Bond Duration and Convexity

Goals for the Session_

• Price sensitivity to interest rates

• Duration
• Bond convexity and it’s use in determining bond strategy
• Immunization: matching of durations
• Passive management strategies
• Active management strategies.
 Bond Price Sensitivity

• Inverse relationship between bond price and interest rate.

• Excluding the default, the main risk facing the investors is the interest rate risk.

• Price sensitivity to interest rate is influenced by:

• Maturity: Bond ‘A’ and bond ‘B’ are similar in all respects except the maturity. Which
bond’s price would be more sensitive to interest rates?

• Coupon: Bond ‘A’ and bond ‘B’ are similar in all respects except the coupon. Which
bond’s price would be more sensitive to interest rates?

• YTM: Maturity: Bond ‘A’ and bond ‘B’ are similar in all respects except the YTM. Which
bond’s price would be more sensitive to interest rates?
Change in Bond Price as a Function of Change
in Yield to Maturity
Long-term bonds tend to be more price sensitive than short-term bonds.
Lower coupon bonds are more sensitive to changes in interest rates.
Low YTM bonds are more sensitive to interest rate changes.
 Bond Pricing Relationships

1. Long-term bonds tend to be more price sensitive than short-term bonds.

a) For a given maturity zero coupon bonds would be more sensitive than coupon bonds.
2. Lower coupon bonds are more sensitive to changes in interest rates.
3. Low YTM bonds are more sensitive to interest rate changes.
4. An increase in a bond’s yield to maturity results in a smaller price change than a
decrease of equal magnitude.
5. As maturity increases, price sensitivity increases at a decreasing rate.
 Duration

• A measure of the effective maturity of a bond

• The weighted average of the times until each payment is received, with
the weights proportional to the present value of the payment
• Duration is shorter than maturity for all bonds except zero coupon bonds.
• Duration is equal to maturity for zero coupon bonds.
 Duration

• A measure of the effective maturity of a bond.

• The weighted average of the times until each payment is received, with the
weights proportional to the present value of the payment

Assume a 3-year coupon bond, its duration can be expressed as follows:

3
𝑖 ∗ 𝐶𝑖 1
𝐷=෍ ∗
1+𝑟 𝑖 𝑃
𝑖=1

3 𝑖
𝑖 ∗ 𝐶𝑖 / 1 + 𝑟
𝐷=෍
𝑃
𝑖=1

3
𝑖 ∗ 𝑃𝑉𝐶𝑖
𝐷=෍
𝑃
𝑖=1
Compute the duration of 3-year, F.V.=Rs.100, 10% coupon bond trading at YTM of
12%.

Step 1: Compute the price of the bond

Step 2: Compute the Duration

Price=Rs.95.20 at the YTM of 12%.

3
𝑖 ∗ 𝐶𝑖 1
𝐷=෍ 𝑖
∗
1+𝑟 𝑃
𝑖=1

1 ∗ 10 2 ∗ 10 3 ∗ 110 1
𝐷= 1
+ 2
+ 3
∗ = 2.73 𝑦𝑒𝑎𝑟𝑠
1 + 12% 1 + 12% 1 + 12% 95.20
Compute the duration of 3-year, F.V.=Rs.100, ZCB coupon bond trading at YTM of
12%.

Step 1: Compute the price of the bond

Step 2: Compute the Duration

3∗100
Price= = 71.17
1+12% 3

3
𝑖 ∗ 𝐶𝑖 1
𝐷=෍ 𝑖
∗
1+𝑟 𝑃
𝑖=1

1∗0 2∗0 3 ∗ 100 1

𝐷= 1
+ 2
+ 3
∗ = 3 𝑦𝑒𝑎𝑟𝑠
1 + 12% 1 + 12% 1 + 12% 71.17
 Inference_

• Duration is weighted average maturity and measured in years.

• Duration of coupon bond is always less than its maturity.

• Duration for zero coupon bond is equal to its maturity since all the
cashflow occurs at one time.
 Duration: Measure of Interest rate sensitivity

• Bond price sensitivity to interest rates is dependent on:

– Coupon
– Maturity
– YTM

• Is it possible to have one measure of % change in bond price to change in

interest rates?
 Duration: Measure of Interest rate sensitivity
𝑛
𝐶𝑖
𝑃=෍ 𝑖
1+𝑟
𝑖=1
Differentiate would sides w.r.t ‘r’
𝑛
𝑑𝑃 𝑖 ∗ 𝐶𝑖
= −෍
𝑑𝑟 1 + 𝑟 𝑖+1
𝑖=1

Dividing both sides by ‘P’

𝑛
𝑑𝑃/𝑃 1 𝑖 ∗ 𝐶𝑖 1
=− ෍ ∗
𝑑𝑟 (1 + 𝑟) 1+𝑟 𝑖 𝑃
𝑖=1

𝑑𝑃/𝑃 1
=− ∗𝐷
𝑑𝑟 (1 + 𝑟)
Where ‘D’: is duration or Macaulay Duration of the bond
Thus duration is also a measure of the sensitivity of price to change in interest rates.
Modifying the above expression by substituting

∗
𝐷
𝐷 =
(1 + 𝑟)

Where D* is the modified duration we get:

𝑑𝑃/𝑃
= −𝐷 ∗
𝑑𝑟

• The negative sign indicates the inverse relationship between price and interest rates.
• Thus by comparing D* of bonds we can easily find which bond is more sensitive to
interest rates.
• Now we don’t have to worry about comparing different parameters of given bonds to
find which is more sensitive.
Given a 3-year, F.V.=Rs.100, 10% coupon bond trading at YTM of 12%. Given the YTM increases
by 0.1%. Macaulay Duration of the bond is 2.73 years. Compute:
a) Actual % change in price
b) Price change through duration rule

