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Chapter 7 Bond Management

7.1 Macaulay Duration
Definition 7.1.1. Suppose an investor purchases a n-year semiannual coupon bond for P0 at time 0 and holds it until maturity. As the amounts of the payments she receives are different at different times, one way to summarize the horizon is to consider the weighted average of the time of the cash flows. We use the present values of the cash flows (not their nominal values to compute the weights. !onsider an investment that generates cash flows of amount Ct at time t = 1, , n, measured in payment periods. Suppose the rate of interest is i per payment period and the initial investment is P. We denote the present value of Ct by PV(Ct), which is given by

"sing PV(Ct) as the factor of proportion, we define the weighted average of the time of the cash flows, denoted by D, as

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As wt 0 for all t and wt = 1, wt are properly defined weights and D is the weighted average of t = 1, , n. We call D the #acaulay duration, which measures the average period of the

investment. D is calculated in terms of the number of payment periods $f there are % payments per year and we desire to e&press the duration in years, we replace t by t/k. 'he resulting value of D is then the #acaulay duration in years.

Example 7.1.2. !alculate the #acaulay duration of a (-year annual coupon bond with )* coupon and a yield to maturity of +.+*. Solution:

Example 7.1.3. !alculate the #acaulay duration of a ,-year semiannual coupon bond with (* coupon per annum and a yield to maturity of (.-* compounded semiannually. Solution: Definition 7.1. . !onsider a bond with face value (also the redemption value F , coupon rate r per payment, and time to maturity of n payment periods. 'he rate of interest i applicable is the yield to maturity per coupon-payment period. .ow Ct is e/ual to Fr for t = 1, , n - 1 and Cn = F r + F, therefore

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We have P=(F r)an + Cvn . 0ence the #acaulay duration of the bond is (in terms of the number of payment periods .

Example 7.1.!. !alculate the #acaulay duration of the bonds in 1&amples 2.3., and 2.3.4 using e/uation (2.3.( . Solution:

7.2 Modified Duration

Definition 7.2.1. While the #acaulay duration was originally proposed to measure the average horizon of an investment, it turns out that it can be used to measure the price sensitivity of the investment with respect to interest-rate changes. 'o measure this sensitivity we consider the derivative dP /di. As the price of the investment P drops when interest rate i increases, dP /di < 0. We consider (the negative of the percentage change in the price of the investment per unit change in the rate of interest, i.e., -(dP /di)/P .

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and call it the modified duration, which is always positive and measures the percentage decrease of the value of the investment per unit increase in the rate of interest. Example 7.2.2. !alculate the #odified duration of the bonds in 1&amples 2.3., and 2.3.4 Solution:

7.3 Duration for price correction

Definition 7.3.1. We now consider the use of the modified duration to appro&imate the price change of a bond when the rate of interest changes. We denote P(i) as the price of a bond when the yield to maturity is i per couponpayment period. When the rate of interest changes to i + i, the bond price is revised to P (i + i). 5or a continuous function (!) with first- and second-order derivatives, the function evaluated at ! + !, i.e., (! + !), can be appro&imated by 'aylor6s e&pansion as follows 7

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'hus, if we e&pand the bond price P (i+i) using 'aylor6s e&pansion up to the first-order derivative, we obtain

0ence, we can use the modified duration to obtain a linear appro&imation to the revised bond price with respect to a change in the rate of interest. .ote that in the above formula , as i is per coupon-payment period, D" and i should also be measured in coupon-payment period. 0owever, we may also e&press D" in years, in which case i is the change in the rate of interest per annum. Example 7.3.2. A 30-year semi-annual coupon bond with coupon rate of 2* is selling to yield ).+* per year compounded semi-annually. What is the bond price if the yield changes to (a )*, and (b ).2*, compounded semi-annually8 Solution:

5igure 2.4.4 illustrates the application of 9efinition 2.4.3. 'he relationship between the bond price and the rate of interest is given by the curve, which is conve& to the origin. 'he final e/uation in definition 2.4.3. appro&imates the bond price using the straight line which is tangent to the point (i, P (i)) with a negative slope of -P (i)D". .ote that due to the conve&ity of the relationship between the interest rate and the bond price, the correction based on the modified duration always under-appro&imates the e&act price.

