Understanding Fixed-

Income Risk and Return

Macaulay Duration
 Effect of Investment Horizon on Returns
when Interest Rates Changes
Investment horizon
Sally Leonard
Equilibrium point Long Investment Horizon
Short Investment Horizon
Interest Rates ↑

Net ↓ in ΔReinvestment Net ↑ in

returns Return returns
Market price risk ΔMarket price Market price risk
dominates insignificant

Interest Rates ↓
Reinvestment risk Reinvestment risk
insignificant Net ↑ in ΔMarket price Net ↓ in dominates
returns returns
ΔReinvestment
Inverse relationship Return Direct relationship
with market IR with market IR

Macaulay Duration
 Investment Horizon
=
Macaulay
Duration Investment horizon
Sally Leonard
Equilibrium point Long Investment Horizon
Short Investment Horizon
Interest Rates ↑

Net ↓ in No change Net ↑ in

returns in returns returns

Interest Rates ↓

Net ↑ in No change Net ↓ in

returns in returns returns

Macaulay Duration
 Macaulay Duration
Duration of a bond - a measure of its interest rate risk

Duration

Yield

Price

time
0

Macaulay Duration
 Macaulay Duration
Duration of a bond - a measure of its interest rate risk

Duration

Yield
High IR risk

Price

time
0

Macaulay Duration
 Macaulay Duration
Duration of a bond - a measure of its interest rate risk

Duration

Yield

Price
Low IR risk

time
0

Macaulay Duration
 Macaulay Duration
Weighted average of the number of years until each of the bond’s promised cash flows is to be paid

PV of each CF
$
Full Value
YTM 5%
$1081.70
$1000 par
$1000

8% annual coupon
Sally
$80 $80 $80

time
0 Maturity
3 yrs

Macaulay Duration
 Macaulay Duration
Weighted average of the number of years until each of the bond’s promised cash flows is to be paid

PV of each CF YTM 5%
Full Value $1081.70 $1000

W3 = 932.94/1081.70 $1080/(1.05)3
$932.94
= 0.8625 $80

W2 = 72.56/1081.70 $80/(1.05)2
$72.56
= 0.0671 $80 Sally

W1 = 76.19/1081.70 $80/(1.05)
$76.19
= 0.0704 $80

time
∑ = 1.0 ∑ = $1081.70
1 2 3

Macaulay Duration
 Macaulay Duration
Weighted
3 Calculate average
weights of the number of years until each of the bond’s promised cash flows is to be paid

PV of each CF YTM 5%
Full Value $1081.70 Identify all the
1 $1000
Discount to PV cash flows
2
using bond’s yield
W3 = 932.94/1081.70 $1080/(1.05)3
$932.94
= 0.8625 $80

W2 = 72.56/1081.70 $80/(1.05)2
$72.56
= 0.0671 $80 Sally

W1 = 76.19/1081.70 $80/(1.05)
$76.19
= 0.0704 $80

time

Macaulay Duration = 0.0704 x 1 + 0.0671 x 2 + 0.8625 x 3 Sum up weight x

4
num of years
= 2.792 years

Macaulay Duration
 Macaulay Duration
Weighted average of the number of years until each of the bond’s promised cash flows is to be paid
semi-annual periods
PV of each CF
Full Value Semi-annual Coupon Bond

W6
W5
W4 YTM/2
W3
W2
W1

time

Macaulay Duration = W1 x 1 + W2 x 2 + W3 x 3 + W4 x 4 + W5 x 5 + W6 x 6
= xx half-years

Macaulay Duration
 Investment Horizon -ΔMarket price
Investment Horizon
$ = =
Macaulay Duration ΔReinvestment Income
YTM >5%
YTM 5% Return 5% No change!
$1081.70
$1000 par
$1000

8% annual coupon
Sally
$80 $80 $80

time
0 Maturity
3 yrs
4.22%

Macaulay Duration = 2.792 years

Macaulay Duration
 Investment Horizon -ΔMarket price
Investment Horizon
$ = =
Macaulay Duration ΔReinvestment Income
YTM >5%
YTM 5% Return 5% No change!
$1081.70
$1000 par
$1000

8% annual coupon
Sally
$80 $80 $80

time
0 Maturity
3 yrs
4.22%

Macaulay Duration = 2.792 years

Macaulay Duration
 Investment Horizon -ΔMarket price
Investment Horizon
$ = =
Macaulay Duration ΔReinvestment Income
YTM
YTM>5%
7%
YTM 5% Return 5% No change!
$1081.70 4.22%

$1000 par
$1000

Sally
$80 $80 $80

time
0 Maturity
3 yrs

Macaulay Duration = 2.792 years

Macaulay Duration
 $1239.62
( $1081.70
)1/2.792 - 1 = 5%
No change in return even when
Investment Horizon bond yield has increased!
$
YTM
YTM>5%
7%
YTM 5% 0.208 yrs
$1081.70
$1000 par
Sale price = 1080/1.070.208 = $1064.91 $1000
Reinvestment return1 = 80x1.071.792 = $90.31
Reinvestment return2 = 80x1.070.792 = $84.40
$1239.62
Sally
$80 $80 $80

time
0 Maturity
3 yrs

Macaulay Duration = 2.792 years

Macaulay Duration
 Macaulay Duration
- Investment Horizon
=
Duration Gap
Investment Horizon
$
YTM
YTM>5%
7% +ve
YTM 5% Market Price Risk
$1081.70 >
Reinvestment Risk
$1000 par
$1000

Sally
$80 $80 $80

time
0 Maturity
3 yrs

Macaulay Duration = 2.792 years

Macaulay Duration
 Macaulay Duration
- Investment Horizon
=
Duration Gap
Investment Horizon
$
YTM
YTM>5%
7% +ve -ve
YTM 5% Market Price Risk Market Price Risk
$1081.70 > <
Reinvestment Risk Reinvestment Risk
$1000 par
$1000

Sally
$80 $80 $80

time
0 Maturity
3 yrs

Macaulay Duration = 2.792 years

Macaulay Duration
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