MEASUREMENT OF RISK

Price-yield rela onship

B
o
n
d

P
r
i Convex
c
e
Yield%

Bond Price-Yield rela onship is a convex shape rela onship. By convex shape we mean that when YTM
increase then bond price decreases but at a slow pace. On the contrary when YTM decreases, bond price
increases but at a higher pace.

Proof of convex rela onship

Eg 1. A Zero coupon bond having maturity a er 5 years.

F.V. = ₹ 1000 is trading at ₹ 600. Calc YTM ?

Solve:
F.V. = PV (1 + r)ⁿ
1000 = 620 (1 + r)⁵
r = 10.03 %

Q Calc New Price of the bond

i) If YTM 60 bps
ii) If YTM 60 bps
{Remember 1% = 100bps}

(i)
If YTM 60 bps i.e. 0.60%
New YTM = 10.03% + 0.60%
= 10.63%

` 1000
New MP =
(1.1063)5
` 603.44
(ii)
If YTM 60 bps i.e. 0.60%
New YTM
10.030% - 0.60%
=9.43%
` 1000
New MP =
(1.0943)5
` 637.26

Conclusion:
If YTM 60 bps then Price rose by ₹ 17.28 or 2.78%
637.26

620

603.44
If YTM 60 bps then Price fell by ₹ 16.56 or 2.67%

VOLATILITY
Measurement of risk is done by calcula on vola lity. Here
vola lity means by how much the bond price will change Standard rate for measurement of risk = 1%
for every 1% change in YTM [i.e. every 1% change in change in the Interest Rate
prevailing interest rates in the economy]

B
o When YTM
n Bond Price
d

P
r
i
c
e When YTM
Bond Price
Present YTM
Yield%
YTM YTM

Now we can observe that the change in price is different in both the direc ons. Now to measure risk, we have to
calculate vola lity.

Ideally, we should measure slope of curve to get the accurate answers however, it is difficult to measure slope of
curve. Therefore, we use a work around by dropping a tangent line at present YTM. Now we measure slope of the
tangent line ignoring convexity feature. The slope of this tangent line is called as VOLATILITY.
2.78% + 2.67%
= 2.725%
2
2.725% i.e. Bond prices will change by 2.725% for every 0.60% Δ (change) in interest rate.
However, vola lity is measured w.r.t. 1% change in interest rates (NOT 0.60%)
Kİ Ì Bond Price

‡0.60% 2.725%

1% ?
1%
2.725% x
0.60%
= 4.54%
Interpreta on of vola lity:
Bond prices will change by 4.54% for every 1% change in YTM [i.e. prevailing interest in the economy] in the
opposite direc on.

Alterna vely above calcula on of vola lity can also be done by using effec ve dura on formula:
Effec ve dura on formula: This
formula is derived
P2 - P1
Effective Duration = using logic already
2 x P0 x 5 y
thought above

here, Po means bond current prices; P₂ & P₁ means new bond price a er change in YTM
5 Ř Ö ÑMŌŒŃOMŌŊÑ ÒŌ Kİ Ì
637.26 - 603.44
=
2 x 620 x 0.60
= 4.54%

Two approaches to calculate Vola lity

Method 1: Effec ve Dura on Method 2: Modified Dura on

Step 1- Find out present bond price & present YTM Step 1- Calculate Macaulay dura on

Step 2- Give interest rate shock [usually less than 1%] Step 2- Calculate Modified dura on
and find out % Δ in price in both the direc on

Step 3- Calculate average % change in price. But this

percentage is with respect to shock %.
Re-express above change with 1% Δ in interest
rates, using unitary method [cross-
mul plica on].
Eg. 2. FV = ₹ 1000, Coupon rate = 12%, life = 5 yrs, current YTM = 10%. Calculate vola lity using both the
methods ?
Method 1: Effec ve dura on Suppose, shock = 0.40%

Year Cash flows PV @ 10% PV @ 9.6% PV @ 10.90%

1-5 120 454.82
5 1000 620.92
1075.81 1092 1060
ĈBDÃ ĈBÇĎÃ 1.5%
\ Average change =
2
= 1.48% for 40 bps D in Interest Rates 1.46%
1 100 bps
\ Volatility = 1.48%x or
0.40 40 bps
= 3.7%
PČ P1
Altenatively, Effective duration =
2x P0 x D y
1092 - 1060
=
2x1075.81 x 0.40
= 3.7%