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"igure 7.3.3: Bond#price approximation u$ing modified duration

7. Con%exity
Definition 7. .1. 'o obtain a better appro&imation for the bond price, we apply 'aylor6s e&pansion in 2.4.3 to the second order, giving

.ow we define the conve&ity of the bond as

So,

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:ased on the definition 2.3.3 the conve&ity is

5or a bond investment, Ct 0 for all t, so that C # 0, verifying the conve&ity relationship. Example 7. .2. ;evisit 1&ample 2.4.,. and appro&imate the bond prices with conve&ity correction. Solution:

7.! Some &ule$ for Duration

We summarize some useful rules for duration.

&ule 1: $%& 'a(a)*a+ d)rati,n D , a -,nd i. a*wa+. *&.. t%an ,r &/)a* t, it. ti0& t, 0at)rit+ n. 1/)a*it+ %,*d. ,n*+ ,r a 2&r,-(,)3,n -,nd.

&ule 2: 4,*din5 t%& ti0& t, 0at)rit+ n , a -,nd (,n.tant, w%&n t%& (,)3,n rat& , int&r&.t r d&(r&a.&., t%& 'a(a)*a+ d)rati,n D in(r&a.&..

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&ule 3: 6t%&r t%in5. -&in5 &/)a*, w%&n t%& +i&*d t, 0at)rit+ i d&(r&a.&., t%& 'a(a)*a+ d)rati,n D in(r&a.&..

&ule : F,r a *&v&* 3&r3&t)it+, t%& 0,di i&d d)rati,n D" i. &/)a* t, 1/i.

&ule !: F,r a *&v&* ann)it+ , n 3a+0&nt., t%& 0,di i&d d)rati,n i.

'his rule can be proved by direct differentiation of the price of the annuity,

&ule ': $%& 0,di i&d d)rati,n D" , a (,)3,n -,nd wit% (,)3,n rat& , r 3&r 3a+0&nt, n 3a+0&nt. t, 0at)rit+ and +i&*d t, 0at)rit+ , i i.

&ule 7: F,r a (,)3,n -,nd .&**in5 at 3ar, t%& 0,di i&d d)rati,n i.

&ule (: 4,*din5 ,t%&r t%in5. (,n.tant, a -,nd7. d)rati,n D ).)a**+ in(r&a.&. wit% it. ti0& t, 0at)rit+ n. Suppose a portfolio of bonds is constructed from ' bonds, with durations D1 D'. <et the bond values be P1, , P' , so that their total is P = P8 (8=1, , '). 9efine w8 = P8 /P as the weight of :ond = in the portfolio, then the duration DP of the portfolio is the weighted average of the bond durations, i.e.,

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Example 7.!.1. A bond manager has a choice of two bonds, A and :. :ond A is a (-year annual coupon bond with coupon rate of )*. :ond : is a ,-year annual coupon bond with coupon rate of (*. 'he current yield to maturity in the mar%et is +.+* per annum for all maturities. 0ow does the manager construct a portfolio of >300 million, consisting of bonds A and :, with #acaulay duration of ,.+ years8 Solution:

