Interest Rates and Bond Valuations

Winter Semester 2011

NCBA&E
Instructor Jamal Nasir Khan

Lecture 3

Objectives
Bonds & Valuation Interest rates

Bond Yields
Bond Prices Bond Price Changes

Duration, Modified Duration & Convexity

Bonds

What is a Bond?

Bonds

What is a Bond Debt instrument to raise money (Loan) Issued by Corporations & Governments

Interest Only Loan

Has a standard Face Value of $1000 (Corp) Coupons are paid semi-annually

Fixed-Income Securities
BONDS
Capital Markets:
Where debt & equity capital is raised. Market for long-term securities (stocks & bonds)

Fixed-Income Securities:
Securities with specified payment dates and amounts, primarily Bonds

Bonds: Future stream of cash flows are known at issue. Principal is paid at maturity. IF, bond is sold before maturity, price will reflect current interest rates.

Fixed-Income Securities
Bond Characteristics
Par Value: Term Bond:

Term to Maturity:
Coupon: Coupon Rate: Zero Coupon: Bond Prices: add zero

Fixed-Income Securities
Bond Characteristics
Par Value:
Face Value of most Bonds is $1000 paid at maturity

Term Bond: Bonds typically mature on a specified date Term to Maturity: Coupon:
how much longer the bond will exist

Periodic interest paid by issuer. Typically semi-annual. Quoted APR

Coupon Rate: Is fixed at issuance & cannot vary

Zero Coupon:
Value

Bond with no coupons sold at discount & redeemed at Face

Bond Prices:

Quoted as a %age of Par Value. Use 100 as conventional par rather than 1,000. So, Price 90 = $900 (90% of 1000). Each point, or a change of 1, represents 1% of 1,000 or $10.

Easy conversion: since quoted in %age, just add an extra ZERO to get price.

Fixed-Income Securities
More Bond Characteristics
Indenture: Registered Form:

Bearer Form:
Security:

Debenture: Sinking Fund:

Fixed-Income Securities
More Bond Characteristics
Indenture: Written agreement b/w corp & creditor Registered Form: Owner is named w/registrar at corp

Bearer Form: Owner is not named w/registrar

Security: collateral (financial) or mortgage (real) used as backing

Debenture: Unsecured debt (mat >10yrs) Sinking Fund: account managed by bond trustees for early bond payments

Fixed-Income Securities
Bond Examples
A 10% coupon Bond has what dollar coupon?:

A Bonds quoted Px is 101 3/8. Whats the $ price?

Interest Rate & Bond Price:

Fixed-Income Securities
Bond Examples
A 10% coupon Bond has what dollar coupon?:
$100 coupon & $50 semi-annual coupon payments.

A Bonds quoted Px is 101 3/8. Whats the $ price?

Represents 101.375% of 1,000, therefore $ price is $1013.75 Price above PAR Premium (& discount)? Interest Rates declined, so price increased.

Interest rates are inversely related to price. More

coverage later chapter.

Interest Rate & Bond Price:

Bond will be exactly worth its face value at maturity. But till then it fluctuates around $1000 to adjust yield according to market interest rates.

Fixed-Income Securities
Bond Characteristics
Call Provision: When is it attractive to the issuer?

Call Premium

Fixed-Income Securities
Bond Characteristics
Call Provision:
Gives the issuer the right to call in a security & retire it by paying off the obligation.

When is it attractive to the issuer?

When interest rates drop in the markets enough to save the issuer money.
Additional cost for the issuer called CALL PREMIUM Issuer will CALL & then issue new ones at lower cost. Most Corp Bonds are callable

Call Premium
Often equals one years interest (if called within a year), then decreases

Fixed-Income Securities TYPES OF BONDS

4 Major Types
Govt Treasuries:
Since Govt can print money to pay off, it is considered risk free (no default risk). Size is 5k,10k,100k,500k & million Notes = Maturities b/w 1 year & 10 years (Bills = < 1year) Bonds = Maturities b/w 10 & 30 years

Govt Agencies: Municipals:

To help specific sectors of the economy, loans are guaranteed by the Govt through agencies. Typically States & Cities. Also called Serial Bonds. Tax exempt, so yield is lower compared with taxable.

Corporates:

Securities issued by Corporations to finance their operations. Typically 20-40yrs maturity, pays semi-annual, callable, par value $1000.

