Chapter 03 – Security Valuation 6th Edition

Chapter Three
Interest Rates and Security Valuation
I. Chapter Outline
1. Interest Rates as a Determinant of Financial Security Values: Chapter Overview
2. Various Interest Rate Measures
a. Coupon Rate
b. Required Rate of Return
c. Expected Rate of Return
d. Required versus Expected Rates of Return: The Role of Efficient Markets
e. Realized Rate of Return
3. Bond Valuation
a. Bond Valuation Formula Used to Calculate Fair Present Values
b. Bond Valuation Formula Used to Calculate Yield to Maturity
4. Equity Valuation
a. Zero Growth in Dividends
b. Constant Growth in Dividends
c. Supernormal (or Nonconstant) Growth in Dividends
5. Impact of Interest Rate Changes on Security Values
6. Impact of Maturity on Security Values
a. Maturity and Security Prices
b. Maturity and Security Price Sensitivity to Changes in Interest Rates
7. Impact of Coupon Rates on Security Values
a. Coupon Rate and Security Price
b. Coupon Rate and Security Price Sensitivity to Changes in Interest Rates
8. Duration
a. A Simple Illustration for Duration
b. A General Formula for Duration
c. Features of Duration
d. Economic Meaning of Duration
e. Large Interest Rate Changes and Duration
Appendix 3A: Duration and Immunization
Appendix 3B: More on Convexity (All appendices are available through McGraw-Hill’s
Connect. Contact your McGraw-Hill representative for more information on making the
appendix available to your students).

II. Learning Goals

1. Understand the differences in the required rate of return, the expected rate of return,
and the realized rate of return.
2. Calculate bond values.
3. Calculate equity values.
4. Appreciate how security prices are affected by interest rate changes.
5. Understand how the maturity and coupon rate on a security affect its price sensitivity
to interest rate changes.
6. Know what duration is.

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Chapter 03 – Security Valuation 6th Edition

7. Understand how maturity, yield to maturity, and coupon rate affect the duration of a
security.
8. Understand the economic meaning of duration.

III. Chapter in Perspective

This is the second chapter that is designed to familiarize the students with the
determinants of fixed income valuation. This chapter has seven closely related sections
which focus primarily on bond pricing and the bond price formula. From the first three
sections of the chapter readers should learn how to calculate a bond’s price, the
difference between the required rate of return, the expected rate of return and the realized
return and how to calculate each. Efficient markets are briefly introduced by relating the
expected and required rates of return and by comparing market prices to calculated fair
present values. Section 4 introduces bond price volatility and illustrates how changing
interest rates can affect FIs. Sections 5 and 6 discuss the effects of maturity and coupon
on bond price volatility. Section 7 introduces the concept of duration and illustrates how
to calculate Macauley’s duration. Appendix 3A provides an example of immunization
using duration and Appendix 3B demonstrates using the concept of convexity its effect
on bond price predictions.

IV. Key Concepts and Definitions to Communicate to Students

Required rate of return Price sensitivity

Expected rate of return Maturity and price sensitivity

Realized rate of return Coupon and price sensitivity

Coupon rate Duration

Market efficiency Elasticity

Zero coupon bonds Modified duration

Par, premium and discount bonds Convexity

Yield to maturity Fair present value

V. Teaching Notes
1. Interest Rates as a Determinant of Financial Security Values: Chapter Overview
This chapter applies the time value of money concepts developed in Chapter 2 to explain
bond pricing and rates of return. The determinants of bond price volatility, duration and
convexity are also discussed. Financial intermediaries are subject to risk from changing
interest rates (termed interest rate risk) because changing rates can cause changes in
profit flows and in market values of both assets and liabilities. This chapter provides the
building blocks needed to understand how to measure and manage interest rate risk.

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Chapter 03 – Security Valuation 6th Edition

2. Various Interest Rate Measures

a. Coupon Rate
b. Required Rate of Return
c. Expected Rate of Return
d. Required versus Expected Rates of Return: The Role of Efficient Markets
The bond’s coupon rate is the annual dollar coupon divided by the face value. Although
the coupon rate is quoted annually, bonds usually pay interest semiannually. If a bond
has no periodic interest payment it is a zero coupon bond. The required rate of return
(r) is the annual compound rate an investor feels they should earn on a bond given the
risk level of the investment. The r is used as the discount rate in the bond price formula
to calculate the fair present value (PV) of the security. The PV is then compared to the
existing market price to ascertain whether the security is over, under or correctly valued.
The expected rate of return (E(r)), or promised yield to maturity, is the annual
compound rate of return the investor can expect to earn if he/she 1) buys the bond at the
current market price, 2) holds the bond to maturity and 3) reinvests each coupon for the
remaining time to maturity and earns the E(r) on each coupon. The E(r) may be
calculated using the current market price as the present value and the expected cash flows
in the bond price formula. Note that this definition of the E(r) assumes that either there is
no possibility of default risk, or the expected cash flows used in the bond price formula
are probability weighted according to the expected probability of default. If the E(r) is
greater than the r, the security is overvalued. If the bond markets are efficient any
divergences between the market price and the PV (or the r and E(r)) are quickly
arbitraged away.

Calculating PV:
For a $90 annual payment coupon corporate bond (INT = $90, with r = 10% maturing in
n = 6 years:

Equation 1

If this same bond has an actual market price of $945, what is the E(r)?

