Debt and Money Markets (Instructor: Junho Oh)

Practice Problem (Chapter 4)

#1. What is interest rate risk?

If an investor needs to sell a bond before its maturity date, an increase in interest rates will
lead to a capital loss, since the bond will have to be sold at a price below its purchase cost.
This is known as interest rate risk or market risk. More generally, interest rate risk refers
to the change in a bond’s price resulting from changes in yields.

#2. Consider 3 year 6% bond with the par of $100 and semi-annual coupon payments. The bond
is priced at $97.34 and YTM is 7%.

a) Fill in the blank below. Derive the Macaulay duration of the bond from the table.

Periods Cash Flow (CF) Periods X Cash flow (t×CF)

1 3 3
2 3 6
3 3 9
4 3 12
5 3 15
6 103 618

I/YR=3.5, CF0=0, CF1=3, CF2=6, CF3=9, CF4=12, CF5=15, CF6=618 →

NPV=542.45

𝟓𝟒𝟐.𝟒𝟓
The Macaulay duration (semi-annual) of the bond is = 𝟓. 𝟓𝟕
𝟗𝟕.𝟑𝟒

𝟓.𝟓𝟕
Therefore, the Macaulay duration (annual) of the bond is = 𝟐. 𝟕𝟗
𝟐

b) What is the modified duration of the bond?

From a), the modified duration can be calculated as

𝟏 𝟏
𝒎𝒐𝒅𝒊𝒇𝒊𝒆𝒅 𝒅𝒖𝒓𝒂𝒕𝒊𝒐𝒏 = ( ) × 𝑴𝒂𝒄𝒂𝒖𝒍𝒂𝒚 𝒅𝒖𝒓𝒂𝒕𝒊𝒐𝒏 = × 𝟐. 𝟕𝟗 = 𝟐. 𝟕𝟎
𝟏+𝒚 𝟏. 𝟎𝟑𝟓
#3. Consider 2 year 8% bond with the par of $100 and semi-annual coupon payments. The bond
is priced at $96.45 and YTM is 10%.

a) What is the modified duration of the bond?

𝒎𝒐𝒅𝒊𝒇𝒊𝒆𝒅 𝒅𝒖𝒓𝒂𝒕𝒊𝒐𝒏 (𝒔𝒆𝒎𝒊 − 𝒂𝒏𝒏𝒖𝒂𝒍)

𝟒 𝟏 𝟒(𝟏𝟎𝟎 − 𝟒/𝟎. 𝟎𝟓)
× [𝟏 − ]+
𝟎. 𝟎𝟓𝟐 (𝟏 + 𝟎. 𝟎𝟓)𝟒 (𝟏 + 𝟎. 𝟎𝟓)𝟒+𝟏
= = 𝟑. 𝟓𝟗
𝟗𝟔. 𝟒𝟓

𝟑. 𝟓𝟗
𝒎𝒐𝒅𝒊𝒇𝒊𝒆𝒅 𝒅𝒖𝒓𝒂𝒕𝒊𝒐𝒏 (𝒂𝒏𝒏𝒖𝒂𝒍) = = 𝟏. 𝟖𝟎
𝟐

Alternatively, you can use the Cash Flow table in the problem #2 and derive Macaulay
and modified duration.

b) What is the price change of the bond if the required yield changes from 10% to 14%? Also,
compute the approximated price after the required yield becomes 14%. Do not need to
consider convexity yet.

𝚫𝐏 = −(𝟏. 𝟖𝟎 × 𝟗𝟔. 𝟒𝟓) × 𝟎. 𝟎𝟒 = −$𝟔. 𝟗𝟒

where (𝟏. 𝟖𝟎 × 𝟗𝟔. 𝟒𝟓) = 𝟏𝟕𝟑. 𝟔𝟏 is the dollar duration of the bond.

After the required yield changes to 14% the price of the bond will be
𝟗𝟔. 𝟒𝟓 − 𝟔. 𝟗𝟒 = $𝟖𝟗. 𝟓𝟏

c) What is the actual price of the bond if YTM is 12%?

