FIN4002

Fixed Income Securities

Part Two: Bond Mathematics

Topic 3: Bond Volatility

0
Outline

• Bond price-yield relationship of an option-free bond

• Factors that affect the price volatility of a bond when yields
change
• Bond price-volatility properties of an option-free bond
• Concept of Duration
- Calculate and interpret the Macaulay duration, modified
duration, and dollar duration of a bond
• Concept of Convexity

1
Bond Price / Yield Relationship
• A fundamental property of a bond is that its price changes in the
opposite direction from the change in the required yield.
• The reason is that the price of the bond is the present value of the
cash flows.
• If we graph the price-yield relationship for any option-free bond, we
will find that it has the “bowed” shape.

Market yield
Holding maturity constant, a rate decrease will raise prices a greater percent
than a corresponding increase in rates will lower prices

2
Bond Price in a Time Path
Assuming constant interest rates over time:
1. If the coupon is lower than the market interest rate the
bond price will be below par. The discount will however
decline as the bond moves towards maturity.
2. If the coupon is higher than the market interest rate the
bond price will be above par. The premium will however
decline as the bond moves towards maturity.
3. If the coupon is the same as the market interest rate the
bond price will be par and will stay so until maturity.
2
Price 3
1

Time
3
Bond Price Volatility – Question

Suppose you are reviewing a price sheet for bonds and see
the following prices. You observe what seems to be several
pricing errors. Without calculating the price of each bond,
indicate which bonds seem to be reported incorrectly, and
explain why. All bonds have a nominal value of 100.
Bond Price CPN (%) Yield (%)
A 90 6 9
B 96 9 8
C 110 8 6
D 105 0 5
E 107 7 9
F 100 6 6

4
Bond Price - Volatility

Measuring the effects of interest rate changes on bond prices

is complex.
This is because the change in price in response to a change
in interest rates depends on the interaction between time to
maturity and coupon size.

5
Bond Price Volatility – Coupon Size

The smaller the coupon then the larger the price volatility.
Bond Value - Different Coupon with Fixed Maturity
Bond Value

High Coupon Bond

Low Coupon Bond

Market Interest Rate

6
Bond Price Volatility – Maturity

The longer the maturity then the larger the price volatility.

Bond Value - 4% Coupon with Different Maturities

$2,500.00

$2,000.00
Years to Mat
1
2
Bond Prices

$1,500.00
3
5
10
$1,000.00
15
20

$500.00 25
30

$0.00
0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 5.5% 6.0% 6.5% 7.0% 7.5% 8.0%
Market Interest Rate

7
Bond Price Volatility - Summary
• Bond prices are inversely related to bond yields.
Implication: When market rates fall, bond prices rise, and vice versa.

• Generally, for a given coupon rate, the longer is the time to maturity, the
greater is the percentage price change for a given shift in yields. (The
maturity effect)
Implication: Long-term bonds are riskier than short-term bonds for a given
shift in yields, but also have more potential for gain if rates fall.

• For a given maturity, the lower is the coupon rate, the greater is the
percentage price change for a given shift in yields. (The coupon effect)
Implication: Low-coupon bonds are riskier than high-coupon bonds given
the same maturity, but also have more potential for gain if rates fall.

• For a given coupon rate and maturity, the price increase from a given
reduction in yield will always exceed the price decrease from an equivalent
increase in yield. (The convexity effect)

8
Properties of Bond Price Volatility
1. Bond prices and market interest rates move in opposite
directions. i.e. an inverse, nonlinear relationship.
2. Small changes in the required yield produce relatively
symmetrical changes in the bond’s price. That is, bond
price increases and decreases that result from small
changes in the required yield are approximately equal.
3. Large changes in the required yield produce unequal
changes in the bond’s price. A large decrease in the yield
will produce a greater increase in the bond’s price when
compared to the decrease in price that results from an
increase in the required yield of the same magnitude.

9
Properties of Bond Price Volatility

4. Coupon versus YTM,

- When coupon rate = YTM, price = par value.
- When coupon rate > YTM, price > par value (premium bond)
- When coupon rate < YTM, price < par value (discount bond)
5. A bond with longer maturity has higher relative (%) price
change than one with shorter maturity when interest rate
(YTM) changes. All other features are identical.
6. A lower coupon bond has a higher relative price change
than a higher coupon bond when YTM changes. All other
features are identical.

