6.

Duration and convexity

1. Duration as an elasticity
2. Duration as a measure of time
3. Modified duration
4. Convexity

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Duration as an elasticity
o Duration measures interest rate risk better than maturity
• 10 year Treasury definitely has more interest rate risk than a 1
month T-bill
• BUT 10 year Treasury has more interest rate risk than a 10 year
mortgage
• Mortgages are fully amortizing so investors receive most principal before
T
o Duration is mainly first derivative of bond price
function with respect to discount rate
• Elasticity = [ % ΔP ] / [ % ΔR ]
• Note ΔR is change in discount factor (e.g.,1.04)

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Maturity to proxy elasticity
o After high inflation of 1970s regulators required banks
to report the maturity profile of their loans
oMaturity buckets for less than 1 year, 1-3, 3-5, 5-10, 10
and over
• Banks with high fraction of assets in high maturity buckets
pressured to reduce exposure to rate changes
o What if all the 10 year loans are floating rate?
o What if all the 10 year loans are fully amortizing and the
5 year loans are zeroes?

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Duration and time
o Duration is the weighted average of the times that cash
flows arrive to the investor
• Zero coupon bond has duration equal to T
• Most debt has cash flows before T
• Weighted average includes times before T so weight on T less than 100%
• Duration is usually less than T
o Weight = fraction of total present value of cash flow
(bond price) arriving at period t

o D = Snt=1[Ct• t/(1+r)t]/ Snt=1 [Ct/(1+r)t]

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Duration
D = Snt=1[Ct• t/(1+r)t]/ Snt=1 [Ct/(1+r)t]

Where
D = duration
t = time period that has a cash flow
Ct = cash flow to be delivered in t periods
n= term-to-maturity & r = yield to maturity
Duration
Or, to rewrite it
D = Snt=1[PV(Ct)• t]/ Bond price

Or,
D = Snt=1[PV(Ct)/Bond price] • t

D = Snt=1wt• t

If calculate wt can check that weights sum to 1

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Duration example
Calculate D of a 1-year 10% semi-annual coupon bond when
YTM=10%:

P = 5 + (100 + 5) = 100
(1.05) (1.05)2

PV of CF1 = $4.76 PV of CF2 =$95.24

Weights = .0476 and .9524

D = (.0476*.5) + (.9524 * 1) = .9762

Factors affecting duration
 Duration decreases whenever cash flows come early:
 Shorter maturity
 Higher coupon
 Amortization of principal
 Duration decreases as interest rates rise
 Higher discount factor means late cash flows don’t count
as much
 When interest rates are zero last cash flow has highest
possible weight
 Bank regulators rely less on maturity buckets and more
on duration of portfolio
Modified duration
o Duration is elasticity = -[ % ΔP ] / [ % ΔR ]
• Much more interested in ΔR than % ΔR
• What happens when Fed raises rates by 25 bp? (assume all rates
go up 25 bp)
• Not, what happens when rates go up 100% (from 25 bp to 50 bp
or 100 bp to 200 bp)?
• More useful to work with modified duration (MD) than D
o Modified duration = D/(1+r)
if bond has annual coupons (almost never)
oModified duration = D/(1+.5r)
if bond has semi-annual coupons (almost always)

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Modified duration
o Use MD to get to % ΔP faster than with D

oD = -[ % ΔP ] / [ % ΔR ]
• Rewrite when looking for % ΔP
• % ΔP = -D * % ΔR
• % ΔP = -MD * ΔR

oΔR is often same as Fed Funds rate change

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Modified duration example
o Suppose a bond has MD of 8
• What happens when Fed raises rates by 25 bp? (assume all rates
go up 25 bp)
• % ΔP = MD * ΔR
• % ΔP = 8 years* ΔR
• % ΔP = 8 years* 25 bp/year
• % ΔP = 200 bp
• % ΔP = 2%
• I.e., a par bond will start trading at 98
• A portfolio of $200m with MD=8 will lose $4 m. if rates rise 25
bp (new value = $196 m.)
• A bank with a MD on loans of 8 will lose more money on its
investments than one a loan MD of 4
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Modified duration
o Duration and modified duration approximate the price
change ( D = [ % ΔP ] / [ % ΔR ] )
• First derivative of bond price function:
• Linear approximation of nonlinear function
• Works well for small changes
• Makes some assumptions about rate changes along entire
yield curve – only first derivative in some circumstances that
may not be realistic

o Better measure of price change if use second derivative

too (Taylor series)

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Convexity
oConvexity adds in second derivative effect
• CX factor is always positive
• Price estimated using duration or MD is
always too low
• First derivative is tangent line (slope =-MD)
• The tangent line only equals curve at one spot
and is off at all others
• Off more if function is curvier
• Two bonds with same MD can have different CX factors –
one is more sensitive to rate changes.

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Convexity

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