E(r) = 10.27% Equation 2

This bond would be a good buy since the market price is less than the fair PV. If the
appropriate opportunity cost (r) is 10%, the investor can expect to earn more than he or
she should (10.27%) for the risk level the investor is bearing.

Teaching Tip:
The third assumption underlying the investor’s expectation of earning the E(r) is that the
coupons have to be reinvested at the E(r). Students may become confused over this

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Chapter 03 – Security Valuation 6th Edition

point. For instance, if you buy a $1,000, 8% coupon bond at par and receive $80 per
year, that appears to be an 8% annual return regardless of what the investor does with the
money. It is in fact an 8% simple interest return, but not an 8% annual compound
return. This concept can be easily demonstrated. If you invest $1,000 for 5 years and
expect to earn an 8% compound rate of return per year, at the end of five years you must
have a pool of assets worth $1,000  1.085 = $1,469.33. If you stash the cash in the
mattress and do not reinvest any coupons you will have only ($80  5) + $1,000 =
$1,400 at the end of five years and your realized annual rate of return will be 6.96%.
Likewise, at any reinvestment rate less than 8%, you will wind up with less than
$1,469.33 and have less than an 8% realized return. (See Gardner, Mills and Cooperman,
Managing Financial Institutions: An Asset/Liability Approach 4th ed. Dryden Press,
2000.)

Teaching Tip:
The current yield is the annual dollar coupon divided by the bond’s closing price. It is
akin to the dividend yield on the stock and it measures the simple interest annual rate of
return if you do not sell the bond. For bond investors who use a buy and hold strategy
and spend the coupons, (the prototypical grandmother living off the coupon income for
example) the current yield is a better measure of the annual rate of return they are earning
than the promised yield to maturity. Students though tend to be confused by the term
‘current yield.’ On a test at least some are liable to think this means the current promised
yield to maturity.

Teaching Tip:
The price calculations in the text are ‘clean’ prices, not ‘dirty’ prices. That is, they do not
include accrued interest. To value a bond between payment dates first calculate the
fraction g of time between the settlement date and the next coupon payment date from the
following: g = days between settlement and next coupon payment / days in coupon
period.1 Treasuries use the actual day count in this calculation while corporates and
munis use 30 days for all months (and 360 days in the year). The calculated present
value a bond buyer must pay is tCFt/(1+r)(t-1+g) where t is an integer representing each
subsequent cash flow. This value is called the ‘dirty’ price, the full price or the invoice
price. The amount of accrued interest (AI) = semiannual coupon(1-g). The bond’s clean
price without accrued interest is the full price minus accrued interest. See the example
below.

1
This method is not in the text and it is drawn from Fabozzi, F., Fixed Income Analysis, 2nd Edition,
2007, Chapter 5.

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Bond pricing example between coupon payment dates example for a 4 payment 6%
coupon, 7% yield Treasury bond with semiannual payments with a settlement date on
April 17, 2014 and the next coupon payment date on June 21, 2014:
C Par ytm
6% 100 7.00%
semi $ 3.00 0.035 Settlement date 4/17/2014 (Purchase Date Today)
Date pmt received CF t PV Coupon date 6/21/2014
6/21/2014 1 $ 3.00 0.357143 $2.9634 65 Days (actual)
12/20/2014 2 $ 3.00 1.357143 $2.8632 fraction g 0.357142857 = 65/182
6/20/2015 3 $ 3.00 2.357143 $2.7663
12/19/2015 4 $ 103.00 3.357143 $91.7657
$100.3585 Thus $100.3585 is the full or dirty price of the bond that the buyer must pay the seller.
(Street Method) This price includes accrued interest and is the full amount due the seller.
The price without accrued interest is called the clean price.
days in the accrued interest period = days in coupon period - days between settlement and next coupon
182 days in coupon period - 65 days between settlement and next coupon
117 days in the accrued interest period

The percentage of the coupon payment that is accrued interest 117/182 = 0.642857143 (earned by seller)
Accrued interest = semiannual coupon payment x 0.642857 $3.00 x 0.642857 = $1.92857
The clean price is the full price or dirty price - accrued interest $100.3585 - $1.92857 = $ 98.42998

e. Realized Rate of Return

The realized rate of return ( ) is the rate of return actually earned over the investment
period. It can be above or below the E(r) and the and can be negative. The text uses a
naïve method to calculate the is to find the interest rate using the realized cash flows in
the bond price formula. If the investor knows the actual reinvestment rate on the coupons
the modified internal rate of return (MIRR) method should be used to calculate the
realized rate of return.2 For example, suppose an investor buys a par bond at 6% and
holds it for three years before selling it at $1,050. However, each $60 coupon was
actually reinvested at an interest rate of 5%. Solving the bond price formula gives an of
7.55%. The future value of the three $60 coupons is actually $189.15, so the actual
future value of all the cash inflows is $1,050 + $189.15 = $1,239.15. With a $1,000
initial investment, the actual rate of return is 7.41%, much less than the solution implied
by the bond price formula. Anytime you solve the bond price formula for the discount
rate you are implicitly assuming the cash flows were reinvested at that discount rate.
Only by coincidence will this be correct. Only if you have no other information about the
reinvestment rate is solving the bond price formula to find the realized rate of return
reasonable. Ex-post, one should know the reinvestment rate; ex-ante, one should use the
term structure to estimate the expected reinvestment rate.