Fixed-Income Securities
Characteristics of Corporates
Senior Securities: Convertible Bonds: Rating Agencies: Bond Ratings:

Fixed-Income Securities
Characteristics of Corporates
Senior Securities:
Corp Bonds are senior to preferred stock, common stock in case of bankruptcy.

Convertible Bonds:
Bonds which are convertible (at holders option) into shares of common stock.

Rating Agencies: Bond Ratings:

3 agencies S&P, Moodys, Fitch provide Bond ratings representing current opinions on relative credit quality of the firm. (PACRA in Pakistan) Letters of the alphabet assigned to Bonds to express probability of default.

Fixed-Income Securities
Bond Ratings
AAA:
Best Quality & lowest default risk

AA:
More common: Very Good Quality.

D:
Lowest rating: means debt is in default.

BBB:
Investment Grade Medium grade. Adequate capacity to pay.

Bond Yields

2 Components of Interest rates

Bond Yields

Components of Interest rates

Real Risk Free rate:
opportunity cost of foregoing consumption (given no inflation)

Nominal Interest Rates:

Real rate PLUS inflation adjustment

Bond Yields

Example of inflation effects

If real rate is 10% & inflation is 12%. Whats the value of $100 investment today?

Bond Yields

Example of inflation effects

If real rate is 10% & inflation is 12%. Whats the value of $110 today?

Bond Yields

Example of inflation effects

If real rate is 10% & inflation is 12%. Whats the value of $110 today? 110 / (1.12) = 98.21 < 100 originally invested! Therefore, an expected inflation premium is needed to adjust purchasing power.

Bond Yields
For T- Bills:

The nominal rate is a function of real rate & expected inflationary premium. RF = RR + EI
Where: RF = T-bill rate RR = real risk free rate

EI = expected inflation rate

Bond Yields

Equation Is called

RF = RR + EI Fisher Hypothesis

(Irving Fisher)

Means:
Nominal rate on ST, RF securities rises point for point with expected inflation, with RR unaffected (consumption opp cost)

Fisher Effect
The nominal rate R is a function of real rate r & expected inflationary premium h. Equation is?

Fisher Effect
The nominal rate R is a function of real rate r & expected inflationary premium h. (1+ R) = (1+r) x (1+h)
Where: R = Nominal Rate r = real risk free rate h = inflation rate

MEASURING RETURNS Formula Real Returns

Real Return (inflation adjusted)
TRia (r) = ( (1+ R (nominal) ) / (1+h) ) 1

TRia = total return inflation adjusted h = inflation rate

PROBLEM

Finding inflation adjusted returns

Suppose the nominal return on a stock is 28.5731% and the inflation rate is 1.6119%.
a) What is the real rate? b) What is the inflation adjusted return?

PROBLEM

Finding inflation adjusted returns

Suppose the nominal return on a stock is 28.5731% and the inflation rate is 1.6119%.
a) What is the real rate?

1.2857/1.0161 = 1.2653 1 = 26.53% b) Same as a!!

POINT TO NOTE
Most financial rates are quoted in NOMINAL. We will use the symbol R for this nominal rate

Determinants of Bond Yields

Term Structure of Interest Rates

1) Real Rate (opportunity cost) 2) Expected Inflation (investors require higher nominal rates) 3) Interest Rate Risk premium (coupon bonds) yield curve

Definition of TSIR
Nominal rate on default-free, pure discount bonds of all maturities

Determinants of Bond Yields

Inflation Premium
Portion of Nominal rate representing compensation for Exp. Inflation

Interest Rate Risk Premium

Compensation for taking on interest rate risk Longer maturity has higher interest risk, therefore positive slope

Term Structure (based on pure discount bonds)

Interest Rate risk premium

Interest Rate

Inflation Premium

Real Rate

Maturity

Yield Curve (plotted against coupon bonds)

A chart of the yields of T-bills & Bonds w/maturity Almost same as the term structure. Difference:
1) Yield curve plotted based on coupon bonds (interest rate component) 2) Term structure based on pure discount bonds (no interest rate risk)
M5

Corp Bonds have additional Premiums

Default risk premium
Compensation for possibility of default

Taxability Premium
Compensation for unfavorable tax implications

Liquidity Premium
Compensation for lack of liquidity (ability to sell)

Bond Determinants Summary

Real Rate
Adjusted for inflation

Expected Inflation
Compensation for inflation expectations

Interest Rate risk

Compensation for future changes in interest rates

Default risk premium

Compensation for possibility of default

Taxability Premium
Compensation for unfavorable tax implications

Liquidity Premium
Compensation for lack of liquidity (ability to sell)

Bond Prices

Valuation Principle Bond Valuation

Bond Prices

Valuation Principle
Price of a security is based on estimated values based on expectations. This is also called the Intrinsic Value.

