond when the market interest rates
change from 5% to 6%
• Repeat the same problem for a change in market
rates from 20% to 21%.
For Bond X
P  P 12%, 5%, 2   120 PVIFA  5%, 2 
 PVIF  5%, 2   1130
P*  P 12%, 6%, 2   120 PVIFA  6%, 2 
 PVIF  6%, 2   1110

Pr ice Volatility 
 P * P 
 1.78%
P
Similarly, Pr ice Volatility of Bond Y   6.42%
 RESULTS
• PX(12%, 5%, 2) = 1130
• PX (12%, 6%, 2) = 1110
• PRICE VOLATILITY OF X = -1.78%

• PY(12%, 5%, 10) = 1541

• PY (12%, 6%, 10) = 1441
• PRICE VOLATILITY OF Y = -6.42%
 CONCLUSION
• As the maturity of the bond increases, the price
sensitivity increases in magnitude.
MATURITY AND BOND PRICE VOLATILITY

Bond Value
Consider two otherwise identical bonds.
The long-maturity bond will have much more volatility with
respect to changes in the discount rate

Par

Short Maturity Bond

C Discount Rate
Long Maturity
Bond
 BOND PRICE SENSITIVITY AND COUPON SIZE:
• Two bonds X and Y are 10% and 80% annual
coupon bonds of the face value of 1,000. They are
redeemed at par after thirty years. Calculate the
percentage change in price of each bond when the
market interest rates change from 5% to 6%
• Repeat the same problem for a change in market
rates from 24% to 25%.
For Bond X
P  P 10%, 5%, 30   100 PVIFA  5%, 30 
 PVIF  5%, 30   1769
P*  P 10%, 6%, 30   100 PVIFA  6%, 30 
 PVIF  6%, 30   1551

Pr ice Volatility 
 P * P 
 12.32%
P
Similarly, Pr ice Volatility of Bond Y   10.72%
 RESULTS
• PX(10%, 5%, 30) = 1769
• PX (10%, 6%, 30) = 1551
• PRICE VOLATILITY OF X = -12.32%

• PY(80%, 5%, 30) = 12523

• PY (80%, 6%, 30) = 11125
• PRICE VOLATILITY OF Y = -10.72%
 CONCLUSION
• As the coupon size of the bond increases, the
price sensitivity decreases in magnitude.
COUPON RATE AND BOND PRICE VOLATILITY

Bond Value
Consider two otherwise identical bonds.
The low-coupon bond will have much more volatility with
respect to changes in the discount rate

High Coupon Bond

Discount Rate
Low Coupon Bond
 PRICE vs YTM PROPERTIES:SUMMARY
1. Bond prices and market interest rates move in opposite
directions.
2. When coupon rate = YTM, price = par value.
When coupon rate > YTM, price > par value
When coupon rate < YTM, price < par value
3. A bond with longer maturity has higher magnitude of
relative (%) price change than one with shorter maturity
when interest rate (YTM) changes. All other features are
identical.
4. A lower coupon bond has a higher magnitude of relative
price change than a higher coupon bond when YTM
changes. All other features are identical.