Chapter Three

Interest Rates
and Security
Valuation
McGraw-Hill/Irwin 3-1 ©2009, The McGraw-Hill Companies, All Rights
 Various Interest Rate Measures
•• Coupon
Coupon rate
rate
–– periodic
periodiccash
cashflow
flowaabond
bondissuer
issuercontractually
contractually
promises
promisestotopay
payaabond
bondholder
holder
•• Required
Required rate
rate of
of return
return (rrr)
(rrr)
–– rates
ratesused
usedby
byindividual
individualmarket
marketparticipants
participantsto
to
calculate
calculatefair
fairpresent
presentvalues
values(PV)
(PV)
•• Expected
Expected rate
rate of
of return
return (Err)
(Err)
–– rates
ratesparticipants
participantswould
wouldearn
earnby
bybuying
buyingsecurities
securitiesatat
current
currentmarket
marketprices
prices(P)
(P)
•• Realized
Realized rate
rate of
of return
return (rr)
(rr)
–– rates
ratesactually
actuallyearned
earnedon
oninvestments
investments

McGraw-Hill/Irwin 3-2 ©2009, The McGraw-Hill Companies, All Rights

 Required Rate of Return

•• The
The fair
fair present
present value
value (PV)
(PV) of
of aa security
security isis
determined
determined using
using the
the required
required rate
rate ofof return
return
(rrr)
(rrr) as
as the
the discount
discount rate
rate
~ ~ ~ ~
CF1 CF2 C F3 CFn
PV     ... 
(1  rrr ) (1  rrr ) (1  rrr )
1 2 3
(1  rrr ) n

CF
CF11==cash
cashflow
flowin
inperiod
periodtt(t(t==1,1,…,
…,n)n)
~~==indicates
indicatesthe
theprojected
projectedcash
cashflow
flowisisuncertain
uncertain
nn==number
numberof ofperiods
periodsin
inthe
theinvestment
investmenthorizon
horizon

McGraw-Hill/Irwin 3-3 ©2009, The McGraw-Hill Companies, All Rights

 Expected Rate of Return

•• The
The current
current market
market price
price (P)
(P) of
of aa security
security isis
determined
determined using
using the
the expected
expected rate
rate ofof return
return
(Err)
(Err) as
as the
the discount
discount rate
rate
~ ~ ~ ~
C F1 C F2 C F3 C Fn
P    ... 
(1  Err ) (1  Err ) (1  Err )
1 2 3
(1  Err ) n

CF
CF11==cash
cashflow
flowininperiod
periodtt(t(t==1,1,…,
…,n)n)
~~==indicates
indicatesthe
theprojected
projectedcash
cashflow
flowisisuncertain
uncertain
nn==number
numberof ofperiods
periodsin
inthe
theinvestment
investmenthorizon
horizon

McGraw-Hill/Irwin 3-4 ©2009, The McGraw-Hill Companies, All Rights

 Realized Rate of Return

•• The
The realized
realized rate rate of
of return
return (rr)
(rr) isis the
the discount
discount
rate
rate that
that just
just equates
equates the
the actual
actual purchase
purchase price price
((P)) to
to the
the present
present value
value of
of the
the realized
realized cashcash flows
flows
(RCF
(RCFt)t) tt(t(t==1,1,…,
…,n)
n)

RCF1 RCF2 RCF3 RCFn

P    ... 
(1  rr ) (1  rr ) (1  rr )
1 2 3
(1  rr ) n

McGraw-Hill/Irwin 3-5 ©2009, The McGraw-Hill Companies, All Rights

 Bond Valuation

•• The
Thepresent
presentvalue
valueof ofaabond
bond(V (Vbb))can
canbe
bewritten
writtenas:
as:
t
2T  
INT 1 M
Vb     
2 t 1  (1  id / 2)  (1  id / 2) 2T
INT
 ( PVIFA i / 2 , 2T
)  M ( PFIVi / 2 , 2T
)
2 d d

MM==thethepar
parvalue
valueofofthe
thebond
bond
INT
INT==thetheannual
annualinterest
interest(or
(orcoupon)
coupon)payment
payment
TT==the
thenumber
numberof ofyears
yearsuntil
untilthe
thebond
bondmatures
matures
ii==the
theannual
annualinterest
interestrate
rate(often
(oftencalled
calledyield
yieldto
tomaturity
maturity
(ytm))
(ytm))