I/YR=7, PMT=4, FV=100, N=4 → PV=$89.84

The actual price of the bond at YTM=14% is $89.84.

d) Compare the results from b) and c).

There is a gap between the approximated price ($89.51) and the actual price ($89.84)
of the bond. This is because the price-yield curve of a bond is non-linear, but the
equation for the approximation is linear, which leads to the gap.
#4. What is the implication of convexity of a bond? Why do we need to adopt the concepts?

Convexity refers to the curvature of the price–yield relationship. In other words, it measures
how much the price–yield curve deviates from its linear approximation based solely on
duration. When a bond has high convexity or when yield changes are large, the price change
estimated using duration alone becomes inaccurate. In such cases, it is necessary to adjust
for convexity to obtain a more precise estimate of the bond’s price change.

#5. Approximation of Price Change, Revisited.

Consider 2 year 8% bond with the par of $100 and semi-annual coupon payments. The bond is
priced at $96.45 and YTM is 10%. (Please see the problem #3)

a) What is the convexity of the bond?

Periods Cash Flow (CF) t × (t+1) × CF

1 4 8
2 4 24
3 4 48
4 104 2080

Calculate convexity measure.

I/YR=5, CF0=0, CF1=8, CF2=24, CF3=48, CF4=2080 → NPV=$1,782.07

𝒏
𝟏 𝟏 𝒕(𝒕 + 𝟏)𝑪 𝒏(𝒏 + 𝟏)𝑭
𝒄𝒐𝒏𝒗𝒆𝒙𝒊𝒕𝒚 (𝒔𝒆𝒎𝒊 − 𝒂𝒏𝒏𝒖𝒂𝒍) = (∑ + )
𝑷 (𝟏 + 𝒚)𝟐 (𝟏 + 𝒚)𝒕 (𝟏 + 𝒚)𝒏
𝒕=𝟏
𝟏 𝟏
= × 𝟏, 𝟕𝟖𝟐. 𝟎𝟕 = 𝟏𝟔. 𝟎𝟗
𝟗𝟔. 𝟒𝟓 (𝟏 + 𝟎. 𝟎𝟓)𝟐

𝟏𝟔. 𝟎𝟗
𝒄𝒐𝒏𝒗𝒆𝒙𝒊𝒕𝒚 (𝒂𝒏𝒏𝒖𝒂𝒍) = = 𝟒. 𝟎𝟐
𝟐𝟐

b) What is the price change of the bond if the required yield changes from 10% to 12%? Also,
compute the approximated price after the required yield becomes 12%. Now consider
convexity of the bond.
𝟏
𝜟𝑷 = −(𝟏. 𝟖𝟎 × 𝟗𝟔. 𝟒𝟓) × 𝟎. 𝟎𝟒 + × 𝟒. 𝟎𝟐 × 𝟗𝟔. 𝟒𝟓 × 𝟎. 𝟎𝟒𝟐 = −𝟔. 𝟔𝟑
𝟐

After the required yield changes to 14% the price of the bond will be
𝟗𝟔. 𝟒𝟓 − 𝟔. 𝟔𝟑 = $𝟖𝟗. 𝟖𝟐
 c) Compare the results from problem #5 b) and problem #3 d).

The gap between the approximated price ($89.82) and the actual price ($89.84) of the
bond becomes significantly narrower than the gap before adjusting convexity. This is
because convexity adjusts the curvature of the yield-curve.

#6. Consider two bonds as follows:

Bond Coupon (%) Maturity (years) YTM (%)

A 4 3 6
B 5 2 6

The par value of the bonds are $100 and the coupons are paid semi-annually. Assume that we hold
these bonds. Which bond is riskier if we expect that the required yield changes from 5% to 7%?
Assume that there is no embedded option in the bonds.

The price sensitivity to change in yields is determined by modified duration and convexity if
there is no embedded option in a bond.

