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# Chapter 5

## Price Yield and Term Structure Relationship

The price of a bond is equal to the present value of all coupon interest and
principal discounted at the required yield. The change in yield (y) as well as
failure to pay coupon interest (C=coupon rate*F) and or principal on a timely
basis adversely affects the value of the underlying bond and at the limit the bond
price will be equal to the recovery value in the state of bankruptcy. For an n year
balloon bond, the intrinsic value (P) is as follows in Equation 5.1.

P= C/(1+ y)^1+ C/(1+ y)^2+ C/(1+ y)^3+ C/(1+ y)^n+ F/(1+ y)^n (5.1)

Where coupon rate can be fixed or floating; F is the face value of the bond; y is
the required yield or yield to maturity of the bond; and n is the maturity of the
issue. An n year bond price in equation 1 can be considered as a portfolio of (n+1)
zero coupon bonds. For example, C/(1+ y)^1 is a 1-year zero, C/(1+ y)^2 is a 2-
year zero and so on.
Bond price can change for the following reasons:
Change in credit quality of a firm resulting a change in required yield;
Change in required yield due to changes in the market yield for comparable
bonds; and
Change in price of a bond without a change in required yield as bond approaches
its maturity (premium or discount bond).
The yield on a bond is affected by the following factors:
Base interest rate
Yields On the run Treasuries (the yield on newly issued versus the yield on the old
issue (off-the run)
Types of issuers
Credit worthiness of the issuer
Inclusion of options
Taxability of the interest
Expected liquidity of an issue
Term to maturity

Risk free interest rates such as the rate on the US Treasury securities set the base
interest rate. For risky issuers such as corporate, financials, utilities, etc, the yield is
adjusted upward by the risk premium (likelihood of default), types of collateral
securing the debt, credit quality of the issuer as AAA bonds yield is lower than a
comparable maturity rated AA. Inclusion of options (callable) increases the yield for
callable bond, as compared to a straight bond with no options. The yield on Putable
bonds is lower than the yield on comparable straight bonds as investors have the
option to put the bond back to issuer usually at the worst time. The yield is also
affected whether or not the coupon interest is taxable or tax exempt (Municipal

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bonds). The yield is inversely related to the expected liquidity (highly liquid
treasuries/ little or no liquidity troubled loan assets on bank balance sheet) of the issue
and positively related to term to maturity.
For example, consider a 30-year zero coupon bond rated to yield 6 percent. The face
value of the bond is \$100 million. Exhibit 5.1 shows the price yield relationship for
this bond assuming various yields. The price yield is non-linear convex demonstrating
inverse relationship between price and yield.

Exhibit 5.1:

Exhibit 5.2 demonstrates the price yield relationship for a 2 year 6 percent coupon
paying bond rated to yield in the range of 2 to 12 percent. While the price and
yield is inversely related, there is little or no convexity in the bond as the price
and yield appear to be linear.

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Exhibit 5.2:

## Nonlinearity is induced by inclusion of options (call or put) in the price generating

process of a bond making it positively convex such as convertible bonds or negatively
convex (concave) such as callable bonds.

## Bond Price Volatility

Price volatility is measured by the duration of a bond which is equal to the slope of the
price yield relationship in Exhibit 5.3 weighted by the market value of the bond.
Duration is the price sensitivity of the bond with respect to change in yield and
therefore can be considered as price elasticity. For that matter, some bonds are more
price elastic than others and offer the potential for enhancing yields in active
portfolio management. For example, consider bond A and B in Exhibit 5.3. Bond B
has greater convexity compared to bond A in Exhibit 5.3. The greater positive
convexity is associated with higher price change for a given change in yield when
yield is falling. However, when yield increases bond B price is expected to fall less
than bond A other things remaining the same. Bond B is likely to be a deep discount
bond or convertible bond whose value is equal to a straight bond plus a call option.
While rising yield adversely affects the value of straight bond, it positively affects
the intrinsic value of call option, therefore reducing the impact of the rising yield on
the value of positively convex bond such as convertibles.

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Exhibit 5.3: Price Yield Relationship

Price

A B

## P [Slope = P / Y]. 1/ P = Duration

Y Actual Price

Forecast Price

Yield
5% 6% 7%

Duration can also be defined in terms of number of years, as is practiced on Wall Street,
as the sum of cash flows (multiplied by the present value of the time) in which each
cash flow is recognized weighted by the market value of the bond. In this context
duration measures the size and timing of the cash flows as seen in Equation 5.2
n
D = [ (t C)/(1+y)^t +(n. F)/ )/(1+y)^n] / P (5.2)
t =1

Where, all the parameters are as previously defined. The term in the bracket is the slope
of the price yield relationship P / Y, first derivative of bond price with respect to
change in yield and is also called dollar duration.
Duration of the three-year bond in Exhibit 5.1 is estimated using Equation 5.2 to be 2.83
years as follows:

## D = {(1x60)/ (1.06) + (2x60)/(1.06)2 + (3x60)/(1.06)3 + (3x1000)/(1.06)3 }/1000

= - 2.83

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Example: Consider a 6 percent coupon bond rated to yield 6 percent. This bond has a
maturity of 15 years and face value of \$1000. The coupon is made once a year. Duration
of this bond is 10.21 year in table 5.1.

