INVESTMENT MANAGEMENT

& BOND DYNAMICS

Dr.Priti Aggarwal
Joint Director
IIBF
1

INDIAN INSTITUTE OF BANKING & FINANCE

6/13/2023
 INVESTMENT PORTFOLIO OF A BANK

SLR Portfolio (Securities eligible Non-SLR Portfolio

for maintenance of SLR)

• Government Securities • Commercial Papers

• State Development Loans (SDLs) • Certificate of Deposit

• Treasury Bills, CMB • Equity / Preference Shares

• Any other securities as directed • Units of Mutual Funds

by the RBI • Bonds and Debentures

• Special Central Govt. Bonds like
Recap bonds
• Subsidiaries & Joint Ventures
• Alternative Investment Fund (AIF)

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INDIAN INSTITUTE OF BANKING & FINANCE

 STATUTORY LIQUIDITY RATIO (SLR)

• GOI Bonds/ SDLs/ TBs/ Cash Management Bills

• Cash with Banks
SLR Securities
• Balance in e-Kuber a/c in excess over CRR balances
• Gold

Regulatory • Governed by BR Act, 1949 (Sect 24)

Requirement of
SLR • 18% of Net Demand and Time Liabilities (NDTL)

Penalty on •Penal Interest @3%+BR for 1st Day and

Default:: •@5% + BR for succeeding days

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INDIAN INSTITUTE OF BANKING & FINANCE

Manner of Holding Mandatory Investments :

 The Securities may be held in either of the three forms viz:

 Physical scrip form,

 Subsidiary General Ledger (SGL) Account and

 Dematerialised account with depositories (NSDL/CDSL, NSCCL).

 In respect of securities with SGL facility, the SGL account can be

maintained in the bank's own name directly with the Reserve Bank, or in
a Constituent SGL Account (CSGL).

 CSGL Account can be opened with any scheduled commercial bank/state

co-operative bank/Primary Dealer (PD) or Stock Holding Corporation of
India Ltd. (SHCIL)
 Investment Policy :

 It should be approved by Board and reviewed on yearly basis.

 Policy should carry:
 objectives of investment transactions

 permitted instruments like bond, equity, mutual fund, CD/CP

etc.
 authority to transact, settlement and reporting
 limit setup and monitoring

 internal control mechanism

 periodic review
PORTFOLIO CLASSIFICATION

 Held to maturity (HTM)

 Available for Sale (AFS)

 Held for Trading (HFT)

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INDIAN INSTITUTE OF BANKING & FINANCE

 HTM: A Part of Banking Book
 1. The securities acquired with the intention to hold them up
to maturity
 2. Eligible securities Under HTM::
 SLR Securities up to the extent permitted
 Recap bonds/Oil Bonds
 Investment in subsidiaries & joint ventures
 RIDF/SIDBI/RHDF deposits
 Investment in infra bonds (remaining maturity should be 7 years)
 Venture Capital Investment/Investment in AIF (for initial 3 years)
 Any Other as directed by the RBI
 3. Regulatory Limits are applicable ; Not subject to MTM

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INDIAN INSTITUTE OF BANKING & FINANCE

 Regulatory Limits Under HTM-SLR
 Limit of HTM holding:: 25% of total investments , Except when -

 (a) the excess comprises only of SLR securities, and

 (b) the total SLR securities held in the HTM category is not more than 19.50% of
NDTL as on the last Friday of the second preceding fortnight.

 COVID DISPENSATION::

HTM –SLR Limit Enhanced to 22% for Securities purchased between 01-09-
2020 to 31stMarch 2022 ; Enhanced Limit will remain Valid till 31st March
2023
 Schedule of Restoration :: To be brought Down to 19.5% as follows
 21% as on 30.06.2023
 20% as on 0.09.2023
 19.50% as on 31.12.2023 6/13/2023 8
INVESTMENT PORTFOLIOS - HTM
 HTM is Part of the Banking Book

 Not subject to marking to market (MTM)

 If securities are bought at a premium to par value, the

premium has to be amortized over the remaining maturity

 Discount is not allowed to be amortized

 Profit on sale of investments in HTM should be first taken to

the P&L Account, and thereafter be appropriated to the
‘Capital Reserve Account’.

