Bond pricing theorems

Bond convexity

The mathematical relationship between bond yields and prices

 Duration

A measure of the average maturity of the stream of payments generated

by a financial asset

D = [ (1)CF1/(1+ ytm)   + (2)CF2/(1+ ytm)2  + ....... + (t)CFt/(1+ ytm)t ] /(Price)

Very often used:

Modified duration: D* = D/(1+ytm)

 Exemplification: A 6% coupon bond

ytm t=-4 t=-3 t=-2 t = -1 t=0

7% $ 966.13 $ 973.76 $ 981.92 $ 990.65 $ 1,000
6% $ 1,000 $ 1,000 $ 1,000 $1,000 $ 1,000
5% $ 1,032.54 $ 1,025.24 $ 1,017.57 $ 1,009.52 $ 1,000
Duration
3.67 2.83 1.94 1 0
( at 6%)
Modified
3.46 2.67 1.83 0.94 0
Duration
 Exemplification: A 6% coupon bond

ytm t=-4 t=-3 t=-2 t = -1 t=0

7% $ 966.13 $ 973.76 $ 981.92 $ 990.65 $ 1,000
6% $ 1,000 $ 1,000 $ 1,000 $1,000 $ 1,000
5% $ 1,032.54 $ 1,025.24 $ 1,017.57 $ 1,009.52 $ 1,000
Duration
3.67 2.83 1.94 1 0
( at 6%)
Modified
3.46 2.67 1.83 0.94 0
Duration

Observation:
Bond prices and yields move inversely.
 Exemplification: A 6% coupon bond

ytm t=-4 t=-3 t=-2 t = -1 t=0

7% $ 966.13 $ 973.76 $ 981.92 $ 990.65 $ 1,000
2.6% decrease in price
6% $ 1,000 $ 1,000 $ 1,000 $1,000 $ 1,000
5% $ 1,032.54 $ 1,025.24 $ 1,017.57
2.5% $ 1,009.52
increase in price $ 1,000
Duration
3.67 2.83 1.94 1 0
( at 6%)
Modified
3.46 2.67 1.83 0.94 0
Duration

Observation:
Dollar changes in bond prices are not symmetrical for a given basis point
increase/decrease in YTM, other things constant
 Exemplification: A 6% coupon bond

ytm t=-4 t=-3 t=-2 t = -1 t=0

7% $ 966.13 $ 973.76 $ 981.92 $ 990.65 $ 1,000
6% $ 1,000 $ 1,000 $ 1,000 $1,000 $ 1,000
5% $ 1,032.54 $ 1,025.24 $ 1,017.57 $ 1,009.52 $ 1,000
Duration
3.67 2.83 1.94 1 0
( at 6%)
Modified
3.46 2.67 1.83 0.94 0
Duration

Observation
The longer the maturity, the longer the duration, other things held constant.
 Exemplification: A 6% coupon bond

ytm t=-4 t=-3 t=-2 t = -1 t=0

7% $ 966.13 $ 973.76 $ 981.92 $ 990.65 $ 1,000
6% $ 1,000 $ 1,000 $ 1,000 $1,000 $ 1,000
5% $ 1,032.54 $ 1,025.24 $ 1,017.57 $ 1,009.52 $ 1,000
Duration
3.67 2.83 1.94 1 0
( at 6%)
Modified
3.46 2.67 1.83 0.94 0
Duration
 Exemplification: A 6% coupon bond

ytm t=-4 t=-3 t=-2 t = -1 t=0

7% $ 966.13 $ 973.76 $ 981.92 $ 990.65 $ 1,000
0.94% decrease
3.4% decrease in price
in price
6% $ 1,000 $ 1,000 $ 1,000 $1,000 $ 1,000
5% $ 1,032.54 $ 3.2%
1,025.24
increase in $ 1,017.57
price $ 1,009.52 $ 1,000
0.95%increase
in price
Duration
3.67 2.83 1.94 1 0
( at 6%)
Modified
3.46 2.67 1.83 0.94 0
Duration

Observation
Longer maturity bonds are more sensitive to yield changes than shorter
maturity bonds, other things held constant
 Exemplification: A 6% coupon bond

ytm t=-4 t=-3 t=-2 t = -1 t=0

7% $ 966.13 $ 973.76 $ 981.92 $ 990.65 $ 1,000
6% $ 1,000 $ 1,000 $ 1,000 $1,000 $ 1,000
5% $ 1,032.54 $ 1,025.24 $ 1,017.57 $ 1,009.52 $ 1,000
Duration
3.67 2.83 1.94 1 0
( at 6%)
Modified
3.46 2.67 1.83 0.94 0
Duration
 Exemplification: A 6% coupon bond

ytm t=-4 t=-3 t=-2 t = -1 t=0

7% $ 966.13 $ 973.76 $ 981.92 $ 990.65 $ 1,000
6% $ 1,000 $ 1,000 $ 1,000 $1,000 $ 1,000
5% $ 1,032.54 $ 1,025.24 $ 1,017.57 $ 1,009.52 $ 1,000
Duration
3.67 0.7% 2.83 0.77% 1.94 0.79% 1 0.94% 0
( at 6%) decrease decrease decrease decrease
in price in price in price in price
Modified
3.46 2.67 1.83 0.94 0
Duration