Table 5.1: McCauley Duration for a 15 year 6 percent bond rated to yield 6 percent
t
(1/
1+
y)^ tc*(1/1+
c tc t y)^t
0.94339
1 60 60 6 56.6037736
0.88999
2 60 120 6 106.799573
0.83961
3 60 180 9 151.131471
0.88999
2 60 120 6 106.799573
0.74725
5 60 300 8 224.177452
0.70496
6 60 360 1 253.785795
0.66505
7 60 420 7 279.323988
0.62741
8 60 480 2 301.157938
0.59189
9 60 540 8 319.62517
0.55839
10 60 600 5 335.036866
0.52678 (n*f)/ FIRST
11 60 660 8 347.679767 ((1+y)^n) DERIVATIVE
0.49696
12 60 720 9 357.817942 6258.975911 10211.68
0.46883
13 60 780 9 365.694437 Price Duration
0.44230
14 60 840 1 371.53281 (\$1,000.00) 10.21
0.41726
15 60 900 5 375.538555
SUM 3952.70511

## McCauley duration is 10.21 years. Duration is weighted by the (1+R) known as

Modified Duration (D/ (1+R)). The modified duration of this bond is 10.21/1.06, or
9.63 year. Duration and yield is inversely related as shown in the Table 5.2.

Table 5.2: Duration and yield for a 15 year 6 percent bond rated to yield 6%

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Yield Duration
0.03 10.95
0.04 10.71
0.05 10.46
0.06 10.21
0.07 9.96
0.08 9.70
0.09 9.45
0.1 9.18
0.11 8.92
0.12 8.68

Duration is indicating that for every +/-100 basis points (1 percent) change in the yield
the bond price is expected to change symmetrically in the opposite direction by -/+ 9.63
percent. Assuming the bond pays coupons semi-annually, the number of periods is
doubled to 30, and the coupon is reduced by half in table 5.1. Therefore, the dollar

## Example: Verify that McCauley duration in table 5.1 assuming semi-annual

compounding is equal to 10.07 years.

The price yield relationship in Exhibit 5.3 is a nonlinear convex set because the
percentage changes in bond or stock prices or the price of any asset, financial or real,
is non-symmetric, while duration as a measure of volatility is linear, additive, and
symmetric.
For example, the price of a stock is currently at \$50. The price goes up to \$75 for a
gain of 50 percent and the price drops to \$50 from \$75 for a loss of 33.33 percent.
The percentage changes are non-symmetric. The additive property of duration
implies that the duration of the portfolio is the simple weighted average of the
duration of individual assets in the portfolio as each asset is weighted by the market
value not the book value against the total market value of the portfolio. The
symmetric property of duration implies that the extent of the exposure to the bond
portfolio as a result of changes in the yield for plus or minus say 100 basis points
will be the same. The exposure is defined in Equation 5.3 as the changes in the
market value of the portfolio of assets or liabilities as P = Pt Pt-1 that is related
linearly to duration of the portfolio (Dp) as well as to the market value of the
portfolio (P) and to the changes in the yield ( Y) as follows:

P = - Dp P. Y (5.3)

## P = - (modified duration)* (market value of the portfolio)* (change in yield)

Example: Horizon bond portfolio currently has a market value of \$350 million with a
modified duration of 9.375 years. The portfolio manager is expecting rates to go up as the

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outlook of higher growth for the economy is improving. Therefore the portfolio manager
is contemplating shortening the duration of its portfolio to seven years assuming the
portfolio manager is expecting a 50 basis point increase in the yield in the next three to
six months. The amount of the exposure for this portfolio is symmetrical to +/-
\$16,406,250 as follows.

## P = -9.375 (\$350,000,000) (+/- .0050)

P = +/-16,406,250

## The above portfolio is expected to decrease or increase in value in excess of \$16.4

million for a 50 basis point increase or decrease in the yield because the yield and price
are inversely related. When the yield changes are small, duration provides an estimate of
the exposure that is close to actual changes in the market value of the portfolio; however,
when the yield changes are large duration underestimates the actual changes in the price
of a bond when the bond price changes in either direction.