 Loss on sale will be recognized in the Profit & Loss

6/13/2023Account 9
 AFS: A Part of Trading Book

 The securities available for sale are those securities where

the intention of the bank is neither to trade nor to hold till
maturity.

 No Regulatory limit is applicable for investment.

 Subject to MTM

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INDIAN INSTITUTE OF BANKING & FINANCE

 HFT: Part of Trading Book
 The securities acquired by banks with the intention to trade by taking
advantage of the short-term price/interest rate movements.

 No Regulatory limit applicable for investment.

 subject to mark to market (MTM).

 Maximum defeasance period i.e. holding period is 90 days.

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INDIAN INSTITUTE OF BANKING & FINANCE

 SALIENT FEATURES OF INVESTMENT BOOK

 1. Maintained on Book Value(BV) basis (BV=FV x Price / 100)

 2. Securities may be purchased at a

 premium,

 at par (Gsec Par value is usually Rs.100) or

 at a discount to its par value

 3.Usually the Book Value remains unchanged throughout the life of the
investment with certain exceptions:

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INDIAN INSTITUTE OF BANKING & FINANCE

Typical Dealing Room….
Issuance Process:

 RBI issues half yearly calendar on borrowing programme

 Before auction (usually a week), RBI issues notification with
actual security and amount
 Government securities are issued through auctions by the
RBI
 Auctions are conducted on the electronic platform called e-
kuber
 Entity having NDS can use e-kuber for bidding in auction
 Other entity can route their bid through SCB/PD
ISSUANCE OF G-SECS & BONDS

Government G-Secs Bonds

RBI (PDO)
Funds
PRIMARY MARKET TRANSACTION
IN G-SECS

Current A/c.

Participate
in auctions

RBI (PDO) SGL A/c.

Yield Based
Auction or Price
Based Auction
SECONDARY MARKET TRADING IN G-SECS

NDS OM/OTC or WDM at NSE

PRIMARY MEMBERS
PRIMARY MEMBERS
Buy/Sell G-Secs
 AUCTION TERMINOLOGIES
 Bids: Bids are to be submitted in terms of yields to maturity/prices as announced at the time of
auction.

 Cut off yield: is the rate at which bids are accepted. Bids at yields higher than the cut-off yield is
rejected and those lower than the cut-off are accepted. The cut-off yield is set as the coupon rate
for the security. Bidders who have bid at lower than the cut-off yield pay a premium on the
security, since the auction is a multiple price auction.

 Cut off price: It is the minimum price accepted for the security. Bids at prices lower than the
cut-off are rejected and at higher than the cut-off are accepted. Coupon rate for the security
remains unchanged. Bidders who have bid at higher than the cut-off price pay a premium on the
security, thereby getting a lower yield. Price based auctions lead to finer price discovery than yield
based auctions.

 Notified amount: The amount of security to be issued is ‘notified’ prior to the auction date, for
information of the public.

 The unsubscribed portion devolves on the Primary Dealers if the auction has been underwritten
by PDs. The devolvement is at the cut-off price/yield.
 AUCTION TECHNIQUES
• Investors bid at a specific price/yield and is allotted securities if the
price/yield quoted is within the cut-off price/yield.
COMPETITIVE • Bids are made by well informed institutional investors such as banks,
BIDDING
financial institutions, PDs, mutual funds, and insurance companies.
• Minimum bid amount is ₹10,000 for G Sec and ₹ 25,000 for T-Bills.
• Multiple bidding is also allowed.