10
Measuring Bond Price Volatility

• Three measures that are commonly employed:

- price value of a basis point (PV01)
- yield value of a price change (YV01)
- Duration

11
Measures of Bond Price Volatility
Price Value of a Basis Point – PV01 (more in later topics)
- The price value of a basis point, also referred to as the dollar
value of an 01 (also known as DV01), is the change in the price
of the bond if the required yield changes by 1 basis point.
- Note that this measure of price volatility indicates dollar price
volatility as opposed to percentage price volatility (price change
as a percent of the initial price).
- Typically, the price value of a basis point is expressed as the
“absolute value” of the change in price.
- PV01 value is the same for an increase or a decrease of 1 basis
point in required yield except in opposite sign “+” or “-”.
- Because this measure of price volatility is in terms of dollar price
change, dividing the price value of a basis point by the initial
price gives the percentage price change for a 1-basis-point
change in yield.

12
Example – PV01 Calculation

• Consider the following bonds with annual coupon:

Bond Coupon Maturity Initial Yield
A 8% 5 yrs 10%
B 5% 20 8%
C 8% 20 8%

• Initial Prices:
5  80  1000
PA =     + = 924.18
t =1 (1 + .10) 
t 5
(1 + .10)
20  50  1000
PB =    + = 705.46
t =1 (1 + .08) 
t
(1 + .08) 20

20  80  1000
PC =    + = 1000.00
t =1 (1 + .08) 
t
(1 + .08) 20

13
Example – PV01 Calculation

• Consider the following bonds with annual coupon :

Bond Coupon Maturity Initial Yield
A 8% 5 yrs 10.01%
B 5% 20 8.01%
C 8% 20 8.01%

• Initial Prices:
5
 80  1000
PA =   (1 + .1001) 
t 
+ 5
= 923.825 PV01 = 0.355
t =1   (1 + .1001)
20
 50  1000
PB =  
 
t 
t =1  (1 + .0801) 
+
(1 + .0801) 20
= 704.694
PV01 = 0.766

20
 80  1000
PC =  
 
t 
t =1  (1 + .0801) 
+
(1 + .0801) 20
= 999.019
PV01 = 0.981

14
Bond Price Volatility Example
• Prices after yields increase by 50 bp:
5  80  1000
PA =    + = 906.43
t =1 (1 + .105) 
t
(1 + .105)5
20
 50  1000
PB =   (1 + .085) t
 + 20
= 668.78
t =1   (1 + .085)
20
 80  1000
PC =   (1 + .085) t
 +
(1 + .085) 20
= 952.68
t =1  

• Percentage price changes:

Bond A: (906.43 - 924.18) / (924.18) = -1.92% (least)

Bond B: (668.78 - 705.46) / (705.46) = -5.20% (most)
Bond C: (952.68 - 1000.00) / (1000.00) = -4.73% (middle)

15
Bond Price Volatility Example
• Question: Where would Bond D, which has a coupon rate of 6% and
a maturity of 19 years, fit into this price sensitivity spectrum?
(Assume its initial yield is also 8%.)

19  60  1000
Initial: PD =    + = 807.93
t =1 (1 + .08) 
t
(1 + .08)19

19  60  1000
After: PD =    + = 768.31
t =1 (1 + .085) 
t
(1 + .085)19

So, percentage change:

Bond D: (768.31 - 807.93) / (807.93) = -4.90%

16
 Measures of Bond Price Volatility
Duration Concept by
• The Macaulay duration is one measure of the approximate change in
price for a small change in yield.
• It is the weighted maturity average of the payment dates, using the
present value of the relative cash payments as the weights.