It is the PV of all EXPECTED Cash Flows from that asset

Bond Prices
Cash Flows from a security can be in any form:
Example??

Bond Prices
Cash Flows from a security can be in any form:
Dividends Interest Payments

Coupons
Redemption value

Bond Prices
Since C/Fs are in future, they must be Discounted And converted to PV.
Sum of all the PVs of C/fs = Estimated Intrinsic Value

Bond Prices
Formula for any asset:
Value = E ??

Bond Prices
Formula for any asset:
Value = E C/Fs / (1+i)^n

Bond Valuation
Bond has TWO types of Cash Flows:?

Bond Valuation
Bond has TWO types of Cash Flows: 1. Coupons 2. Face Value Both of these are known in advance

Bond Prices
Formula for Bonds:
Value = E C/Fs / (1+i)^t + FV/(1+i)n
Note: Coupons are ? t= n= i=

Bond Prices
Formula for Bonds:
Value = E C/Fs / (1+i)^t + FV/(1+i)n
Note: Coupons are semi-annual t = period on semi-annual basis n = periods also semi-annual i = semi-annual rate

Bond Prices
Formula for Bonds:
Value = E C/Fs / (1+i)^t + FV/(1+i)n
Note: Coupons are semi-annual t = period on semi-annual basis n = periods also semi-annual i = semi-annual rate
John Burr Williams published this eq. in 1938

Bond Prices
Formula Breakdown:
Value = E C/Fs / (1+i)^t + FV/(1+i)^n
3 stages: 1) Coupons?? 2) FV is single C/F: 3) Add all PVs together Find simple PV

Bond Prices

Formula Breakdown:
Value = E C/Fs / (1+i)^t + FV/(1+i)^n
3 stages: 1) Coupons make it an annuity: Find Annuity PV 2) FV is single C/F: 3) Add all PVs together Find simple PV

Calculating Bond Price

Example bond A
A new 8% coupon bond with 10 year maturity, PAR of 1000, semiannual is issued. What is the Price of the Bond?

M55

Calculating Bond Price

Example bond A
A new 8% coupon bond with 10 year maturity, PAR of 1000, semiannual is issued. What is the Price of the Bond? Ordinary annuity of 40 APV = 40 x ((1- 1/1.04^20) / .04 = 40 *( 1-0.4563)/ .04 = 40*13.59 = 543.61 (coupons PV) FV PV = (1000) / (1.04)^20 = 1000*.45638 = 456.38

Bond PV = 543.61 + 456.38 = 1000 (same as Face value)

Calculating Bond Price

Example bond A NOW INTEREST RATES GO UP
Same 8% coupon bond with 10 year maturity, PAR of 1000, semiannual is issued. But market interest rates are at 10%. What is the NEW Price of the Bond?

Calculating Bond Price

Example bond A NOW INTEREST RATES GO UP
Same 8% coupon bond with 10 year maturity, PAR of 1000, semi-annual is issued. But market interest rates are at 10%. What is the NEW Price of the Bond? Ordinary annuity of 40 APV = 40 x ((1- 1/1.05^20) / .05 = 40 *( 1-0.3768)/ .05 = 40*12.46 = 498.48 (coupons PV) FV PV = (1000) / (1.05)^20 = 1000*.3768 = 376.89

Bond PV = 498.48 + 376.89 = 875.36 (Now at discount since i is up)

Bond Price over time

Interest rate DROPS Price Rises Cos Discounting at lower rate

FV = 1000 at issue
Bond Px

FV = 1000 at end

Interest rate RISES Price DROPS Cos discounting & higher rate

Converge to Par Value over time

Bond Price Changes

Why is this happening?

Bond Price Changes

Why is this happening?
1. Coupons are the same
2. Face Value is the same

3. If interest rates in the market change,

ONLY the PV can & must change

to reflect the interest rates

Bond Price Changes

What does price change do?

1. Therefore,

Capital Gain (LOSS) is built in to compensate the investor for the change in interest rates in the market. Discount = gain Premium = Loss

Calculating Bond Price

Checking the discount gain logic Example bond A
Same 8% coupon bond with 10 year maturity, PAR of 1000, semiannual is issued. But market interest rates are at 10%.