McGraw-Hill/Irwin 3-6 ©2009, The McGraw-Hill Companies, All Rights

 Bond Valuation

•• A
A premium
premium bond bond has
has aa coupon
coupon raterate (INT)
(INT)
greater
greater then
then the
the required
required rate
rate of
of return
return (rrr)
(rrr)
and
and the
the fair
fair present
present value
value ofof the
the bond
bond (V (Vbb)) isis
greater
greater than
than the
the face
face value
value (M)
(M)
•• Discount
Discount bond:
bond: ifif INT
INT << rrr,
rrr, then
then VVbb<< MM
•• Par
Par bond:
bond: ifif INT
INT == rrr,
rrr, then
then VVbb== MM

McGraw-Hill/Irwin 3-7 ©2009, The McGraw-Hill Companies, All Rights

 Equity Valuation

•• The
The present
present value
value of
of aa stock
stock (P
(Pt)t) assuming
assuming zero
zero
growth
growth in
in dividends
dividends can
can bebe written
written as:as:
Pt D / is
DD==dividend
dividendpaid
paidatatend
endof ofevery
everyyear
year
PPt t==the
thestock’s
stock’sprice
priceatatthe
theend
endof
ofyear
yeartt
iiss==the
theinterest
interestrate
rateused
usedto
todiscount
discountfuture
futurecash
cash
flows
flows

McGraw-Hill/Irwin 3-8 ©2009, The McGraw-Hill Companies, All Rights

 Equity Valuation

•• The
The present
present value
value ofof aa stock
stock (P
(Pt)t) assuming
assuming
constant
constant growth
growth in
in dividends
dividends can can be be written
written as:
as:
D0 (1  g ) t Dt 1
Pt  
is  g is  g

DD00==current
currentvalue
valueof
ofdividends
dividends
DDt t==value
valueof
ofdividends
dividendsatattime
timett==1,1,2,2,…,
…,∞∞
gg==thetheconstant
constantdividend
dividendgrowth
growthrate
rate

McGraw-Hill/Irwin 3-9 ©2009, The McGraw-Hill Companies, All Rights

 Equity Valuation

•• The
The return
return on
on aa stock
stock with
with zero
zero dividend
dividend growth,
growth,
ifif purchased
purchased at
at price
price PP00,, can
can be
be written
written as:
as:
is D / P0
•• The
The return
return onon aa stock
stock with
with constant
constant dividend
dividend
growth,
growth, ifif purchased
purchased at at price
price PP00,, can
can be
be written
written as:
as:
D0 (1  g ) D1
is  g  g
P0 P0

McGraw-Hill/Irwin 3-10 ©2009, The McGraw-Hill Companies, All Rights

 Determinants of Financial Security
prices
•• The
The factors
factors that
that affect
affect the
the value
value of
of the
the security
security
are:
are:
•• Interest
Interest rates.
rates.
•• The
The time
time remaining
remaining toto maturity.
maturity.
•• The
The coupon
coupon rate.
rate.

•• Also
Also affect
affect the
the degree
degree of of responsiveness
responsiveness of of
security’s
security’s price
price to
to aa given
given change
change in
in interest
interest rate
rate
(i.e.
(i.e. affect
affect the
the degree
degree of of price
price sensitivity).
sensitivity).
McGraw-Hill/Irwin 3-11 ©2009, The McGraw-Hill Companies, All Rights
 Relation between Interest
Rates and Bond Values
•• There
There isis an
an inverse
inverse relationship
relationship between
between presentpresent
values
values (i.e.
(i.e. Bond
Bond price)
price) and
and interest
interest rates.
rates.
•• This
This inverse
inverse relation
relation isis not
not linear,
linear, that
that is,
is, the
the
percentage
percentage change
change in in the
the present
present value
value of of aa bond
bond
to
to aa given
given change
change in in interest
interest rate
rate isis smaller
smaller when
when
interest
interest rates
rates are
are higher.
higher.
•• In
In other
other words,
words, thethe present
present value
value of of bond
bond
decreases
decreases at at aa decreasing
decreasing raterate as
as interest
interest raterate
increases.
increases.
McGraw-Hill/Irwin 3-12 ©2009, The McGraw-Hill Companies, All Rights
 Relation between Interest
Rates and Bond Values
Interest
Interest
Rate
Rate
12%

10%

8%

Bond
BondValue
Value
874.50 1,000 1,152.47

McGraw-Hill/Irwin 3-13 ©2009, The McGraw-Hill Companies, All Rights

 Impact of Maturity on
Interest Rate Sensitivity
•• The
The factor
factor that
that affect
affect the
the degree
degree to
to which
which the the price
price
of
of aa bond
bond changes
changes as as interest
interest rates
rates change
change isis the
the
time
time remaining
remaining to to maturity.
maturity.
•• The
The change
change in in the
the price
price of of aa bond
bond asas aa result
result of
of the
the
change
change in in interest
interest rate
rate isis called
called price
price sensitivity.
sensitivity.
•• The
The larger
larger the
the percentage
percentage changechange inin the
the bond’s
bond’s
value
value for
for aa given
given interest
interest rate
rate change,
change, the the larger
larger
the
the price
price sensitivity.
sensitivity.