• Open to CSGL A/c holders

• Maximum of 5% of the notified amount is reserved for non-competitive bids.
NON-
COMPETITIVE • Allotment is made at Weighted. Avg. price
BIDDING • No multiple bidding
• Maximum bid amount is Rs 2 crore
• Price/yield is not mentioned in the bid
 AUCTION TECHNIQUES
• Generally conducted when a new G-sec is issued.
• Investors bid in yield terms up to two decimal places
• Bids are arranged in ascending order and the cut-off yield is arrived at
Yield Based
the yield corresponding to the notified amount of the auction
Auction • The cut-off yield is taken as the coupon rate for the security.
• Successful bidders are those who have bid at or below the cut-off yield.
• Bids which are higher than the cut-off yield are rejected.
• It is conducted when Government of India re-issues securities issued
earlier
Price Based • Bidders quote in terms of price per Rs.100 of face value of the security

Auction (e.g., Rs.102.00, Rs.99.00).

• Bids are arranged in descending order and the successful bidders are
those who have bid at or above the cut-off price.
Yield based auction of a new security:

 Maturity Date: December 19, 2028

 Coupon: It is determined in the auction (8.22% as
shown in the next slide)
 Auction date : September 09, 2022
 Settlement date : September 12, 2022
 Notified amount : 2000 crore
Yield based auction of a new security:

Price* with
Amount of bid Cummulative
Bid No. Bid Yield coupon as
(Rs. crore) amount (Rs.Cr)
8.22%

1 8.19% 600 600 100.19

2 8.20% 400 1000 100.14
3 8.20% 500 1500 100.13
4 8.21% 300 1800 100.09
5 8.22% 200 2000 100
6 8.22% 200 2200 100
7 8.23% 150 2350 99.93
8 8.24% 150 2500 99.87
Price Based Auction:

Amount of Implicit Cumulative

Bid no. Price of bid
bid (Rs. Cr) amount
yield
1 100.31 600 8.19% 600
2 100.26 400 8.20% 1000
3 100.25 500 8.20% 1500
4 100.21 300 8.21% 1800
5 100.20 200 8.21% 2000
6 100.20 200 8.21% 2200
7 100.16 150 8.21% 2350
8 100.15 150 8.22% 2500
 AUCTION TECHNIQUES

• all the successful bidders are required to pay for the

Uniform Price allotted quantity of securities at the same rate, i.e.,
auction at the auction cut-off rate, irrespective of the rate
quoted by them.

• successful bidders are required to pay for the allotted

Multiple Price quantity of securities at the respective price / yield at
auction which they have bid.
• Winners’ curse

INDIAN INSTITUTE OF BANKING & FINANCE

Trading in G-Sec:

 Over the Counter (OTC)/ Telephone Market

 can be directly with counterparty
 or through broker
 Negotiated Dealing System – Order Matching
(NDS-OM)
 order driven electronic system
 participants can trade anonymously
 NDS-OM is operated by the Clearing Corporation of
India Ltd. (CCIL) on behalf of the RBI
NDS OM Screen:
Settlement of G-Sec :

 The CCIL is the clearing agency for Government securities

 It acts as a Central Counter Party (CCP) for all transactions
in Government securities by interposing itself between two
counterparties
 It works out participant-wise net obligations on both the
securities and the funds leg
 settlement takes place by simultaneous transfer of funds and
securities under the ‘Delivery versus Payment’ system
 CCIL also guarantees settlement of all trades in Government
securities
 FIXED INCOME SECURITIES ::
 1. Debt instruments/securities which provide a fixed income in the form of
periodical coupon payments irrespective of any change in the interest rate in
the system/market.

 2. A bond is a stream of cash flows in the form of periodic coupons and the face
value at maturity (redemption).

 3. Price of a bond will always change with the change in market interest rate

 4. such Equilibrating change in bond price is known as ‘Bond

Dynamics’.

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INDIAN INSTITUTE OF BANKING & FINANCE

 • Also known as the par value and stated on the face of the bond. It represents the
amount borrowed by the firm, which it promises to repay after a specified period.
Face Value Bonds are generally issued at par or the face value.

