DURATION AND

CONVEXITY

Duration

In 1938, Frederick Macaulay suggested a method for

determining price volatility of bonds.
He gave the name duration to the measure
now called Macaulay duration
Due to regulation there was very little volatility of interest
rates, so Duration was not popular till the 1970s
1970s onwards interest rates started to rise dramatically
Investors and traders became interested

Macaulay Duration

Measures how long, in years, it takes for the price of

a bond to be repaid by its internal cash flows.
Or Weighted average life of a bond
Which considers the size and timing of each cash flow
The weight assigned to each time period is the PV of the
cash flow paid at that time as a proportion of the price of
the bond

Features of Duration

Duration for Zero coupon bonds will be same as

maturity

The Duration has a value between 0 and maturity

period

Duration of a Zero-Coupon Bond

(maturing in 4 years)

The red lever above represents the four-year time period it takes for a zero-coupon
bond to mature.
The money bag balancing on the far right represents the future value of the bond.
The fulcrum, represents duration, which must be positioned where the red lever is
balanced.
The entire cash flow of a zero-coupon bond occurs at maturity, so the fulcrum is located
directly below this one payment.

Duration of a Coupon Bond

(coupons paid annually and maturing in five years)

The moneybags represent the cash flows you will receive over the fiveyear period.
To balance the red lever at the point where total cash flows equal the
amount paid for the bond, the fulcrum must be farther to the left, at a
point before maturity.
It pays coupon payments throughout its life and therefore repays
the full amount paid for the bond sooner

Bonds with high coupon rates and, in turn, high yields will tend
to have lower durations than bonds that pay low coupon rates
or offer low yields.

Macaulay Duration

The Formula
n

Ct (t )

t
(
1

i
)
t 1
D n

Ct

t
(
1

i
)
t 1

t PV (C )
t

t 1

price

where:
t = time period in which the coupon or principal payment occurs
Ct = interest or principal payment that occurs in period t
i = yield to maturity on the bond

Or

Duration t wt
t 1

CFt Cash Flow for period t

Coupon 8% paid annually;

Time to maturity 8 years
Discount rate 10% pa
Face and maturity value 1000

Calculate the Duration of the Bond

Time

Cash Flow

PV at 10%

Time x PV

80

72.73

72.73

80

66.12

132.23

80

60.11

180.32

80

54.64

218.56

80

49.67

248.37

80

45.16

270.95

80

41.05

287.37

1080

503.83

4030.62

Sum

5441.15

Price
Duration

=Sum/Price

893.30
5441.15/893.3

6.09105

years

Duration Calculation

Time
1
2
3
4
5
6
7
8

Cash Flow
80
80
80
80
80
80
80
1080
Price

PVs Proportion
Time X PVs
PV at 10% of Price (Wt) Proportion of Price
72.73
0.08
0.081
66.12
0.07
0.148
60.11
0.07
0.202
54.64
0.06
0.245
49.67
0.06
0.278
45.16
0.05
0.303
41.05
0.05
0.322
503.83
0.56
4.512
893.3
1.00
Duration

6.091
(in years)

Betty holds a five-year bond with a par value of $1,000 and coupon rate of
5%. For simplicity, let's assume that the coupon is paid annually and that
interest rates are 5%. What is the Macaulay duration of the bond?

= 4.55 years

Another example

Coupon 12% annually

Time to maturity 8 years
Discount rate 10% pa
FV and MV 1000

Time

Cash Flow

PV at 10%

Time x PV

120

109.09

109.09

120

99.17

198.35

120

90.16

270.47

120

81.96

327.85

120

74.51

372.55

120

67.74

406.42

120

61.58

431.05

1120

522.49

4179.91

Sum

6295.69

Price

1,106.70

Duration =

6295.691/1106.7
= 5.689

Time

Cash Flow

Proportion of
Total value

PV at 10%

Time X
Proportion of
Total Value

120

109.09

0.10

0.099

120

99.17

0.09

0.179

120

90.16

0.08

0.244

120

81.96

0.07

0.296

120

74.51

0.07

0.337

120

67.74

0.06

0.367

120

61.58

0.06

0.389

1120

522.49

0.47

3.777

Price

1,106.70
Duration

5.689

Importance of Duration

Measures bond price sensitivity to interest rate movements,

which is very important in any bond analysis

If two bonds have the same coupon rate and yield, then the bond
with the greater maturity has the greater duration.
If two bonds have the same yield and maturity, then the one with
the lower coupon rate has the greater duration.