Whats the PV of $20(100-80) coupon not paid by this Bond?

Calculating Bond Price

Checking the discount gain logic Example bond A
Same 8% coupon bond with 10 year maturity, PAR of 1000, semiannual is issued. But market interest rates are at 10%.

Whats the PV of $20(100-80) coupon not paid by this Bond?

APV = 10x ((1- 1/1.05^20) / .05 = 10 *( 1-0.3768)/ .05 = 10* .62/.05 = 10*12.464 = 124.64 (missed coupons PV) NOTICE: Bond Discount was 1000-875.36 = 124.64 & PV OF $20 MISSED ANNUITY IS ALSO 124.64 TO COMPENSATE FOR PREMIUM: INVESTOR WILL HAVE TO PAY EXTRA

Calculating Bond Price

Example bond A NOW INTEREST RATES GO DOWN
Same 8% coupon bond with 10 year maturity, PAR of 1000, semi-annual is issued. But market interest rates are at 6%. What is the NEW Price of the Bond? Ordinary annuity of 40

Calculating Bond Price

Example bond A NOW INTEREST RATES GO DOWN
Same 8% coupon bond with 10 year maturity, PAR of 1000, semi-annual is issued. But market interest rates are at 6%. What is the NEW Price of the Bond? Ordinary annuity of 40 APV = 40 x ((1- 1/1.03^20) / .03 = 40 *( 1-0.55366)/ .03 = 40*14.87 = 595.099 (coupons PV) FV PV = (1000) / (1.03)^20 = 1000*.55366 = 553.66

Bond PV = 595.099 + 553.669 = 1148.775 (Now at premium since i is down)

Calculating Bond Price

Checking the premium loss logic Example bond A
Same 8% coupon bond with 10 year maturity, PAR of 1000, semiannual is issued. But market interest rates are at 6%.

Whats the PV of $20(80-60) coupon paid extra by this Bond?

Calculating Bond Price

Checking the premium loss logic
Example bond A
Same 8% coupon bond with 10 year maturity, PAR of 1000, semiannual is issued. But market interest rates are at 6%.

Whats the PV of $20(80-60) coupon paid extra by this Bond?

APV = 10x ((1- 1/1.03^20) / .03 = 10 *( 1-0.553676)/ .03 = 10* .4463/.03 = 10*14.877 = 148.77 (extra coupons paid PV) NOTICE: Bond Premium was 1148.775-1000 = 148.77 & PV OF $20 Extra ANNUITY IS ALSO 148.77 (offset by charging more)

Relationship Bond Px & Interest Rates

Bond Px is?

Relationship Bond Px & Interest Rates

Bond Px is
INVERSELY Related TO Interest Rates

Bond Yields

Looking at Risk Now

All rates are affected by 2 variables from the Risk free rate: a) Maturity b)Risk Premium c) Coupon Rate Risk
Keep this in mind!

Time Factor (maturity differentials & i )

All Interest Rates are affected by TIME FACTOR. Therefore, Longer Term maturities yield more than shorter term
Thus, Bonds i > Notes i > Bills (Typical relationship)

For Bonds

Longer the maturity, higher the Interest Rate Risk WHY?

For Bonds

Longer the maturity, higher the IR risk WHY?

Cos Longer term has a greater discounting effect (compounding curve) on the Face Value received at maturity!

For Bonds Maturity exposure

Longer the maturity, higher the IR risk Therefore

Since the Principal is at end, Bonds Px is more sensitive to time (maturity)

PV on 30yrs is more sensitive to PV on 1 year!! (for Face Value) NOTE: But it increases (term risk) at a decreasing rate

For Bonds The other factor

Coupon Rate risk ? WHY?
M20

For Bonds The other factor

Coupon Rate risk Lower Coupons have higher risk. WHY?
M20

For Bonds The other factor

Coupon Rate risk Lower Coupons have higher risk.
Lower coupons make Bond Px more dependant on FV!
(Risk = % changes in Bond px for given chg in interest rates)

WHY?
Since C/Fs are paid towards the back end of time line & relative to Face value are smaller in size! (affected more
by discounting)

NOTE: compare PV of zero-coupon vs regular

Third Factor

All interest rates other than risk less are affected by a THIRD Factor Risk Premium
Also called yield spread OR differential

What affects Bond Prices

Effects of Maturity? +ve

Effects of Coupon Size? -ve

What affects Bond Prices

Effects of Maturity?
For a given change in rates, price of longer term bonds will change more than shorter term bonds

Effects of coupon size?