• A bond carries a specific rate of interest, which is also called as the coupon rate. It’s
Coupon Rate actually a rate of interest liability attached to a security. In good old days there used to be
interest coupons attached or issued for interest payment and hence the word coupon.

• A bond is issued for a specified period. Maturity date or maturity date relate the end date
Maturity on which the bond is to be repaid.

• Unlike shares, all bonds are repayable and the amount which the bondholder gets on
Redemption Value maturity is the redemption amount which generally is the face value.

• This is applicable where the bonds are listed and traded on a stock exchange. The price
at which such bonds are traded is the market price or value. Listing offers the
Market Value bondholder an option to get money earlier but from the market and it has no impact on
redemption date.

• It is a method of calculating interest earned6/13/2023

or accrued on a bond.
30 On Govt Sec
Day count conventions (30/360), On T Bills, Corp Bonds , CP, CD (Actuals/365)
 BOND VALUATION & BOND DYNAMICS

 Bond is a contractual obligation that pays:

i. Fixed coupon at fixed intervals and
ii. Par value or principal amount at maturity
 Price of a bond is therefore:
i. Present value of the future stream of cash flows
ii. Discounted by a rate that people place on their time value of
money i.e. market interest rate
iii. Ideally, at the time of issue, coupon rate = market interest rate

Bond price = C1/(1+r)+C2/(1+r)^2…+Cn/(1+r)^n + P/(1+r)^n

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INDIAN INSTITUTE OF BANKING & FINANCE

 BOND CHARACTERISTICS
 Example of a typical GOI bond

 Par Value of Rs. 100

 Coupon rate of 8% payable semiannually

 Maturity period of 12 years

 Explanation::

 The holder of the bond gets Rs 100 at the end of 12 years

 An annual interest of 8% (4% semi annually) on the face value

 At every six months

6/13/2023 32
 Bond Price Formula::
 If “P” is the Bond Price,

 ‘r’ is the current or expected interest rate ,

 “C” is periodical coupon amount and

 “M” is the redemption amount on maturity then the bond price can be expressed
as -

n
C M
P  t 1 (1  r ) t

(1  r ) n

6/13/2023 33
Bond Pricing
 Same is written as
n
1 1
P  C M
t 1 (1  r ) (1  r )
t n

P  C * PVIFA ( r , n )  M * PVIF ( r , n )
PVIFA = 1/(1+r)t = Present Value Interest Factor Annuity

PVIF = 1/( 1+r)n =Present Value Interest Factor

6/13/2023 34
Bond Price Calculations::
 Example 1
 What is the price of a 12 year bond of Rs 1000 par value with
an annual coupon of 8% with an expected return of 10%?
 1. Coupon = Rs 80/- p.a.
 2. Face Value = 1000/-
 3. Market Yield = 10% or 10/100
 4. Maturity = 12 years
 Price =???
P  80 * PVIFA (10,12)  1000* PVIF (10,12)
P  80* 6.814  1000* 0.3186
Price (P)= Rs 545.13+ Rs 318.60= Rs 863.73
6/13/2023 35
Bond Price with Semi Annual Coupon Payment

 Price of Semiannual coupon paying bonds

 Annual coupon rate will be divided by two i.e.(C/2)

 number of periods will be twice the no. of years i.e. (2n)

 discount rate will be half of annual discount rate i.e.(r/2)

2n
C/2 M
P 
t 1 (1  r / 2) (1  r / 2)
t 2n

6/13/2023 36
Bond Price calculation
 Example

 Eight year bond (FV Rs 1000/-) with 12% coupon paid semiannually. What is
the price of the bond if required yield is 14% per annum

 Solution:: C=Rs 60 ; M = Rs 1000; r = 7% ; n= 16; P=???

2n
C/2 M
P 
t 1 (1  r / 2) t
(1  r / 2) 2n

16
60 1000
P 
t 1 (1  0.07) (1  0.07)
t 16

P= 905.54 6/13/2023 37
 YIELD OF A BOND
 Nominal yield/Coupon rate: Stated interest rate of the bond
which is paid semi-annually. Thus, a bond with a Rs 100 par value
that pays 6% coupon will make 2 semi-annual payments of Rs 3 each.

