Duration

Applications

Portfolio
Immunization
Recall: Duration

 Duration is the weighted-average time to

Duration is the weighted-average time to
maturity
maturity (measured
(measured in in years)
years) on
on aa financial
financial
security
security
 Duration measures the sensitivity (or
Duration measures the sensitivity (or
elasticity)
elasticity) of
of aa fixed-income
fixed-income security’s
security’s price
price to
to
small
small interest
interest rate
rate changes
changes
 Duration captures the coupon and maturity
Duration captures the coupon and maturity
effects
effects on
on volatility.
volatility.

Biswas - Money and Capital Markets - Interest rates and Bond Valuation
Recall: Duration and Implied Price Volatility
 Given
Givenan
aninterest
interestrate
ratechange,
change,the
theestimated
estimatedpercentage
percentage
change
changein
ina(n)
a(n)(annual
(annualcoupon
couponpaying)
paying)bond’s
bond’sprice
priceisisgiven
given

[ ]
by
by
Δ𝑃 Δ𝑟
=− D
𝑃 1+𝑟
 where ==interest
where interestrate,
rate,DD==duration,
duration,PP==price
priceof
ofthe
thebond,
bond,
∆P
∆P==(new
(newprice
price––old
oldprice),
price),i.e.,
i.e.,change
changein
inthe
theprice
priceofofthe
the
bond,
bond,ininresponse
responseto tothe
theinterest
interestrate
ratechange
change
The estimated percentage change in price, ∆P/P, is called
The estimated percentage change in price, ∆P/P, is called
the
theImplied
ImpliedPrice
PriceVolatility
VolatilityororIPV.
IPV.
An more commonly used version of this formula is:
An more commonly used version of this formula is:

Biswas - Money and Capital Markets - Interest rates and Bond Valuation
Recall: Interest rate (or price) risk for
1-year and 10-year 10% coupon bonds

Asymmetric Interest Rate Risk:

• Start with 10% yield. Prices of both 1-year and 10-year bonds are
trading at par, as both are 10% coupon bonds
• 5% rise in yield leads to a fall in bond prices
• 5% decline in yield leads to a rise in bond prices, but
asymmetrically (4.8%>4.5%; 38.6%>33.5%)
• The price responses are greater for the 10-year bond
• The asymmetry is greater for the 10-year bond

1-Year 10-Year
rd Price Change Price Change
5.0% $1,048 $1,386
4.8% 38.6%
10.0% $1,000 $1,000
4.5% 33.5%
15.0% $957 $749 4
Recall: Convexity

 Convexity
Convexity (CX)
(CX) isis the
the degree
degree of
of curvature
curvature of
of the
the
price-interest
price-interest rate
rate curve
curve around
around some
some interest
interest rate
rate
level
level
 Convexity
Convexityisisdesirable
desirable
 The
Thegreater
greaterthe
theconvexity
convexityof ofaasecurity
securityor
orportfolio,
portfolio,the
themore
more
insurance or interest rate protection an investor or FI manager
insurance or interest rate protection an investor or FI manager
has
hasagainst
againstrate
rateincreases
increasesandandthe
thegreater
greaterthe
thepotential
potentialgains
gains
after
afterinterest
interestrate
ratefalls
falls
 All
Allfixed-income
fixed-incomesecurities
securitiesare
areconvex
convex
 As
Asinterest
interestrates
rateschange,
change,bond
bondprices
priceschange
changeat
ataanonconstant
nonconstant
rate
rate

Biswas - Money and Capital Markets - Interest rates and Bond Valuation
Recall: Duration Based Prediction
Errors
When we use the Duration-based Implied Price Volatility formula
to capture the price response, we approximate the price
response, along the straight line. When we calculate the actual
price change, we are on the convex, true graph.

Biswas - Money and Capital Markets - Interest

rates and Bond Valuation
Practice Problem: (iii) Duration and Implied
Price Volatility (IPV):
 (i) Calculate the duration of a 2-year, $1,000 bond that
pays an annual coupon of 11 percent and trades at a
yield of 12 percent.
Answer = ?
 (ii) What is the implied price volatility (IPV) of the above
bond if interest rates decline by 0.60 percent or 60 basis
points? Use
Answer = ?
 (iii) What is the actual price volatility (APV) of the above
bond in part (i) if interest rates decline from 12 percent,
by 60 basis points? Use your financial calculator to find the new
price with the lower YTM.
Answer = ?

Biswas - Money and Capital Markets - Interest

rates and Bond Valuation
Duration of a Portfolio of Fixed
Income Securities
 The duration of a portfolio of bonds or any other fixed
income securities is the weighted average of the
individual bonds’ durations.
 For example, if a bond portfolio has 2 bonds, A and B,
each with Duration DA and DB respectively, and the
weight of each bond in the total portfolio is WA and WB,
then the Duration of that portfolio, DPF, will be:
DPF = WADA + WBDB
 Illustrative example: Consider a $200 million portfolio, with $150
million invested in a bond with a duration of 2 years. The rest of the
money is invested in a bond with a duration of 3 years. What is the
duration of this portfolio?
 Answer = ?
Biswas - Money and Capital Markets – Duration
Applications