## Dollar Value of 1 Basis Point (DVO1)

DV01 can be estimated using Equation 5.3 for a bond or portfolio of credits. For
example, DV01 for the above portfolio is:

## P = -9.375 (\$350,000,000) (+/- .0001)

= +/- \$328,125

The portfolio value is expected to change by +/-\$328,125 for every 1 basis point change
in the yield. DV01 conveys useful information to a portfolio manager as some of the
proprietary web sites such as Bloomberg and Reuters report this statistics for their
member clients. The portfolio duration for the Treasury sector is equal to 6.56 year as
individual duration is value weighted by the respective duration in Table 5.3.

Table 5.3: A Few Key Statistics for Treasury and Corporate Sector
Issuer Coupon Maturity YTM Modified DV01 Par Full S&P
% % Duration \$ Amount Price Credit
(Year) (million) (000) Rate
Treasury 6.5 2/15/10 4.55 6.56 50,109.87 67 76,387
Treasury 5.625 5/15/08 4.64 5.48 54,121.57 92 98,762
Treasury 5 8/15/11 4.57 7.77 203,838.95 84 87,192
Treasury 6.56 172,095.69 262,341
Sector
Time Warner 8.18 8/15/07 5.47 4.72 44,231.12 82 93,710 BBB+
Enterprise
Texas 6.375 1/1/08 6.19 5.06 15,523.06 30 30,678 BBB
Utilities
Rockwell 6.15 1/15/08 6.04 5.13 26,735.52 52 52,837 A
International
Transamerica 9.375 3/1/08 6.34 4.93 8,600.38 15 17,445 AA-

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Corporation
Coastal 6.5 6/1/08 6.76 5.25 15,830.32 30 30,153 BBB
Corporation
United 6.831 9/1/08 5.99 5.51 22,011.89 38 39,949 A-
Airlines
Source: Bloomberg Financial

In the Treasury sector all three bonds are premium bond as the respective coupon is
higher than the yield. In the corporate sector all bonds are premium bonds, except for the
bond issued by Coastal Corporation with face value of \$30 million, and full price of
\$30.153 million that is a typo error. The full price (market value has to be below \$30
million face value as yield is higher than coupon of 6.5 percent). Duration of portfolio is
defined as follows in equation 5.4:
Dp= Wi*Di (5.4)

Where wi and Di are respectively the proportion and duration of the i-th bond in the
portfolio. For the Treasury sector duration of the portfolio Dp is as follows:

Dp = 76,387/262,341*6.56+98762/262,341*5.48+87192/262,341*7.77
= 6.56

Consider the three bonds in Exhibit 5.4 the forecasted percentage price changes based on
duration and actual percentage price changes for plus or minus 100 basis points change in
the yield.

Exhibit 5.4: Actual and Forecasted Percentage Price Changes Based on Duration
Maturity Coupon Yield Price Modified Duration Actual% price change for
+ 100 - 100 a
bps bps

## 3 6 6 1000 2.67 - 2.66 + 2.75

20 0 6 306.55 18.87 -17.60 +21.49
25 6 9 703.57 10.62 -9.76 +11.60
a
Actual percentage price changes are estimated as (Pn Pi)/ Pi where Pn and Pi are,
respectively, new price and initial price of the bond.

The 20-year pure zero coupon bond has the highest price volatility as reflected in the
modified duration of 18.87 years. The actual percentage price change for this bond is
17.60 and +21.49 percent respectively for +/- 100 basis points change in the yield as seen
in Exhibit 5.4. The forecast based on duration is predicting that the price is expected to
change by +/-18.51 percent for every 1 percent change in the yield. The duration alone is
not sufficient to capture the percentage change in price of bond due to convexity of this
bond.1
Similarly, the 20-year bond in Exhibit 5.4 has more convexity than the other two bonds
as reflected in the actual price changes for +/-100 basis points change in the yield when
compared to the other two bonds. The convexity captures the curvature of the price yield
relationship as bond B in Exhibit 5.2 enjoys higher convexity (positive) as compared to

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bond A. The price of the positively convex bond is expected to increase more for a
decrease in yield, while the price is expected to drop less in the event of an increase in the
yield than a bond with smaller or no convexity.
For example, for 3 and 25-year coupon paying bonds, the actual percentage price
changes and the forecast of the percentage price changes based on their respective
duration are approximately close as shown in Exhibit 5.4. For example, the price of a 25-
year coupon paying bond is expected to change by +/-10.62 percent as reflected in its
duration. However, the actual percentage price changes of this bond are respectively
-9.76 and +11.6 percent for +/-100 basis point change in the yield as seen in Exhibit 5.4.