The modified duration and convexity of the bonds are

Bond Coupon (%) Maturity (years) YTM (%) Price Duration Convexity
A 4 3 6 94.58 2.77 9.25
B 5 2 6 98.14 1.87 4.48

The percentage price change due to change in the required yield is

𝚫𝐏 𝟏
Bond A: = −(𝟐. 𝟕𝟕) × 𝟎. 𝟎𝟐 + 𝟐 × 𝟗. 𝟐𝟓 × 𝟎. 𝟎𝟐𝟐 = −𝟎. 𝟎𝟓𝟑𝟔 𝐨𝐫 − 𝟓. 𝟑𝟔%
𝐏

𝚫𝐏 𝟏
Bond B: = −(𝟏. 𝟖𝟕) × 𝟎. 𝟎𝟐 + 𝟐 × 𝟒. 𝟒𝟖 × 𝟎. 𝟎𝟐𝟐 = −𝟎. 𝟎𝟑𝟔𝟓 𝐨𝐫 − 𝟑. 𝟔𝟓%
𝐏

Since bond A is more sensitive to the change in the required yield, we can say that bond A is
riskier than B.
#7. As of Feb-12-2013, the following bonds are traded to produce a 1% yield per annum (p.a.). All
these bonds pay coupons semi-annually on the 12th of the month, and the last coupon is paid at
each bond’s maturity. These bonds are not callable, and assume that each month consists of 30
days, and thus, there are 360 days in each year.

Table III: As of Feb-12-2013

Bond Time to maturity Coupon rate
Face value ($) Maturity date
Number (years) p.a.
#1 1,000 Feb-12-2014 1 0
#2 1,000 Feb-12-2015 2 0
#3 1,000 Feb-12-2016 3 0
#4 1,000 Feb-12-2014 1 1.00%
#5 1,000 May-12-2015 2.25 2.00%

Which bond has the shortest Macaulay duration (4 points)? For this bond, answer the following
two questions:

a) (4 points) Compute the Macaulay duration of the bond.

Bond 4 has the shortest Macaulay duration.

The price of bond 4 is $1,000. (Since it is par bond).

In order to compute duration, let us construct the table:

Periods Cash Flow (CF) Periods X Cash flow (t×CF)

1 5 5
2 1,005 2,010

I/YR=0.5, CF0=0, CF1=5, CF2=2010 → NPV=1,995.02

𝟏𝟗𝟗𝟓.𝟎𝟐
The Macaulay duration (semi-annual) of bond 4 is = 𝟏. 𝟗𝟗𝟓𝟎
𝟏𝟎𝟎𝟎

𝟏.𝟗𝟗𝟓𝟎
Therefore, the Macaulay duration (annual) of the bond is = 𝟎. 𝟗𝟗𝟕𝟓
𝟐

b) (4 points) Compute how much the bond’s price changes if the yields of all bonds decrease
by 100 bps (i.e., 1%). Use the price-sensitivity formula to answer this question. Do not
need to consider convexity in this problem.

𝟎.𝟗𝟗𝟕𝟓
The modified duration of the bond is = 𝟎. 𝟗𝟗𝟐𝟓
𝟏.𝟎𝟎𝟓

∆P=-(0.9925)*1000*(-0.01) = $9.925
#8. Determinants of Macaulay Duration

a) Compute the Macaulay duration of a 2-year, 8% (annual) coupon bond, if the

current yield is 10%. Assume that the par value of the bond is $100.

Periods Cash Flow (CF) Periods X Cash flow (t×CF)

1 8 8
2 108 216

First, calculate the price of the bond.

I/YR=10, CF0=0, CF1=8, CF2=108 → NPV=$96.53

Next, calculate Macaulay duration.