3. Bond Valuation
a. Bond Valuation Formula Used to Calculate Fair Present Values
To calculate the PV of a bond with semi-annual compounding, divide the coupon rate and
the r by two and multiply the number of periods by two. Note that the r (or promised
yield) is an APR for bonds that pay interest semi-annually. The effective annual return
for the bond is larger than the bond’s APR.

2
The MIRR method is not in the text.

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For the same bond used above, the PV with semiannual compounding would be:
INT = 90 per year, r = 10%, n = 6 years, m = 2 compounding periods per year}

Equation 3

Premium bonds are priced above par, discount bonds are priced below par.

Teaching Tip: If a fixed income bond is paying a 12% coupon and has a 10% required
(and expected) rate of return, the only way the investor will earn less than the coupon rate
in a given year is if they have a capital loss to offset the extra 2% interest they are
earning. This tells us that when the coupon rate is above the r the bond is selling at a
premium to par and that this premium disappears as maturity approaches. Likewise, a
bond paying only an 8% coupon that has a 9% required yield must be selling below its
redemption value (discount bond), and must be expected to increase in price as maturity
approaches because this is the only way one can expect to get the 8% interest yield up to
a 9% total rate of return. If the bond’s coupon rate and required rate are equal, the price
will equal par regardless of maturity because the entire rate of return is received through
the coupon and no price adjustment is needed.

Example:
A bond’s return (r) consists of the sum of two components:
1. Receiving (and reinvesting) the coupon payment
2. Capital gain or loss on the bond’s value
Both are measured in relation to the purchase price of the bond. Ignoring any
reinvestment on the coupon, a bond’s one year holding period return is the sum of the
current yield and percentage price change of the bond.

Premium bond pricing and annual return:

If a semiannual payment bond has a 15 year maturity with a 6% coupon and a 4% ytm the
bond’s price is $1,223.96. The same bond with a 14 year maturity should have a price of
$1,212.81. Ignoring any reinvestment income from the semiannual coupon, the bond’s
current yield is $60/$1,223.96 = 4.90%. The percentage change in the price of the bond
is -0.90%. The total annual holding period return is 4.90% + -0.90% = 4.00%. Since the
investor is supposed to earn 4% and the yield from the coupon is higher than this amount
the investor must have a capital loss of 0.90% to offset the high coupon.

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Discount bond pricing and annual return:

If a semiannual payment bond has a 15 year maturity with a 6% coupon and an 8% ytm
the bond’s price is $827.08. The same bond with a 14 year maturity should have a price
of $833.37. Ignoring any reinvestment income from the semiannual coupon, the bond’s
current yield is $60/$827.08 = 7.25%. The percentage change in the price of the bond is -
0.75%. The total annual holding period return is 7.25% + 0.75% = 8.00%. Since the
investor is supposed to earn 8% and the yield from the coupon is only 7.25% the investor
must have a capital gain of 0.75% to offset the low coupon.

Bonds are priced at par if the coupon is equal to the yield because the yield rom earning
the coupon equals the required return on the bond so no price change is required to
provide the investor with the necessary return.

Pull to par:
Bond prices approach par as a bond approaches maturity. Premium bonds approach par
from above and discount bonds from below. This is termed the ‘pull to par.’

Teaching Tip: The normal annual discount or premium amortization due to approaching
maturity is taxed as ordinary income (loss), not as a capital gain or loss.

b. Bond Valuation Formula Used to Calculate Yield to Maturity

Assuming away default risk and noting the reinvestment assumption above, this is the
same as calculating the bond’s required rate of return using the bond price formula. It
cannot be solved algebraically in the multiperiod case, but most business calculators are
preprogrammed to find the promised yield. Note that on the Hewlett-Packard and Texas
Instrument business calculators either the left hand side or all of the right hand side of the
bond price formula must be negative. A common mistake students make is to enter only
part of the right hand side as negative (either the coupon or the future value, but not
both.).

4. Equity Valuation Models

The text presents the zero growth, the constant growth and the two stage dividend
discount growth models for equities.
P = D / rs in the zero growth case (Dt = Dividend in time t)
P = D1 / (rs – g) in the constant growth case and

for the two stage growth model where D1 to Dt must be

estimated, using individual growth rates or an average growth rate g1, and g2 is the long
term steady state growth rate that applies from time n through .

5. Impact of Interest Rate Changes on Security Values

Open market interest rates fluctuate daily due to the actions of traders. Buying, selling
and issuing securities all affect interest rates, which in turn affect security prices.

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Mathematically, as required rates rise, PVs fall since the required rate is in the
denominator of the bond price formula. Conceptually, the actions of traders force market
prices to act in similar fashion. If you are holding a bond expected to yield 10% and
identical new bonds are issued that pay 12%, you are not happy! Enough traders begin to
sell the low yield bond so that its price begins to fall and at the lower price its yield rate
rises. This continues until the yield rate moves to 12%. Hence, prices and interest rates
move inversely. Since the cash flows are discounted at a compound rate of return (rates
raised to an exponent) the bond price is not linear with respect to interest rates.

Take the same bond above and let the r rise to 11%
The new PV is

This is a drop in PV of $41.87 (=$955.68 – $913.81). A financial intermediary (FI)

primarily holds financial assets (such as loans and bonds) and financial liabilities.
Consequently the FI must manage the relative price changes of its financial assets and
liabilities. If interest rates rise and the PV of the assets fall by more than the PV of their
liabilities, the PV of the equity will decline. Because most FIs employ very large
amounts of leverage and little equity, an institution that fails to manage its interest rate
risk can quickly face insolvency due to unfavorable interest rate moves.

