FIN4002

Fixed Income Securities

Part Two: Bond Mathematics

Topic 3: Bond Volatility

1
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

2
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.

Price

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

3
Price-Yield Relationship for a 20-Year 9%
Coupon Bond
20 year 9% semi annual coupon Bond Bond Price / Yield Relationshio
Required Yield PV of 40 coupons PV of Principal Bond Price
Convex (to
5.00 112.16 37.69 149.85 160.00
the origin).
6.00 103.23 31.18 134.41 140.00
See later

7.00 95.35 25.84 121.19

120.00
8.00 88.36 21.45 109.82

Bond Price
100.00
9.00 82.16 17.84 100.00
10.00 76.62 14.86 91.49 80.00

11.00 71.67 12.40 84.07 60.00

12.00 67.22 10.37 77.59 40.00
13.00 63.22 8.68 71.90 0.00 3.00 6.00 9.00 12.00 15.00
14.00 59.61 7.28 66.88 Required Yield
* Principal = $100

4
Bond Price in a Time Path
20 year 9% semi annual coupon Bond at r = 12% Time Path of a Bond
Years Left PV of 40 coupons PV of Principal Bond Price
20.00 67.22 10.37 77.59
19.00 66.29 11.61 77.90
18.00 65.25 13.00 78.25 Time
Years Leftto Ma
17.00 64.08 14.56 78.64 turity
16.00 62.77 16.31 79.08
15.00 61.30 18.27 79.57
20 15 10 5 0
14.00 59.65 20.46 80.12
105
13.00 57.81 22.92 80.73
12.00 55.75 25.67 81.42 100
11.00 53.44 28.75 82.19 95
10.00 50.85 32.20 83.05
9.00 47.95 36.06 84.02 90
8.00 44.71 40.39 85.10 85
7.00 41.07 45.23 86.31

P
r e
ic
6.00 37.00 50.66 87.67 80
5.00 32.44 56.74 89.19 75
4.00 27.34 63.55 90.89
3.00 21.62 71.18 92.79 70
2.00 15.21 79.72 94.93 65
1.00 8.04 89.29 97.32
60
0.00 0.00 100.00 100.00 Bond Price

5
Bond Price – Time Path to Maturity

Price PAR

Time
6
Bond Price – 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

7
Bond Price - Volatility

Price Volatility is the amount of change in bond price.

- Measuring the effects of interest rate changes on bond
prices is complex.
- This is because the change in bond price in response to a
change in interest rates depends on the interaction between
time to maturity and coupon size.
size

8
 Bond Value - Different Coupon with Fixed Maturity
Bond Value

High Coupon Bond

Low Coupon Bond

Market Interest Rate

9
Bond Price Volatility – Maturity Effect

10
Bond Price Volatility - Summary

11
YTM and Coupon
• Example: A US government bond has semi annual coupon of
• 6 3/8%p.a. maturing in December 2009. Today is 1 Jan 2002.
- The Par Value of the bond is $1,000.
- Coupon payments are made semi-annually (in June 30 and
December 31 cycle).
Since the coupon rate is 6 3/8%pa the payment is $31.875.
- On January 1, 2002 the size and timing of cash flows are:
0 $31.875 $31.875 $31.875 $1031.875

1/1/02 6/30/02 12/30/02 6/30/09 12/31/09

12
YTM and Coupon
$1400

1300

1200
Bond Value

1100 When the YTM = coupon (6 3/8%),

the bond trades at par.

1000

800
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
6 3/8
Interest Rate

13
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.

14
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.

15
Measuring Bond Price Volatility

• Common measures:
- price value of a basis point (PV01)
- Duration

16
Measures of Bond Price Volatility
Price Value of a Basis Point – PV01 (more in later topics)

17
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:

PA = (80/10%)[1 – 1/(1.1)5] + 100/(1.1)5 = 924.18

PB = (50/8%)[1 – 1/(1.08)20] + 100/(1.08)20 = 705.46

PC = (80/8%)[1 – 1/(1.08)20] + 100/(1.08)20 = 1000.00

18
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:

PA = (80/10.01%)[1 – 1/(1.1001)5] + 100/(1.1001)5 = PV01 = 0.355

923.825
PB = (50/8.01%)[1 – 1/(1.0801)20] + 100/(1.0801)20 = PV01 = 0.766
704.694
PC = (80/8.01%)[1 – 1/(1.0801)20] + 100/(1.0801)20 = PV01 = 0.981
999.019

19
Bond Price Volatility Example

PA = (80/10.5%)[1 – 1/(1.105)5] + 100/(1.105)5 = 906.43

PB = (50/8.5%)[1 – 1/(1.085)20] + 100/(1.085)20 = 668.78

PC = (80/8.5%)[1 – 1/(1.085)20] + 100/(1.085)20 = 952.68

20
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%.)
Recall -

Initial:
After: PD = (60/8%)[1 – 1/(1.08)19] + 100/(1.08)19 = 807.93
PD = (60/8.5%)[1 – 1/(1.085)19] + 100/(1.085)19 = 768.31
So, percentage change:
Bond D: (768.31 - 807.93) / (807.93) = -4.90% (volatility risk is between B &
C).
How do you observe this from coupon & maturity relationship especially comparing
Bond C and Bond D?

21
Measures of Bond Price Volatility
Two definitions of Duration Concept:
Definition1 : The Macaulay duration is one measure of the approximate change in price for a small
change in yield.