I/YR=10, CF0=0, CF1=8, CF2=216 → NPV=185.79

𝟏𝟖𝟓.𝟕𝟗
→ Macaulay duration= = 𝟏. 𝟗𝟐𝟒𝟕
𝟗𝟔.𝟓𝟑

The Macaulay duration of this bond at YTM of 10% in annual coupon frequency is 1.9247
year

b) Repeat the calculation above for a 2-year, 15% coupon bond. Why is the
duration smaller for this case?

Periods Cash Flow (CF) Periods X Cash flow (t×CF)

1 15 15
2 115 230

First, calculate the price of the bond.

I/YR=10, CF0=0, CF1=8, CF2=108 → NPV=$108.68

Next, calculate Macaulay duration.

I/YR=10, CF0=0, CF1=15, CF2=230 → NPV=203.72

𝟐𝟎𝟑.𝟕𝟐
→ Macaulay duration= = 𝟏. 𝟖𝟕𝟒𝟓
𝟏𝟎𝟖.𝟔𝟖
The Macaulay duration of this bond at YTM of 10% with annual coupon payment
frequency is 1.874525 year.

This is smaller than 1.924658 year that you got in part a) for 8% coupon bond. This 15%
coupon bond pays more coupons than 8% coupon bond, which makes you reach to the
break-even point of your investment even earlier.

c) Compute the Macaulay duration of a 2-year, 8% (annual) coupon bond, if the

current yield is 8%. Why is the duration higher for this case than in a)?

In this case, the duration of the bond is 1.9259 years (see the cash flow table in part a)).
When you replace the old YTM of 10% with the new YTM of 8%, this duration value
becomes slightly greater than the 1.9247 years obtained in part a).

Intuitively, the price–yield curve is convex, and because of this convexity, the absolute
value of the slope of the tangent line to the curve decreases as the YTM increases. Since
duration is proportional to the absolute value of this slope, duration decreases as the YTM
increases.

d) Compute the Macaulay duration of a 2-year, 8% (semi-annual) coupon bond, at

the current yield of 10%. Why is this duration different from the one that you got in a)?

Periods Cash Flow (CF) Periods X Cash flow (t×CF)

1 4 4
2 4 8
3 4 12
4 104 416

First, calculate the price of the bond.

I/YR=5, CF0=0, CF1=4, CF2=4, CF3=4, CF4=104 → NPV=$96.45

Next, calculate Macaulay duration.

I/YR=5, CF0=0, CF1=4, CF2=4, CF3=4, CF4=104 → NPV=$363.68

𝟑𝟔𝟑.𝟔𝟖
→ Macaulay duration (semi-annual)= = 𝟑. 𝟕𝟕𝟎𝟓
𝟗𝟔.𝟒𝟓

𝟑.𝟕𝟕𝟎𝟓
→ Macaulay duration (annual)= = 𝟏. 𝟖𝟖𝟓𝟑
𝟐
 The duration of the 8% coupon bond with semiannual coupon payments is 1.8853 years,
which is smaller than the 1.9247 years calculated in part (a). When coupons are paid more
frequently, investors receive their first payment sooner, reducing the average time to recover
their investment — and thus lowering the bond’s duration.

e) Compute the Macaulay duration of a 5-year, 8% (annual) coupon bond, if the

current yield is 10%. Compare this with your answer in a) and explain why it is
different.
Periods Cash Flow (CF) Periods X Cash flow (t×CF)
1 8 8
2 8 16
3 8 24
4 8 32
5 108 540

First, calculate the price of the bond.

I/YR=10, CF0=0, CF1=8, CF2=8, CF3=8, CF4=8, CF5=108 → NPV=$92.42

Next, calculate Macaulay duration.

I/YR=10, CF0=0, CF1=8, CF2=8, CF3=8, CF4=8, CF5=108 → NPV=$395.68

𝟑𝟗𝟓.𝟔𝟖
→ Macaulay duration (semi-annual)= = 𝟒. 𝟐𝟖𝟏𝟒
𝟗𝟐.𝟒𝟐

The duration of this bond is 4.2814 year, which is greater than the duration in part a).
Duration increases with maturity.