6. Impact of Maturity on Security Values

a. Maturity and Security Prices
Fixed income security prices approach par as maturity nears (the so called ‘pull to par’)
even if interest rates don’t change. The discount or premium on non par bonds decreases
slightly each year.

b. Maturity and Security Price Sensitivity to Changes in Interest Rates

Price sensitivity or price volatility is the percentage change in a bond’s price for a given
current change in interest rates. Note the specificity of this definition. Students will often
think that a longer term bond is more price volatile because over a longer time period
rates are more likely to change. Their logic is correct but this belies the definition. Price
sensitivity measures how much a bond’s price will change if rates change right now.
Longer term bonds are more price sensitive because the current worth of distant cash
flows is very sensitive to the discount rate. The price sensitivity increases at a decreasing
rate, so a twenty year bond is not twice as price sensitive as a ten year bond. See IM
Figure 3.1 below from an Excel spreadsheet:

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Chapter 03 – Security Valuation 6th Edition

Coupon 6.00%
Par $ 1,000
yield rate old 7.00%
yield rate change 0.50%
yield rate new 7.50%
Absolute
Maturity Price old Price new Rate of change
1 $ 990.65 $ 986.05 0.47%
5 $ 959.00 $ 939.31 2.05%
10 $ 929.76 $ 897.04 3.52%
15 $ 908.92 $ 867.59 4.55%
20 $ 894.06 $ 847.08 5.25%
25 $ 883.46 $ 832.80 5.74%
30 $ 875.91 $ 822.84 6.06%
35 $ 870.52 $ 815.91 6.27%
40 $ 866.68 $ 811.08 6.42%
45 $ 863.94 $ 807.72 6.51%
50 $ 861.99 $ 805.38 6.57%
55 $ 860.60 $ 803.75 6.61%
60 $ 859.61 $ 802.61 6.63%
65 $ 858.90 $ 801.82 6.65%
70 $ 858.40 $ 801.27 6.66%
75 $ 858.04 $ 800.88 6.66%
80 $ 857.78 $ 800.61 6.66%
85 $ 857.60 $ 800.43 6.67%
90 $ 857.47 $ 800.30 6.67%
95 $ 857.37 $ 800.21 6.67%
100 $ 857.31 $ 800.14 6.67%
105 $ 857.26 $ 800.10 6.67%
Predicted limit price change =
1 - (r old / r new) 6.67%
IM Figure 3.1
IM Figure 3.1 illustrates the limit of the price change for a given coupon rate and a yield
rate increase of 50 basis points for bonds of different maturity. Notice that as maturity is
increased from 1 to 5 to 10 years, the price volatility increase is quite large on a
percentage basis. However as maturity is increased beyond 30 years there are only small
increases in price volatility.3 At the limit, the price change is equal to 1 – (rold / rnew). This
limit formula is correct for all coupon paying bonds, with higher coupon bonds reaching
the limit more quickly, and low coupon bonds reaching the limit price change much more
slowly.

Teaching Tip: Extreme examples often help to illustrate a concept. For example, if you
are holding a 5% coupon bond that you can’t get rid of for 30 years and suddenly rates
rise from 5% to 10%, you might expect that you and other investors in the bond are not
very happy and its price will drop a large amount. However, if the bond matures
tomorrow, would you expect its price to move much?

Teaching Tip: Any security that pays more money back sooner, ceteris paribus, will be
less price volatile. Specifically, the value of any security that returns a greater percentage
of the initial investment sooner will be less sensitive to interest rate changes. Text Tables
3-7 through 3-10 can be used to illustrate this simple concept for different coupons and
different maturity.

7. Impact of Coupon Rates on Security Values

3
As maturity increases the bond price formula converges to the present value of a perpetuity where PV = $
Coupon / r. This allows one to develop the predicted limit price change as (C/r new / C/rold) – 1.

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a. Coupon Rate and Security Price

Ceteris paribus, the higher the coupon rate the higher the bond’s price. See the Teaching
Tip in 3a for an explanation.

b. Coupon Rate and Security Price Sensitivity to Changes in Interest Rates

A higher coupon results in lower bond price sensitivity to interest rate changes, ceteris
paribus. The bigger the coupon the greater the percentage of your initial investment that
is recovered in the near term (see the last Teaching Tip in 5.b.), or the bigger the coupon
the sooner you recover the investment. Suppose you are comparing two five year bonds,
one with a zero coupon and one with a 15% coupon. If interest rates rise the 15% coupon
bond pays you a much larger sum of money quickly with which you can reinvest and earn
the new higher interest rate. The zero coupon bond gives you no money with which you
can reinvest and earn the higher rate so the zero drops more in value. IM Figure 2 below
illustrates the effect of coupon on price volatility for a 10 year maturity bond with a yield
rate change from 7% to 6.5% for bonds with different coupons. Notice that lower coupon
bonds exhibit a greater price change for the given rate change. The greatest volatility is
exhibited by the zero coupon bond, but as with maturity, the price change increases at a
decreasing rate for a declining coupon rate. At this point in the development an investor
needs to consider both maturity and coupon to understand their exposure to interest rate
risk. One of the purposes of developing the duration concept in the next section is that
duration reduces the analysis to one dimension by incorporating the effect of coupon into
the maturity effect on price volatility.
Coupon Varies Maturity
Par $1,000 10 years
rate old 7.00%
rate change -0.50%
rate new 6.50% Absolute
Rate of
Coupon rate Price old Price new change
6.00% $ 929.76 $ 964.06 3.69%
5.50% $ 894.65 $ 928.11 3.74%
5.00% $ 859.53 $ 892.17 3.80%
4.50% $ 824.41 $ 856.22 3.86%
4.00% $ 789.29 $ 820.28 3.93%
3.50% $ 754.17 $ 784.34 4.00%
3.00% $ 719.06 $ 748.39 4.08%
2.50% $ 683.94 $ 712.45 4.17%
2.00% $ 648.82 $ 676.50 4.27%
1.50% $ 613.70 $ 640.56 4.38%
1.00% $ 578.59 $ 604.61 4.50%
0.50% $ 543.47 $ 568.67 4.64%
0.00% $ 508.35 $ 532.73 4.80%
IM Figure 2 Coupons and Price Volatility