7.' )mmuni*ation Strategie$

5inancial institutions are often faced with the problem of meeting a liability of a given amount sometime in the future. We consider a liability of amount V to be paid $ periods later. A simple strategy to meet this obligation is to purchase a zero- coupon bond with face value V, which matures at time $.
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'his strategy is called ca$h#flo+ matching. When cash-flow matching is adopted, the obligation is always met, even if there is fluctuation in the rate of interest. 0owever, zero-coupon bonds of the re/uired maturity may not be available in the mar%et. $mmunization is a strategy of managing a portfolio of assets such that the business is immune to interest-rate fluctuations. 5or the simple situation above, the target#date immuni*ation strategy may be adopted. 'his involves holding a portfolio of bonds that will accumulate in value to V at time $ at the current mar%et rate of interest. 'he portfolio, however, should be constructed in such a way that its #acaulay duration D is e/ual to the targeted date of the liability $. Suppose the current yield rate is i, the current value of the portfolio of bonds, denoted by P (i), must be P (i) = V/ (1 + i)$ $f the interest rate remains unchanged until time $ , this bond portfolio will accumulate in value to ? at the maturity date of the liability. $f interest rate increases, the bond portfolio will drop in value. 0owever, the coupon payments will generate higher interest and compensate for this. @n the other hand, if interest rate drops, the bond portfolio value goes up, with subse/uent slow-down in accumulation of interest. "nder either situation, as we shall see, the bond portfolio value will finally accumulate to V at time $ , provided the portfolio6s #acaulay duration D is e/ual to $ . We consider the bond value for a ,n&-ti0& .0a** (%an5& in the rate of interest. $f interest rate changes to i + i immediately after the purchase of the bond, the bond price becomes P (i + i) which, at time $ , accumulates to P (i + i)(1 + i + i)$ if the rate of interest remains at i + i. We appro&imate (1 + i + i)$ to the first order in Ai to obtain (apply 'aylor6s e&pansion to (i) = (1 + i)$ )

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0owever, as D" = D/(1+i) and $ = D, the above e/uation becomes

Example 7.'.1. A company has to pay >300 million 4.)2)3 years from now. 'he current mar%et rate of interest is +.+*. 9emonstrate the funding strategy the company should adopt with the )* annual coupon bond in 1&ample 2.3.,. !onsider the scenarios when there is an immediate one-time change in interest rate to (a +*, and (b )*. Solution:

Example 7.'.2. A company has to pay >300 million ( years from now. 'he current mar%et rate of interest is +.+*. 'he company uses the )* annual coupon bond in 1&ample 2.3., to fund this liability. $s the bond sufficient to meet the liability when there is an immediate one-time change in interest rate to (a +*, and (b )*8 Solution:

5igure 2.).4 describes the wor%ing of the target-date immunization strategy. $f a financial institution has multiple liability obligations to meet, the manager may adopt cash-flow matching to each obligation. 'his is a dedication $trategy in which the manager selects a portfolio of bonds (zerocoupon or coupon bonds to provide total cash flows in each period to match the re/uired obligations.
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B 'he manager may also consider the liability obligations as a whole and construct a portfolio to fund these obligations with the ob=ective of controlling for the interest-rate ris%. A commonly adopted strategy is duration matching.

"igure 7.'.3: )llu$tration of target#date immuni*ation We assume a financial institution has a stream of liabilities 91, 9: 9; to be paid out at various times in the future. $t will fund these liabilities with assets generating cash flows <1, <:, <' at various times in the future. We assume that the rate of interest i am fiat for cash flows of all maturities and apply to both assets and liabilities.

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We denote the #acaulay durations of the assets and liabilities by D< and D9, respectively. 'he duration matching strategy involves constructing a portfolio of assets such that the following conditions hold7 3. V< V9 ,. D< = D9. !ondition , ensures that, to the first-order appro&imation, the asset- liability ratio will not drop when interest rate changes. 'his result can be deduced as follows7

Example 7.'. . A financial institution has to pay >3,000 after , years and >,,000 after ( years. 'he current mar%et interest rate is 30*, and the yield curve is assumed to be fiat at any time. 'he institution wishes to immunize the interest rate ris% by purchasing zerocoupon bonds which mature after 3, 4 and + years. @ne member in the ris% management team of the institution, Alan, devised the following strategy7 B Curchase a 3-year zero-coupon bond with a face value of >((.2(, B Curchase a 4-year zero-coupon bond with a face value of >,,(+0.-4, B Curchase a +-year zero-coupon bond with a face value of >+00.00. (a 5ind the present value of the liability. (b
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Show that Alan6s portfolio satisfies the conditions of the duration matching