Bond Px fluctuations (volatility) are inversely related to coupon rates.
The larger the coupon, for same maturity, the lower the volatility
m40 Bond Px sensitivity ( 100bp chg on 10% & 100% coupons effect on %px chg!)

Bond Yields

Components of Interest rates Measuring Bond Yields

Current yield (CY) Yield to maturity (YTM) Yield to call (YC) Realized Compound yield (RCY)

Re-investment Risk

Measuring Bond Yields

Measuring Bond Yields

There are 4 measures

Current Yield Yield to Maturity Yield to Call Realized Compound Yield

Measuring Bond Yields

There are 4 measures

Current Yield (CY)

A Bonds annual coupon divided by current market price.

Yield to Maturity (YTM)

Promised Compound rate of return at the current market price till mat.

Yield to Call (YC)

Promised return on a Bond from present till date it is likely to be called

Realized Compound Yield (RCY)

Yield earned based on actual reinvestment rates-Historical

Measuring Bond Yields

Current Yield (CY)
A Bonds annual coupon divided by current market price.

Ratio of coupon interest to current Mkt px. e.g.

A 3 year 10% coupon Bond with interest payments occurring exactly 6 mths from now & so on. Current price of the Bond is $1052.42 Whats the current yield?

Measuring Bond Yields

A 3 year 10% coupon Bond with interest payments occurring exactly 6 mths from now & so on. Current price of the Bond is $1052.42 Whats the current yield? C/Px = 100 / 1052.10 = 9.5%

Measuring Bond Yields

Yield to Maturity (YTM) semiannual rate
Promised Compound rate of return at the current market price till mat.

The rate most often quoted

Return based on fixed assumptions???

Measuring Bond Yields

Yield to Maturity (YTM) semiannual rate
Promised Compound rate of return at the current market price till mat.

The rate most often quoted

Return based on fixed assumptions 1) The Bond is held to Maturity

2) Coupons are re-invested at the YTM

Means: Compounded return giving PV of Bond as its current price

Same as IRR for the Bond

Measuring Bond Yields

Yield to Maturity (YTM)
Promised Compound rate of return at the current market price till mat.

Small letters = semi-annual Capital letters = annual

PV = E c/(1+ytm)^t + FV/ (1+ytm)^n

FV = 1000 N= no. of semiannual periods & t=payment period

Measuring Bond Yields

Yield to Maturity (YTM)
Promised Compound rate of return at the current market price till mat.

Bond Equivalent Yield

Yield on an annual basis derived by doubling the semi-annual yield.

eg. 5.1% semi-annual ytm is 5.1x2 = 10.2% BEY

YTM
Example on zero-coupon
A zero coupon bond has 12 yrs to maturity & is selling for $300.

Calculate the ytm & BEY?

YTM
Example on zero-coupon
A zero coupon bond has 12 yrs to maturity & is selling for $300.
Calculate the ytm & BEY.

PV = FV / (1+ytm)^n
300 = 1000 / (1+ytm)^24 (1+ytm)^24 = 1000/300

(1+ ytm) = 3.33^(1/24)

ytm = 3.33^.04166 = 1.0514 1 = 5.14% ytm 5.14x2 = 10.28% BEY

YTM
Example on regular coupon bond
A bond has 3 yrs to maturity & is selling for 1052.42 Calculate the ytm & BEY.

YTM
Example on regular coupon bond
A bond has 3 yrs to maturity & is selling for 1052.42 Calculate the ytm & BEY.

PV = E 50/(1+ytm)^t + 1000/(1+ytm)^6 1052.42 = 50 x 5.242 (APVF) + 1000x 0.790 (PVF) Trial & error will cover after basic theory Ytm = 4% semi annual BEY = 4x2 = 8% annual

Measuring Bond Yields

Yield to Call (YTC)
Promised rate of return on a bond from present till called.

Steps to calculate: USE SAME FORMULA & MODIFY

a) find n till call date

b)

Call Price substituted for Face Value

Measuring Bond Yields

Realized Compound Yield (RCY)-historical
Yield earned based on actual re-investment rates (IRR)

Semi-annual realized compound yield is:

RCY = ( total wealth=FV / Pur. Px=PV ) ^ 1/n - 1

NOTE: comes from the FV=PV(1+i)^n, reshuffling for i

RCY (realized c yield)

Example on regular coupon bond
An investor had $1000 to invest 3 yrs ago. She purchased a 10% coupon bond with a 3 year maturity at Face Value. The YTM was 10%. Assume the investor re-invested each coupon at the semi-annual rate or ytm of 5%. What is the total ending wealth after 3 yrs?