 Current yield: Coupon/Current market price. Hence, if a bond

trades at a discount, Current yield will be higher than coupon. And if
it trades at a premium, Current yield will be lower than coupon.

 Yield to Maturity (YTM): Rate of discount at which all the future

cash flows of the bond are discounted to arrive at a present value (PV)
which is equal to the market price of the bond.

6/13/2023 38

INDIAN INSTITUTE OF BANKING & FINANCE

 BOND YIELD RELATIONSHIPS
WHEN THE BOND YIELD
BONDHOLDER PAYS... RELATIONSHIPS

Yield to Maturity > Current Yield

Less than par value (discount).
> Coupon Yield

Coupon Yield = Current Yield =

Par value.
Yield to Maturity

Coupon Yield > Current Yield >

More than par value (premium).
Yield to Maturity
 Current Yield
 It measures the return, that a bond gives without taking into account
the capital gain or loss on redemption. (If the security is bought for
less than its redemption value, there is a capital gain and vice versa).

ILLUSTRATION::

(1) Face Value= Rs 100 ; coupon = 8% p.a.

Market Price= Rs. 105 (including accrued interest),

The current yield = 8 *100/105= 7.62% p.a.

(2) if the purchase price of the bond is Rs 95 (face Value =Rs 100;

The current yield =8*100/95 = 8.42%

6/13/2023 40
 YTM
 The interest rate which equates the future coupon and principal redemption
cash flows from the bond with its current market price.
 Solving for “r” in the formula (formula assumes 180 days coupon intervals and
360 days in a year):
 c/ (1 + r)^1 + c/(1 + r)^2 + ...... c/ (1 + r)^n + M /(1 + r)^n = Price(P)
 Where :
 c = annual coupon payment
 n = number of years to maturity
 B = par value
 P = purchase price
 r= YTM/ Market Rate/ IRR
 Value of r can be calculated by trial & error method or through excel formula

6/13/2023 41
 Calculating Yield
 Computation of yield requires trial and error procedure

 Example: Bond with par value of Rs 1000 carrying a coupon of 9% p.a. currently selling at Rs.
800. Maturity 8 years, What is the YTM?

 1. Face Value =Rs 1000/-

 2. Coupon =RS 90/- p.a.

 3. Maturity =8 years
8
1 1
 4. Price = 800/-
800  90  1000
 What is the r(yield)? t 1 (1  r ) t
(1  r ) 8

 Let us place the values in the formula

6/13/2023 42
 Calculating Yield:: Trial & Error method

8
1 1
800  90  1000
t 1 (1  r )t (1  r )8

800  90 * PVIFA ( r %,8)  1000* PVIF ( r %,8)

800  90 * PVIFA (12%,8)  1000* PVIF (12%,8)

 1. Calculating for r = 12%
800  90* 4.968  1000* 0.404  851.0

800  90 * PVIFA (14%,8)  1000* PVIF (14%,8)

 2. Calculating for r = 14%
800  90* 4.6931000* 0.351 768.1
6/13/2023

43
 Calculating Yield when Price is given
 3. Calculating for r = 13% 800  90 * PVIFA (13%,8)  1000* PVIF (13%,8)

800  90* 4.800 1000* 0.376  808

Note:: Price at (Higher Rate)14% is Rs 768.1 and at (Lower rate)13% Rs 808

 Apparently the value of “r” lies between (Higher rate)14% and (Lower Rate)13%
 Now the yield rate is proportionately decided as below:
 (Higher rate)14% and (Lower Rate)13% respectively ;
 Higher pv = Rs808 ; Lower pv 768.10 ;
 mv = Rs800 ;

 Lower rate +(Diff. between the two rates)* (diff. betw. higher pv and the mv)

 (diff betw. higher pv and the lower pv)

808  800
13%  (14%  13%)  13.2% Y= 13.2%
808  768.1
6/13/2023 44
BOND PORTFOLIO STRATEGIES

45
BOND PORTFOLIO MANAGEMENT STRATEGIES

 Two approaches of Bond Portfolio Management::

 (1) The passive approach ::

 A buy and hold strategy.

