Fixed Income

Yield change risk, part 1

© 2018, Charles J. Cuny

 Basic intuition

• PV(cash flow) is sensitive to the interest rate r.

How sensitive depends on the maturity.
• Consider: PV of 2-year and 3-year cash flows:
PV(CF t = 2 ) = CF/(1 + r)2
PV(CF t = 3 ) = CF/(1 + r)3
• Also consider: PV of 20-year and 30-year cash flows:
PV(CF t = 20 ) = CF/(1 + r)20
PV(CF t = 30 ) = CF/(1 + r)30
• The value of long-dated cash flows is more sensitive to
changing interest rates.
 Bond price is sensitive to yield
• Notice the relationship is non-linear. For small yield
variations, approximately linear.
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 Bond pricing relationships

• Bond prices and yields are inversely related.

• An increase in a bond’s YTM results in a smaller price
change than an equal magnitude YTM decrease
(convexity)
• Long-term bond prices tend to be more sensitive to
interest rate changes than short-term bond prices; bond
price sensitivity to yield change increases with maturity.
• High-coupon bond prices are less sensitive to yield
changes than low-coupon bond prices.
• Bond price sensitivity to a yield change is decreasing in
the yield.
 Macaulay’s duration

• Bond duration is the weighted average time until the CFs

(coupon or principal) of the bond.
• Weights are proportional to the PV of the CFs.

D = [PV(CF1)·1 + ... + PV(CFT)·T]/[PV(CF1) + ... + PV(CFT)]

= [PV(CF1)·1 + ... + PV(CFT)·T]/ P
= 1·[PV(CF1)/P] + ... + T·[PV(CFT)/P]

• For each time t: PV(CFt) = CFt /(1 + y)t.

 Examples

• Example 1. Duration of a zero coupon bond equals the

bond maturity.

• Example 2. 4-year 5% coupon bond priced at par (100).

At par, YTM = coupon rate.

D = [1·(5/1.05) + 2·(5/1.052) + 3·(5/1.053) + 4·(105/1.054)]/100 = 3.72

Duration is 3.72 years.

 Duration is sensitivity to yield changes

• Duration captures “average” time until the promised CFs.

• The following relation holds for small YTM changes:

∆P/∆y ≈ –DP/(1 + y) or ∆P/P ≈ –D · ∆y/(1 + y)

• Technical aside: Why is this true? Write

P = Σt CFt /(1 + y)t
and take the derivative with respect to y:
dP/dy = –DP/(1 + y)
 Duration is sensitivity to small yield changes ...

• Example 3. 10-year Zero yielding 5%; priced at 61.39.

Suppose yield goes to 5.1%

∆P ≈ –10(61.39)(.001)/(1.05), or ∆P ≈ –.58, so P ≈ 60.81

Correct within rounding.
or, ∆P/P ≈ –10(.001)/(1.05) = –.95% price change

• Example 4. 4-year 5% coupon bond priced at par (100).

Suppose yield goes to 5.1%

∆P ≈ –3.72(100)(.001)/(1.05), or ∆P ≈ –.35, so P ≈ 99.65

Correct within rounding.
 .. but not quite for large yield changes

• Example 5. 10-year Zero yielding 5%; priced at 61.39.

Suppose yield goes to 6%

∆P ≈ –10(61.39)(.01)/(1.05), or ∆P ≈ –5.85, so P ≈ 55.54

Actual is 55.84.

• Example 6. 4-year 5% coupon bond priced at par (100).

Suppose yield goes to 6%

∆P ≈ –3.72(100)(.01)/(1.05), or ∆P ≈ –3.54, so P ≈ 96.46

Actual is 96.53
 Alternative to duration

• We have computers. Can’t we calculate the sensitivity of a

bond price to various interest rate changes in “longhand”?
• Yes, but duration does have the advantage of capturing all
magnitude price changes in just one statistic.
• Granted, the statistic [duration] isn’t quite right for large
magnitude changes, but we’ll partly fix that later.
 Modified duration

• An alternative form:
• Define the modified duration as D* = D/(1 + y). Then

∆P/∆y ≈ –D*·P or ∆P/P ≈ –D* · ∆y

• Example 7. 10-year Zero yielding 5%; priced at 61.39.

D* = 10/1.05 = 9.52. If yield goes to 6%,
∆P ≈ –9.52(61.39)(.01), or ∆P ≈ –5.85, so P ≈ 55.54,
(exactly as Example 5),
or, ∆P/P ≈ –9.52(.01) = –9.52% price change
• The latter formulation is particularly attractive:
% price change proportional to modified duration.
 Duration rules

• Duration of a zero coupon bond equals its time to maturity.