Bonds with higher durations carry more risk and have higher
price volatility than bonds with lower durations.
Allows comparison of effective lives of bonds that differ in
maturity, coupon
Used in bond management strategies particularly
immunization

But Duration does not tell investors exactly how

much a bond's price changes given a change in
yield.
There is a relationship between Macaulay duration
and the first derivative of the price/yield function.
This relationship lead to the definition of modified
duration

Modified Duration and Bond Price Volatility

Modified Duration provides a good approximation,

particularly when interest-rate changes are small, for how
much the security price changes for a given change in
interest rates
Modified Duration Formula (D mod)

Dmod

Macaulay Duration

YTM
1
m

where:
m = number of payments a year
YTM = nominal YTM

Betty holds a five-year bond with a par value of $1,000 and

coupon rate of 5%. The coupon is paid annually and that interest
rates are 5%. Macaulay duration is 4.55

= 4.33 years for Bettys problem

where:
Dmod is the modified duration;
D is the Macaulay duration;
i is the periodic yield;
P(i) is the price of the bond at yield i.

This formula can be used to estimate the change in price for a small change
in the periodic yield:

Modified Duration and Bond Price Volatility

As A Measure of Bond Price Volatility

Bond

price movements will vary proportionally with

modified duration for small changes in yields

% change in price =

P
Dmod i
P

where:
P = change in price for the bond
P = beginning price for the bond
-Dmod = the modified duration of the bond
i = yield change in %

A Bond with Mac D of 8 years and YTM to be 10% with semi annual
compounding
Modified Duration = 8/(1+.05) = 7.62

Assume the YTM to decline by 75 basis points from 10 to 9.25%

The estimate change in the price of the bond

= - 7.62 x (-0.75%) = 5.72%
This means the bond price should increase approximately 5.72% in
response to the 75 basis points decline in YTM
If price was Rs 900 before change, then after the drop in interest
rates, the price would be 951.48

Modified Duration and Bond Price Volatility:

Trading Strategies Using Modified Duration
To

maximize returns fund managers constantly adjust the

duration of the bond portfolio
Longest-duration security provides the maximum price
variation
If you expect a decline in interest rates, increase the
average modified duration of your bond portfolio to
experience maximum price volatility i.e., buy long bonds
If you expect an increase in interest rates, reduce the
average modified duration to minimize your price decline
i.e. sell long bonds and buy short bonds or come into
cash.

Bond Convexity

Modified duration is a linear approximation of bond price

change for small changes in market yields
But, price changes are not linear, but a curvilinear (convex)
function of bond yields
Convexity refers to the degree to which duration changes as the
yield to maturity changes
The estimate using only modified duration will underestimate the
actual price increase caused by a yield decline and overestimate
the actual price decline caused by an increase in yields
Modified Duration is to be combined with the convexity to get a
better approximation of price

Some relationships

There is an inverse relationship between coupon and

convexity (yield and maturity constant)that is, lower
coupon, higher convexity.
There is a direct relationship between maturity and
convexity (yield and coupon constant)that is, longer
maturity, higher convexity.
There is an inverse relationship between yield and
convexity (coupon and maturity constant). This means
that the priceyield curve is more convex at its loweryield (upper left) segment.

Exhibit 18.21
18-29

Bond Convexity
The

Formula
d 2P
2
di
Convexity
P

3 year Bond

9% YTM

12% Coupon

FV 1000

Years

CF

PV

t2+t

Product

120

110.09

220.18

120

101.00

606.01

1120

864.85

12

10378.15

Price

1075.94

Sum

11204.34

Sum/(1.09^2)

9430.47

Convexity

8.76

Price change due to convexity

= x convexity x (change in yield^2)

Example

Consider an 8% 10-year bond at a price of 100 and a modified

duration of 6.80.
If the yield increases to10%, duration estimates the price change as
follows:
Price change = -[Duration] x [Yield Change]
Price change = -[6.80] x [2]
Price change = -13.60
The duration estimated price is 86.40 (100 13.60).
Similarly, for a 2% decrease in yields, the estimated price is 113.60
(100 + 13.60).
The actual prices should be 87.71 and 114.72, and therefore,
duration tends to underestimate the price during both rising and
falling rates.

We can get a better approximation of the new price by

including convexity :
Price Change = (- Duration x Price Yield) + (0.5 x Convexity
x (Yield Change)^2))
If the 8% 10-year bond has a 0.60 convexity, the new
estimated price change is :
Price Change = (-6.80 x 2) + (0.5 x 0.60 x 4)
Price Change = -12.40
The estimated price using convexity is now 87.60 (100
12.40).
The convexity estimate of 87.60 is much closer to the actual
price of 87.71 than the duration estimate.