 Involves investing in securities and holding them till maturity (HTM)or

earlier redemption (in case of bonds with call option).

 The coupon payments from the bond are reinvested in similar securities

 (2) The Active Approach::

 bond portfolio management involves switching and swapping bonds as

circumstances change in the market
46
 LADDER OR SPACED MATURITY STRATEGY::

 (1)maximum acceptable maturity is decided by the Treasury.

 (2) investment in equal proportion in each of several maturity intervals is made

 Example: Assume 8 years as maximum acceptable maturity.

 (a) invest 12.50% of its investment portfolio in securities 1 yr – 2 yrs maturity

 (b)another 12.50% in securities maturing within 2 yrs – 3 yrs maturity.

 (c)another 12.50% in 3 yrs to 4 yrs maturity and so on…., until the eight year point is reached.

 ANALYSIS::

 (a) It helps avoid income fluctuations, but does not maximize returns by ensuring periodic
availability of funds from the redemptions,

 (b) An easy way to build a ladder will be to participate in the auctions conducted by the RBI for sale
47

of treasury bills and dated securities.

6/13/2023 49
THE FRONT-END LOADED MATURITY STRATEGY

 Bank may make all its investments in bonds which mature within a
brief period of time, say two years.

 Within this two year period, the bank may decide that 20% may be
invested in maturities up to one year and 80% in maturities between
>1 to 2 years

 ANALYSIS::

 This approach emphasizes more as a source of liquidity and less as

a source of income.

51
THE BACK-END LOADED MATURITY STRATEGY

 The strategy may be to increase the net interest income by

borrowing short and investing long.

 A bank placing emphasis on income as opposed to liquidity may

adopt a policy of investing in medium to long term bonds (say, 8
or 10 years).

 ANALYSIS::

 This entails interest rate (maturity mismatch) risk for the bank
(ALM mismatch).

52
BARBELL STRATEGY- A Blend of the earlier Two

 The Barbell strategy is a combination of front ended and back ended

approaches.

 The bank makes most of its investments -

 (i) in short term bonds (to provide liquidity)

 (ii) long term bonds (to provide income associated with high coupons)

 (iii) And minimal investments in the intermediate maturities.

 ANALYSIS::

(a)This strategy is a balanced approach to portfolio management

(b) Bank gets the advantage of managing liquidity and the income both. 53
Immunization Strategy or Duration Approach

 Immunization is a strategy which applies the concept of duration

in bond portfolio management.

 WHAT IS DURATION??

 Duration is the weighted-average measure of a bond’s life, where the various

time periods in which the bond generates cash flows are weighted according to
the relative size of the present value of those cash flows.

 Duration is the measure of average time for receipt of the cash flows from a
bond in present value terms.

 This is also the point of time in the life of the bond when the capital gain/loss
is exactly countervailed by their reinvestment loss/gain.

 Duration of couponed Bond is always less than the residual maturity.

 Duration of Zero coupon bond is equal to the residual maturity of the bond. 54
Understanding Duration Approach

 If a bond is sold exactly at the point of its Duration the investor

will not suffer any loss in return and his realized yield will be
same as the Expected Yield at the time of purchase of bond.

 In other words, investment is immunized from loss, if bank

takes care to ensure that the investment horizon matches with
the duration of his portfolio

 If the investment horizon is two years, the duration of the

portfolio should be two years and as such, the nominal maturity
will be higher.
55
Approach to Immunization

 Immunization using the concept of duration, to be effective, has to

be a continuous process, as duration changes with the change in
yields as also the remaining period to maturity.
 Let us see a Hypothetical Situation::
 If the initial investment horizon is three years, the initial duration of the
portfolio should be three years.