McGraw-Hill/Irwin 3-14 ©2009, The McGraw-Hill Companies, All Rights

 Impact of Maturity on
Interest Rate Sensitivity
•• The
The closer
closer the
the bond
bond isis to
to maturity,
maturity, thethe closer
closer the
the
fair
fair present
present value
value ofof the
the bond
bond (i.e.
(i.e. bond’s
bond’s price)
price) toto
the
the face
face value,
value, then
then the
the lower
lower the
the percentage
percentage
change
change in in the
the bond’s
bond’s value
value for
for aa given
given interest
interest rate
rate
change
change (i.e.
(i.e. the
the less
less sensitive
sensitive the
the price).
price).
•• However,
However, the the relationship
relationship isis not
not linear.
linear.
•• As
As the
the time
time remaining
remaining to to maturity
maturity increases,
increases, price
price
sensitivity
sensitivity increase
increase at at decreasing
decreasing rate.
rate.

McGraw-Hill/Irwin 3-15 ©2009, The McGraw-Hill Companies, All Rights

 Impact of Maturity on
Interest Rate Sensitivity

McGraw-Hill/Irwin 3-16 ©2009, The McGraw-Hill Companies, All Rights

 Impact of Maturity on
Interest Rate Sensitivity
Absolute
AbsoluteValue
Valueofof
Percent
PercentChange
Changein inaa
Bond’s
Bond’sPrice
Pricefor
foraa
Given
GivenChange
Changein in
Interest
InterestRates
Rates

Time to Maturity

McGraw-Hill/Irwin 3-17 ©2009, The McGraw-Hill Companies, All Rights

 Impact of Coupon Rates on
Interest Rate Sensitivity
•• The
The factor
factor that
that affect
affect thethe degree
degree to to which
which the
the price
price
of
of aa bond
bond changes
changes as as interest
interest rates
rates change
change isis the
the
coupon
coupon [Link].
•• The
The higher
higher the
the coupon
coupon rate,rate, the
the higher
higher itsits present
present
value
value atat any
any given
given interest
interest rate
rate (i.e.
(i.e. discount
discount rate).
rate).
•• The
The higher
higher the
the bond’s
bond’s coupon
coupon rate,
rate, the
the smaller
smaller the
the
price
price changes
changes on on the
the bond
bond for
for aa given
given change
change in in
interest
interest rate
rate (i.e.
(i.e. lower
lower sensitivity).
sensitivity).

McGraw-Hill/Irwin 3-18 ©2009, The McGraw-Hill Companies, All Rights

 Impact of Coupon Rates on
Interest Rate Sensitivity
•• The
The higher
higher the
the bond’s
bond’s coupon
coupon rate,
rate, the
the higher
higher the
the
fair
fair present
present value
value of
of the
the bond
bond (i.e.
(i.e. bond
bond price)
price) to
to the
the
face
face value,
value, then
then the
the lower
lower thethe percentage
percentage change
change in in
the
the bond’s
bond’s value
value for
for aa given
given interest
interest rate
rate change
change (i.e.
(i.e.
less
less price
price sensitivity).
sensitivity).
•• The
The intuition
intuition behind
behind thisthis is:
is:
•• The
The higher
higher (lower)
(lower) the
the coupon
coupon raterate on
on the
the bond,
bond, thethe
larger
larger (smaller)
(smaller) isis the
the portion
portion ofof the
the required
required rate
rate of of
return
return paid
paid onon the
the form
form of of coupon
coupon payment.
payment.

McGraw-Hill/Irwin 3-19 ©2009, The McGraw-Hill Companies, All Rights

 Impact of Coupon Rates on
Interest Rate Sensitivity
•• Therefore,
Therefore, any
any security
security that
that returns
returns aa greater
greater
(smaller)
(smaller) proportion
proportion of
of an
an investment
investment sooner
sooner isis
more
more (less)
(less) valuable
valuable and
and less
less (more)
(more) price
price volatile.
volatile.