• All else equal: bond duration decreases with coupon rate.
• All else equal: bond duration generally increases with time
to maturity.
• All else equal: duration of a coupon bond decreases with
yield to maturity.
• Duration of a bond portfolio is the weighted average of
component bonds’ durations;
weights are proportional to the funds placed in each asset.
 Duration of extreme bonds

• At one extreme, the duration of a Zero is the time to

maturity T.

• At the other extreme, the duration of a perpetuity is

(1 + y)/y = (1/y) + 1
(Assumes last coupon just paid.)
• Example 8. Suppose the yield on an annual perpetuity is
8%. The duration is then 1.08/.08 = 13.5 years.
(or 1/.08 + 1 = 12.5 + 1 = 13.5 years)
 Duration of an annuity

• For an annuity, the duration is

D = [(1 + y)/y] – T/[(1 + y)T –1]

(Assumes last coupon just paid.)

Clearly, lower duration than corresponding perpetuity.
• Example 9. For a 10-year annuity, with a yield-to-maturity
of 8%, the duration is 4.87 years.
(Letting T = 10, y = .08)
• Intuitively, this is less than for the corresponding
perpetuity (13.5 years), and certainly less than 10 years
(longest-dated CF).
 Duration of a coupon bond

• For a coupon bond (coupon = c, YTM = y, maturity = T),

the duration equals

D = [(1 + y)/y] – [(1 + y) + T(c – y)]/(c[(1 + y)T –1] + y)

• Example 10. For a 10-year 8% coupon bond with yield-to-

maturity of 8%: c = y = .08, T = 10 and duration is 7.25
years.
• Example 11. For a 10-year 6% coupon Treasury with yield
8% (all semiannual): c = .03, y = .04, T = 20 and duration
is 14.91 periods = 7.45 years
 Useful formulae?

• We can calculate durations via a spreadsheet as well.

• Example 12. Use a spreadsheet to calculate duration for a
10-year 8% coupon bond with yield-to-maturity of 8%:
c = y = .08, T = 10
• Example 13. Use a spreadsheet to calculate duration for a
10-year 6% coupon Treasury with yield 8% (all
semiannual):
c = .03, y = .04, T = 20
 Duration and convexity

Price

Pricing Error
from convexity

Duration
Approx.
Yield
 Convexity correction

• Define convexity as
C = Σt [t(t + 1)CFt /(1 + y)t] / [P(1 + y)2]
= Σt [(t2 + t)CFt /(1 + y)t] / [P(1 + y)2]
= (1 + y)–2 · Σt [(t2 + t)·PV(CFt )/P]
• We can get an improvement over the [duration] price
sensitivity to yield:
∆P/P ≈ –D* · (∆y) + (1/2) Convexity · (∆y)2
• The convexity adjustment is positive, no matter which way
yields move.
• Technical aside: These are the first two terms of a Taylor
series expansion
• Example 14. For a 10-year 8% coupon bond with yield-to-
maturity of 8%: c = y = .08, T = 10. Price is 100. Duration
is 7.25 years. Modified duration is 6.71 years. Convexity is
60.53 (years2).

∆P/P ≈ –D* · (∆y) + (1/2) Convexity · (∆y)2

= –6.71 (∆y) + 30.27 (∆y)2
For changes in yield:
YTM = 9% (∆y = .01), ∆P/P ≈ –6.41% to 93.59, Actual 93.58
YTM = 10% (∆y = .02), ∆P/P ≈ –12.21% to 87.79, Actual 87.71
YTM = 7% (∆y = –.01), ∆P/P ≈ +7.01% to 107.01, Actual 107.02
YTM = 6% (∆y = –.02), ∆P/P ≈ +14.63% to 114.63, Actual 114.72
 Some convexity formulae

• For a zero-coupon bond, convexity is T(T + 1)/(1 + y)2

• For a perpetuity, convexity is 2/y2
• For an annuity, or a coupon bond, better off calculating
convexity using a spreadsheet
• Many institutions such as pension funds and insurance
companies try to insulate their bond portfolios from
interest rate risk.
• This is easiest to visualize for a pension fund:
Have a series of cash outflows to meet.
Have a set of bonds generating a set of cash inflows.
• Ideally: cash inflows and outflows will match.
• In practice:
– PV(cash inflows) may equal PV(cash outflows)
– Would still like PVs to be equal as interest rates
change. So they don’t face a shortfall.)
 Immunization

