DURATION
INTRODUCTION
The duration of a Plain Vanilla bond may
be defined as its average life
It is very easily defined for a zero-
coupon bond
In such cases there is a single cash flow at
maturity
Thus, there is no difference between the
average time to maturity and the actual
time to maturity
The duration of a ZCB is equal to its stated
time to maturity
INTRODUCTION (CONT…)
The definition is not clear cut for a
coupon paying bond
Such assets give rise to a sequence of cash
flows - usually on a semi-annual basis
They also give rise to a relatively large cash
flow at maturity
Thus, to compute the average life we need
to take cognizance of the times to maturity
of each cash flow
Obviously, we need to factor in the Time
Value of Money
INTRODUCTION (CONT…)
Macaulay came up with the concept of
Duration
`It is the weighted average maturity of
the bond’s cash flows where the Present
Values of the cash flows serve as the
weights’
This definition is comprehensive
It accounts for all the cash flows
It takes into account the time value of
money
MATHEMATICAL
DEFINITION
SYMBOLS
CFt is cash flow at time `t’
The cash flows from the first to the
penultimate will be equal to C/2 for a bond
paying coupons on a semi-annual basis
The terminal cash flow will be C/2 + M
Y is YTM on an annual basis
P is Dirty price of the bond
NOTE
t represents the corresponding semi-
annual period
So, the final value will be in half years
It will have to be divided by two in order
to annualize it
ILLUSTRATION
Consider a T-note with 5 years to
maturity
Face value is $1,000
Coupon is 6% payable semi-annually
YTM is 6.50% per annum
The dirty price is:
30xPVIFA(3.25,10) + 1,000PVIF(3.25,10)
= $978.9440
ILLUSTRATION (CONT…)
DURATION BETWEEN
COUPON DATES
Assume that the next coupon is k
periods away where k < 1
k is computed using the prescribed day-
count convention
FORMULA
ILLUSTRATION
Take the five year T-note
Assume that it has 4.875 years to
maturity
ILLUSTRATION (CONT…)
PROPERTIES OF
DURATION
Duration of a ZCB is equal to its stated
time to maturity
Keeping maturity and yield constant, the
higher the coupon rate, the lower is the
duration
The greater the relative weights of the
earlier cash flows the lower will be the
duration
In the case of bonds paying high coupons
the weights associated with the earlier cash
flows are higher
This brings down the duration
PROPERTIES (CONT…)
Holding coupon and yield constant, the
duration of a bond generally increases
with the time to maturity
For par and premium bonds, duration always
increases with the time to maturity
For discount bonds duration generally
increases with the time to maturity
But there could be bonds trading at a
substantial discount for which duration could
decrease with the time to maturity
Holding coupon and maturity constant,
the higher the YTM of the bond the lower
is the duration
FACTORS THAT
INFLUENCE DURATION
There are four primary influences on a
plain vanilla bond’s duration
Term to maturity
Coupon
Accrued Interest
Coupon Frequency
Market Yield Level
TERM TO MATURITY
Duration is positively related to a bond’s
remaining term to maturity
Duration increases as maturity is
extended but it does so at a decreasing
rate
For a ZCB duration increases at a
constant rate as the maturity lengthens
ILLUSTRATION
Time to Maturity Duration
1 0.980769
2 1.887546
3 2.725911
5 4.217666
8 6.059194
10 7.06697
20 10.29224
25 11.17074
40 12.436
50 12.7426
EXPLANATION
Duration and time to maturity are
positively related for two key reasons
One is that the principal repayment is a
large contributor to the bond price and
is a major influence on its duration
Ifthis cash flow is postponed it pulls the
duration with it
In addition the long-term coupon payments
assist this process
EXPLANATION (CONT…)
Second long maturity bonds have cash
flows that occur after a shorter-term
security matures
Consider three bonds with a coupon and
YTM = 10%
We have a 5-year; a 10-year; and a 30-year
bond
A 10 year bond receives 75% of its cash flows
after a five year bond matures
A 30 year bond receives 87.50% of its cash
flows after a 5 year bond matures
And 75% of its cash flows after a 10 year
bond matures
EXPLANATION (CONT…)
A 10 year bond has a total cash flow of
20x50 + 1000 = 2000
Of this $ 1500 comes after 5 years
This is 75% of $ 2000
A 30 year bond has a total cash flow of
60 x 50 + 1000 = 4,000
Of this $ 3,500 comes after 5 years
This is 87.50% of $4,000
$3,000 comes after 10 years
This is 75% of 4,000
EXPLANATION (CONT…)
These longer cash flows create a higher
duration for the long maturity bond
However duration increases at a
decreasing rate
Because long-term cash flows (of a fixed
nominal amount) are assigned progressively
lower present values
COUPON
Duration is inversely related to a bond’s
coupon rate of interest
Keeping all other factors constant a high
coupon rate corresponds to a lower
duration.
