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2
1. Bond prices and yields are inversely
related.
2. An increase in a bonds yield to
maturity results in a smaller price
change than a decrease of equal
magnitude.
3. Long-term bonds tend to be more
price sensitive than short-term
bonds.
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4. As maturity increases, price
sensitivity increases at a
decreasing rate.
5. Interest rate risk is inversely
related to the bonds coupon rate.
6. Price sensitivity is inversely related
to the yield to maturity at which
the bond is selling.
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A measure of the effective maturity
of a bond
The weighted average of the times
until each payment is received,
with the weights proportional to
the present value of the payment
Duration is shorter than maturity
for all bonds except zero coupon
bonds.
Duration is equal to maturity for
zero coupon bonds.
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8

CF
t
=cash flow at time t
| | Price ) 1 ( y
CF w
t
t t
+ =
t w t D
T
t

=
=
1
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9
Price change is proportional to
duration and not to maturity


D
*
= modified duration

(1 )
1
P y
Dx
P y
( A A +
=
(
+

*
P
D y
P
A
= A
Calculate the price and duration of a 2 year
maturity, 8% coupon bond making
semiannual coupon payments when the
market interest rate is 9%.

Time
until
Payment
(years)
Cash Flow
(Discount rate
= 5%)
PV of CF (Discount
rate = 5%)
Weight
Column
(1) x
Column
(5)
1 $40.00
0.9524

38.095 0.039 0.039
2 $40.00
0.907

36.281 0.0376 0.0752
3 $40.00
0.8638

34.554 0.0358 0.1074
4 $1040.00
0.8227

855.611 0.8871 3.5484
Column Sums $964.540 1 3.77
D = 3.77 (semiannual) = 1.885
years
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12
Two bonds have duration of 1.8852 years.
One is a 2-year, 8% coupon bond with
YTM=10%. The other bond is a zero coupon
bond with maturity of 1.8852 years.
Duration of both bonds is 1.8852 x 2 =
3.7704 semiannual periods.
Modified D = 3.7704/1+0.05 = 3.591
periods
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Suppose the semiannual interest rate
increases by 0.01%. Bond prices fall by:



=-3.591 x 0.01% = -0.03591%
Bonds with equal D have the same interest
rate sensitivity.

y D
P
P
A =
A
*
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Coupon Bond
The coupon bond,
which initially sells
at $964.540, falls
to $964.1942 when
its yield increases
to 5.01%
percentage decline
of 0.0359%.


Zero
The zero-coupon
bond initially sells
for $1,000/1.05
3.7704
= $831.9704.
At the higher yield,
it sells for
$1,000/1.05
3.7704
=
$831.6717. This
price also falls by
0.0359%.

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15
Rule 1 The duration of a zero-coupon
bond equals its time to maturity

Rule 2 Holding maturity constant, a
bonds duration is higher when the
coupon rate is lower

Rule 3 Holding the coupon rate
constant, a bonds duration
generally increases with its time to
maturity


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Rule 4 Holding other factors
constant, the duration of a coupon
bond is higher when the bonds
yield to maturity is lower

Rules 5 The duration of a level
perpetuity is equal to: (1+y) / y


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19
The relationship between bond
prices and yields is not linear.

Duration rule is a good
approximation for only small
changes in bond yields.

Bonds with greater convexity have
more curvature in the price-yield
relationship.
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20
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21

=
(

+
+ +
=
n
t
t
t
t t
y
CF
y P
Convexity
1
2
2
) (
) 1 ( ) 1 (
1
Correction for Convexity:
2
1
[ ( ) ]
2
P
D y Convexity y
P
A
= -A + A
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Bonds with greater curvature gain more in
price when yields fall than they lose when
yields rise.
The more volatile interest rates, the more
attractive this asymmetry.
Bonds with greater convexity tend to have
higher prices and/or lower yields, all else
equal.

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24
As rates fall, there is a ceiling on the
bonds market price, which cannot rise
above the call price.
Negative convexity
Use effective duration:

/
Effective Duration =
P P
r
A
A
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The number of outstanding callable
corporate bonds has declined, but the
MBS market has grown rapidly.
MBS are based on a portfolio of callable
amortizing loans.
Homeowners have the right to
repay their loans at any time.
MBS have negative convexity.

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Often sell for more than their principal
balance.
Homeowners do not refinance as soon as
rates drop, so implicit call price is not a firm
ceiling on MBS value.
Tranches the underlying mortgage pool is
divided into a set of derivative securities
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Duration measures the interest rate sensitivity of
an asset or liabilitys value to small changes in
interest rates



The duration gap is a measure of overall interest
rate risk exposure for an FI
To find the duration of the total portfolio of assets
(D
A
) (or liabilities (D
L
)) for an FI
First determine the duration of each asset (or
liability) in the portfolio
Then calculate the market value weighted
average of the duration of the assets (or
liabilities) in the portfolio
) 1 /(
security a of ue market val in the %
R R
D
+ A
A
=
The change in the market value of the asset
portfolio for a change in interest rates is:



