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Price Yield Relationship

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Price Yield Relationship

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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)

Risk premium

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

209

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.

210

Exhibit 5.2:

process of a bond making it positively convex such as convertible bonds or negatively

convex (concave) such as callable bonds.

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.

211

Exhibit 5.3: Price Yield Relationship

Price

A B

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:

= - 2.83

212

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

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%

213

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

duration is adjusted

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)

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

214

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 = +/-16,406,250

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.

DV01 can be estimated using Equation 5.3 for a bond or portfolio of credits. For

example, DV01 for the above portfolio is:

= +/- $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-

215

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

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

216

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.

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.

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

217

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.

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

218

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:

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.

The approximate convexity for a 20-year zero-coupon bond assuming yield changes by

+/-100 basis points is as follows:

= 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

= +/- .1851 +.0194

= + .2045, -.1657

219

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.

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.

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%

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

221

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.

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

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 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:

(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+ (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.

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

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.

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.

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

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

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

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

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

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

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.

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.

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.

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

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

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).

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