McGraw-Hill/Irwin 3-20 ©2009, The McGraw-Hill Companies, All Rights

 Impact of Coupon Rates on
Interest Rate Sensitivity

McGraw-Hill/Irwin 3-21 ©2009, The McGraw-Hill Companies, All Rights

 Impact of Coupon Rates on
Interest Rate Sensitivity
Bond
Bond
Value
Value
High-Coupon Bond

Low-Coupon Bond

Interest Rate

McGraw-Hill/Irwin 3-22 ©2009, The McGraw-Hill Companies, All Rights

 Duration

•• The
The percentage
percentage change
change in
in the
the bond’s
bond’s present
present value
value
(i.e.
(i.e. value)
value) for
for aa given
given change
change in in interest
interest rate
rate can
can
be
be directly
directly measured
measured by by Duration.
Duration.

•• Duration
Duration isis the
the weighted-average
weighted-average time time to
to maturity
maturity
(measured
(measured in in years)
years) on
on aa financial
financial security
security using
using
the
the relative
relative present
present values
values of of the
the cash
cash flow
flow as
as
weights.
weights.

McGraw-Hill/Irwin 3-23 ©2009, The McGraw-Hill Companies, All Rights

 Duration

•• In
In other
other words,
words, itit weights
weights the the time
time atat which
which cash
cash
flows
flows are are received
received by by the
the relative
relative importance
importance in in
present
present value
value terms
terms of of the
the cash
cash flows
flows arriving
arriving atat
each
each point
point in in time
time ..
•• according
according to to this,
this, itit measures
measures the the weighted
weighted
average
average of of when
when cash
cash flows
flows are
are received
received on on aa
security.
security.
•• ItIt incorporate
incorporate the the time
time of of arrival
arrival of of all
all cash
cash flows
flows
on
on an an asset
asset or or liability
liability along
along with
with the
the asset
asset or
or
liability’s
liability’s maturity
maturity date. date.
McGraw-Hill/Irwin 3-24 ©2009, The McGraw-Hill Companies, All Rights
 Duration (Cont.)
•• Duration
Duration(D)
(D)for
foraafixed-income
fixed-incomesecurity
securitythat
thatpays
paysinterest
interest
annually
annuallycan
canbe
bewritten
writtenas:
as:
T
CF t t T

 (1  R ) t  PVt t
D  tT1  t 1T
CF t
t 1 (1  R )
t 
t 1
PVt

tt==11totoT,
T,the
theperiod
periodininwhich
whichaacash
cashflow
flowisisreceived
received
TT==thethenumber
numberof ofyears
yearstotomaturity
maturity
CF
CFt t==cash
cashflow
flowreceived
receivedatatend
endof
ofperiod
periodtt
RR==yield
yieldtotomaturity
maturityororrequired
requiredrate
rateof
ofreturn
return
PV
PVt ==present
presentvalue
valueof
ofcash
cashflow
flowreceived
receivedatatend
endof
ofperiod
periodtt
t

McGraw-Hill/Irwin 3-25 ©2009, The McGraw-Hill Companies, All Rights

 Duration (Cont.)

•• Duration
Duration (D)
(D) (measured
(measured inin years)
years) for
for aa fixed-
fixed-
income
income security
security in
in general
general can
can be
be written
written as:as:
T
CF t t
 (1  R / m ) mt
D  t 1T/ m
CF t

t 1 / m (1  R / m ) mt

m
m==the
thenumber
numberof
oftimes
timesper
peryear
yearinterest
interestisispaid
paid

McGraw-Hill/Irwin 3-26 ©2009, The McGraw-Hill Companies, All Rights

 Duration (Cont.)

•• The
The denominator
denominator ofof the
the duration
duration equation
equation isis the
the
present
present value
value of
of the
the cash
cash flows
flows on
on the
the security.
security.

•• The
The numerator
numerator isis the
the present
present value
value of
of each
each cash
cash
flow
flow received
received onon the
the security
security multiplied
multiplied oror
weighted
weighted byby the
the length
length of
of time
time required
required to
to receive
receive
the
the cash
cash flow.
flow.

McGraw-Hill/Irwin 3-27 ©2009, The McGraw-Hill Companies, All Rights

 Duration (Cont.)

•• Example:
Example: suppose
suppose thatthat you
you have
have aa bond
bond that
that
offers
offers aa coupon
coupon raterate of
of 10%
10% paidpaid semiannually.
semiannually.
the
the face
face value
value of of the
the bond
bond isis $1,000
$1,000 and
and itit matures
matures
in
in 44 years,
years, ifif the
the current
current yield
yield to
to maturity
maturity isis 8%,
8%,
what
what isis the
the duration
duration for for that
that bond????
bond????

