Tutorial 10

Bonds Valuation:
Duration & Convexity
1) How does duration differ from time to
maturity? What does duration tell you?

– Duration accounts for the entire pattern (both size and

timing) of a bond's cash flows over its life.

– It tells investors (in years) the economic lifetime of a

bond, whereas time to maturity focuses only on the
return of principal at the maturity date.
2) Explain about the 2 components of
interest rate risk.

– Price risk – Changes in interest rate will affect the bond’s price in a
negative way. The higher the interest rate, the lower the bond’s
price.

– Reinvestment rate risk – Changes in interest rate will affect the

bondholder’s future reinvestment income generated from the
coupon received. The higher the interest rate, the higher the
reinvestment income.
3) Explain the concept of immunization.
What role does duration play in this
concept?
– Immunization is the strategy of immunizing (protecting) a portfolio
against interest rate risk. It involves offsetting the two components
of interest rate risk--the price risk and the reinvestment rate risk-
which move in opposite directions.

– Duration is the basis for immunization theory. A portfolio is

immunized if its duration is made equal to a preselected
investment horizon for the portfolio.
4) Assume you have correctly forecast that interest rates will
soon decline sharply. Also assume that you will invest only in
fixed income securities and that your time horizon is one year,
how would you construct a portfolio?

– A sharp decline in interest rates is, of course, the ideal environment for
the bond investor seeking capital gains.
– They should concentrate on low coupon, long maturity bonds, or bonds
with the longest duration. All bonds will perform well in such an
environment, but investors may prefer certain types depending on the
circumstances.
– For example, yield spreads should be considered. The after-tax return of
municipals may be superior. Zero coupons offer maximum volatility. And
so forth.
5) Given a 10 percent, three-year bond with a price
of $1,025.79, where the market yield is 9 percent,
calculate its duration.

– 1. list out the periods involve

– 2. list out the cash flow for each period
– 3. Calc the PV of each cash flow
– 4. Total up the PV of all cash flows
– 5. Calc weightage (= PV of each cash flow / Total PV of all cash
flows)
– 6. Weight * Period
– 7. Total up all the values in (6).
Workings to calculate duration.
6) Forte Company has just issued an 8% annual
coupon payment bond. The bond which will mature
in 15 years was sold at a market price of RM1,085.

– a) Calculate the bond’s expected rate of return based on the information given.
– Use trial and error method.
– PV of bond par value + PV of coupon = 1085
– PV of bond par = FV / (1 + r) n +
– Ans: 7.06%

– b) Will you purchase the bond if your required rate of return is 10%? Explain
your answer.
– No, because the expected return is lower than the required return.
 Duration

– Refer to Question 5 workings…

– Take note: Annual bond

a. BOND 1 = 4.28 years, BOND 2 = 5 years

b. FACTORS that affect bond’s duration:

-The longer the time to maturity, the higher the duration.
-The higher the YTM, the lower the duration.
-The higher the coupon rate, the lower the duration.
-The higher the coupon payment frequency, the lower the duration.
-Duration for a zero coupon bond is its time to maturity, duration for coupon bond
always less than its time to maturity.
c. Importance

– Duration measures bond price sensitivity to interest rate

movements, which is very important in any bond analysis.
Duration is also used in bond management strategies such as
immunization (i.e. the strategy of immunizing against interest
rate risk).