For duration based active bond portfolio management see the following excerpt taken
from Bondweek:

Indiana Farm Bureau Insurance will look to swap out of financials into triple-B utilities
on the view that utilities are oversold as a result of Enron-related worries. The
Indianapolis-based insurer has an effective duration of approximately 5.58 years. It does
not follow a benchmark, but does not like to let duration fall below 5.5 years. It allocates
56.7 percent to corporates, 13.6 percent to utilities, 9.5 percent to CMOs, 8.6 percent to
collateralized debt obligations, 3.1 percent to Treasuries, 3 percent to taxable municipal
bonds, 2.8 percent to Fannie Mae Delegated Underwriting and Servicing pools, 1.5
percent to asset-backed securities, 7 percent to agency pools, and 0.3 percent to agencies.

## Source: www.Bondweek.com January 7, 2002.

Approximate Duration: When the yield changes are small the forecast price based on
duration is nearly the same as the actual price as is evidenced in Exhibit 5.4.
However, the forecast error increases as the changes in yield becomes substantial.
The changes in the yield in reality are relatively small in the market and approximate
duration (Da) in Equation 5.5 provides a reasonable estimate of the exposure to bond
or bond portfolio as follows:

Da = (P+- P -) / (2 Pi Y) (5.5)

Where P+ is the new price of bond when yield increases, P - is the new price of the bond
when yield decreases, and Pi is the initial price of the bond. The approximate duration
estimated using Equation 5.5 for bonds are shown in Exhibit 5.5.

## Exhibit 5.5: Estimates of Approximate Duration

Maturity Coupon Yield Price Modified Duration Approximate Duration
3 6 6 1000 2.67 2.709
20 0 6 306.55 18.87 19.54

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25 6 9 703.57 10.62 10.68

With the exception of the long-term 20-year pure zero coupon bond, the approximate
duration provides a reasonable estimate of the volatility of bond. This procedure will be
employed throughout the remainder of the book. When the yield changes are relatively
high duration and convexity combined can be used to measure the exposure to the bond
or the bond portfolio. The percentage change in price due to duration and convexity is
defined in Equation 5.6.

## P/P = - (modified duration) (change in yield) + (convexity) (change in yield)2

Where C is the convexity of the bond and other parameters are as defined previously.
Convexity is defined as the second derivative of the bond with respect to change in yield
weighted by the market value of the bond P as (dP2/ dy2) (1/ P). The convexity can be
calculated as follows in equation 5.7:
n
[dP / dy ]*1/ P = [ (t) (t+1). C) / (1+y) ^t+2 + (n) (n+1)*F / (1+y) ^ n+2] / P
2 2
(5.7)
t =1
The convexity of the bond in table 5.1 is estimated as follows in table 5.4.

Table 5.4: Estimate of Convexity for a 15 year 6 percent bond rated to yield 6 percent
1/
t*(t+1) (1+y)^t+ t*(t+1)*C*1/ (n) (n+1)*F / (1+y) ^
t C *C 2 (1+y)^t+2 n+2
0.839619 15*16*1000/
1 60 120 283 100.754314 (1+0.06)^17
0.792093
2 60 360 663 285.1537188 89127.46046
0.747258
3 60 720 173 538.0258845
0.704960
4 60 1200 54 845.9526485
0.665057
5 60 1800 114 1197.102805
0.627412
6 60 2520 371 1581.079176
0.591898
7 60 3360 464 1988.778837
0.558394
8 60 4320 777 2412.265436
0.526787
9 60 5400 525 2844.652637
0.496969
10 60 6600 364 3279.9978

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0.468839
11 60 7920 022 3713.205056
0.442300
12 60 9360 964 4139.937027
0.417265 126918.491
13 60 10920 061 4556.534463 Second derivative 1
0.393646
14 60 12600 284 4959.943175 Price 1000
0.371364 126.9
15 60 14400 419 5347.647628 Convexity 1
SUM 37791.03061

Assuming the coupon is paid semi-annually; the convexity in half a year has to be
converted into convexity in years as follows:

## Convexity in years = convexity in half year/m2

Where, m is the frequency of compounding per year.
Approximating percentage change in the price of a bond in Exhibit 5.4 using both
duration and convexity provide far more reliable estimate of the actual change. For
example, the percentage price change for +/- 100 basis points change in yield produce an
expected change in price of + 10.26 percent, or -9 percent.

P/P = - Dp. Y + C. ( Y) 2
=- 9.63(+/- .01) + *126.91*(+/-.01)2
= +/- .0963+.0063=.1026 or -.09

The actual percentage change in price of bond in Exhibit 5.4 for +/- 100 basis points is
equal to +11.03 percent or -9.08 percent. Approximating percentage price change based
on duration alone produces +/- 9.93 percent. As is evidenced from the example, inclusion
of convexity improves forecasts. This improvement is far more significant for deep
discount bond as compared to coupon paying bonds.
The approximate convexity (Ca) is defined in Equation 5.8.