Proportionate Change in Bond Price

Maculay's Duration  
Proportionate Change in (1  r)
ΔP/P
Definition2 D
: ItMac  weighted maturity average%ofchange
is the in bond price
the payment dates, using the present value of the
relative cash paymentsΔ(1 asr)/(1
the  r) .
weights % change in (1+r)
P = Bond Price, R = Redemption Yield

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

22
Why is Duration Important?

23
Measuring Duration (Macaulay, Modified, Dollar)
Macaulay duration is a weighted average of the cash flows for the bond
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

24
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:
5
 PV CFt  
D Mac     t
t 1  P 

  (109.09)    99.17     90.16  

D MAC   1,075.82 x1   1,075.82 x2    1,075.82 x3
         

  81.96     695.43  
    x 4    1,075.82  x5   4.0740
 1,075.82     

25
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    4 
 0.06 0.05 [(1  0 . 06) - 1] 0.06 
 1.02 
 17.667 -  
 0.05(0.2625 - 1)  0.05 
 17.667 - 13.9535  3.7132

26
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

27
Uses of Duration

1. Immunization strategies: (Topic 10)

- 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)

28
Duration Application - Estimating Price Changes
ΔP/P
D Mac   ; ΔP/P  - D Mac Δ(1  r)/(1  r)
Δ(1  r)/(1  r)
Δr
P = Change in Bond Price   ΔP  -D MAC  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

29
Duration Application - Estimating Price Changes

- 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%

30
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?

31
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%
Time Cashflow PV Factor PV PV x t
1 1/(1 + 10%/2) = 0.952
2 1/(1 + 10%/2)2 = 0.907

3 1/(1 + 10%/2)3 = 0.864

4
5
6
7
8
9
10
Total

32
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.

 (1  r) 1  r  [N(c - r)] 
DMac = 8107.82/1000 = 8.107 (this is semi annual) D MAC   
 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
33
Macaulay’s Duration
• Duration depends on three factors
- Maturity of the bond
- Coupon payments
- Yield to maturity

34
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

8
D u r a tio n

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

Maturity

35
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
D u r a tio n

12

10

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

Coupon Rate

36
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
D u r a t io n

10

Yield

37
Modified Duration

D Mac
D Mod 
1  r/n 

38
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

Rearranging the equation Note: (1+r) = 1+r – (1+r’) = r-r’ = r

39
Example - Modified Duration
10 year semi-annual bond, YTM 10%p.a., DMac is 4.055

D Mod  D Mac / 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 (P/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%

40
Using Modified Duration to calculate PV01

Using Dmod equation to estimate P ΔP   D Mod  Δr  P

41
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.

ΔP/P
D Mod  
Δr Or P = -$D x r

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%?
 in Bond Value =P = -$D x r = -$100,000 x (-0.1%) = $100
 A 10bp rate change causes $100 price change.
$ D   D Mod x Bond Price
ΔP/P ΔP
$D- xP-
r r
42
Portfolio Duration
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.

43
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 Bond Price = 88.6%

$25 Million 11% 8 yrs 9.38% $27,243,887 5.633 Bond Price = 108.97%
$25 Million 9% 6 yrs 9.10% $24,886,343 4.761 Bond Price = 99.55%
$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

44
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

45
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

46
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

47
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
Price estimate
$1,200 is good when Bond Price estimated
yield change is by duration
$1,100 small

$1,000
D
P Error from
$900 using duration
only
Y
Yield to Maturity (%)

Y*

48
Problems with Duration

Price
Underestimate of Price Increase
When the Yield Falls

Overestimate of Price Decrease

When the Yield Rises

Convex Price-Yield
Curve
Yield

49
Convexity
The relationship between bond prices and market yields is CONVEX.

250.0

200.0
B o n d P r i c e ($ )

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.

50
Convexity

n
Ct  t(t  1)/(1  r) t 1 n
Ct  t(t  1)
Conv   2
 2  t
t 1 P(1  r) P(1  r) t 1 (1  r)
CFt: Cashflow (including coupon & bond value) ; r = yield; t = nth coupon
period; P=bond price

51
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):
Ct  t(t  1)/(1  r) t
n
1 n
Ct  t(t  1)
Conv    
t 1 P(1  r) 2 P(1  r) 2 t 1 (1  r) t
(t^2+t) × PV of
Period Discount Factor CF PV of CF t^2+t
CF
1 0.96 6 5.769 2 11.538
2 0.92 6 5.547 6 33.284
3 0.89 6 5.334 12 64.008
4 0.85 6 5.129 20 102.577
5 0.82 6 4.932 30 147.947
6 0.79 106 83.773 42 3518.480
　 　 　 110.484 　 3877.834
Conv = 1/(1 + 0.04)^2 × 3877.83/110.48 = 32.45

52
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

1 = 78.294 half years
Conv  t 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

53
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 value 2 x ΔP

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

54
Estimate Bond Price through Duration With
Convexity – adjustment

55
Bond Price Estimation with Duration and
Convexity

P (Change in Price) =

Price
Underestimate of Price Increase
When the Yield Falls P Change in Price due to Duration Adjustment term

Overestimate of Price Decrease +

When the Yield Rises
Convex Price-Yield P Change in Price due to Convexity
Curve
Yield

% P/P due to Duration = DMac / (1 + r) x % Yield Change

% P/P due to Convexity = 1/2 x Conv x (% Yield Change)2

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Bond Price Estimation with Duration and
Convexity
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 (% r)2 =
1/2 x 94.36 x (0.03)2 = 4.25%

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

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Bond Price Estimation with Duration and
Convexity
Another 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
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Bond Price Estimation with Duration and
Convexity
% 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
P/P = 0.5 x Conv x (%r)2
= 0.5 x 170.22 x (0.02)2 = 3.4044%

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

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Convexity

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

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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.
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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.

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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.” 

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Properties of Convexity
All option-free bonds have the following convexity properties:

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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:

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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.

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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.

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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.

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