McGraw-Hill/Irwin 3-28 ©2009, The McGraw-Hill Companies, All Rights

 Duration (Cont.)

McGraw-Hill/Irwin 3-29 ©2009, The McGraw-Hill Companies, All Rights

 Duration (Cont.)

•• The
The higher
higher the the coupon
coupon payments
payments the the shorter
shorter isis the
the
duration
duration (i.e.
(i.e. itit takes
takes shorter
shorter time
time to
to recover
recover the
the initial
initial
investment).
investment).
•• The
The higher
higher the the discount
discount rate,
rate, the
the shorter
shorter thethe
duration
duration (i.e.
(i.e. the
the higher
higher the
the YTM
YTM on on the
the bond,
bond, the
the
more
more the
the investor
investor earns earns on
on reinvested
reinvested coupons,
coupons, the
the
shorter
shorter the
the time
time needed
needed toto recover
recover initial
initial investment).
investment).
•• The
The shorter
shorter the the maturity
maturity the the shorter
shorter thethe duration
duration isis

McGraw-Hill/Irwin 3-30 ©2009, The McGraw-Hill Companies, All Rights

 Duration (Cont.)
Economic Sense
•• Duration
Duration measures
measures the the sensitivity
sensitivity (or(or elasticity)
elasticity) of of aa
fixed-income
fixed-income security’s
security’s priceprice toto small
small interest
interest rate
rate
changes.
changes.
•• InIn other
other words,
words, itit isis aa direct
direct measure
measure of of its
its interest
interest
rate
rate sensitivity,
sensitivity, or
or elasticity.
elasticity.
•• The
The larger
larger the
the numerical
numerical value value of of duration,
duration, the the more
more
the
the sensitivity
sensitivity the
the price
price ofof that
that bond
bond toto small
small changes
changes
in
in interest
interest rate.
rate.
-- Duration
Duration produces
produces an an accurate
accurate measure
measure for for sensitivity
sensitivity
for
for relatively
relatively small
small changes
changes in in interest
interest rate.
rate.

McGraw-Hill/Irwin 3-31 ©2009, The McGraw-Hill Companies, All Rights

 Duration and Modified Duration

•• Given
Given an
an interest
interest rate
rate change,
change, thethe estimated
estimated
percentage
percentage change
change in in aa (annual
(annual coupon
coupon paying)
paying)
bond’s
bond’s price
price isis found
found byby rearranging
rearranging the
the duration
duration
formula:
formula:

P  R 
 D    MD R
P 1 R 

MD
MD==modified
modifiedduration
duration==D/(1
D/(1++R)
R)

McGraw-Hill/Irwin 3-32 ©2009, The McGraw-Hill Companies, All Rights

 Duration and Modified Duration

•• Whether
Whether interest
interest rate
rate isis compounded
compounded annually
annually or or
semiannually,
semiannually, and and for
for any
any small
small change
change in in interest
interest
rate;
rate; Duration’s
Duration’s equation
equation shows
shows that
that bond
bond prices
prices
move
move in in an
an inversely
inversely proportional
proportional manner
manner
according
according to to the
the size
size of
of D. D.
•• That
That is,
is, for
for any
any given
given change
change in in interest
interest rates,
rates,
securities
securities with
with longer
longer maturity
maturity will
will have
have aa larger
larger
capital
capital loss
loss (higher
(higher capital
capital gain)
gain) when
when interest
interest
rates
rates rise
rise (fall)
(fall) than
than do
do short
short duration
duration securities.
securities.

McGraw-Hill/Irwin 3-33 ©2009, The McGraw-Hill Companies, All Rights

 Duration and Modified Duration

•• Example:
Example:
Consider
Consider aa 4-year
4-year bondbond with
with semiannual
semiannual 10% 10%
coupon
coupon rate
rate and
and 8% 8% yield
yield to to maturity.
maturity. IfIf the
the
bond’s
bond’s price
price isis $$ 1,067.34
1,067.34 and and its
its Duration
Duration isis 3.42
3.42
years.
years. Suppose
Suppose that that yield
yield to to maturity
maturity increases
increases byby
10
10 basis
basis points,
points, what
what isis the
the %% change
change in in the
the
bond’s
bond’s price,
price, what
what isis the
the new
new price
price for
for that
that bond?
bond?