## Ca = [(P++ P -) - 2 Pi]/ ( Pi ( Y) 2 (5.8)

The approximate convexity for a 20-year zero-coupon bond assuming yield changes by
+/-100 basis points is as follows:

## Ca = [(252.56 + 372.42) - 2 x 306.55]/ (306.55) (.01) 2

= 387.53

The percentage change in price due to duration and convexity in Equation 5.7 for the 20-
year zero-coupon bond will be equal to

## P/P = -18.51(+/- .01) + (387.53) (.01)2

= +/- .1851 +.0194
= + .2045, -.1657

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The actual convexity of the above bond is equal to 386.47. 2 The percentage price changes
due to duration and convexity combined are respectively +.2045 and -.1657, which is a
substantial improvement over the estimates provided by duration alone in Exhibit 5.4.

## Theories of Term Structure of Interest Rates

Assuming the Treasury yields for various maturities are upward sloping (i.e., long-term
rates are higher than their short-term counterparts). The forward rates will be greater than
their spot counterpart. However, if the spot rate curve or the term structure of the spot
rates is inverted then the forward rate derived from the spot rates will be below their spot
counterpart. Exhibit 5.6 shows the behavior of the yield to maturity, spot rates and the
forward rates.

When the yield is upward sloping the spot rate is over and above the yield to maturity and
the forward rates is greater than the spot rates. However, in an inverted yield market the
reverse is true. That is, the forward rates will be below the spot rates and spot rates below
the yield to maturity.

Spot Rate: The spot rate or theoretical spot is the rate that equates the present value of
cash flows from a portfolio of zero coupon bonds to the market value of the coupon
paying debt instrument. For example, any coupon paying debt instrument can be defined
as a portfolio of zero coupon bonds with a maturity corresponding to the maturity of the
coupon that is discounted at a portfolio of spot rates. The yield to maturity and spot rate
are the same for any zero coupon bond of any maturity. In the treasury spot market, the
zero coupon bonds are the securities with a maturity of one year or less (i.e., 90 and 180
days). When the yields are up ward sloping, the yield to maturity, spot rate and forward
rate are as follows in Exhibit 5.6. The forward rate is higher than the spot rate and the
spot rate is higher than the yield to maturity. However, in an inverted market, the
behavior of the three yields is reversed in the order shown in Exhibit 5.7.

Exhibit 5.6: Behavior of the Various Yields over Time (Normal Market)
Yield to Maturity, Spot and Forward Rates
Forward Rate
Spot Rate (Zero Coupon)
Yield to Maturity

Time

220
Exhibit 5.7: Behavior of the Various Yields over Time (Inverted Market)

Yield

Yield to Maturity
Spot Rate (Zero Coupon)
Forward Rate
Time

Example: Consider one, two, and three-year bonds rated to yield 5, 5.5, and 6 percent,
respectively. The first bond is a pure discount issue, and the last two bonds are priced at
par (the coupon and yield are identical). All three bonds have \$1,000 face values as
shown in Exhibit 5.8.

## Exhibit 5.8: Price and Various Interest Rates

Maturity Coupon Yield to Maturity Price Spot Rates Forward Rates
1 0 5 \$952.38 5
2 5.5 5.5 \$1000 ? = 5.51 % ?=6%
3 6 6 \$1000 ? = 6.04 % ? = 7.01%

## \$1000 = [55 / (1+. 05)] + [1055 / (1+?) 2]

The unknown rate is the two-year spot rate that equates the present value of the cash flow
from the coupon-paying instrument to the portfolio of zeros. Solving for the unknown the
two-year spot rate is equal to 5.51 percent. The first coupon (one-year zero coupon bond)
was discounted at a one-year spot rate of 5 percent as opposed to 5.5 percent yield to
maturity. The second coupon and the principal in two years are discounted at the two-year
spot rate of 5.51 percent, preventing risk-less arbitrage from stripping coupons. The
above procedure is known as bootstrapping for estimation of the spot rates.
The three-year bond which can be defined as a portfolio of three zero coupon bonds of
one, two, and three years maturity whose present values discounted at respective spot
rates must be equal to the present value of the three-year coupon-paying bond as follows:

P = \$1000 = 60 + 60 + 1060
(1+. 05) (1+. 0551) 2 (1+?) 3

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The three-year spot rate can be found by solving for the unknown. The three-year spot
rate turned out to be equal to 6.04 percent. The relationship between an n-year spot rate
(R (0, n)) prevailing at time zero and forward rates ((1, n)), the rate prevailing between
time (1 and n) are demonstrated schematically in Exhibit 5.9.