8. Duration
a. A Simple Illustration for Duration
Duration is the weighted average time to maturity on a financial security using the
relative present values of the cash flows as weights. This definition will initially mean
very little to students. To understand the concept implied by the definition, think of an N
year annual payment coupon bond as a portfolio of N zero coupon bonds where the first
N-1 of the bonds pay the coupon amount and the last one pays the coupon plus the par
amount. The coupon bond’s duration is the average maturity of the portfolio of zero

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coupon bonds. However, we cannot take a simple average because not all the cash flows
in each year are identical. Moreover, Chapter 2 tells us that we cannot compare a cash
flow in year 1 with a cash flow in year N. So we construct a series of weights that tell us
what percentage of our money (in today’s dollars) we recover in each year. To do this
take the present value of each cash flow divided by the purchase price of the bond. For
instance, for a 5 year bond suppose we recover in present value terms 5% of our
investment in year one , 4% in year two, 3% in year three, 2% in year four and 86% in
year five. We receive cash in each of the next five years (or a zero matures in each of the
next five years): 1, 2, 3, 4 and 5. Thus, the bond’s duration is the weighted average
maturity of the zeros or (5%1) + (4%2) + (3%3) + (2%4) + (86%5) = 4.6 years.
Duration may perhaps be slightly better defined as a weighted average of the times in
which cash is received, a slightly different wording than the more common definition
above.

Teaching Tip: The above 5 year maturity coupon bond has the same price sensitivity as
a 4.6 year maturity zero coupon bond (ignoring convexity).

Teaching Tip: Thinking of duration as a weighted average life of a bond assumes the
bond’s cash flows do not change over the life. This concept of duration is problematic
for mortgage bonds or any bond with embedded options. In some of these cases duration
may be longer than the life of the bond or may be negative and the time concept of
duration then makes no sense. In these situations one should think of (modified) duration
as the percentage price change for a 100 basis point change in interest rates.

b. A General Formula for Duration

Equation 4

For example: INT = $90 per year, annual r = 10%, Maturity = 6 years, m = 2
compounding periods per year, PV = $955.68}

Annual duration = 9.46 ÷ 2 = 4.73 years

Closed form version of the duration equation:

Equation 5

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This formula is from: Caks, J., W. Lane, R. Greenleaf, and R. Joules. (1985). A Simple
Formula For Duration, The Journal of Financial Research, 8(3).

INT
= Periodic cash flow in dollars
r = periodic interest rate
n = Number of compounding or payment periods
Dur = Duration = # Compounding or payment periods

Teaching Tip:
Variations of the basic duration formulae can be used. The versions shown above may be
used for annual or semiannual payment bonds or for amortizing loans. The duration
answer obtained from these equations will be in the number of compounding or payment
periods. For instance, if you use Equation 4 or 5 to find the duration of a semiannual
payment bond as shown above, you will get an answer in terms of the number of semi-
annual periods, rather than years. If one replaces PV in Equations 4 and 5 with (m*PV),
then the resulting duration answer will be in years.4 Alternatively, Equation 4 could be
modified as follows to give an annual duration result for a semiannual payment bond:

Equation 4a
where PVCFt is the present value of the cash flow in time t, where t = ½, 1, 1½ , … N.

c. Features of Duration
Duration of a security with fixed cash flows and term may be thought of as a time
measure, usually presented in years. A greater coupon payment results in a shorter bond
duration. With a greater coupon the percentage weights on the early years are increased,
thus reducing the average maturity. The duration of a zero coupon bond is its maturity
because it has a 100% weight on the year in which the terminal cash flow occurs and a
0% weight on all other years. Except for certain deep discount bonds, the longer the
maturity of a bond the longer the bond’s duration (see the charts below). Notice that
duration increases at a decreasing rate as maturity increases. Duration has a limit with
respect to maturity for a given interest rate. The maximum duration of a bond can be
found as (1/ r) +1 where r is the periodic rate found as the ytm/2 for a bond and the
solution is the maximum number of payment periods. As you can see in the chart, for a
premium bond, the duration increases monotonically towards this maximum (26 periods
or 13 years. With an 8% APR the periodic rate for a semiannual payment bond is 4% and
the maximum is found as (1/0.04) + 1) as N is increased. Note that in the charts, m = c or
the number of compounding periods.