What is the RCY?

RCY
Example on regular coupon bond
An investor had $1000 to invest 3 yrs ago. She purchased a 10% coupon bond with a 3 year maturity at Face Value. The YTM was 10%. Assume the investor re-invested each coupon at the semi-annual rate or ytm of 5%. What is the total ending wealth after 3 yrs? (1+.05)^6= 1.340095 * 1000 = 1340.09 (includes the initial outlay)

thus,

earnings were 340.09

What is the RCY? (1340.10 / 1000 )^ 1/6 1 = 1.05 1 = .05 RCY x2 = 10% BEY

Points to Note
Coupons are seldom re-invested at same rates YTM is totally dependant on some assumptions

RCY is the actual rate earned at the end.

Assumptions:
a) b) Bond is held to maturity Coupons are re-invested at same rates as YTM

YTM = IRR

Re-investment Riskassumption
Part of interest rate risk resulting from uncertainty about the rate at which future interest coupons can be re-invested Assumption is unlikely in real lifewhy?

Bonds sources of returns

Coupons
Capital Gains Interest on interest (coupon re-investment):
largest part of the RCY POINTS to NOTE:

a) As maturity increases, reinvestment risk increases.

b) Higher the coupon rate, the higher reinvestment risk.

Bonds sources of returns

For a zero-coupon bond. What is the RCY equal to?

Bonds sources of returns

For a zero-coupon bond. What is the RCY equal to? RCY = YTM since there are NO COUPONS & therefore no re-investment risk

Illustration of re-investment portion

Example on regular coupon bond
A 10% coupon bond with 20yr maturity purchased at PAR ($1000). If all coupons are re-invested at 5% on semi-annual basis, (ytm=5%), then. What is the total dollar return at end 20yrs? What is the break down of returns? FV+Coupons+interest on interest

M20

Illustration of re-investment portion

Example on regular coupon bond
A 10% coupon bond with 20yr maturity purchased at PAR ($1000). If all coupons are re-invested at 5% on semi-annual basis, (ytm=5%), then. What is the total dollar return at end 20yrs? Ordinary annuity of 50 AFV = 50 x ((1+.05)^40 1 ) / .05 = 50 *( 7.03-1)/ .05 = 50*120.79

= 6039.50 (includes coupons) + FV (1000) = $7040

What is the break down of returns? FV+Coupons+interest on interest 1000+2000+4040 = 7040 Note: 6040-2000 coupons = 4040 POINT: 4040/7040 = 57% comes from re-investment!!

What is one advantage of

Zero-coupon bond.in terms of risk?

What is one advantage of

Zero-coupon bond.in terms of risk?

NO Re-investment risk, since no coupons

Horizon Return
All yield measures have problems.
How do investors solve this pblm?
1. They make future assumptions about the re-investment rates. 2. Calculating the return on bonds based on future assumptions is called, Horizon Return NOTE: Yield curve moves based on this.

Measuring Volatility: Duration

Duration?

Measuring Volatility: Duration

Duration
A measure of a bonds lifetime which accounts for the entire pattern of cash flows. Measures the weighted average maturity of C/Fs on a PV basis.

To solve which problem?

Changes in interest rates result in different % changes in Bond Pxs. Duration combines the coupon & maturity (size & timing) of C/F effects into one yardstick.

Measuring Volatility: Duration Example

Duration of 4.054 (on 5 yr bond) means:

The TVM weighted average number of years needed to recover the cost of this Bond is 4.054.
Although the bond has 5 yrs to maturity, interest payments are received in the first 4 yrs

Calculating Duration
Duration (stated in yrs)
Convert TIME to a weighted time period. Concept
All time periods are weighted & summed. The result is duration. PV of each cash flow as a %age of the current price serves as the weights, which are then applied to time periods. SUM of these equals 1.0

Duration
Formula :
Duration D = E (PV (CFt) / Mkt Px ) x t

PV of CF is found at YTM discount

Mkt Px is current PV of bond

Exercise
Coupon 10% 5% 50

Maturity

10

coupon $

Price

1000

C/F

PV Factor

PV of CF

PV/Px

t x (PV/Px)

