Fall 2011

Duration and Term Structure

Prof. Page

BUSM 411: Derivatives and Fixed Income 6.

6.1.

Duration and Convexity

Interest rate sensitivity

Bond prices and yields are inversely related: as yields increase, bond prices fall and vice versa An increase in a bonds yield to maturity results in a smaller price change than a equal decrease in yield (convexity) Prices of long-term bonds tend to be more sensitive to interest rate changes than prices of short-term bonds The sensitivity of bond prices to changes in yields increases at a decreasing rate as maturity increases Interest rate risk is inversely related to the bonds coupon rate: high-coupon bonds are less sensitive to changes in interest rates than low-coupon bonds The sensitivity of a bonds price to yield changes is inversely related to the yield at which the bond currently sells

Fall 2011

Duration and Term Structure

Prof. Page

6.2.

Duration

Maturity is the key determinant of a bonds interest rate risk Even the relation between coupon rates and interest rate sensitivity really boils down to maturity: Bonds with higher coupons have more of their cash ows occurring at shorter horizons relative to low or zero coupon bonds Hence, high coupon bonds have a lower eective maturity Duration is a measure of the eective maturity of a bond or portfolio of bonds Duration combines the eects of coupon rates and actual maturity into a summary measure of interest rate risk Macaulay duration is simply a weighted average of the horizons of each of the bonds cash ows, weighted by their present value:
T

D=
t=1

CFt /(1 + y )t Bond price

where CFt is the cash ow in period t. Duration tells us how much a bonds price changes for a given change in (gross) yields: (1 + y ) B = D B (1 + y ) Practitioners often express this in a simpler, more intuitive form by dening modied duration, D = D/(1 + y ), so that B = D y B

Fall 2011

Duration and Term Structure

Prof. Page

6.3.

Properties of duration

The duration of a zero coupon bond equals its time to maturity Holding maturity constant,a bonds duration is lower when the coupon rate is higher Holding coupon rate constant, duration increases with maturity Holding other factors constant, duration of a coupon bond is higher when yield to maturity is lower Duration of perpetual bond is
1+y y

Fall 2011

Duration and Term Structure

Prof. Page

6.4.

Duration and convexity

Duration is only a local, linear approximation of the relationship between yield changes and bond price changes

We can improve our approximation of this relationship by accounting for convexity The formula for the convexity of a bond with maturity of T years and annual coupon payments is T 1 CFt (t2 + t) Convexity = 2 P (1 + y ) t=1 (1 + y )t We can then incorporate convexity into our expression for price changes as a function of yield changes: P 1 = D y + Convexity (y )2 P 2

Fall 2011

Duration and Term Structure

Prof. Page

Example: 30-year bond with 8% coupon, selling at initial yield to maturity of 8% Macaulay duration:
3

D= Modied duration:

0t=1 t

CFt /(1 + y )t $1000

= 12.16

D = D/(1 + .08) = 11.26 Convexity: 1 Convexity = $1000(1.08)2

30

t=1

CFt 2 (t + t) = 212.4 (1.08)t

Suppose the yield increases from 8% to 10%: Price = a decline of 18.85% The linear duration rules predicts a price change of P = D y = 11.26 .02 = .2252 or 22.52% P Accounting for convexity gives P 1 1 = D y +( )Convexity (y )2 = 11.26.02+( )212.4(.02)2 = .1827 or 18.27% P 2 2 a much more accurate prediction. $80 1 $1000 1 + = $811.46 3 .10 (1.10) 0 (1.10)3 0

Fall 2011

Duration and Term Structure

Prof. Page

6.5. 6.5.1

The Term-Structure of Interest Rates The yield curve

Interest rates can and often do dier for cash ows of dierent maturities. The relationship between yield and maturity is known as the term-structure of interest rates, and the graphical representation of this relationship is called the yield curve. Examples:

Figure 1: Treasury yield curves

Yield curves are typically constructed from the yields on Treasury securities, in order to isolate the relationship between yield and maturity (no default risk)

Fall 2011

Duration and Term Structure

Prof. Page

6.5.2

The yield curve and future interest rates

Where does the shape of the yield come from? Interest rate certainty (we know what the future path of interest rates will be): Suppose the yield curve is upward sloping as in the example above: the 1-year yield is 5% and the 2-year yield is 6%. Consider two strategies: (i) buy a 2-year zero-coupon bond, or (ii) buy a 1-year zero coupon bond and roll it over next year into another 1-year bond. If we invest the same initial amount (say $100) in both strategies, they must oer the same return (or else wed have an arbitrage opportunity, since neither strategy involves any risk): Buy & hold 2-year zero = Roll over 1-year bonds $100 (1.06)2 = $100 (1.05) (1 + r2 )

Solve for r2 : r2 =

(1.06)2 1 = .0701 or 7.01% > 5% (1.05)

Upward sloping yield curve means interest rates will rise! Spot rate: the current yield on a zero coupon bond of a given maturity. In the example above, the 1-year spot rate is 5% and the 2-year spot rate is 6%. Short rate: the yield for a given time interval (say a year) at dierent points in time. In the example above, todays short rate is 5% and next years short rate is 7.01%. More generally, we can nd the short rate for n periods ahead using the formula: (1 + rn ) = (1 + yn )n (1 + yn1 )n1

In reality, we dont know future interest rates with certainty, so we refer to the interest rate backed out in this manner the forward rate. The forward rate need not equal the actual future short rate or even the expected future short rate if investors require some sort of liquidity premium. Forward rates and interest rate risk: 7

Fall 2011

Duration and Term Structure

Prof. Page

Investors with short horizons prefer to lock in an interest rate by investing in short-term bonds, rather than long-term bonds to be sold for an uncertain price in the future. Short-term investors would require a liquidity premium to invest longer-term bonds forward rate is higher than expected future short rate Long-term investors would prefer to lock in long-term interest rates, rather than subjecting themselves to interest rate risk by rolling over Forward rate is lower than expected short rate!

Fall 2011

Duration and Term Structure

Prof. Page

6.5.3

Theories of the term structure

Expectations hypothesis Slope of the yield curve is due to expectations of changes in short-term interest rates Under this hypothesis, forward rate equals the market consensus expectation of future short rate This can lead to either upward or downward sloping yield curves depending on what the expectations of future short rates are Liquidity preference People prefer liquidity (matching maturity to investment horizons) Short-term investors dominate the market, so long-term bonds must oer a liquidity premium in order to get individuals to invest in them. The liquidity premium on longer-term bonds leads to an upward sloping yield curve (which is what we usually observe) The two theories arent mutually exclusive. Expectations of future short rates interact with required liquidity premia to produce various shapes of the yield curve:

Fall 2011

Duration and Term Structure

Prof. Page

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Fall 2011

Duration and Term Structure

Prof. Page

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Fall 2011

Duration and Term Structure

Prof. Page

6.5.4

Interpreting the term structure

If term structure reects market expectations of future interest rates, we can use the term structure to infer the markets expectations This expectation can serve as a benchmark for our own analysis and help guide our investment decisions Problem: we cannot tell how much an upward sloping yield curve is due to expectations of interest rate increases and how much is dues to a liquidity premium fn = E [rn ] + Liquidity premium Still, very steep yield curves are typically taken as an indicator of interest rate increases We can more safely interpret a downward sloping yield curve as evidence that interest rates are expected to decline

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