4
Recall that m = number of compounding periods per year. In the prior chapter the text used c for m.

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Premium Bond
Bond Terms Bond
$C 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00%
N (# years) 4 8 16 32 64 128 200 400
m 2 2 2 2 2 2 2 2
# of periods 8 16 32 64 128 256 400 800
ytm or k 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00%
PAR $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000
PRICE $ 1,067.33 $ 1,116.52 $ 1,178.74 $ 1,229.69 $ 1,248.35 $ 1,249.99 $ 1,250.00 $ 1,250.00

Terms for calculating duration

$C/2 $ 50 $ 50 $ 50 $ 50 $ 50 $ 50 $ 50 $ 50
r or k/2 0.04 0.04 0.04 0.04 0.04 0.04 0.04 0.04
T = n*m 8 16 32 64 128 256 400 800
2
r 0.0016 0.0016 0.0016 0.0016 0.0016 0.0016 0.0016 0.0016
T
(1+r) 1.36856905 1.87298125 3.50805875 12.3064762 151.4493558 22936.9074 6506324.497 4.23323E+13
T+1
(1+r) 1.423311812 1.9479005 3.6483811 12.7987352 157.50733 23854.3837 6766577.477 4.40255E+13
term in brackets 28.91332575 89.3964155 236.665987 467.169434 624.5789609 649.692635 649.9983631 650
$C/2 * bracket 1,445.67 4,469.82 11,833.30 23,358.47 31,228.95 32,484.63 32,499.92 32,500.00
Par term 5845.52164 8542.53081 9121.85408 5200.51387 845.1670155 11.1610513 0.061478643 1.88981E-08
Numerator 7,291.19 13,012.35 20,955.15 28,558.99 32,074.12 32,495.79 32,499.98 32,500.00
Denominator 1067.327449 1116.52296 1178.73551 1229.68549 1248.349283 1249.9891 1249.999962 1250
Duration ( m periods) 6.831257 11.654352 17.777655 23.224626 25.693222 25.996861 25.999985 26.000000
Duration in years 3.41563 5.82718 8.88883 11.61231 12.84661 12.99843 12.99999 13.00000
Duration limit | r 26 periods
Duration limit | r 13 years

For a deep discount bond, the duration initially rises with maturity and then declines as
illustrated below:
Discount Bond
Bond Terms Bond
$C 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00%
N (# years) 4 8 16 32 64 128 200 400
m 2 2 2 2 2 2 2 2
# of periods 8 16 32 64 128 256 400 800
ytm or k 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00%
PAR $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000
PRICE $ 764.35 $ 592.17 $ 374.43 $ 196.10 $ 130.78 $ 125.04 $ 125.00 $ 125.00

Terms for calculating duration

$C/2 $ 5 $ 5 $ 5 $ 5 $ 5 $ 5 $ 5 $ 5
r or k/2 0.04 0.04 0.04 0.04 0.04 0.04 0.04 0.04
T = n*m 8 16 32 64 128 256 400 800
2
r 0.0016 0.0016 0.0016 0.0016 0.0016 0.0016 0.0016 0.0016
T
(1+r) 1.36856905 1.87298125 3.50805875 12.3064762 151.4493558 22936.9074 6506324.497 4.23323E+13
T+1
(1+r) 1.423311812 1.9479005 3.6483811 12.7987352 157.50733 23854.3837 6766577.477 4.40255E+13
term in brackets 28.91332575 89.3964155 236.665987 467.169434 624.5789609 649.692635 649.9983631 650
$C/2 * bracket 144.57 446.98 1,183.33 2,335.85 3,122.89 3,248.46 3,249.99 3,250.00
Par term 5845.52164 8542.53081 9121.85408 5200.51387 845.1670155 11.1610513 0.061478643 1.88981E-08
Numerator 5,990.09 8,989.51 10,305.18 7,536.36 3,968.06 3,259.62 3,250.05 3,250.00
Denominator 764.3539294 592.169654 374.425698 196.100776 130.7775089 125.038148 125.0001345 125
Duration ( m periods) 7.836799 15.180638 27.522641 38.431062 30.342081 26.069038 26.000398 26.000000
Duration in years 3.91840 7.59032 13.76132 19.21553 15.17104 13.03452 13.00020 13.00000
Duration limit | r 26 periods
Duration limit | r 13 years

Teaching Tip: Students should be aware that although duration is a modified measure of
maturity, it is still a measure of maturity and maturity is the predominant effect on
duration.

The higher the promised yield to maturity the shorter the duration. Using a higher
interest rate decreases the percentages weights on more distant cash flows (because of the

Ch 3- 13
Chapter 03 – Security Valuation 6th Edition

compounding effect the present value of more distant cash flows drops (%) more than the
present value of near term cash flows).

d. Economic Meaning of Duration

Taking the partial derivative of the bond price formula with respect to interest rates for a
zero coupon bond yields a simple relationship:
%P = - Maturity  r / (1 + r) (r = yield to maturity)
%P = elasticity
Maturity can be used to predict the price change for small interest rate changes when
there are no coupons. This equation does not work for coupon bonds; its use in this case
would overestimate the volatility since coupons dampen a bond’s price volatility.
Duration is however a modified measure of maturity that reflects the reduced maturity
due to the early payment of interest (coupons) prior to maturity. In particular the duration
of a coupon bond has the same price sensitivity as a zero coupon bond that has a maturity
equal to the coupon bond’s duration (ignoring convexity). Thus it follows (without
calculus even) that %P = - Duration  r / (1 + r) for a coupon bond. Duration may
be used to predict price changes for small interest rate changes for coupon bonds. For
convenience, practitioners sometimes calculate what is called ‘modified duration’ which
for bonds is Duration / (1 + rsemi) so that the only variable to be added to predict the price
change is r.
Important Note: Modified duration is Duration / (1 + rperiod). The ‘period’ would be
semiannual for most bonds and monthly for most loans. However when modified
duration is used to predict the price change in the formula, the rate change used is an
annual rate: %P = - Modified Duration / (1 + rannual). This can be a confusing point for
students.