Proportion ate Change in Bond Price

Maculay' s Duration  
Proportion ate Change in (1  r)

ΔP/P Proportionate change in bond price

D Mac  
Δ(1  r)/(1  r) Proportionate change in (1+r)

P = Bond Price, R = Redemption Yield

17
Why is Duration Important?

• Macaulay Duration measures how long it takes, in years,

for an investor to be repaid the bond’s price by the bond’s
total cash flows
• Duration application
- Allows comparison of effective lives of bonds that differ in maturity,
coupon
- Used in bond management strategies particularly immunization.
- Measures bond price sensitivity to interest rate movements, which is
very important in any bond analysis

18
Measuring Duration (Macaulay, Modified, Dollar)
Macaulay duration is a weighted average of the cash flows for the bond
PVCFt  n
Wt  ; D Mac   Wt  t where PVCFt   CFt /(1  r) t
P t -1

n
PVCFt   t
D Mac  CFt = Cash Flow at period t (Coupon & Principal)
t 1 P P = Bond Price; t = period

Example: A bond has 2 years maturity pays a $6 coupon semi annually. The yield
curve is flat at an semi annual interest rate of 10%p.a.
 6 6 6 106 
P 1
 2
 3
 4
 (1.05) (1.05) (1.05) (1.05) 
 $5.71 $5.44  $5.18  $87.21  $103.54
4
PV(CFt)  t  5.71x1 5.44x2 5.18x3 87.21x4 
 D Mac  -    
t 1 P 103.54 103.54 103.54 103.54 
 0.055  0.105  0.15  3.369  3.68 years (semi annual)
Annual DMac = Semi DMac /2 = -3.68/2 = -1.84 years 19
Example: Macaulay Duration Calculation

Consider a 5 year, 12% annual payment bond having a face value of

$1,000. Suppose that the bond is priced at a premium to yield 10% (p.a.).
The price of the bond is $1,075.82 and the Macaulay duration is 4.074:
Year Cash Flow (CF) PV at 10% PV/Price (PV/Price) x t

1 120 109.09 0.1014 0.1014

 PVCFt  
5 2 120 99.17 0.0922 0.1844
D Mac    t 3 120 90.16 0.0838 0.2514
t 1  P 
4 120 81.96 0.0762 0.3047
5 1120 695.43 0.6464 3.2321
$1075.82 1.0000 4.074 yrs

or:
  (109.09)     99.17     90.16  
DMAC     x1    1,075.82  x2    1,075.82  x3 
 1,075.82        
  81.96     695.43  
    x 4    1,075.82  x5   4.0740
 1,075.82     

20
Macaulay Duration Calculation – A simplified Equation

n
PVCFt   t  (1  r) 1  r  [n(c - r)] 
D Mac  can be simplified to D MAC   
t 1 P  r c [(1  r) n - 1] r 
c = coupon; r = yield to maturity; N = no. of period
Example: Consider a 2-year coupon bond with a face and redemption value of
$100 and a coupon rate of 10% p.a. payable semiannually and a yield to maturity
of 12% p.a compounded semiannually. Find the Macaulay Duration.
c=5%; r=6%; N=4

 (1  0.06) 1  0.06  [4(0.05 - 0.06)] 

D MAC    
 0.06 0.05 [(1  0. 06 ) 4
- 1] 0.06 
 1.02 
 17.667 -  
 0.05(0.262 5 - 1)  0.05 
 17.667 - 13.9535  3.7132

21
Other Duration Formulas

1. Annuity cashflow:
DMac = ((1+r)/r) - N/((1+r)N -1)

2. Perpetuity cashflow:
DMac = (1+r)/r
DMod = (1/r)

Remember: P = C/(1+r)1 + C/(1+r)2 + C/(1+r)3 + … + C/(1+r)T + …. = C/r

22
Uses of Duration

1. Immunization strategies:
- If you equate the duration of an asset (bond) with
the duration of a liability, you will (subject to some
limitations) immunize your investment portfolio from
interest rate risk.
2. Used in predicting (or estimating) bond prices given a
change in interest rates (yields)

23
Duration Application - Estimating Price Changes
ΔP/P
D Mac  ; ΔP/P  - D Mac Δ(1  r)/(1  r)
Δ(1  r)/(1  r)
Δr
DP = Change in Bond Price   ΔP  -DMAC  P
(1  r)
Duration is positively related to maturity and negatively related to coupon.
Changes on Bond price are also directly related to duration.
 As a result the % Change in the Bonds Price Is Proportional to Its
Duration