Approaches for measuring interest rate risk:

Full Valuation Approach

Simplest yet comprehensive way to measure interest rate risk in a

bond.
We start with the current market yield and price of the bond.
Then we fix on the different scenarios (interest rate changes) at
which we want to value the bond, say a 0.5% increase in interest
rates.
We then re-value the bond for each interest rate scenario.
The new value is then compared to the current value to determine
the gain/loss due to changes in interest rates.
This method is also sometimes referred to as scenario analysis.
While performing scenario analysis on a portfolio of bonds, each
bond is re-valued at different interest rates and the portfolio value
is recalculated.

Approaches for measuring interest rate risk:

The Duration Convexity Approach

Full Valuation Approach is recommended and most

accurate approach to measuring interest rate risk
But it is not always practical especially when its a large
portfolio.
The full valuation approach is also very time consuming.
Managers may prefer a simpler approach which could
quickly give them an idea of how bond prices will
change with changes in interest rates.
This can be achieved by using the duration/convexity
approach.

BOND PORTFOLIO MANAGEMENT

STRATEGIES

Bond Portfolio Strategies

Passive Portfolio Strategies

Active Management Strategies

Hybrid: Immunization

Passive Portfolio Strategies

Buy and hold

A

manager selects a portfolio of bonds based on the

objectives and constraints of the client with the intent of
holding these bonds to maturity

Indexing
The

objective is to construct a portfolio of bonds that

will track the performance of a bond index

Active Management Strategies

Active management strategies attempt to beat

the market
Mostly the success or failure is going to come
from the ability to accurately forecast future
interest rates

Active Management Strategies

Forecasting Interest-rate changes

Riskiest as it involves relying on uncertain forecasts of
interest rates
Preserve capital if interest rates are expected to increase
Achieve high capital gains if interest rates are expected
to decline

Valuation Analysis
Select bonds based on their intrinsic value
Credit Analysis: detailed analysis of the bond issuer to
determine expected changes in its default risk

Exploiting Mispricing among securities

Hybrid Techniques

Immunization Strategies

The process is intended to eliminate interest rate risk that

includes:
Price Risk
Coupon Reinvestment Risk

A portfolio manager (after client consultation) may

decide that the optimal strategy is to immunize the
portfolio from interest rate changes
The immunization techniques attempt to derive a
specified rate of return during a given investment horizon
regardless of what happens to market interest rates

Classical Immunization
Immunize

a portfolio from interest rate risk by

keeping the portfolio duration equal to the
investment horizon

Consider a 12.5% bond redeemable on

1/July/2020 at a premium of 5%. If the interest
rates prevailing is 15% on 1/July/2015, what will
be price of the bond?

Face Value 100 Interest rate is 15%

12.50% Redeemable at 5% premium
Date
No. of
years

1-Jul-16

1-Jul-17

1-Jul-18

1-Jul-19

1-Jul-20

Cash Flow
Present
Value

12.5

12.5

12.5

12.5

117.5

10.87

9.45

8.22

7.15

58.42

Coupon

Total

94.11

ie the Price

Calculate the Duration

Date

1-Jul-16

1-Jul-17

1-Jul-18

1-Jul-19

1-Jul-20

No. of years

Cash Flow
Present
Value

12.5

12.5

12.5

12.5

117.5

10.87

9.45

8.22

7.15

58.42

94.11

Year * PV

10.87

18.90

24.66

28.59

292.09

375.11

DURATION

375.11/94.11
3.99

or 4 years

Total

An investor buys the 5 year bond on 1/July/2015 Sells the

bond on 1/July/2019; Holding period 4 years same as the
Duration ; Reinvest the interest amounts at 15%
Date 1-Jul-16 1-Jul-17 1-Jul-18 1-Jul-19 1-Jul-19 Total
No. of
years
1
2
3
4
4
Cash
(is the PV of 117.5 to be
Flow
12.5
12.5
12.5
12.5
102.17 received after one year)
Terminal
Value
19.01
16.53
14.38
12.50 102.17 164.59 at 15%

If the interest rates rise to 16%

Date
No. of
years
Cash Flow
Terminal
Value

1-Jul-16

1-Jul-17

1-Jul-18

1-Jul-19

1-Jul-19Total

1
12.5

2
12.5

3
12.5

4
12.5

4
101.29

19.51

16.82

14.50

12.50

101.29

164.62

If the interest rate falls to 14%

Date
No. of
years
Cash Flow
Terminal
Value

1-Jul-16

1-Jul-17

1-Jul-18

1-Jul-19

1-Jul-19Total

1
12.5

2
12.5

3
12.5

4
12.5

4
103.07

18.52

16.25

14.25

12.50

103.07

164.58

For the 4 year holding period (equal to Duration),

there is no interest rate risk at all as we see no change in the terminal value