Topic Three

Fixed-Income Securities

What is the value of a bond? How do you measure and manage

the risk of a bond portfolio?
Topic Three

Sub-Topics

Bond Pricing

Interest Rate Risk

Macaulay Duration

Modified Duration

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Topic Three

Learning Objectives
After completing this topic you should be able to do the following:

Explain the pricing, characteristics, and risk determinants of bonds.

Explain the interest rate risk in bond portfolios management.

Understand the concept of duration, how it can be measured, and its use in the
management of bond portfolios.

Able to use the modified duration to calculate the approximate percentage change in
bond’s price.

03-3
Topic Three

References

Textbook

Bodie, Z., Kane, A., and Marcus, A.J., 2011, Investments
and Portfolio Management, 9th edition, McGraw Hill.
Chapters 14 and 16.

03-4
Bond Pricing

Bonds are valued as the present value of all expected

future cash flows.

Critical things to identify:
 All possible cash flows (the coupons and principal are known)
 The required rate of return (r) to be used to discount the cash
flows.

Cash flows are neatly split into coupons and principal
repayment:
Bond Value = PV of Coupons + PV of Par Value

03-5
Bond Pricing

The bond pricing formulas treat coupons as an annuity

and par value as a single cash flow:

Coupon  1  Par value

Bond Price = 
 1− T
 + T
r  (1 + r )  (1 + r )
= Coupon × Annuity Factor(r , T ) + Parvalue × PVfactor (r , T )

Annuity and PV factors come from the PV tables.

03-6
Bond Pricing

Price of a bond is a function of its coupon rate, its

maturity, and market movements in interest rates.

Longer maturities move more with changes in
interest rates.

Premium bond has a market value that is above par
value (occur when market interest rates are below
bond’s coupon rate).

Discount bond has a market value that is below par
value (occur when market interest rates are above
bond’s coupon rate).

03-7
Bond Pricing
Example 3-1: Bond Valuation

A coupon bond that pays interest semi-annually has a

par value of $1,000, 8% coupon rate, matures in 30
years, and has a required return of 10%.
 Calculate the intrinsic value of the bond today.

03-8
Bond Pricing
Example 3-1: Bond Valuation

Calculate the intrinsic value of the bond today.

The bond has 60 coupon payments of $40. The bond
value is calculated as:
40  1  1000
Bond Price = 1 − + = $810.71
 60

0.05  (1 + 0.05 )  (1 + 0.05 ) 60

The value is also calculated if the market rate of interest

= 8% (4% semi-annual) same as the coupon rate, the
bond price = Par value.

If the interest rate (required yield) is below the coupon
rate – bond value is above par (trading at a premium).

03-9
Bond Pricing
Bond Prices and Yields

At higher interest rate, the PV of the payments to be

received by the bondholder is lower (discounting at
higher interest rate).

Therefore, the bond prices fall as market interest rates
rise. Bond prices and interest rates are negatively
related.

This is illustrated in Figure 14.3. It also introduces the
concept of convexity.

03-10
Bond Pricing
Bond Prices and Yields

03-11
Bond Pricing
Bond Prices and Yields

Starting at 8% - a 2% fall in rates will raise bond price by

more than a 2% increase in rates will lower price.

That is, an increase in the interest rate results in a price
decline that is smaller than the price gain resulting from
a decrease of equal magnitude in the interest rate.

Progressive increase in the interest rate result
progressively smaller reductions in the bond price.

03-12
Bond Pricing
Interest Rate Risk

If interest rates change, the PV of all future cash flows

will change but the coupons stay constant.

Thus if interest rates rise, bond price will fall and you
suffer a capital loss.

The effect of this is more pronounced the longer the life
of the bond you are locked into the predetermined
coupon for longer, larger loss in value.

The risk of loss is called interest rate risk. Some
investors invest in short-term bonds to avoid this risk.

What maturity you would buy depends on your opinion of
interest rate movements.
03-13
Interest Rate Risk
Price Sensitivity

Interest rate risk refers the variability in returns on debt

securities arising from changes in interest rates.

When interest rates rises (falls), bond price falls (rises),
this happens because the PV of the cash flows change.

This section is about understanding how much bond
price changes when interest rate changes.

Price sensitivity – how much bond price changes when
interest rate changes.

To examine price sensitivity, we use duration.

03-14
Interest Rate Risk
Six Rules about Interest Rates and Bond Value

1. Bond prices and yields are inversely related.

2. Bond price does not respond symmetrically to a given
change in bond yield.
3. Long-term bonds are more sensitive than shorter term
bonds to interest rate changes.
4. Interest rate risk rises with maturity.
5. Interest rate risk is inversely related to the coupon rate.
6. Interest sensitivity of bond price decreases with yield to
maturity.

03-15
Interest Rate Risk
Six Rules about Interest Rates and Bond Value

These results are useful if we are trying to decide which

bond to purchase.

There are several effects and we would like to
summarize them in one number or variable.

The effect is summarized in something called Macaulay
duration which is referred to as average time to maturity.

Weighted average time of each cash flow.

03-16
Macaulay Duration
The Effective Maturity of a Bond

Bond duration is the average amount of time that it takes

to receive the interest and the principal.

The weighted average of the times until each payment is
received, with the weights proportional to the present
value of the payment.

Duration is shorter than maturity for all bonds except
zero-coupon bonds.

Duration is equal to maturity for zero coupon bonds.

Duration is measured in years.