## Exhibit 5.9 Term Structure of Spot and Forward Rates

0 R (0,1) = .05 1 (1,2) 2 (2,3) 3

## 0 R (0,1) = .05 1 (1,3) 3

0 R (0, 3) = .06 3

Forward Rate: The forward rate is the rate that is expected to prevail in the future
between any two adjacent periods. For example, from Exhibit 5.9 the forward rate
between periods 1 and 2 as well as the forward rate between periods 2 and 3 can be
inferred from the market data. The number of forward rates in the n periods will be equal
to n (n-1) /2. In Exhibit 5.9 there are three forward interest rates: (1,2), (2,3), and
(1,3), which are defined as forward rates between years 1 and 2, years 2 and 3, and years
1 and 3.

## Example: Consider an individual with a two-year investment horizon who is endowed

with \$5,000. This individual can invest in a two-year bond in Exhibit 5.8 or in a one-year
bond and rollover the proceeds in another one-year bond at a rate that is expected to
prevail between years 1 and 2. The payoff from either alternative has to be the same
assuming the absence of riskless arbitrage as follows:

## Option 1: Invest \$5,000 in a two-year bond, \$5000 (1.055)2 = \$5,565.125

Option 2: Invest \$5,000 in a one-year bond and at the maturity date rollover to another
one-year bond at the forward rate of (1,2) that is expected to prevail between years 1
and 2 and the payoff of this option is identical to the payoff of option 1:

## \$5000 (1.05) (1+ (1,2)) = \$5,565.125

(1+ (1,2)) = 1.06, (1,2) = 0.06

The above scenario exposes investors to reinvestment rate risk, which is assumed to be
equal to zero under the expectation hypothesis.

Option 3: Buy the three year bond and sell the bond at the end of two years. There is
interest rate risk associated with this option and the longer the maturity the greater is the
interest rate risk. The expectation theory is plagued with two fundamental flaws namely
interest rate risk and reinvestment rate risk are assumed to be zero, therefore, bonds of
varying maturities are a perfect substitute for one another.3

222
Assuming the forward interest rate is greater than 6 percent it pays-off to invest in a one-
year bond and rollover the proceeds into another one-year security. A riskless arbitrage
profit can be realized following this strategy. However, as demand for a one-year forward
bond increases, the price goes up and the yield drops.
Likewise, if the forward interest rate is less than 6 percent, it pays off to invest in a two-
year bond and as demand for two-year bonds increases, the demand will push its price
higher and its yield down until the pay-off from either option is identical and arbitrage
profit disappears.
The forward rate [ (2,3)] can also be estimated from the observed rates in two and
three year bonds. Let us define any long-term interest rates as the geometric average of
the short-term rates. For instance, define the two-year rate as the geometric average of
two one-year rates; one that is observed and the other is an unobservable one-year
forward rate. Similarly, let us define the n-year rate as the geometric average of n one-
year rates as shown in Equation 5.9.

(1+R (0, n)) n = (1+R (0, 1)) (1+ (1,2)) (1+ (2,3)) ++ (1+ (n-1, n)) (5.9)
For n equal to 3

(1+R (0, 3))3 = (1+R (0, 1)) (1+ (1,2)) (1+ (2,3))

Plugging the numbers from Exhibit 5.2 for three and one-year spots and one-year forward
rate ((1,2)), and solving for the (1+ (2,3)) produces:

## (1+. 06)3 = (1+. 05) (1+. 06) (1+ (2,3))

(1+ (2,3)) = 1.0701, (2,3) = .0701

The one-year forward rate prevailing between years two and three are equal to 7.01
percent. This result can be obtained using the observed yield for two and three-year bonds
as seen in Equation 5.10.

(1+ (2,3)) = [(1+R (0, 3)) 3]/ [(1+R (0, 2))2] (5.10)
(1+ (2,3)) = (1.06)3/ (1.055)2 = 1.0701, (2,3) = .0701

The forward rates are the market consensus and are assumed to be unbiased predictors of
the future spot rates.

## Determinants of the Shape of the Term Structure of Interest Rates

Plotting the yield to maturity, spot rate, and forward rates against various maturities over
time, the likely scenario may be a normal upward sloping term structure, however, at
times other shapes such as downward sloping as well as relatively flat or hump shaped
yield curves have been observed. The yield curve at any point in time is a snap shot of
various debt instruments of varying maturities against time assuming other things
remaining the same, that is, coupon, default risk, liquidity risk, and maturity risk.

