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CONVEXITY
Duration
Macaulay Duration
Features of Duration
period
The red lever above represents the four-year time period it takes for a zero-coupon
bond to mature.
The money bag balancing on the far right represents the future value of the bond.
The fulcrum, represents duration, which must be positioned where the red lever is
balanced.
The entire cash flow of a zero-coupon bond occurs at maturity, so the fulcrum is located
directly below this one payment.
The moneybags represent the cash flows you will receive over the fiveyear period.
To balance the red lever at the point where total cash flows equal the
amount paid for the bond, the fulcrum must be farther to the left, at a
point before maturity.
It pays coupon payments throughout its life and therefore repays
the full amount paid for the bond sooner
Bonds with high coupon rates and, in turn, high yields will tend
to have lower durations than bonds that pay low coupon rates
or offer low yields.
Macaulay Duration
The Formula
n
Ct (t )
t
(
1
i
)
t 1
D n
Ct
t
(
1
i
)
t 1
t PV (C )
t
t 1
price
where:
t = time period in which the coupon or principal payment occurs
Ct = interest or principal payment that occurs in period t
i = yield to maturity on the bond
Or
Duration t wt
t 1
Time
Cash Flow
PV at 10%
Time x PV
80
72.73
72.73
80
66.12
132.23
80
60.11
180.32
80
54.64
218.56
80
49.67
248.37
80
45.16
270.95
80
41.05
287.37
1080
503.83
4030.62
Sum
5441.15
Price
Duration
=Sum/Price
893.30
5441.15/893.3
6.09105
years
Duration Calculation
Time
1
2
3
4
5
6
7
8
Cash Flow
80
80
80
80
80
80
80
1080
Price
PVs Proportion
Time X PVs
PV at 10% of Price (Wt) Proportion of Price
72.73
0.08
0.081
66.12
0.07
0.148
60.11
0.07
0.202
54.64
0.06
0.245
49.67
0.06
0.278
45.16
0.05
0.303
41.05
0.05
0.322
503.83
0.56
4.512
893.3
1.00
Duration
6.091
(in years)
Betty holds a five-year bond with a par value of $1,000 and coupon rate of
5%. For simplicity, let's assume that the coupon is paid annually and that
interest rates are 5%. What is the Macaulay duration of the bond?
= 4.55 years
Another example
Time
Cash Flow
PV at 10%
Time x PV
120
109.09
109.09
120
99.17
198.35
120
90.16
270.47
120
81.96
327.85
120
74.51
372.55
120
67.74
406.42
120
61.58
431.05
1120
522.49
4179.91
Sum
6295.69
Price
1,106.70
Duration =
6295.691/1106.7
= 5.689
Time
Cash Flow
Proportion of
Total value
PV at 10%
Time X
Proportion of
Total Value
120
109.09
0.10
0.099
120
99.17
0.09
0.179
120
90.16
0.08
0.244
120
81.96
0.07
0.296
120
74.51
0.07
0.337
120
67.74
0.06
0.367
120
61.58
0.06
0.389
1120
522.49
0.47
3.777
Price
1,106.70
Duration
5.689
Importance of Duration
If two bonds have the same coupon rate and yield, then the bond
with the greater maturity has the greater duration.
If two bonds have the same yield and maturity, then the one with
the lower coupon rate has the greater duration.
Bonds with higher durations carry more risk and have higher
price volatility than bonds with lower durations.
Allows comparison of effective lives of bonds that differ in
maturity, coupon
Used in bond management strategies particularly
immunization
Dmod
Macaulay Duration
YTM
1
m
where:
m = number of payments a year
YTM = nominal YTM
where:
Dmod is the modified duration;
D is the Macaulay duration;
i is the periodic yield;
P(i) is the price of the bond at yield i.
This formula can be used to estimate the change in price for a small change
in the periodic yield:
% change in price =
P
Dmod i
P
where:
P = change in price for the bond
P = beginning price for the bond
-Dmod = the modified duration of the bond
i = yield change in %
A Bond with Mac D of 8 years and YTM to be 10% with semi annual
compounding
Modified Duration = 8/(1+.05) = 7.62
Bond Convexity
Some relationships
Exhibit 18.21
18-29
Bond Convexity
The
Formula
d 2P
2
di
Convexity
P
3 year Bond
9% YTM
12% Coupon
FV 1000
Years
CF
PV
t2+t
Product
120
110.09
220.18
120
101.00
606.01
1120
864.85
12
10378.15
Price
1075.94
Sum
11204.34
Sum/(1.09^2)
9430.47
Convexity
8.76
Example
Hybrid: Immunization
Indexing
The
Valuation Analysis
Select bonds based on their intrinsic value
Credit Analysis: detailed analysis of the bond issuer to
determine expected changes in its default risk
Hybrid Techniques
Immunization Strategies
Classical Immunization
Immunize
1-Jul-16
1-Jul-17
1-Jul-18
1-Jul-19
1-Jul-20
Cash Flow
Present
Value
12.5
12.5
12.5
12.5
117.5
10.87
9.45
8.22
7.15
58.42
Coupon
Total
94.11
ie the Price
1-Jul-16
1-Jul-17
1-Jul-18
1-Jul-19
1-Jul-20
No. of years
Cash Flow
Present
Value
12.5
12.5
12.5
12.5
117.5
10.87
9.45
8.22
7.15
58.42
94.11
Year * PV
10.87
18.90
24.66
28.59
292.09
375.11
DURATION
375.11/94.11
3.99
or 4 years
Total
1-Jul-16
1-Jul-17
1-Jul-18
1-Jul-19
1-Jul-19Total
1
12.5
2
12.5
3
12.5
4
12.5
4
101.29
19.51
16.82
14.50
12.50
101.29
164.62
1-Jul-16
1-Jul-17
1-Jul-18
1-Jul-19
1-Jul-19Total
1
12.5
2
12.5
3
12.5
4
12.5
4
103.07
18.52
16.25
14.25
12.50
103.07
164.58
there is no interest rate risk at all as we see no change in the terminal value