 After say 6 months, investment horizon will be 2 and half years,

 but the duration of portfolio would be different from two and half years on
account of changes in the market yields and the nominal residual maturities
of the bonds in the portfolio reducing by six months.

 The portfolio will now have to be rebalanced by buying/selling appropriate

bonds such that the duration is brought to two and half years 56
Limitations of Immunization Technique

(i) Continual rebalancing of portfolio would entail

considerable transaction cost.

(ii) When the market is illiquid, it may not be possible

to bring about the desired changes in portfolio.

57
 ASSUMPTIONS INVOLVED IN DURATION::
 The coupon cash flows before maturity are reinvested at the IRR (YTM).

 However, The actual (post-facto) IRR will invariably be different as the

coupon reinvestment rates will not be the same as the YTM calculated
today.

 YTM is a standard measure of bond price and is universally adopted.

 Day Count Conventions::

 In the case of GSecs the year is reckoned as 360 days and a month of 30
days.

 In other instruments (TB, Corporate Bonds) interest is calculated for

actual days in a month and for 365 days a year.
6/13/2023 58
DURATION - An important concept for managing
investment portfolio

 In all the aspects of bonds, valuation the underlying

assumption is that the periodic interest ( Coupon) is reinvested at
the prevailing market rate at the time of purchase .

Concept of Duration::
 The duration of a bond is the concept arising from the fact that
when the interest rate in the market increases, the market price
of the bond comes down but the holder of the bond gains on
the reinvestment of his periodic interest receipts and vice
versa.
6/13/2023 59
 How to Calculate Duration?

Suppose the annual coupon is 8% on a G-Sec. The face value of the 6 yr bond is

Rs.1000 and the current YTM is 8%.

Solution:: Par Value= Rs1000 ; C= Rs 80 ; t = 6 yrs ; y = 8% ; D = ????

time Ct Pt (weights) Pt X t
1 80 74.07 74.07
2 80 68.59 137.18 4.992.71
3 80 63.51 190.53 D= = 4.993 yrs.
4 80 58.80 235.20 1000
5 80 54.45 272.25
6 1080 680.58 4083.48
1000.00 4992.71
6/13/2023 60
PROPERTIES OF DURATION::
1. Duration measures the interest rate sensitivity of a bond.

2. The duration of bond portfolio is the weighted average of the durations of

individual bonds in the portfolio.

3. However, this will not accurately measure the interest rate change impact on
the portfolio, unless the yield curve shift is entirely parallel.

4. Duration is the spot measure of interest rate sensitivity. It keeps changing

with YTM and time.

5.The dealer should keep on buying and selling securities such that the
specified duration is maintained at the policy level at all time.

6. Depending on their risk appetite , the banks’ board decide a level within
which they desire to maintain the portfolio duration 6/13/2023 61
PROPERTIES OF DURATION.. Contd

7. Duration is a point of time within the maturity period and hence is always less
than the maturity term of the bond.

8. Price volatility (Duration) of a long term bond is greater than that of a short
term bond.

9. The duration of Zero Coupon bond is equal to its residual maturity.

10. Duration and YTM are inversely related; Larger the coupon rate, smaller the
duration of a bond.

11. Low coupon bonds are more volatile and price sensitive to changes in market

rates than high coupon bonds.

12. An increase in the frequency of coupon payments decreases the duration, while
a decrease in frequency of coupons increases it. 6/13/2023 62

13. Duration of a bond declines as the bond approaches maturity.

 BOND DYNAMICS

 Value of a bond will change if there is a change in interest rate for similar type of
instrument. If interest rate goes up, value of the bond will fall and vice versa.

 However, periodical coupons can be reinvested at higher market rates (since

interest rates have gone up).

 If the interest rates move upward, the base purchase price of the bond will be
lowered, which will attract more buyers in expectation of capital gains.

 More demand for the bond tends to appreciate the price of the bond which leads to
lowering of YTM of the bond.

 Investors will gain on pricing of the bond but lose on reinvestment of the future
coupons at higher interest rates.