Teaching Tip:
Why should students have to learn duration when today one can easily predict the bond
price change via a hand calculator, or better yet, with a spreadsheet? Two reasons:
1) Duration can be used as a strategic tool in trying to earn a higher rate of return, or to
minimize the risk associated with earning the promised yield to maturity. For
instance, for a given investment horizon one can try to lock in the current promised
yield to maturity by choosing a bond with a duration equal to the investment horizon.
This is a standard institutional bond investment strategy called immunization and it is
described in Appendix A. However, one can also try to beat the promised yield. If
interest rates are projected to fall one could choose a bond with a duration greater than
the investment horizon. If the investor is correct and rates fall, the gain in sale price of
the bond will more than outweigh the lost reinvestment income caused by the lower
reinvestment rate and the overall realized rate of return will be greater than the
promised yield. Conversely, one who is projecting rising rates can beat the promised
yield by choosing a bond with a duration shorter than the investment horizon.
2) Given the individual bond durations, the duration of a portfolio is a simple weighted
average of the durations of the bonds in the portfolio. Using the portfolio’s duration
makes it very easy to predict the net value change of the portfolio for a given change
in interest rates.

Ch 3- 14
Chapter 03 – Security Valuation 6th Edition

e. Large Interest Rate Changes and Duration

Duration is an accurate predictor of price changes only for very small interest rate
changes. For day to day fluctuations duration works quite well but when interest rates
move significantly, such as when the Fed makes an announcement of a rate change, the
predicted pricing errors can become significant. The prediction errors arise because bond
prices are not linear with respect to interest rates. At lower yield rates, bond prices are
more sensitive to interest rate changes than at higher initial promised yields. A given
percentage change in interest rates will result in a larger bond price change for a low
yield bond than for a high yield bond. Thus, a graph of bond prices versus interest rates
would be convex to the origin. Duration does not capture this change in sensitivity (or
convexity) of bond prices to interest rates. Duration predicts that the price changes of
bonds are linear with respect to changes in interest rates and thus duration predicts
symmetric price changes of a given interest rate increase or decrease. An examination of
Text Figures 3-7 and 3–8 indicates that this is not a true assertion. As mentioned above,
the bond’s price with respect to interest rates is convex to the origin. The duration is the
first derivative or slope of the line in Text Figure 3-7. Hence, the error in the bond price
prediction is due to the curvature of the line, and the degree of curvature is called the
convexity. Greater convexity leads to greater pricing prediction errors. The errors can
be quite economically significant for larger portfolios and for bigger interest rate
changes. Notably, convexity works in the investor’s favor. Duration over-predicts the
price drop that follows from an interest rate increase and under-predicts the price increase
that results from a yield decline. Investors will desire convexity in their bonds.5 The
greater the interest rate change, the greater the error in predicted prices and rates of return
from ignoring convexity. All fixed income securities that have cash flows prior to
maturity exhibit convexity. For more on convexity see Appendix 3B.

Appendix 3A: Duration and Immunization (Available on Connect or from your

McGraw-Hill representative)
Suppose you have a 5 year investment horizon and you are looking to immunize and lock
in the current promised 8% ytm. You find a likely candidate in an 8% coupon, 8% ytm
corporate bond with a 6 year maturity.

Duration: [80/1.08 + (80*2)/1.082 + (80*3)/1.08 3 + (80*4)/1.08 4 +(80*5)/1.085 +

(1080*6)/1.086] / 1000 = 4.9927, approximately 5 years

At the end of 5 years you must have achieved an ending wealth position of $1000 * 1.085
= $1469.33 if you are to have actually earned an 8% compound rate of return per year
(ytm).

Case 1: Rates stay same:

Future value (FV) coupons = $80 * [(1.085 - 1)/.08] = $ 469.33
Price of bond end of 5th year = $1000.00
Total Ending Wealth = $1469.33

Case 2: Rates fall immediately after purchase to 7.5%:

5
This assumes that investors are long in bonds.

Ch 3- 15
Chapter 03 – Security Valuation 6th Edition

Future value (FV) coupons = $80 * [(1.0755 - 1)/.075] = $ 464.67

Price of bond end of 5th year = $1080/1.075 = $1004.65
Total Ending Wealth = $1469.32

Realistically the investor must sell the bond immediately after the rate change, otherwise
rates may stay low for 4.9 years and then increase at the time of sale at year 5. The sale
will yield a price of $1,023.47, which can be reinvested at 7.5% for five years to give a
future value of $1,469.32

Case 3: Rates rise immediately after purchase to 8.5%:

Future value (FV) coupons = $80 * [(1.0855 - 1)/.085] = $ 474.03
Price of bond end of 5th year = $1080/1.085 = $ 995.39
Total Ending Wealth = $1469.42

Realistically the investor must again sell the bond immediately after the rate change.
This will yield a price of $977.23, which can be reinvested at 8.5% for five years to give
a future value of $1,469.42
If an investor chooses a bond with a duration greater than their investment horizon, their
pretax nominal realized yield will be improved by falling interest rates because the gain
in sale price will more than outweigh the loss in reinvestment income. Likewise, If an
investor chooses a bond with a duration less than their investment horizon, their realized
yield will be improved by rising interest rates because the loss in sale price will be
smaller than the gain in extra reinvestment income. (This example is drawn from
Gardner, Mills and Cooperman, Managing Financial Institutions: An Asset/Liability
Approach 4th ed. Dryden Press, 2000.)