Observation

As maturity approaches, bond prices converge towards their face value at an

increasing rate, other things held constant.
 A 6% coupon bond

ytm t=-4 t=-3 t=-2 t = -1 t=0

7% $ 966.13 $ 973.76 $ 981.92 $ 990.65 $ 1,000
6% $ 1,000 $ 1,000 $ 1,000 $1,000 $ 1,000
5% $ 1,032.54 $ 1,025.24 $ 1,017.57 $ 1,009.52 $ 1,000
Duration
3.67 2.83 1.94 1 0
( at 6%)
Modified
3.46 2.67 1.83 0.94 0
Duration

A 5% coupon bond
ytm t=-4 t=-3 t=-2 t=-1 t=0
7% $ 932.25 $ 947.51 $ 963.84 $ 981.31 $ 1,000
6% $ 965.34 $ 973.27 $ 981.67 $ 990.57 $ 1,000
5% $1,000 $1,000 $1,000 $1,000 $ 1,000
Duration
3.71 2.85 1.952 1 0
( at 6%)
Modified
3.5 2.69 1.84 0.94 0
Duration
 A 6% coupon bond

ytm t=-4 t=-3 t=-2 t = -1 t=0

7% $ 966.13 $ 973.76 $ 981.92 $ 990.65 $ 1,000
6% $ 1,000 $ 1,000 $ 1,000 $1,000 $ 1,000
5% $ 1,032.54 $ 1,025.24 $ 1,017.57 $ 1,009.52 $ 1,000
Duration
3.67 2.83 1.94 1 0
( at 6%)
Modified
3.46 2.67 1.83 0.94 0
Duration

A 5% coupon bond
ytm t=-4 t=-3 t=-2 t=-1 t=0
7% $ 932.25 $ 947.51 $ 963.84 $ 981.31 $ 1,000
6% $ 965.34 $ 973.27 $ 981.67 $ 990.57 $ 1,000
5% $1,000 $1,000 $1,000 $1,000 $ 1,000
Duration
3.71 2.85 1.952 1 0
( at 6%)
Modified
3.5 2.69 1.84 0.94 0
Duration

Observation
The lower the coupon rate the longer the duration
 A 6% coupon bond

ytm t=-4 t=-3 t=-2 t = -1 t=0

7% $ 966.13 $ 973.76 $ 981.92 $ 990.65 $ 1,000
3.4% decrease in price
6% $ 1,000 $ 1,000 $ 1,000 $1,000 $ 1,000
5% $ 1,032.54 $3.2%
1,025.24 $ 1,017.57
increase in price
$ 1,009.52 $ 1,000
3.2% increase in price
Duration
3.67 2.83 1.94 1 0
( at 6%)
Modified
3.46 2.67 1.83 0.94 0
Duration

A 5% coupon bond
ytm t=-4 t=-3 t=-2 t=-1 t=0
7% $ 932.25
3.43%$ decrease
947.51
in price$ 963.84 $ 981.31 $ 1,000
6% $ 965.34 $ 973.27 $ 981.67 $ 990.57 $ 1,000
5% $1,000 $1,000 $1,000 $1,000 $ 1,000
3.6% increase in price
Duration
3.71 2.85 1.952 1 0
( at 6%)
Modified
3.5 2.69 1.84 0.94 0
Duration

Observation

Lower coupon bonds are more sensitive to yield changes than higher coupon bonds
 Bond Pricing Theorems: A Summary
I. Bond prices and yields move inversely.

II. As maturity approaches, bond prices converge towards their face

value at an increasing rate, other things held constant.

III. Dollar changes in bond prices are not symmetrical for a given basis
point increase/decrease in YTM, other things constant.

IV. Lower coupon bonds are more sensitive to yield changes than
higher coupon bonds, other things held constant.

V. Longer maturity bonds are more sensitive to yield changes than

shorter maturity bonds, other things held constant.
 Duration Theorems: A Summary

I. The duration of a zero coupon bond always equals its time to

maturity.

II. The lower the coupon rate the longer the duration, other things
held constant.

III. The longer the maturity, the longer the duration, other things held
constant.

IV. The lower the yield to maturity, the longer the duration, other
things held constant
Using duration to approximate bond price changes

The following formula approximates the change in bond prices for

small changes in yields:
(P1 - P0)/P0 = - D* (ytm1- ytm0)
 
A better approximation is given by the following formula:
(P1 - P0)/P0 = - D*(ytm1- ytm0) + (0.5)(Convexity)(ytm1- ytm0)2

Convexity

The rate of change of  the rate of change of the bond price (the curvature of the
relationship between yields and prices).