• Immunization refers to strategies used by such investors to

shield their overall financial status from exposure to
interest rate fluctuations.
• How? Match durations of assets and liabilities.
• Example 15. An insurance company must make a payment
of $19,487 in 7 years. Interest rates are 10%, so the present
value of the obligation is $10,000.
The company’s portfolio manager wishes to fund the
obligation using 3-year zero coupon bonds and perpetuities
paying annual coupons.
How can the manager immunize the obligation?
• Duration of the obligation is 7 years.
• Construct bond portfolio with duration D = 7 years.
• Zero has D = 3. Perpetuity has D = 1.1/.1 = 11.
• Use weighted (w, 1 – w) mix of Zeros and Perps.

3w + 11(1 – w) = 7

• Solve: w = .50.
Manager should invest $5000 in Zeros and $5000 in Perps.
• Example 16. A year passes. Interest rate are still 10%.
Is the portfolio still immunized?
• The Zeros are now 2-year Zeros, worth $5500.
The Perps are still worth $5000, but paid a $500 coupon.
PV(obligation) = 19487/1.16 = $11,000
PV(portfolio) = 5500 + 5000 + 500 = $11,000
Still fully funded.
• Duration of obligation, D = 6 years
• Duration of bond portfolio
D = [5500(2) + 5000(11) + 500(0)]/11,000 = 6 years
• Still immunized
• Example 17. Suppose instead, that after a year, interest
rates went to 9.5%. Is the portfolio still immunized?
• The Zeros are now 2-year Zeros, (face 6655), worth $5550
The Perps are now worth $5263, and paid a $500 coupon.
PV(obligation) = 19487/1.0956 = $11,305
PV(portfolio) = 5550 + 5263 + 500 = $11,313
Still fully funded (approximately).
• Duration of obligation = 6 years
• Duration of bond portfolio
D = [5550(2) + 5263(11.53) + 500(0)]/11,313 = 6.39 years
(Perpetuity now has D = 1.095/.095 = 11.53 yrs)
• No longer immunized
• To stay immunized, bond portfolio must be adjusted to
keep durations of assets and liabilities the same.
• If convexities of assets and liabilities are the same, then the
durations will tend to stay close for a longer time, with less
adjustment necessary.
• Example 18. An insurance company must make a payment
of $19,487 in 7 years. Interest rates are 10%, so the present
value of the obligation is $10,000.
The company’s portfolio manager wishes to fund the
obligation using 3-year zero coupon bonds, perpetuities
with annual coupons, and 1-year zero coupon bonds.
How can the manager match duration and convexity?
• PV(obligation) = $10,000
Duration(obligation) = 7
Convexity(obligation) = 46.28 (obligation like a Zero)
• Duration(3-yr Zero) = 3
Convexity(3-year Zero) = 9.92
• Duration(Perp@y=10%) = 11
Convexity(Perp@y=10%) = 200
• Duration(1-Yr Zero) = 1
Convexity(1-Yr Zero) = 1.65
• Use (w1, w2, 1 – w1 – w2) mix of 3-yr 0’s, Perps, 1-yr 0’s.
3w1 + 11w2 + 1(1 – w1 – w2) = 7
9.92w1 + 200w2 + 1.65(1 – w1 – w2) = 46.28
• Solve: w1 = 2.369, w2 = .126, 1 – w1 – w2 = –1.495
3-yr Zeros $23,690, Perps $1260, 1-yr Zeros –$14,950
• (More asset choices and we could get no short position.)
• Example 19. What would happen to the position in one
year if interest rates fell to 9.5%?
• 3-yr Zeros are now 2-year Zeros, worth $26,295
Perps are now worth $1329
Cash (perp coupon, and 1-yr Zeros) –$16,319
• PV(portfolio) = $11,305
PV(obligations) = $11,305
Still fully funded (within rounding)
• Duration(obligations) = 6
• Duration(portfolio)
D = [26295(2) + 1329(11.53) – 16319(0)]/11305 = 6.007
• Notice that all of these examples assumed a flat term
structure of interest rates.
• More precisely: Duration and convexity measure
sensitivities of bond prices to vertical shifts in the term
structure on interest rates.
• Other changes are possible.
For example, the term structure could become steeper
(long-term interest rates could rise relative to short-term
interest rates).
• We will not examine such shifts right now.