1 2

0.5 1.0

50 50

0.9524 0.9070

47.6190 45.3515

0.0476 0.0454

0.0238 0.0454

3
4 5 6 7 8 9 10

1.5
2.0 2.5 3.0 3.5 4.0 4.5 5.0

50
50 50 50 50 50 50 1050

0.8638
0.8227 0.7835 0.7462 0.7107 0.6768 0.6446 0.6139

43.1919
41.1351 39.1763 37.3108 35.5341 33.8420 32.2304 644.6089

0.0432
0.0411 0.0392 0.0373 0.0355 0.0338 0.0322 0.6446

0.0648
0.0823 0.0979 0.1119 0.1244 0.1354 0.1450 3.2230

TOTALS

1000

1.00

4.0539

Coupon

10%

5%

50

Maturity

10

coupon $

Price

1000

C/F

PV Factor

PV of CF

PV/Px

t x (PV/Px)

1 2 3 4 5 6 7 8 9 10

0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0

50 50 50 50 50 50 50 50 50 1050

0.9524 0.9070 0.8638 0.8227 0.7835 0.7462 0.7107 0.6768 0.6446 0.6139

47.6190 45.3515 43.1919 41.1351 39.1763 37.3108 35.5341 33.8420 32.2304 644.6089

0.0476 0.0454 0.0432 0.0411 0.0392 0.0373 0.0355 0.0338 0.0322 0.6446

0.0238 0.0454 0.0648 0.0823 0.0979 0.1119 0.1244 0.1354 0.1450 3.2230

TOTALS

1000

1.00

4.0539

Duration
Shorter Formula :
Duration D = (1+ytm)/ytm . ( 1- (1/ytm^n)) Use semi-annual rate

Double the n
Divide answer by 2 to convert to annual basis
M10

Understanding Duration
Duration depends on 3 factors: Final Maturity of Bond
Duration expands with time to maturity: directly related: For zero coupon, D=Maturity

Coupon Payments
Coupon size is inversely related to duration.

YTM
YTM is inversely related to duration

Understanding Duration
What does Duration tell us? Difference b/w effective LIVES of bonds

Allows us to compare bonds on this basis

D is a measure of bond-price sensitivity to interest rate movements. It measures interest rate risk

Understanding Duration
Example

Given a 10% coupon bond, ytm of 10%.. If maturity is 5yrs, D = 4.054 (effective life!)

If maturity is 10yrs, D = 6.76

If maturity is 20yrs, D = 9.36

If maturity is 50yrs, D = 10.91 yrs
Reason is, C/Fs in distant future result in smaller PVs

Modified Duration
Defined

Mod Duration is Duration divided by (1+ytm)

Mod D* = D / (1+ytm)

Ytm = semi-annual

Mod D, is used to calculate % price change for a given change in interest rates (usually 100bp)

Modified Duration
EXAMPLE

Using Duration of 4.054 yrs & YTM of 10%,

What is the Modified Duration?

Mod D* = D / (1+ytm)
Ytm = semi-annual

Modified Duration
EXAMPLE

Using Duration of 4.054 yrs & YTM of 10%,

What is the Modified Duration? D* = 4.054 / (1+.05) = 3.861 Now we use this to calculate change in Px for a given interest rate change

Modified Duration
EXAMPLE

To calculate %change in Price, use

% Chg in Px = -D* x yield change So, whats the change in Px of example, if yield changes by + 20 bp?

M5

Modified Duration
EXAMPLE

To calculate %change in Price, use % Chg in Px = -D* x yield change

So, whats the change in Px of example, if yield changes by + 20 bp?

-3.861 x (+0.002) x 100 = -0.772%
100 is to convert to % basis.

Convexity Concept
Mod. D is an approximation because, the relationship of Mod D to actual price changes is convex.
Mod D itself is a linear relationship. Mod D is a tangent to the actual relationship & therefore is accurate for smaller changes, but diverges for larger changes.

Convexity
Price Approximation Using Duration
155 145 135

125 115

Price

105

95 85

75 65

55 0 0.02 0.04 0.06 0.08 0.1 Yield PRICE EST. PRICE 0.12 0.14 0.16 0.18 0.2

Chapter 17 Bond Yields & Prices What we have learnt

Bonds & Valuation Interest rates

Bond Yields
Bond Prices Bond Price Changes

Duration, Modified Duration & Convexity