Fixed-Income Securities

Bond Pricing Under Continuous Compounding

Duration as a measure of bond price volatility is valid under
very restrictive set of assumptions. First, as there is only
one interest rate, it obviously assumes flat yield curve. This
is inconsistent with the fact that long term interest rates are
generally higher than the short term interest rates. Secondly,
it assumes that the yield curve shifts in a parallel way (this
implies that the short term rates move in the same direction
and with the same magnitude as the long term rates). This
is also inconsistent with the general pattern of the yield
curve change. Thirdly, duration measure assumes that the
shifts in the yield curve is of infinitesimally small
magnitude, which is unlikely to be true as interest rates do
change in large amount.
Therefore, a more generalized model is required that
considers non-infinitesimal and non-parallel shifts in the
non-flat yield curve.
The Continuously Compounding Spot Yield C
To derive a more generalized duration model, first a
continuously compounding non-flat spot yield curve have
to be defined. The following expression shows the
continuously compounding non-flat spot yield curve:
r(t) = A0 + A1* t + A2* t2 + A3* t3 + ……
The constants A0, A1, A2, …. are defined as:
A0 = height parameter
A1 = slope parameter
A2 = curvature parameter and
A3, A4, …..= other yield curve shape parameters
The above equation defines the continuously compounded
spot yield curve as a polynomial function of the term to
maturity t. If the spot yield curve is sufficiently smooth,
then any shape of the yield curve can be approximated very
The Continuously Compounding Spot Yield C
Bond Pricing Using Continuously Compounding Spot
Rates – Example-2 xls
The Duration Vector Model (DVM) measures the
price volatility or interest rate risk of bonds under non-
infinitesimal and non-parallel shifts in non-flat yield
curve. This is, in fact, a modification of the Macaulay
duration model. Under the duration vector model, the
riskiness of bonds is captured by a vector of risk
measures, given as D(1), D(2), D(3), etc. Usually, the first
two to five duration vector measures are adequate to
capture all of the interest rate risk inherent in default-free
bonds and bond portfolios.
The initial continuously compounding non-flat spot yield
curve is represented by r(t) and after the non-infinitesimal
and non-parallel shift in non-flat yield curve, the new
curve is denoted by r′( t).
The Continuously Compounding Spot Yield C
The new continuously compounding non-flat spot yield
curve can be expressed as r՜(t) = (A0+∆A0) + (A1+∆A1)*t
+ (A2+∆A2)*t2 + (A3+∆A3)*t3 + ……
The change in non-flat spot yield curve ∆r(t) = r՜(t) - r(t)
= ∆A0 + ∆A1* t + ∆A2* t2 + ∆A3* t3 + ……
Therefore, if the price as per the initial spot yield curve is
B0 and after the non-infinitesimal and non-parallel shift in
non-flat yield curve is B՜0 then ∆B = B՜0 - B0
By substituting the values of r՜(t) and r(t) in the above
equation and considering the expression of e x = 1 + x/1! +
x2/2! + x3/3! + ….
The duration vector model is ∆B/B0= – D(1)*∆A0 –
D(2)*[∆A1- (∆A0)2/2!] – D(3)*[∆A2 – ∆A0*∆A1–
(∆A0 )3/3!] – …..
The Continuously Compounding Spot Yield C
The duration vector model provides one of the most
important conceptual frameworks for analyzing and
understanding the interest rate risk characteristics of fixed
income securities. This model also presents very
insightful approach in understanding issues such as
►impact of changes in interest rates by the central bank
►the different aspects of bond convexity
►the trading strategies of bond portfolio managers when
short-term rates move in the opposite direction to the
long-term rates.
►the hedging or immunization strategies of pension
funds and insurance companies etc.
The Continuously Compounding Spot Yield C
Computation of Duration Vectors Example 3 xls
Computation of New Parameters Example 4 xls
Bond Pricing Using New Parameters Example 5 xls
Macaulay Duration under Continuously
Compounding Spot Yield Curve
Macaulay duration model assumes an infinitesimal
parallel shift in a flat yield curve. The flat yield curve
assumption can be corrected by assuming a continuously
compounded non-flat spot yield curve. Under this
assumption, the Macaulay duration will be equal to D(1)
in the previous model and is equal to 4.146 as determined
in the example 3. However, the assumptions
infinitesimal and parallel shift in a flat yield curve can
not be corrected. Under these assumptions, the percentage
price change as per Macaulay duration model = ∆B/B0 = -
D(1)* ∆A0
The Continuously Compounding Spot Yield C
Since the model assumes parallel shift, the change in
slope, curvature, and other higher order shape parameters
will be equal to zero. The only non-zero term is the
infinitesimal parallel shift in A0 which is represented by
∆A0. Therefore, the percentage price change as per the
model for example 4=- 4.146*.005 = -0.02073 or -2.073%
As the above model does not consider slope shift, it gives
the wrong estimate of percentage price change, which is
negative 2.073%. Whereas, the duration vector model
provides almost the correct percentage price change of
positive 1.771% only a deviation of .02% from the actual
percentage price change.