Method 2: Modified dura on

Stap - 1: Macaulay dura on

1 2 3 4 5

120 120 120 120 120

1000

PV PV PV PV PV
of 120 of 120 of 120 of 120 of 1120

Macaulay dura on

PV
of Cf’s is
used as
weights

Macaulay Dura on (or simply say ‘dura on’) of the bond is weighted average maturity of its cash flow
structure , where present value of CFs discounted at current YTM are assigned as weights.
 Year CF PV @ YTM 10% Weights Weights x Year
1 120 109.09 109.09 / 1075.82 0.1014
2 120 99.17 99.17 / 1075.82 0.1843
3 120 90.16 90.16 / 1075.82 0.2514
4 120 81.96 81.96 / 1075.82 0.3047
5 1120 695.43 695.43 / 1075.82 3.231
1075.82 1 4.074
Macaulay Dura on = 4.074 years

Alterna vely we may use produc on method to calculate weighted average.

Year CF PV @ 10% [w] WxD

1 120 109.09 109.09
2 120 99.17 198.34
3 120 90.16 270.48
4 120 81.96 327.84
5 1120 695.43 3477.15
Σw = 1075.82 ΣWD = 4382.90

Duration =
åJ G
åW
4382.90
1075.82
= 4.074 years

Step 2: Modified Duration

Duration
Modified Duration =
1 + YTM
4.074
=
1 + 0.10
4.074
=
1.10
= 3.70%
Significance of Macaulay dura on
Eg. Vace value = ₹ 1000
Coupon rate = 12%
Life = 5 yrs.
YTM = 10%

Calculate value that an Investor will recieve if he holds the bond for x years & YTM changes to y%
if YTM
changes to 9% 10% 11%
if the bond
is held for

3 1446 1432 1418

[WN#2]
4
5 1718 1733 1747
[W.N.1]

YTM = 10%
W.N.1
0 1 2 3 4 5

120 120 120 120 1120

120 x 1.10 132
120 x 1.10²
145.2
120 x 1.10³
159.72
120 x 1.10⁴
175.69
1732.61
~
1733
0 1 2 3 4 5
WN#2
120 120 120 120 1120

132
120 x 1.10 120 120
+
1.10 1.102
120 x 1.10²
145.2

1034
1432
 If Bond is held for
₹ 5 years

Value If Bond is held for dura on equivalent to its

from
Macaulay dura on (in our case 4.014 year)
bond

If Bond is
held for
3 years

X%
9% 10% 11%

YTM
Conclusion: Dura on of the bond is that point of me for which if the bond is held, then an investor is insulated
(protected) from both types of risk [interest rate risk as well as reinvestment rate risk]
0 1 2 3 4 5

120 120 120 120 1120

Reinv
e stme
nt ra
r i s k te ris
rate k
re st Dura on
Inte

In the ini al years, Interest rate risk has a greater impact on the value of bond but as the me passes and nears the
maturity, interest rate risk effect lightens down. On the contrary, reinvestment rate risk has negligible role to play
in the ini al years but as the me passes, its dominance increases. At Dura on, both the risks tends to offset each
other.
The concept of dura on is also used for ‘Bond Immuniza on’.

Bond selec on decision

Decision Making using the concept of dura on

then prefer prefer

If Interest rates Bond price low vola lity low dura on
are expected to

Ye Decision FD samajh ke le to aur asaan h

int = FD short - term
int = FD long - term
Dura on of Bond Por olio

is weighted average dura on of individual bonds where market values are the assigned weights.

Dura on of bonds por olio = ΣDura on i x Wi

weights are market values

Deriva on of modified Dura on formula i.e. vola lity

Rule of Differ a on
1 ì æ 1 1 ö - 1 - 2ü
d 1 / x) = íd ç 1 + 2 ÷ = 2
Č ý
x î èx x ø x x3 þ
Price

Yield %
C1 C2 CD
P= + + ...............+
1 r) (1 + r ) (1 + r )
1 2 5

taking differen a on of Price with respect to change in r i.e.YTM

dŐ - C1 2C2 5 C5
= = - ..................
1 + r) (1 + r ) (1 + r )
2 3 6
dr
However, above differen a on will give changes in rupee term but we want it in % terms. Therefore dividing
above equa on by price (P0)
dp - C1 2 C2 - 5 CD
- ............
1 + r ) (1 + r ) ( 1 + r)
2 3 6
dr
=
P C1 C2 C5
+ + ...............
(1 + r ) (1 + r ) (1 + r )
1 2 5

-1 2 C2 5 C5
+ + ............ +
1 + r (1 + r ) 2
(1 + r)
5

Volatility i.e. modified duration =

C1 C2 CD
+ + ............
(1 + r ) 1 + r ) (1 + r )
1 2 5

-1
V= x Duration
1+r
- Duration
=
1 + YTM this is periodic YTM