Appendix 3B: More on Convexity (available in Connect or through your McGraw

Hill representative)
I. Measuring Convexity
There are various ways to measure convexity (CX). Cornett & Saunders measure CX
from the following formula:
CX = Scaling factor * [% loss in bond price from a 1 basis point rise in rates + % gain in
bond price from a 1 basis point drop in rates] written as:
CX = 108 * [(ΔP- / P) + (ΔP+ / P)] (This is called effective convexity)
8
The scaling factor used is 10 ; the factor is chosen to scale up the result to represent a 100
basis point change in rates.
The instructor may wish to include the following example calculation of CX for a 4 year
bond that pays interest semiannually (8 periods total) with a 10% annual coupon and an
8% annual promised ytm (r):
(m = number of compounding periods per year rather than c)

Ch 3- 16
Chapter 03 – Security Valuation 6th Edition

Duration and Convexity Version June 05

C% Quote 10.00%
Par $1,000
Bond Terms $C/2 $50.00
(semi-annual
rannual 8.00%
payment)
m=2 r semi 4.00%
Years 4 years
Priceold $1,067.33
Semiannual
rate change 0.00005
CX = 108 * [(P- / P) + (P+ / P)] New r 4.0050% 3.9950%
P(Old) = $ 1,067.33 P- P+
8
10 = 100,000,000 $1,066.98 $1,067.68
P- / P  0.000328359) ΔP ($0.35047) $0.35061
P+ / P 0.000328493
[(P-/P) + (P+/P)] 1.34315E-07
CX = 13.43145

Teaching Tip:
If your students have had calculus, convexity can be found by taking the second
derivative of the bond price formula with respect to interest rates. The result is:

(m = # compounding periods per year)

see for instance, Page 650 in Chapter 21in Investments: A Global Perspective, J.C.
Francis and R. Ibbotson, 2002, Prentice Hall, Upper Saddle River, NJ 07458.

II. Using Convexity

The predicted change in bond price for a given change in interest rates can now be found
from:
ΔP / P = -Dursemi*Δrsemi/(1+r) + 1/2*CX*(Δrsemi*2)2
where the first term is the price change based on duration and the second term adds the
correction needed due to convexity. An example is provided below:
With the convexity correction, there is only a negligible pricing prediction error.
Convexity increases with maturity and is inversely related to the coupon rate and
promised yield rates.
Predicting Price Change with Duration and Convexity
P / P = -Dursemi*rsemi/(1+r) + 1/2*CX*(rsemi*2)2
rsemi 4.00%
rsemi -0.005 
rsemi new 3.50%
Price  Due to Dur 3.28426%
Price  Due to CX 0.06716%
P / P = 3.35142%
Old Price $ 1,067.33
$ Predicted $ 35.77
Predicted New Price $ 1,103.10
Actual New Price $ 1,103.11

Ch 3- 17
Chapter 03 – Security Valuation 6th Edition

VI. Web Links

[Link] Financial Times, won two Espy awards for best new site
and best non U.S. news site. Coverage of global events and
markets.

[Link] Website of the American Banker’s Association

[Link] A bond oriented website with daily market commentary

and yield spreads

[Link] The Bond Market Association website has a wealth of

information for individual bond investors.

[Link] Although not the best site for bond data the Markets Data
Center does have some key bond statistics

VI. Student Learning Activities

1. Using a spreadsheet construct a graph depicting how a bond’s price is affected by

interest rates for the following two annual payment corporate bonds:
Bond A: 5 year maturity, 12% coupon
Bond B: 25 year maturity, 6% coupon
Using whole number interest rates ranging from 4% to 15% calculate the associated
PVs and graph them. How do the two graphs differ? Why?

2. In number 1 above, if interest rates are initially at 8% and they increase to 8.5% what
is the predicted price change for each bond? What is the actual price change for
each? What is the error in the predicted price change for each bond? Why is the
error greater for one bond than the other? Do your answers differ if rates fall from
8% to 6.5%? Why or why not?

3. Go to the following website of the Bond Market Association:

[Link] and read in the section entitled, “Bond Basics,” under the
“Learn More” tab the subsection on fundamental investment strategies. Describe the
four strategies found there.

4. Go to [Link] and describe the ‘bond of the day.’ What services are
available at this website?

5. Go to [Link] and read the daily bond market commentary. Briefly

describe the major news events of the day.

Ch 3- 18
Chapter 03 – Security Valuation 6th Edition

6. Find the approximate spread between AAA and BBB rated bonds. Discuss why this
spread exists. If a AAA and a BBB rated bond have the same duration and convexity
will they have the same level of interest rate risk? Why or why not?

Ch 3- 19