24
Duration Application - Estimating Price Changes
Use of Duration to predict prices changes when yield changes
Example – % Change in Price (using Duration rule)
We have a 15 year bond with 8%p.a. annual coupon offering at
$84.63 to yield 10%. If Duration (DMac) = 8.45 years, we can infer what
is the impact on the bond price for a small changes on the yield.
So let yield increase to 10.10%  change in yield is 0.1%

- ΔP/P
D Mac   ΔP/P  - D Mac  Δ(r)/(1  r)
Δ(1  r)/(1  r)
(0.1%)
ΔP/P  8.45   0.00768
(1  10%)
ΔP/P  - 0.768% % Change due to a change in yield of 0.1%

ΔP  -0.768% x $84.63 -$0.650 Price change due to a change in yield of 0.1%

25
Macaulay’s Duration - Example
A 5 year bond paying a semi annual coupon of 10%p.a. with a price of
$1000 and a YTM of 10%p.a.

n
PVCFt   t
D Mac 
t 1 P

What does this duration value mean?

26
Macaulay’s Duration - Example
A 5 year bond paying a semi annual coupon of 10%p.a. with a price of
$1000 and a YTM of 10%p.a.

DMac = 8107.82/1000 = 8.107 (this is semi annual)  (1  r) 1  r  [N(c - r)] 

DMAC   
 r c [(1  r) N - 1] r 
DMac (annual) = DMac (semiannual) /2 = 4.05 years.
This duration value means if the bond was sold at 4.05 years the investor
will get their money back in PV terms i.e. $1000
27
Macaulay’s Duration
• Duration depends on three factors
- Maturity of the bond
- Coupon payments
- Yield to maturity

28
Properties of Duration - Maturity

• Duration increases with time to maturity but at a decreasing rate

- For coupon paying bonds, duration is always less than maturity
- For zero coupon-bonds, duration equals time to maturity

Duration
(as a function of the bond maturity)

10

9
8

7
Duration

5
4

2
1

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Maturity

29
Properties of Duration - Coupon

• Duration increases with lower coupons (all others being

equal)
Duration
(as a function of the coupon rate)

20

18

16

14
Duration

12

10

0
1% 3% 5% 7% 9% 11% 13% 15% 17% 19%

Coupon Rate

30
Properties of Duration - YTM

• Duration increases with lower yield to maturity (all others

being equal)

Duration
(as a function of the yield)

16

14

12

10
Duration

0
1% 3% 5% 7% 9% 11% 13% 15% 17% 19%

Yield

31
Modified Duration

Modified duration (DMod ) is a formula that expresses the

change in the value of a bond in response to a % change in
interest rates. Calculated as:
D Mac
D Mod 
1  r/n 
- DMac= Maculay Duration
- r = redemption or the yield to maturity (YTM)
- n = number of coupon payment per year

32
Modified Duration
If a bond pays annual coupons (once per year)  n = 1
Then Modified Duration, DMod :
D Mac ΔP/P
D Mod  Remember : D Mac  
1  r/1 Δ(1  r)/(1  r)

 ΔP/P  1 ΔP/P ΔP/P

D Mod     
 Δ(1  r)/(1  r)  1  r Δ(1  r) Δr

Note: D(1+r) = 1+r – (1+r’) = r-r’ = Dr

So Modified Duration (DMod) is the price duration of a bond that shows the
% change in the bond price resulting from a % change in the redemption
yield. To get the % change in bond price, the % change must be
multiplied by the original bond price.
33
Example - Modified Duration
10 year semi-annual bond, YTM 10%p.a., DMac is 4.055

DMod  DMac / 1  r/n   4.055/(1  (10%/2))  3.86

This shows that for every 1% movement in interest rates, the bond is this
example would inversely move in price by 3.86%.

