Professional Documents
Culture Documents
3 Part3
3 Part3
beatriz.balbas@uah.es
CONTENTS
Fixed income securities and portfolios
Term structure of interest rates
Internal rate of return
Implied forward rates
Price and quotation: Accrued interest
Interest rate risk: Macaulay duration
Net Present Value (NPV)
Interest Rate of Return (IRR)
Fisher intersection
Annuities and mortgages
2
PRICE AND QUOTATION: ACCRUED INTEREST
Consider the bond below, issued several years ago, which is going to
pay the coupon in a few moments,
0; 1∆ ; 2 ∆ ; … . ∆
19
, ; ;….
where the time ∆ between consecutive maturities may equal one year, six
months, etc.
At every date ∆ 1 ∆ , for 0,1,2, … . , 1, we will
define the accrued interest as
∆
20
∆
3
Or
ℎ ℎ !
" # $ ℎ
4
Thus, the accrued interest is almost % a few moments before the
coupon maturity and it is almost zero a few moments after the
coupon maturity.
Expression
*
'
& )
'+, 1 ()
5
Data providers do not give the bond price, but the bond quotation.
Denoting by -. and -/ . the price and the quotation of the bond at 0,
1 will be computed with the TSIR at , while 12 is defined by
12 1 21
Consequently, if you check a panel data because you are going to buy or
sell a bond, bear in mind that you have to add the accrued interest
so as to compute the price to be paid for this asset.
Notice that 1 12 almost equals if the coupon maturity is
approaching, whereas 1 and 12 are almost identical if the coupon was
paid a few moments ago.
Whence, 12 does not jump (fall) when is paid and shows a continuous
path with respect to time, which is a significant distinction with respect
to 1 .
6
EXAMPLE 15
Suppose a bond with maturity in 5 years, a coupon, %
3%, and a face value, 5 677. Compute the accrued
interest (i) today; (ii) in half a year; (iii) in one year; (iv) in
one year and a half; (v) in 2 years and 3 months.
7
EXAMPLE 16
Consider the bond from example 15 and imagine the ideal
situation where 8. 3% over the 5 years.
8
EXERCISES (III)
9
Traders and practitioners prefer the quotation because it is
more intuitive and closely related to the present TSIR value
situation.
They know they have to pay something else for the bond (the
accrued interest) but they also know it is provoked because
they don’t have to wait for the whole period to receive the first
cash flow.
10
INTEREST RATE RISK: DURATION AND MACAULAY DURATION
We should not confuse “DURATION” (9) with the maturity of a bond
( * ).
It is defined as the weighted average life of the cash flows, using the
present value of each cash flow as a weighting basis. If the current
value is changed by its approximation calculated with the IRR, we will
face the “MACAULAY DURATION”.
11
Consider Bond :1;,
0; ,; <; …; *
; ,; <; … ; *
12
MACAULAY DURATION:
Weights, ' , are
,
,
1 ( A
<
<
1 ( B
*
*
1 ( D
13
MODIFIED DURATION (=G ):
It is computed as
=
=G
:1 (;
14
DURATION (with respecto to the TSIR):
Weights, ' , are
1 HIA∗ , ,
, ,
A
A
K A
1 (A
1 ∗
HID * *
* *
D
D
K D
1 (D
where ?6 ?3 ⋯ ?F 6 holds.
15
So the general formula is
as the absolute contribution of every cash flow to the global price, and
every
'
)
1 ()
16
Duration and Macaulay Duration are weighted averages of the set of
maturities, every date being weighted according to its relative contribution. In
fact, duration is measured in years and, if every ' is positive, then = satisfies
, L=L *
because it is an average value.
For a zero coupon bond, maturity obviously equals duration and Macaulay
Duration, .F 9, since we have to compute an average with a unique number.
For coupon bonds such as
0; 1∆ ; 2 ∆ ;…. ∆
,
, ; ;….
duration is lower than the longest maturity, but both quantities are quite
similar because the weight of the last cash flow is much higher than the
remaining ones.
17
Properties of duration. Suppose that M, , M< ,…, MN are the available
bonds, whose prices and durations are given by 1, , 1< ,…, 1N and =, ,
=< ,…, =N respectively. Let O O, , O< , … , ON be the portfolio investing
the percentage OP in the Q ℎ bond, Q 1,2, … . At the moment we
accept short sales, i.e., some OP may be negative as long as the
restriction ∑NP+, OP 1 holds. Then:
N
=S & =P OP 25
P+,
18
EXAMPLE 17
Consider Bond (7)
7; 6; 3;
.
%7 ; 677; 67677;
19
EXAMPLE 18
Consider Bond :Y;
7; 6, Z
.
VX7; 6777
Compute its duration.
20
EXAMPLE 19
Consider the following portfolio:
One unit of Bond [
Two units of the zero coupon Bond Y
Compute portfolio´s duration.
21
EXERCISES (IV)
22
Instructor: Beatriz Balbás Aparicio
beatriz.balbas@uah.es