Various theories have been advanced to explain the shape of the yield curve:4
Expectation theories and market segmentation theory

223
Expectations theories can take several forms: pure expectation theory, liquidity
premium theory, and preferred habitat theory. Various forms of expectation theories
assume the forward rates are the market consensus of the future interest rates and embody
no risk premium over time.5 For example, based on the pure expectation theory the long-
term rate is the geometric average of the portfolio of short-term rates that is expected to
prevail in the future. A falling term structure such as Exhibit 5.11 indicates that the
market expects forward interest rates to continue to fall in the near future, as witnessed in
the past due to falling inflationary expectations producing an inverted yield curve that
was observed in the last business day in August 1981. Likewise, a flat term structure
reflects future short term interest rates that will be expected to remain constant, and a
rising term structure hints that the short term interest rates (the forward rates) are
expected to go up, producing an upward sloping scenario for U.S. treasury securities as of
October 1982 (see Exhibit 5.10).

## Exhibit 5.10:6.5 U.S. Treasury Securities (October

Exhibit
1982)

11.50

11.00

10.50

10.00

9.50

9.00

8.50

8.00

7.50

7.00
th

th

r
r

ea

ea

ea
ea

ea

ea
on

on

-Y

-Y

-Y
Y

Y
M

2-
1-

5-

10

20

30
3-

6-

The pure expectation theory has been criticized by assuming that the bonds of varying
maturities are a perfect substitute for one another. Clearly this is not the case and longer-
term bonds as compared to short-term bonds are more prone to higher price and
reinvestment rate risk.

224
Exhibit 5.11:
Exhibit 6.4 U.S. Treasury Securities (August
1981)

17.00

16.50

16.00

15.50

15.00

14.50

14.00

r
r

r
r

ea

ea

ea
ea

ea

ea

ea

ea

-Y

-Y

-Y
Y

Y
3-

5-
1-

2-

7-

10

20

30
Liquidity Preference Theory: Given the uncertainty about future interest rates and the
greater price and reinvestment rate risk associated with long term bonds, investors
are likely to demand higher risk premiums that are expected to increase uniformly as
the maturity of the bond increases.6 Based on this theory, long-term interest rates are
greater than the geometric average of short-term rates expected to prevail in the
future. An investors aversion to risk and uncertainty of long-term bond and
preference for greater liquidity of the short-term bills and notes increases demand for
short-term debt, pushing their yields down and price up.7 Similarly, the supply of
long-term debt tends to exceed the demand depressing the price and pushing the
yield higher producing an upward sloping yield curve. Investors will be enticed to
invest in the long end of the bond market if they are compensated by higher rates.
The forward interest rate is expected to be a biased predictor of the future short-term
interest rates as advocated by the liquidity preference theory.

Preferred Habitat Theory: This theory was advanced by Modigliani and Sutch (1966)
and assumes that the term structure embodies an expectation of future interest rates as
well as risk premium. However, risk premium is not expected to rise or fall uniformly as
maturity increases or decreases as advocated by the proponents of the liquidity preference
theory. Preferred investment or financing horizon is dictated by the nature of the assets
and liabilities of the financial institutions in making asset allocation decisions.
Institutions will only be enticed to shift from their preferred horizon only if sufficient
compensation in the form of higher yield is offered.
For example, life insurance companies have a long-term investment horizon since their
liabilities are long-term. Property casualty, however, invests in the intermediate segment
of the market and will only be induced to move into the long end of the market if a higher

225
risk premium offered mitigates aversion to interest rate and price risk associated with
long-term bonds.

## Market Segmentation Theory: According to this theory regulatory or self imposed

restrictions dictate asset allocation decisions of the financial institutions to invest in a
particular segment of the market. It is the supply and demand in each segment of the
market that determines the price and yield as well as the shape of the yield curve.8
Borrowers or lenders may not be enticed to shift from one maturity segment to another
one, even if opportunities arise from differences in the yield differentials between any
two segments.

## Example 1-7: FRM Exam 1998--Question 17

1) A bond is trading at a price of 100 with a yield of 8%. If the yield increases by 1
basis point, the price of the bond will decrease to 99.95. If the yield decreases by 1
basis point, the price of the bond will increase to 100.04. What is the modified
duration of the bond?
a) 5.0
b) -5.0
c) 4.5
d) -4.5

## Example 1-6: FRM Exam 1998--Question 22

2) What is the price impact of a 10-basis-point increase in yield on a 10-year par
bond with a modified duration of 7 and convexity of 50?
a) -0.705
b) -0.700
c) -0.698
d) -0.690

## Example 1-8: FRM Exam 1998--Question 20

3) Coupon curve duration is a useful method for estimating duration from market
prices of a mortgage-backed security (MBS). Assume the coupon curve of prices for
Ginnie Mae in June 2001 is as follows: 6% at 92. 7% at 94. and 8% at 96.5. What is
the estimated duration of the 7s?
a) 2.45
b) 2.40
c) 2.33
d) 2.25

## Example 1-9: FRM Exam 1998--Question 21

4) Coupon curve duration is a useful method for estimating convexity from market

226
prices of a MBS. Assume the coupon curve of prices for Ginnie Mae in June 2001 is
as follows: 6% at 92. 7% at 94. and 8% at 96.5. What is the estimated convexity of
the 7s?
a) 53
b) 26
c) 13
d) -53