The modified duration (DMod) can be used to estimate the % bond price
change (DP/P) as interest rates change
ΔP
% ΔBond Price   D Mod  Δr
P

Example: If the annual interest rates increases from 10% to 10.2% (0.2%
increase) then we can estimate the bond price by usind Dmod.
-3.86*0.2 = -0.772%

34
Using Modified Duration to calculate PV01
• Consider a five-year, 12% annual coupon bond with a YTM of 10%
trading at 107.582:
- Macaulay D = 4.074
- Modified D = 3.704 [= 4.074 /(1+0.1)]
This means that an increase in yields of 1% or 100 bp will change the
bond’s price by approximately 3.704% in opposite direction

ΔP  DMod  Δr  P

- For 1 bp change i.e DP =

- PV01 = (DMod)(Dr)(P) = (3.704)(0.01%)(107.582) = $0.0398
This means that a 1 bp change in yields will cause the bond’s price to
move by about $0.0398 (around ~4 cents) per $100 of par value (which
would correspond to a 40 cent movement for a bond with a par value of
$1000)

35
Dollar ($) Duration
• The Dollar duration ($D) is defined as the product of the
Modified Duration and the bond price (value). It gives the
variation in a bond's dollar value for a small variation in the
yield.
$ D  D Mod x Bond Price D 
ΔP/P
Mod
Δr
ΔP/P ΔP
$D- xP-
Dr Dr

Example : Suppose a bond has a dollar duration ($D) of $100,000.

How much will its value change if rates fall by 10bp or 0.1%?
D in Bond Value =DP = -$D x Dr = -$100,000 x (-0.1%) = $100
 A 10bp rate change causes $100 price change.

36
Calculating Duration in a Bond Portfolio
The duration of a portfolio is simply the weighted average
duration of the bonds in the portfolios. Portfolio duration is
simply the weighted duration of all the bonds in the portfolio:
N
Portfolio Duration   w j x Duration j
j1

j is the jth bond in the portfolio.

Wj is the percentage weight of jth bond in the portfolio.
N is the number of bond in the portfolio.

37
Portfolio Duration
Consider the following portfolio of semiannual payment bonds.
Face Value Coupon Maturity Yield (s.a.) Market Value Annual Duration
$50 Million 8% 12 yrs 9.62% $44,306,787 7.652
$25 Million 11% 8 yrs 9.38% $27,243,887 5.633
$25 Million 9% 6 yrs 9.10% $24,886,343 4.761
$96,437,017

The weighted duration of the portfolio can be estimated as:

 44,306,787   27,243,887   24,886,343 
 7.652 x    5.633 x    4.761 x 
 96,437,017   96,437,017   96,437,017 

= 6.336

38
Portfolio Duration
Question : What is the duration of a portfolio consisting of 75%
of 1.5 year zero coupon bond and 25% of 30 year zero coupon
bond?
Answer :
The Duration (DMac) of the 1.5 year zero coupon bond is 1.5
and the Duration (DMac) of the 30 year zero coupon bond is 30.
 Portfolio Duration (DMac) = (75% x 1.5) + (25% x 30) = 8.625

39
Portfolio Duration - Example

Portfolio
(Annual) Contribution to
Holdings Weight
Duration Portfolio Duration

Bond 1 0% 4.95 0
Bond 2 12.1% 3.44 0.42
Bond 3 44.9% 3.58 1.61
Bond 4 13.9% 5.04 0.7
Bond 5 1.7% 3.16 0.05
Bond 6 27.4% 6.35 1.74
Total 100% 4.52

40
Duration Conclusions

Duration is a gauge of a bond's basic price volatility.

Macaulay duration (DMac) is the weighted term to maturity
expressed in years where the weights are the present values of
the cash flows occurring in those years.
Modified duration measures bond price volatility and provides an
estimate of the rate of change in bond price due to a change in
yield. As such, modified duration measures a bond's sensitivity to
interest rate changes and its exposure to interest rate risk.

• To obtain maximum price volatility, investors should choose

bonds with the longest duration
• Duration measures volatility which isn’t the only aspect of
risk in bonds

41
Problems with Duration
• It assumes a straight line relationship between the changes in bond
price given the change in yield to maturity…however, the actual
relationship is curvilinear…therefore, the greater the change in YTM,
the greater the error in predicted bond price using duration…as can be
seen…
Error from
Bond using duration Current bond
Price only price
Bond Price
Price estimate is good estimated by
$1,200 when yield change is duration
small
$1,100
Actual
$1,000 Bond Price

$900 D

Y
Yield to Maturity (%)

Y*

42
Problems with Duration
Duration is a conservatively biased estimate of actual price changes from
the perspective of the asset-holder.
Duration underestimates price increases when rates fall and
overestimates price reductions when rates rise.
The reason for the bias is the of the price-yield curve for a fixed
income instrument that contains no embedded put or call options. The bias
is greater, the greater is the change in yield. For small rate changes,
duration can be a very accurate predictor of the price change.
Price
Underestimate of Price Increase
When the Yield Falls

Overestimate of Price Decrease

When the Yield Rises
Convex Price-Yield
Curve
Yield

43
Convexity
The relationship between bond prices and market yields is CONVEX.

250.0

200.0
Bond Price ($)

150.0
Convex (to
the origin).
100.0

50.0

0.0
0% 5% 10% 15% 20%

Yield

Convexity means that as the YTM falls from 10% the rate of increase in
the bond price accelerates.

