V: Bonds 15: Duration
Mar 28, 2015
V: Bonds
15: Duration
Chapter 15: Duration © Oltheten & Waspi 2012
Duration
Concept Calculation Duration and Price Volatility
Chapter 15: Duration © Oltheten & Waspi 2012
Fundamental Risk
Reinvestment Risk: The risk that coupons, paid out of the bond,
cannot be reinvested at the same YTM. Price Risk:
The risk that the price of the bond will fall Note that this is a risk only if we sell the bond before
it matures. There is no price risk if we hold the bond to maturity.
Chapter 15: Duration © Oltheten & Waspi 2012
Duration
Duration:Weighted by Net Present Value average term to maturity. Duration can be calculated
on any cash flow structure.
Chapter 15: Duration © Oltheten & Waspi 2012
A Tale of Two Bonds
$10005% Annual Coupon
$50 $50 $50 $50 $50
Price: $918.00
$10009% Annual Coupon
$90 $90 $90 $90 $90
Price: $1,082.00
Chapter 15: Duration © Oltheten & Waspi 2012
A Tale of Two Bonds
5
1t5t
1.07
1
$1000
1.07
1
$90$1082.00
5
1t5t
1.07
1
$1000
1.07
1
$50$918.00
Income Yield: 5.45%
Income Yield: 8.32%Capital Gain 1.73%
Capital Gain -1.56%
Yield to Maturity: 7.00%Yield to Maturity: 7.00%
5 year capital gain = 8.93%
Annual capital gain = 1.73%
5 year capital gain = - 7.58%
Annual capital gain = - 1.56%
Chapter 15: Duration © Oltheten & Waspi 2012
A Tale of Two Bonds
$50 $50 $50 $1050$50
$90 $90 $90 $1090$90
How much of my investment faces a reinvestment risk every year?
Chapter 15: Duration © Oltheten & Waspi 2012
Calculating Duration I
5 year 5% Annual Coupon Bond at 7%
T CashFlow
NPV NPV/P
1 year $50 $46.73 5.09%
2 years $50 $43.67 4.76%
3 years $50 $40.81 4.45%
4 years $50 $38.14 4.16%
5 years $1050 $748.64 81.55%
Total NPV =$918.00 100.00%
Chapter 15: Duration © Oltheten & Waspi 2012
A Tale of Two Bonds
How much of each bond must be reinvested after 1,2,3,4 and 5 years?
© Oltheten & Waspi 2012
7.8% 7.3%
6.8%
6.3%71.8
%
9% Bond5.1%4.8% 4.4
%4.2%
81.6%
5% Bond
Chapter 15: Duration © Oltheten & Waspi 2012
Calculation
5 year 5% Annual Coupon Bond at 7%
T CashFlow
NPV NPV/P DurationT*NPV/P
ConvexityD*(T+1)
1 year $50 $46.73 5.09% .050903 .101806
2 years $50 $43.67 4.76% .095146 .285439
3 years $50 $40.81 4.45% .133383 .533530
4 years $50 $38.14 4.16% .166209 .831044
5 years $1050 $748.64 81.55% 4.077553 24.465317
Total NPV =$918.00 100.00% 4.523 yrs 26.217 yrs2
Chapter 15: Duration © Oltheten & Waspi 2012
A Tale of Two Bonds
Chapter 15: Duration © Oltheten & Waspi 2012
Duration & Price Risk
Volatility:Change in the price of the bond due to a change in market yield.
Yd Δ*Yd1
Duration
Price
Price ΔVolatility
Chapter 15: Duration © Oltheten & Waspi 2012
Duration & Volatility
5% annual bond: 4.523 yrs * 1% =
4.227%1.07
Modified Duration is 4.227 years If Yd1%
then P4.227% If Yd 1%
then P4.227%
9% annual bond: 4.272 yrs * 1% =
3.993%1.07
Modified Duration is 3.993 years If Yd1%
then P3.993% If Yd 1%
then P3.993%
Chapter 15: Duration © Oltheten & Waspi 2012
Price Yield Curve
60
70
80
90
100
110
120
130
140
150
1% 3% 5% 7% 9% 11% 13%
Chapter 15: Duration © Oltheten & Waspi 2012
Price Yield Curve
70
80
90
100
110
120
1% 3% 5% 7% 9% 11% 13%
5 year 5% annual coupon 7% yield
Chapter 15: Duration © Oltheten & Waspi 2012
Price Yield Curve
0
25
50
75
100
125
150
175
200
1% 3% 5% 7% 9% 11% 13% 15%
20 year 6% semi-annual coupon 8% yield
Chapter 15: Duration © Oltheten & Waspi 2012
Calculating Duration II
Calculate the duration and convexity of a semi-annual bond $10,000 6% coupon December 31, 2017
Settles March 2, 2014 102.000
Chapter 15: Duration © Oltheten & Waspi 2012
Calculating Duration II
Base Price: 62/180 days Accrued Interest: Invoice Price:
YTM: 5.41186%
$10,200.00 $103.33
$10,303.33
Chapter 15: Duration
Calculating Duration II
© Oltheten & Waspi 2012
Chapter 15: Duration © Oltheten & Waspi 2012
Exercise
Calculate the duration and convexity of a semi-annual bond $1000 6% coupon 2.5 years to maturity
Priced to yield 8%
Chapter 15: Duration © Oltheten & Waspi 2012
Semi-Annual Bonds
1 1/2 year 6% Semi-Annual Coupon Bond at 8%
T CashFlow
NPV NPV/P DurationT*NPV/P
ConvexityD*(T+1)
1
2
3
4
5
Chapter 15: Duration © Oltheten & Waspi 2012
Volatility
Duration: First derivative of the Price Yield Curve .D = dP/dY Slope of the Yield Curve
Convexity: Second derivative of the Price Yield Curve .C = dP2/d2Y Curvature of the Yield Curve
Chapter 15: Duration © Oltheten & Waspi 2012
22 y
2y
1
Convexity21
y
2y
1
DurationPP
ΔΔΔ
Volatility
Taylor Expansion:
Modified Duration Modified Convexity
Yield at which duration was calculated
Chapter 15: Duration © Oltheten & Waspi 2012
Volatility
$1000 6% semi-annual
coupon 2 ½ years to
maturity
Priced to Yield 8%
Duration: 2.355 yrs Modified D: 2.355 =2.264
(1.04) Convexity: 6.922 yrs2
Modified C: 6.922 = 6.400(1.04)2
Chapter 15: Duration © Oltheten & Waspi 2012
Δ Yield +200 basis points
Duration only Convexity Correction
Total
-2.355 (+.02) + 1 6.922 (+.02)2 =
(1.04) 2 (1.04)2
Chapter 15: Duration © Oltheten & Waspi 2012
Δ Yield -200 basis points
Duration only Convexity Correction
Total
-2.355 (-.02) + 1 6.922 (-.02)2 =
(1.04) 2 (1.04)2
Chapter 15: Duration © Oltheten & Waspi 2012
Price Yield Curve
0
25
50
75
100
125
150
175
200
1% 3% 5% 7% 9% 11% 13% 15%
Convexity corrections are always positive
Price effect is asymmetric
Chapter 15: Duration © Oltheten & Waspi 2012
Volatility
Yields increase by 2%- 4.5288% + 0.128% = - 4.4009%
Yields decrease by 2%+ 4.5288% + 0.128% = + 4.46568%
Convexity corrections are always positive
Price effect is asymmetric
Chapter 15: Duration © Oltheten & Waspi 2012
Spreadsheet Exercise
15-1 15-2
Bonds IV© Oltheten & Waspi 2012