Price at YTM of 12%=95.2

Price at YTM of 11.9%=95.43
% change in price=0.244%
Using duration rule, given D=2.73 so modified duration is

∗
2.73
𝐷 = = 2.43
(1 + 12%)
𝑑𝑃
= −2.43 ∗ 0.1% = −0.243%
𝑃

Thus duration is also a measure of sensitivity of the bond price to interest rates.
 Rules for Duration
Rule 1 The duration of a zero-coupon bond equals its time to maturity

Rule 2 Holding maturity constant, a bond’s duration is higher when the coupon rate is
lower

Rule 3 Holding the coupon rate constant, a bond’s duration generally increases with
its time to maturity

Rule 4 Holding other factors constant, the duration of a coupon bond is higher when
the bond’s yield to maturity is lower

Rules 5 The duration of a level perpetuity is equal to: (1+y) / y

Bond Price Convexity: 30-Year Maturity, 8%
Coupon; Initial YTM = 8%
• A bond of face value Rs.100, coupon rate 10% for a maturity of 3 years is trading at a yield
of 12%.
• Compute the % change in price (for a 1% decrease/increase in YTM) using the duration
rule.
• Compute the actual % change in price if YTM increases by 1%? What if the YTM
decreases by 1%?
As per Duration rule

𝑑𝑃
= −2.43 ∗ 1% = −02.43%
𝑃

Actual Change

YTM 11% 13%

Old Price 95.20 95.20

New Price 97.56 92.92

% change 2.48% -2.40%
 Inference

• The relationship between bond prices and yields is not linear.

• % Price change is not equal for similar increase and decrease of interest
rates.

• Duration rule is a good approximation for only small changes in bond

yields.

• Bonds with greater convexity have more curvature in the price-yield

relationship.
 Incorporating Convexity
𝑑𝑃/𝑃
Duration was expressed as , convexity is expressed as
𝑑𝑟
𝑛
𝑑2 𝑃/𝑃 1 𝑖 ∗ 𝑖 + 1 ∗ 𝐶𝑖 1
= 2෍ ∗ = 𝐶𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦
𝑑𝑟 2 1+𝑟 1+𝑟 𝑖 𝑃
𝑖=1
This 2nd derivative is what is called as convexity of the bond.
As per taylor’s series given a function f(x), the change in f(x) for a given change is x, can be expressed as follows:
1
𝑑𝑓 𝑥 = 𝑓 ′ 𝑥 ∗ 𝑑𝑥 + 𝑓 ′′ 𝑥 ∗ 𝑑𝑥 2 + ………..
2
Using taylor’ series the dP/P can be expressed as
𝑛 𝑛
𝑑𝑃 1 𝑖 ∗ 𝐶𝑖 1 1 1 𝑖 ∗ 𝑖 + 1 ∗ 𝐶𝑖 1 2
=− ෍ ∗ ∗ 𝑑𝑟 + ∗ 2෍ ∗ ∗ 𝑑𝑟
𝑃 1+𝑟 1+𝑟 𝑖 𝑃 2 1+𝑟 1+𝑟 𝑖 𝑃
𝑖=1 𝑖=1

𝑑𝑃 1
= −𝐷 ∗ 𝑑𝑟 + ∗ 𝑐𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 ∗ 𝑑𝑟 2
𝑃 2
In discrete terms it can be expressed as
∆𝑃 1
= −𝐷 ∗ ∆𝑟 + ∗ 𝑐𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 ∗ ∆𝑟 2
𝑃 2
• A bond of face value Rs.100, coupon rate 10% for a maturity of 3 years is trading
at a yield of 12%. Given the modified duration of bond is 2.43 years while its
convexity is 8.42
• Compute the % change in price (after correcting for convexity) if YTM decreases
by 1% and if it increase by 1%?
For increase in interest rate
𝑑𝑃 1
= −2.43 ∗ (13% − 12%) + ∗ 8.42 ∗ (13% − 12%)2
𝑃 2

𝑑𝑃
= −2.43% + 0.042% = −2.39%
𝑃
Actual change =-2.395%
For decrease in interest rate
𝑑𝑃 1
= −2.43 ∗ (11% − 12%) + ∗ 8.42 ∗ (11% − 12%)2
𝑃 2

𝑑𝑃
= 2.43% + 0.042% = 2.47%
𝑃
Actual change =-2.48%

• Thus convexity has corrected for the over/under prediction for % price change by duration rule for
increase/decrease in interest rates.
 Why do Investors Like Convexity?

• Bonds with greater curvature gain more in price when yields fall than they lose when yields
rise.
• The more volatile interest rates, the more attractive this asymmetry.
• Bonds with greater convexity tend to have higher prices and/or lower yields, all else equal.
 Callable Bonds

• As rates fall, there is a ceiling on the bond’s market

price, which cannot rise above the call price.
• Negative convexity
• Use effective duration:

P / P
Effective Duration =
r
Price –Yield Curve for a Callable Bond
 Mortgage-Backed Securities

• The number of outstanding callable corporate bonds

has declined, but the MBS market has grown rapidly.
• MBS are based on a portfolio of callable amortizing
loans.
– Homeowners have the right to repay their loans at
any time.
– MBS have negative convexity.
 Mortgage-Backed Securities

• Often sell for more than their principal balance.

• Homeowners do not refinance as soon as rates drop, so
implicit call price is not a firm ceiling on MBS value.
• Tranches – the underlying mortgage pool is divided into a set
of derivative securities
Price-Yield Curve for a Mortgage-Backed Security