44
Convexity
•

45
Convexity
• Bond Convexity is a direct measure of the duration sensitivity of a bond
when its interest rate is changing. As bond yields go higher, price goes
lower. This relationship between price and yield has a convex structure
in nature. The term used to describe this relationship is also known as
convexity. 2
1 d (P)
Conv 
P dr 2
• Mathematically, convexity is the rate of change of duration. The degree
to which the graph is curved shows how much a bond's yield changes
in response to a change in price. Convexity is such measure to
compare bonds.
n
Ct  t(t  1)/(1  r) t 1 n
Ct  t(t  1)
Conv    
t 1 P(1  r) 2
P(1  r) 2
t 1 (1  r) t

Ct: Coupon; r = yield; t = nth coupon period; P=bond price

46
Calculating a bond’s convexity

Example: A 6% annual payment bond matures on 14 February 2022 and

is purchased for settlement on 11 April 2014. The YTM is 4%. Calculate
the bond’s convexity (actual/actual convention):

Period Time to CF PV of CF t^2+t (t^2+t) × PV of CF

Receipt
1 0.8466 6 5.80 1.56 9.07
2 1.8466 6 5.58 5.26 29.34
3 2.8466 6 5.37 10.95 58.76
4 3.8466 6 5.16 18.64 96.19
5 4.8466 6 4.96 28.34 140.58
6 5.8466 106 84.28 40.03 3373.63
111.15 3707.57
Conv = 1/(1 + 0.04)^2 × 3707.57/111.15 = 30.84

47
Calculating a bond’s convexity – another example

Example: 5 years 8% coupon (semi annual) bond with yield of 10%,

P=92.27826. Ct=4, r=5%, t=10
Conv = 7965.4/[(1.05)2 x 92.27826]
n
 Ct  t(t  1) 
  (1  r) t

= 78.294 half years
Conv  t 1 
1
(1  r) t
P(1  r) 2
or = 78.294/4 = 19.58 years

In general, if the cash flows

occur m times per year,
convexity is adjusted to an
annual figure as follows:

convexity measure in year 

convexity measure in m period per year
m2

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Dollar Convexity
• The Dollar Convexity ($Conv) is convexity multiplied by the
price (value). Dollar convexity is one source of error in
approximating the dollar price of a bond generated by
change in yield using dollar duration alone.
$ Conv  Conv x Bond Price

2 x Δ in bond dollar val ue 2 x ΔP

$ Conv  
Δ in interest rate 2
Δr 2

49
Convexity

• Duration measures are only approximations for small

changes in yield, they do not capture the effect of the
convexity of a bond on its price performance when yields
change by more than a small amount (see diagram on the
next slide).
• The duration measure can be supplemented with an
additional measure to capture the curvature or convexity
of a bond.
• The tangent shows the rate of change of price with
respect to a change in interest rates at that point (yield
level) – Duration concept.

50
Price Estimation - Convexity and Duration
Estimating Price Change Using Duration and Convexity Measures
Using duration and convexity measures together gives a better
approximation of the actual price change for a large movement in the
required yield.