## Example 1-10: FRM Exam 2001-Question 71

5) Calculate the modified duration of a bond with a Macauley duration of 13.083
years. Assume market interest rates are 11.5% and the coupon on the bond is paid
semiannually.
a) 13.083
b) 12.732
c) 12.459
d) 12.371

## Example I-II: FRM Exam 2002-Question 118

6) A Treasury bond has a coupon rate of 6% per annum (the coupons are paid
semiannually) and a semiannually compounded yield of 4% per annum. The bond
matures in 18 months and the next coupon will be paid 6 months from now. Which
number is closest to the bond's Macaulay duration?
a) 1.023 years
b) 1.457 years
c) 1.500 years
d) 2.915 years

## Example 1-12: FRM Exam 1998-Question 29

7) A and B are two perpetual bonds; that is, their maturities are infinite. A has a
coupon of 4% and B has a coupon of 8%. Assuming that both are trading at the same
yield, what can be said about the duration of these bonds?
a) The duration of A is greater than the duration of B.
b) The duration of A is less than the duration of B.
c) A and B have the same duration.
d) None of the above.

## Example 1-13: FRM Exam 1997-Question 24

8) Which of the following is not a property of bond duration?
a) For zero-coupon bonds. Macaulay duration of the bond equals its years to
maturity.
b) Duration is usually inversely related to the coupon of a bond.

227
c) Duration is usually higher for higher yields to maturity.
d) Duration is higher as the number of years to maturity for a bond selling at
par or above increases.

## Example 1-14: FRM Exam 1999-Question 75

9) Suppose that your book has an unusually large short position in two investment grade
bonds with similar credit risk. Bond A is priced at par yielding 6.0% with 20 years to
maturity. Bond B also matures in 20 years with a coupon of 6.5% and yield of 6%. If risk
is defined as a sudden and large drop in the interest rate, which bond contributes greater
market risk to the portfolio?
a) Bond A.
b) Bond B.
c) Bond A and bond B will have similar market risk.
d) None of the above.

## Example 1-15: FRM Exam 200l-Question 104

10) When the maturity of a plain coupon bond increases, its duration increases:
a) Indefinitely and regularly
b) Up to a certain level
c) Indefinitely and progressively
d) In a way dependent on the bond being priced above or below par

## Example 1-16: FRM Exam 200D-Question 106

11) Consider the following bonds:
Bond Number Maturity (yrs) Coupon Rate Frequency Yield (ABB)
I 10 6% 1 6%
2 10 6% 2 6%
3 10 0% I 6%
4 10 6% I 5%
5 9 6% I 6%
How would you rank the bonds from shortest to longest duration?
a) 5-2-1-4-3
b) 1-2-3-4-5
c) 5-4-3-1-2
d) 2-4-5-1-3
Example 1-17: FRM Exam 2002-Question 57
12) A bond portfolio has the following composition:
I) Portfolio A: price \$90,000, modified duration 2.5, long position in 8 bonds
II) Portfolio B: price \$110,000, modified duration 3, short position in 6 bonds
III) Portfolio C: price \$120,000, modified duration 3.3, long position in 12 bonds
All interest rates are 10%. If the rates rise by 25 basis points, then the bond portfolio
value will:

228
a) Decrease by \$11,430
b) Decrease by \$21,330
c) Decrease by \$12,573
d) Decrease by \$23,463

## Example 1-18: FRM Exam 2000-Question 110

13) Which of the following statements are true?
I. The convexity of a 10-year zero-coupon bond is higher than the convexity of a l0-
year, 6% bond.
II. The convexity of a 10-year zero-coupon bond is higher than the convexity of a 6%
bond with a duration of 10 years.
III. Convexity grows proportionately with the maturity of the bond.
IV. Convexity is positive for all types of bonds.
V. Convexity is always positive for "straight" bonds.
a) I only
b) I and II only
c) I and V only
d) II, III, and V only

EndNotes

229
1
See Chicago Board of Trade Publications 1989.
2
Convexity is defined as second derivative of the bond with respect to change in yield weighted by the market value of
the bond as (dP2/ dR2) (1/ P). The convexity can be calculated as follows:

n
[dP2/ dR2]1/ P = [ (t) (t+1). C) / (1+R) t+2 + (n) (n+1)F / (1+R) n+2 ] / P
t =1
Where C is the coupon interest, F is the face value of the bond, R is the yield to maturity and n is the maturity of the
bond.
3
See Lutz (1940).
4
See Homer et al. (1971).
5
Fama (1976).
6
See Hicks (1946)
7
See Cox et al. (1981).
8
See Culbertson (1957).