Similarly, the change in the market value of the
liability portfolio for a change in interest rates is:
) 1 (
) (
R
R
D A A
A
+
A
= A
) 1 (
) (
R
R
D L L
L
+
A
= A
Finally, the change in the market value of equity of
an FI given a change in interest rates is determined
from the basic balance sheet equation:

By substituting and rearranging, the change in net
worth is given as:


where k is L/A = a measure of the FIs leverage
E L A E L A A + A = A + =
) 1 (
) (
R
R
A kD D E
L A
+
A
= A
The effect of interest rate changes on the market
value of equity or net worth of an FI breaks down
to three effects:
The leverage adjusted duration gap = (D
A
kD
L
)
measured in years
reflects the duration mismatch on an FIs balance
sheet
the larger the gap, the more exposed the FI to
interest rate risk
The size of the FI
The size of the interest rate shock
Duration Gap Example
Assets $ Amount Weight Duration Weight x Duration
T-bills 90 2.96% 0.500 0.015
T-notes 55 1.81% 0.900 0.016
T-bonds 176 5.78% 4.393 0.254
Loans 2,724 89.46% 3.000 2.684
Liabilities & Equity $ Amount Weight Duration Weight x Duration
Deposits 2,092 68.70% 0.500 0.344
Federal funds 102 3.35% 0.010 0.000
Borrowings 536 17.60% 5.500 0.968
Equity 315 10.34% 0.000
3,045 100.00% DurL 1.312
k 72.05%
Duration Gap DurA - kDurL 2.023
R 12%
AR 0.005
AE -$27.51
{ } =
1.12
0.005
3,045 2.023
{ }
R) (1
R
A kDur Dur E
L A
+
=
Suppose a bank with $500 million in assets
has an average asset duration of 3 years, and
an average liability duration of 1 year. The
bank also has a total debt ratio of 90%. R may
be thought of as the required return on
equity or perhaps as the average interest rate
level. If r is 12% and the bank is expecting a
50 basis point increase in interest rate by
how much will the equity value change?
A = 500 million
D
A
= 3 years
D
L
= 3 years
k
TD= 3 years
r = 12%
Ir = 50% basis point




{ }
R) (1
R
A kDur Dur E
L A
+
=
9.375% - mill 50 4,687,500/ - E/E
million 50 0.90) - (1 500 ( E
= =
= = mill
{ }
{ }
% 375 . 9
(1.12)
0.0050
x mill mill/50 500 1) X 0.90 ( 3 E/E
R) (1
R
A/E kDur Dur E/E
L A
=
=
+
=
or
(a) Calculate the leverage-adjusted duration gap
of an FI that has assets of $1million invested
30-year, 10 percent semiannual coupon
Treasury bonds selling at par and whose
duration has been estimated at 9.94 years. It
has liabilities of $900,000 financed through
a two years. 7.25 percent semiannual
coupon note selling at par?
(b) What is the impact in equity values if all
interest rates falls 20 basis points that is
= 0.0020
R) (1
R
+
The leverage adjusted duration gap = (D
A
kD
L
)

= [9.94 (900,000/1,000,000)(1.8975)] = 8.23 years


b. Change in net worth using leveraged adjusted
duration gap is given by



{ }
R) (1
R
A kDur Dur E
L A
+
=
{ } 50 . 464 , 16 $ ) 002 . 0 ( 1mill 8.23 E = =
Difficulties emerge when applying the duration
model to real-world FI balance sheets
Duration matching (immunization) can be costly as
restructuring the balance sheet is time consuming, costly,
and generally not desirable
Immunization is a dynamic problem
Duration of assets and liabilities change as they
approach maturity
The rate at which the duration of assets and liabilities
change may not be the same
Duration is not accurate for large interest rate changes
unless convexity is modeled into the measure
Convexity is the degree of curvature of the price-yield
curve around some interest rate level
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Substitution swap
Intermarket swap
Rate anticipation swap
Pure yield pickup
Tax swap
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44
Select a particular holding period
and predict the yield curve at end of
period.
Given a bonds time to maturity at
the end of the holding period,
its yield can be read from the
predicted yield curve and the end-
of-period price can be calculated.
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45
Two passive bond portfolio strategies:

1. Indexing
2. Immunization

Both strategies see market prices as
being correct, but the strategies have
very different risks.
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46
Bond indexes contain thousands of issues,
many of which are infrequently traded.
Bond indexes turn over more than stock
indexes as the bonds mature.
Therefore, bond index funds hold only a
representative sample of the bonds in the
actual index.
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48
Immunization is a way to control interest rate
risk.

Widely used by pension funds, insurance
companies, and banks.

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49
Immunize a portfolio by matching the interest
rate exposure of assets and liabilities.
This means: Match the duration of the assets and
liabilities.
Price risk and reinvestment rate risk exactly cancel
out.
Result: Value of assets will track the value of
liabilities whether rates rise or fall.

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Cash flow matching = automatic
immunization.
Cash flow matching is a dedication
strategy.
Not widely used because of constraints
associated with bond choices.