03-17
Macaulay Duration
The Effective Maturity of a Bond

The weight is each cash flow’s proportion of total bond

value:
t
CFt (1 + y )
wt =
Bond Price

We calculate the weighted average of the cash flows
(interest and principal payments) of the bond,
discounted to the present time.

The duration is the sum of the product of time (in years)
of each cash flow with the weight.
T
Dt = ∑ t × wt
t >0
03-18
Macaulay Duration
The Effective Maturity of a Bond

Steps in calculating duration:

 1: Find present value of each coupon and principal payment.
 2: Divide this present value by current market price of bond.
 3: Multiple this relative value by the year in which the cash flow
is to be received.
 4: Repeat steps 1 through 3 for each year in the life of the bond
then add up the values computed in step 3

03-19
Macaulay Duration
The Effective Maturity of a Bond

Generally speaking, the bond duration has the following

properties:
 Bonds with higher coupon rates have shorter durations.
 Bonds with longer maturities have longer durations.
 Bonds with higher yield to maturity (YTM) lead to shorter
durations.

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Macaulay Duration
Example 3-2: Duration

A two-year 8% coupon bond has a yield to maturity of

10% with a face value of $1,000. Coupons are paid
semi-annually.
 Calculate the duration of the bond.
 What is the duration if the yield to maturity falls to 9%?
 Suppose the coupon rate increases to 12%, find the duration of
the bond. Assuming that the YTM is 10%.

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Macaulay Duration
Example 3-2: Duration

Calculate the duration of the bond.

Time (yrs) Cashflow ($) Present Value Weight Time x Weight
0.5 40 38.0952 0.0395 0.0197
1.0 40 36.2812 0.0376 0.0376
1.5 40 34.5535 0.0358 0.0537
2.0 1040 855.611 0.8871 1.7741
Total 964.540 1.0000 1.8852

Duration = 1.8852 years or 1.8852 x 2 = 3.7704 periods

03-22
Macaulay Duration
Example 3-2: Duration

What is the duration if the yield to maturity falls to 9%?

Time (yrs) Cashflow ($) Present Value Weight Time x Weight
0.5 40 38.2775 0.0390 0.0195
1.0 40 36.6292 0.0373 0.0373
1.5 40 35.0519 0.0357 0.0535
2.0 1040 872.104 0.8880 1.7761
Total 982.062 1.0000 1.8864

The duration increases to 1.8864 years. Price increases
to $982.062. The final payment is more heavily weighted
toward the later period.
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Macaulay Duration
Example 3-2: Duration

Suppose the coupon rate increases to 12%, find the

duration of the bond. Assuming that the YTM is 10%.
Time (yrs) Cashflow ($) Present Value Weight Time x Weight
0.5 60 57.1429 0.0552 0.0276
1.0 60 54.4218 0.0526 0.0526
1.5 60 51.8303 0.0501 0.0751
2.0 1060 872.065 0.8422 1.6844
Total 1035.46 1.0000 1.8396

Duration = 1.8396 years, which is less than the duration
at the coupon rate of 8% as the coupon payment is more
heavily weighted toward the earlier period.
03-24
Modified Duration
Duration and Convexity

The whole point of duration is to use it to work out what

happens to bond price when interest rate changes:
∆P
= − D* × ∆y
P

Using this equation, may have duration, change in
interest rate (one basis point is 0.01%), work out %
change in price.

The modified duration, D* is:
D
D* =
(1 + y )
03-25
Modified Duration
Example 3-3: Duration and Convexity

A two-year 8% coupon bond has a yield to maturity of

10% with a face value of $1,000. Coupons are paid
semi-annually. The bond’s duration is 1.8852 years. You
expect that interest rates will rise by 0.02% later today.
 Calculate the bond’s price.
 Use the modified duration to find the new price of the bond.
 Recalculate the bond’s new price on the basis of a 10.02% per
annum yield to maturity.

03-26
Modified Duration
Example 3-3: Duration and Convexity

Calculate the bond’s price.

c 1  Parvalue
Bond price = 1 − +
r  (1 + r )T
 (1 + r )T

40  1  1000
= 1 − 4 
+
0.05  (1.05)  (1.05) 4
= $964.54

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Modified Duration
Example 3-3: Duration and Convexity

Use the modified duration to find the new price of the

bond.
D 1.8852
D* = = = 1.7954
(1 + y ) (1.05)

Approximate percentage price change using modified
duration
∆P
= − D * ×∆y = −1.7954 × (0.02%) = −0.03591%
P
New price = 964.54(1 − 0.0003591) = $964.19

03-28
Modified Duration
Example 3-3: Duration and Convexity

Recalculate the bond’s new price on the basis of a

10.02% per annum yield to maturity.

The bond’s new price at its new yield to maturity.
40  1  1000
Bond price =  1 −  +
0.0501  (1.0501) 4  (1.0501)4
= $964.19

This is consistent with the answer using modified
duration.

03-29
Modified Duration
Duration and Convexity

The duration relationship is useful but is an

approximation.

For small changes in YTM, the approximation is fine but
for larger changes in YTM, larger error.

The error depends on the curvature of the bond price,
the bond yield curve.

This is called the convexity of the bond.

03-30
Modified Duration
Duration and Convexity

Price

P*
Pricing error from
P convexity
2

P0

P*
P Duration
1

Yield
Y Y Y
2 0 1

03-31
Modified Duration
Duration and Convexity

In practical terms, we add another bit to the duration

equation:
∆P 1 2
= − D* × ∆y + × convexity × (∆y )
P 2

When you want to know the effects of a change in YTM
on bond price, you will get a more accurate estimate if
you have and use the above equation with convexity.

03-32