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strategy. (c 9efine surplus = = V< - V9, calculate S when there is an immediate one-time change of interest rate from 30* to (i D*, (ii 33*, (iii 3+*, (iv 40* and (v -0*. (d 5ind the conve&ity of the portfolio of assets and the portfolio of liabilities at i E 30*. Solution:

'o protect the asset-liability ratio from dropping when interest rate changes, the ;edington immunization strategy, named after the :ritish actuary 5ran% ;edington, imposes the following three conditions for constructing a portfolio of assets7 3. V< V9 ,. D< = D9. 4. C< # C9.

Example 7.'.!. 5or the financial institution in 1&ample 2.).(, a ris% consultant, Alfred, recommended the following strategy7 Curchase a 3-year zero-coupon bond with a face value of >3+(.3), Curchase a 4-year zero-coupon bond with a face value of >,,3-).0(, Curchase a +-year zero-coupon bond with a face value of >))0.3-. (a Show that Alfred6s portfolio satisfies the three conditions of the ;edington immunization strategy. (b 9efine surplus = = V< - V9, calculate S when there is an immediate one-time change of interest rate from 30* to (i D*, (ii 33*, (iii 3+*, (iv 40* and (v -0*. Solution:

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"nder certain conditions, it is possible to construct a portfolio of assets such that the net-worth position of the financial institution is guaranteed to be non-negative in any positive interest rate environment. A full immunization strategy is said to be achieved if under any one-time shift of interest rate from i0 to i, =(i) = V<(i) - V9(i) 0, ,r i # 0.

We consider the e&ample of a single liability of amount 9 to be paid $9 periods later. 5ull immunization strategy involves funding the liability by a portfolio of assets which will produce two cash inflows. 'he first inflow of amount <1 is located at time $1, which is 1 periods before time $9. 'he second inflow of amount <: is at time $:, which is : periods after time $9. 5igure 2.).) illustrates these three cash flows . $t should be noted that all the values of i0, i, <1, <:, 9, 1, :, $9 , $1 and $: are positive, and A3 is not necessarily e/ual to :.

$n this particular e&ample, the conditions for constructing a portfolio of assets under the full immunization strategy are7 3. V<= V9 ,. D< = D9

"igure 7.'.' 'he above conditions can be rewritten as7

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Example 7.'.7. 5or the financial institution in 1&amples 2.).( and 2.).+, an actuary, Albert, constructed the following strategy7 B Curchase a 3-year zero-coupon bond with a face value of >(+(.++, B Curchase a 4-year zero-coupon bond with a face value of >3,(+D.0D, B Curchase a +-year zero-coupon bond with a face value of >3,300.00. (a Show that Albert6s portfolio satisfies the conditions of the full immunization strategy. (b 9efine surplus = = V< - V9, calculate = when there is an immediate one-time change of interest rate from 30* to (i D*, (ii 33*, (iii 3+*, (iv 40* and (v -0*. Solution: 'o compare the duration matching, ;edington and full immunization strategies, the results of 1&amples 2.).(, 2.).+ and 2.).2 are plotted in 5igure 2.).-.

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7.7 ,a$$i%e %er$u$ -cti%e Bond Management

A bond fund may adopt a passive or active strategy. A passive strategy adopts a non e&pectational approach, without analyzing the li%ely movements of the mar%et. $mmunization, inde&ing and buy-and-hold are passive bond management strategies. An active bond management strategy may involve some form of interest-rate forecasting. A broader active management framewor% would ta%e a /uantitative approach in assessing the value of a bond, ta%ing into account all embedded options and structures of the bond, and includes assessment of the sector of the bond issuer and its credit profile.

Financial Mathematics- Actuarial 2013-2014 Jihane Bou Zakhem