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 large interest rate changes &
Duration
•• Duration
Duration accurately
accurately measures
measures thethe price
price sensitivity
sensitivity
of
of financial
financial securities
securities only
only for
for small
small changes
changes in
in
interest
interest rate.
rate.
•• In
In case
case of
of large
large interest
interest rate
rate changes,
changes, such
such as
as 2%
2%
or
or above,
above, which
which happened
happened during
during aa financial
financial
crisis,
crisis, Thus,
Thus, duration
duration becomes
becomes lessless accurate
accurate
measure
measure of of interest
interest rate
rate sensitivity.
sensitivity.
•• See
See the
the next
next figure
figure

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 Figure 3-7

McGraw-Hill/Irwin 3-36 ©2009, The McGraw-Hill Companies, All Rights

 large interest rate changes &
Duration
•• Compare
Comparebetween
betweenthethechange
changeininbond’s
bond’sprice
price due
duetoto
interest
interestrate
ratechange
changeaccording
accordingto tothe
theduration
duration and
andthe
the
true
truerelationship.
relationship.
•• Remember
Rememberthat thatduration
durationpredicts
predictsaaproportional
proportional
relationship
relationshipbetween
betweeninterest
interestrate
ratechanges
changesand
andaa
security’s
security’sprice.
price. HOWEVER,
HOWEVER,
•• For
Forlarge
largeinterest
interestrate
rateincreases
increases(decreases)
(decreases)duration
duration
overpredicts
overpredicts(underpredicts)
(underpredicts)the
thefall
fall(increase)
(increase)in
inthe
the
security’s
security’sprice.
price.

McGraw-Hill/Irwin 3-37 ©2009, The McGraw-Hill Companies, All Rights

 large interest rate changes &
Duration
•• The
The duration
duration model
model predicts
predicts symmetric
symmetric effects
effects for
for
rate
rate increases
increases andand decreases
decreases on on aa bond’s
bond’s price.
price.
•• In
In contrast,
contrast, under
under the
the actual
actual relationship
relationship between
between
interest
interest rate
rate and
and value
value ofof security,
security, the
the capital
capital loss
loss
effect
effect ofof large
large rate
rate increases
increases tends
tends to
to be
be smaller
smaller
than
than the
the capital
capital gain
gain effect
effect of
of large
large rate
rate decreases.
decreases.
•• This
This isis because
because of of the
the convexity
convexity in in bond’s
bond’s price-
price-
interest
interest rate
rate relationship.
relationship. Thus,
Thus,

McGraw-Hill/Irwin 3-38 ©2009, The McGraw-Hill Companies, All Rights

 large interest rate changes &
Duration
•• The
The percentage
percentage change
change in in bond’s
bond’s price
price to
to aa change
change
in
in interest
interest rates
rates depends
depends on on the
the level
level from
from which
which
the
the interest
interest rate
rate ss change.
change. Which
Which means,
means,
•• The
The higher
higher the
the interest
interest rate
rate the
the smaller
smaller aa bond’s
bond’s
price
price sensitivity
sensitivity to to interest
interest rate
rate changes.
changes.
•• Implication:
Implication: convexity
convexity isis aa desirable
desirable feature.
feature.
HOW?
HOW?

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 large interest rate changes &
Duration
•• Buying
Buying aa bond
bond oror aa portfolio
portfolio ofof assets
assets that
that exhibits
exhibits
aa lot
lot of
of convexity
convexity in in the
the price-yield
price-yield curve
curve
relationship
relationship isis similar
similar to to buying
buying partial
partial interest
interest
rate
rate risk
risk insurance.
insurance.

•• For
For the
the same
same large
large changes
changes of of interest
interest rates
rates (up
(up
and
and down)
down) capital
capital gain
gain isis more
more than
than capital
capital loss.
loss.

McGraw-Hill/Irwin 3-40 ©2009, The McGraw-Hill Companies, All Rights

 Convexity

•• Convexity
Convexity (CX)(CX) measures
measures thethe change
change in in slope
slope of
of
the
the price-yield
price-yield curve
curve around
around interest
interest rate
rate level
level RR
•• Convexity
Convexity incorporates
incorporates thethe curvature
curvature of of the
the price-
price-
yield
yield curve
curve into
into the
the estimated
estimated percentage
percentage price
price
change
change ofof aa bond
bond given
given an
an interest
interest rate
rate change:
change:

P  R  1 2 1 2
 D    CX ( R )  MD R  CX ( R )
P 1 R  2 2

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