% DP (Change in Price) =
Price
Underestimate of Price Increase
When the Yield Falls % DP Change in Price due to Duration Adjustment term

Overestimate of Price Decrease

+
When the Yield Rises
Convex Price-Yield % Change in Price due to Convexity
Curve
Yield

% Change in Price due to Convexity = 1/2 x Conv x (% Yield Change)2

% Change in Price due to Duration = DMac / (1 + r) x % Yield Change

51
Price Estimation - Convexity and Duration
Example
8%, 15 years bond with yield = 10%
DMac = 8.4495; P = 84.6275; Convexity = 94.36
If yield rises to 13% (from 10%)
% Change in Price due to Duration
ΔP/P  - D Mac Δ(1  r)/(1  r)
 [-8.4495/(1  0.1/2)]  0.03  - 24.1%
% Change in Price due to Convexity =
1/2 x Conv x (% Dr)2 =
1/2 x 94.36 x (0.03)2 = 4.25%

Total % Change = -24.1% + 4.25% = -19.85%

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Convexity and Duration for Price Estimation
Exercise
Suppose 5%, 20 years bond with yield = 9%.
Duration (DMac) = 10.87; Convexity (Conv) = 170.22
If yield changes from 9% to 11% (2% or 200 basis point
increase).
Estimate the change in bond price?

% Change in Price =
% Change in Price due to Duration
+
% Change in Price due to Convexity
53
Convexity and Duration for Price Estimation

% Change in Price due to Duration :

ΔP/P  - D Mac Δ(1  r)/(1  r)
 [-10.87/(1  0.9/2)]  0.02
 - 20.8%
% Change in Price due to Convexity
DP/P = 0.5 x Conv x (%Dr)2
= 0.5 x 170.22 x (0.02)2 = 3.4044%

Total % Change = -20.8% + 3.4% = -17.4%.

54
Convexity

Value of Convexity
• The two bonds have the same duration and are offering
the same yield; they have different convexities, however,
Bond B is more convex (bowed) than bond A.

55
Convexity
Coupon Time to Maturity YTM Duration
Bond A 15% 3 10% 3.154
Bond B 13.78% 3.89 10% 3.154

If YTM increases from Y*, the

price of A falls less in % terms
than that of B. If yield falls then the
gain made on bond A is larger.

Two bonds have the same yield but one exhibits greater convexity,
changes in interest rates will affect each bond differently.
56
Observations:
• A bond with greater convexity is less affected by an
increase in interest rates than a bond with less convexity.

• A bond with greater convexity will have a higher price

than a bond with lower convexity, regardless of whether
interest rates rise or fall.

57
Convexity

Value of Convexity
• The market considers a bond’s convexity
• If investors expect that market yields will change by
very little, investors should not be willing to pay much
for convexity.
• If the market prices convexity high, investors with
expectations of low interest rate volatility will probably
want to “sell convexity.”

58
Properties of Convexity

All option-free bonds have the following convexity properties:

 A bond with greater convexity will have a higher price than a
bond with lower convexity, regardless of whether interest rates
rise or fall.
 Convexity is (in general) inversely related to coupon i.e the
curvature is flatter for higher coupon bonds.
 Convexity is positively related to time to maturity and duration.
 Convexity is inversely related to YTM. As the yield increases, the
convexity falls i.e. the curve becomes flatter.

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Portfolio Convexity

The duration of a portfolio is simply the weighted average

duration of the bonds in the portfolios. Portfolio convexity is
simply the weighted convexity of all the bonds in the portfolio:
N
Portfolio Convexity   w j x Conv j
j1

j is the jth bond in the portfolio.

Wj is the percentage weight of jth bond in the portfolio.
N is the number of bond in the portfolio.

• Portfolio dollar convexity is simply the weighted dollar

convexity of all the bonds in the portfolio:

60
Portfolio Convexity

Example : Consider a portfolio consisting of $25,174 par value

of 10 year zero coupon bond; $91,898 par value of 30 year
zero coupon bond

Portfolio $ Convexity = ($25,174 x 54.7987 + $91,898 x

129.8015) = $13,307,997.

61
Summary
Duration and convexity are measures of sensitivity of a bond
price to changes in yield.
Duration is the first derivative and convexity is the second
derivative
Convexity is the rate of change of duration with changes in
yield.
Convexity is ‘correction’ to duration
Both Duration and Convexity has the same relationship:
directly related to time to maturity,
inversely related to coupon size and
inversely related to YTM.

62
Summary
Used as a risk measure for interest rate sensitivity
Determine hedging of interest rate risk (immunization)
There are several different definitions of duration:
• Macaulay duration (DMac) and modified duration (DMod)
• Differ by factor of (1+yield)
Zero-coupon long-dated bonds have the highest duration.

63