Consider a bond with a face value of
$1,000; 10 years to maturity; and a YTM
of 7%
COUPON (CONT…)
Coupon Rate Duration
1% 9.341265
2% 8.82775
3% 8.416202
4% 8.078993
5% 7.797649
7% 7.354919
8% 7.177614
10% 6.885319
12% 6.654326
15% 6.386328
20% 6.071655
COUPON (CONT…)
As we can see duration declines as the
coupon increases keeping time to
maturity and YTM constant
However duration falls at a decreasing
rate as the coupon rate increases
EXPLANATION
Duration and coupon are inversely
related for two primary reasons
First higher coupon bonds have greater
amounts of cash flows occurring before
the final maturity
This reduces the influence of the principal
repayment at maturity
Take the 10% 10-year bond
It has 50% of its cash flows coming in the
form of coupons
A 30 year bond has 75% of its cash flows
coming in the form of coupons
EXPLANATION (CONT…)
The discounting process has less effect
on the early cash flows (coupon
payments) than on later cash flows
(coupons as well as principal)
Thus larger coupon cash flows are
assigned greater weights in present
value terms
ACCRUED INTEREST
A bond’s duration is inversely related to the
amount of accrued interest attached to the
bond
The duration computation is based on the Dirty
Price and not on the Clean Price
Thus AI has an impact on duration
Accrued Interest is an investment with a
zero duration
The upcoming coupon payment reimburses
the bond holder for the AI paid upfront
Thusa bond with a higher AI will have a lower
duration than a similar bond with less AI
ACCRUED INTEREST
(CONT…)
Thus the AI component of a bond’s dirty
price drags down the bond’s overall
duration
When the bond’s coupon payment is
made the AI component disappears and
the duration will lengthen because the
bond is relieved of its zero duration
component
ILLUSTRATION
Consider a $1000 face value T-bond with
a coupon = YTM = 7% and 30 years to
maturity.
The bond has been issued on 15 July
2014 and we are on 14 January 2015
The Duration is 12.4116 years
On the next day the Duration is 12.8432
years because the Dirty Price on that
day no longer includes the accrued
interest
COUPON FREQUENCY
The Accrued Interest induced effect is
more pronounced in the case of bonds
which pay coupons on an annual basis
Because the buildup of accrued interest
is greater in the case of bonds that pay
coupons on an annual basis
A full year’s coupon has to be accrued
Whereas in the case of bonds paying
coupons on a semi-annual basis only a
maximum of C/2 is accrued
ILLUSTRATION (CONT…)
The jump in duration is significantly
higher for the bond paying annual
coupons
Notice that the bond paying annual
coupons has a higher duration on the
coupon date than the bond paying semi-
annual coupons
This is because the entire coupon is
received at year-end
Whereas in the case of semi-annual bond
half the coupon is received after six months
YTM
Duration is inversely related to the YTM of
a bond
High yield environments lead to low duration
Low yield environments create high durations
Consider a bond with 30 years to maturity
The face value is $ 1,000
The coupon is 7% per annum paid semi-
annually
As can be seen the duration is inversely
related to the YTM
ILLUSTRATION
YTM Duration
1% 19.00552
2% 17.97389
3% 16.92821
4% 15.88424
5% 14.85735
7% 12.9089
8% 12.00854
10% 10.38785
12% 9.019842
15% 7.409989
20% 5.630574
EXPLANATION
There are two reasons why duration and
YTM are inversely related
First duration is based on the present
value weights of a bond’s cash flows
As rates rise we assign relatively lower
weights to long-term cash flows and
higher weights to short term cash flows
This brings down the duration
Besides the present value of the principal
amount falls disproportionately driving
down its relative contribution to the bond
price
EXPLANATION (CONT…)
Second newly issued bonds have a
coupon that is close to the prevailing
YTM
Higher yield environments lead to higher
coupon bonds
Lower yield environments lead to lower
coupon bonds
In a high yield environment the coupon
component of a newly issued bond’s
market value is even higher
Thus it is very sensitive to changes in yield
PERCENTAGE PRICE
CHANGE AND DURATION
PRICES CHANGES AND
DURATION
PRICE CHANGES AND
DURATION
MODIFIED DURATION
Duration can obviously be used as a
measure of a bond’s riskiness
A longer duration implies a higher degree of
price sensitivity
Therefore longer duration bonds are more
vulnerable to market risk
MODIFIED DURATION
(CONT…)
Consider a 3-year bond with a face
value of $1,000
The coupon = YTM = 10%
The duration is 2.6647 years
The modified duration is 2.6647/1.05 =
2.54
MODIFIED DURATION
(CONT…)
Modified duration is a measure of the
sensitivity of a bond’s price to changes
in the YTM
%age change in bond price = - Modified
Duration x Change in Yield (in bp)/100
Consider a bond with a modified
duration of 5 years
If the yield falls by 100 basis points the
price rises by approximately 5%
If the yield falls by 200 bp, the price rises by
approximately 10%
MODIFIED DURATION
(CONT…)
We know that prices and yields are
inversely related
Thenegative sign attached to the modified
duration captures this
Modified Duration acts as a multiplier
The larger the modified duration the greater
is the price impact for a given change in
interest rates
MODIFIED DURATION
(CONT…)
If we plot price versus yield we get a
Convex relationship
Theslope of the tangent to this curve at
any point is the modified duration at that
point.
Strictly speaking the slope of the tangent is
-Modified Duration x Market Price
Thus modified duration captures the Price-
Yield relationship on a straight line basis
Thus it is only an estimate of the true price-yield
relationship
The larger the change in yield the greater will be
the error due to the approximation
DOLLAR DURATION
The product of the modified duration
and the price of the bond is referred to
as the Dollar Duration of the bond
In our case
Modified duration = 4.3853/(1.0325) =
4.2472 years
Price was 978.9440
Dollar duration = 4157.802