 Such equilibrating adjustment in bond is the crux of bond dynamics.

6/13/2023 63

INDIAN INSTITUTE OF BANKING & FINANCE

First Bond Theorem :

 Price and yield are inversely related i.e. if interest rate

increases, price of the bond falls and if interest rate
falls, price of the bond rises
Second Bond Theorem :

 Appreciation in the value of Bond when interest rates fall

is more than the depreciation in the value of the Bond
when interest rates rise by same amount
 In the example:

 Price of bond, when interest rate decreases (@ 6% YTM ) =

104.21 (change of 4.21%)

 Price of bond, when interest rate increases (@ 8% YTM ) =

96.01 (change of 3.99%)
 Third Bond Theorem :

 Longer the maturity higher the price volatility

 Let us consider two bonds with same Coupon but different Maturity.
7.00% GOI 2021 and 7% GOI 2024 and interest rates of 6%, 7% and 8%.The PV’s in
each case can be similarly worked out
Fourth Bond Theorem :
 The percentage price change increases at a diminishing rate as the
maturity time increases
Lets take one more example of long maturity bonds - 2021, 2024, and 2027 with
same coupons etc and look at the sensitivity
FifthBond Theorem:
 Price volatility of a bond with a lower coupon rate will be more and that
of a higher coupon rate will be less.
Now take example of same maturity bond with different Coupons and just see how the
sensitivity of these bonds work
 Duration ( Macaulay Duration ):
 The term duration has a special meaning in the context of bonds. It is a measurement
of how long, in years, it takes for the price of a bond to be repaid by its internal cash
flows. It is an important measure for investors to consider, as bonds with higher
durations carry more risk and have higher price volatility than bonds with lower
durations

 Zero-Coupon Bond – Duration is equal to its time to maturity

 Vanilla Bond - Duration will always be less than its time to maturity

 In other word, Duration is weighted average maturity of a bond where present value
of the cash flow are used as weights
.
M Duration:
 It is known as Modified Duration ((sometimes abbreviated MD)

 It measures the sensitivity of bond price to the interest rates

 though Macaulay duration and modified duration are closely related, they are
conceptually distinct

 Macaulay duration is a weighted average time until repayment (measured in

units of time such as years) while modified duration is a price sensitivity
measure
M Duration:

 PVBP- Price Value Basis Point refers to Bond Price change

on one basis point change in Market yield

 For Example, if a 5-year bond @8.00% yield is priced at

Rs.96.01 and @8.01% is priced at Rs.95.97, PVBP is Rs.0.04.

 It is also reflected in MDuration which is 4.05%

 Higher the Maturity=>Higher the Duration=> Higher the

MDuration=>Higher PVBP.
6/13/2023 73
 Convexity
 Modified Duration refers to the %age increase in price of the bond if yield goes
down by100 bps and vice versa. ( Refer example on MD)

 POINTS TO PONDER::

 Does that mean that with the changes in yield in both side by 1% the price change
will be similar??? ---- Answer is A BIG NO

 The duration rule of calculating the percentage change in the price of bond is only
approximation and holds good only when the yield change is very small.

 At higher yields, the slope is smaller than the slope at lower yields.

 We know that price-yield curve is downward slopping. However, the slope is not
uniform at all points on the curve. This is the property of convexity.
 Properties of Convexity
 Convexity is a measure of the curvature in the relationship between bond prices and bond

yields that demonstrates how the modified duration of a bond changes as the interest rate

changes.

 Convexity is used as a risk-management tool, which helps measure and manage the

amount of market risk to which a bonds is exposed.

 Duration and Modified Duration always assumes the yield curve as a straight line. But

actually, any yield curve has curvature. Actually, convexity measures this curvature effect

and hence always an add on factor to Modified Duration.

 Convexity is the second order derivative of Duration and hence always a positive number.

 This measure is normally used when the interest volatility is very high or the bond has a

high face value.

75
Thank You
Q&A Please

INDIAN INSTITUTE OF BANKING6/13/2023

& FINANCE 76