INVESTMENTS

Instructor:
Dr. Kumail Rizvi, PhD, CFA, FRM
KEY CONCEPTS & SKILLS
Understand bond values and why they fluctuate
How Bond Prices Vary With Interest Rates
Four measures of bond price sensitivity to
interest rate
Maturity
Macaulay Duration (Effective Maturity)
Modified Duration
Convexity
Understand the term structure of interest rates
and the determinants of bond yields

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VALUING A BOND
Bond Value = PV of coupons + PV of par
Bond Value = PV of annuity + PV of lump sum

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N
N
r
C
r
C
r
C
PV
) 1 (
000 , 1
...
) 1 ( ) 1 (
2
2
1
1
+
+
+ +
+
+
+
=
t
t
r) (1
F
r
r) (1
1
- 1
C Value Bond
+
+
(
(
(
(

+
=
VALUING A BOND
Example
If today is October 1, 2007, what is the value of the following
bond? An IBM Bond pays $115 every September 30 for 5 years.
In September 2012 it pays an additional $1000 and retires the
bond. The bond is rated AAA (AAA YTM is 7.5%)

Cash Flows
Sept 08 09 10 11 12
115 115 115 115 1115
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VALUING A BOND
Example continued
If today is October 1, 2007, what is the value of the following bond? An
IBM Bond pays $115 every September 30 for 5 years. In September
2012 it pays an additional $1000 and retires the bond. The bond is rated
AAA (AAA YTM is 7.5%)
( ) ( ) ( ) ( )
84 . 161 , 1 $
075 . 1
115 , 1
075 . 1
115
075 . 1
115
075 . 1
115
075 . 1
115
5 4 3 2
=
+ + + + = PV
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WHY BONDS PRICES FLUCTUATE?
The price of a bond is a function of the promised
payments and the market required rate of return.
Since the promised payments are fixed, bond prices
change in response to the changes in the market
determined required rate of return.

Bond price = f (required rate of return)
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HOW BOND PRICES FLUCTUATE?
Interest Rates, %
Required rate of return
YTM
B
o
n
d

P
r
i
c
e
,

%

80.00
85.00
90.00
95.00
100.00
105.00
110.00
115.00
0 1 2 3 4 5 6 7 8 9
1
0
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HOW BOND PRICES FLUCTUATE?
Bond prices or present values decrease as rates
increase. It means,

if we increase our yield above the coupon, the present
value (price) must decrease below par.

On the other hand, if we decrease our yield below the
coupon, the present value (price) must increase above
par.


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WHY THE RELATIONSHIP IS INVERSE?
Think that
the yield-to-maturity is the interest rate required on
newly issued debt of the same risk and that debt
would be issued so that the coupon = yield.
Then, suppose that the coupon rate on your bond is
8% and the yield is 9%.
Which bond you would be willing to pay more for?
You would pay more for new bond since it is priced to
sell at $1,000, the 8% bond must sell for less than
$1,000.



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WHY THE RELATIONSHIP IS INVERSE?
Another way to look at it is that
return = dividend yield + capital gains yield.
The dividend yield in this case is just the coupon
rate. The capital gains yield has to make up the
difference to reach the yield to maturity. Therefore, if
the coupon rate is 8% and the YTM is 9%, the capital
gains yield must equal approximately 1%. The only
way to have a capital gains yield of 1% is if the bond
is selling for less than par value. (If price = par, there
is no capital gain.)
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HOW TO MEASURE BOND PRICE
SENSITIVITY TO YIELD CHANGES?
Four measures of bond price sensitivity to
interest rate
1) Maturity
2) Macaulay Duration (Effective Maturity)
3) Modified Duration
4) Convexity

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MATURITY: SENSITIVITY MEASURE (1)
Simple maturity is just the time left to maturity on a bond.
We generally think of 5-year bonds or 10-year bonds. It is
straightforward and requires no calculation.

The longer the time to maturity the more sensitive a
particular bond is to changes in the required rate of return.
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MATURITY: SENSITIVITY MEASURE (1)
Consider two zero coupon bonds, each with a face
value of $1,000. Bond A matures in 10 years and has
a required rate of return of 10%. The price of Bond A
is $376.89, where



Bond B has a maturity of 5 years and also has a
required rate of return of 10%. Its price is $613.91 or
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MATURITY: SENSITIVITY MEASURE (1)
If the required rate of return for each bond was to
increase by 100 basis points to 11%, the prices would
then be $342.73 for Bond A and $585.43 for Bond B.
This translates into a -9.1% change in price for Bond
A and -4.6% for Bond B.

Thus, for zero coupon bonds simple maturity can be
used to compare price sensitivity
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MACAULAY DURATION: SENSITIVITY
MEASURE (2)
The relationship between price and maturity is not as clear
when you consider non-zero coupon bonds.
For a coupon-paying bond, many of the cash flows occur
before the actual maturity of the bond and the relative
timing of these cash flows will affect the pricing of the
bond.
In order to deal with this, Frederick Macaulay in 1938
suggested that investors use the effective maturity of a
bond as a measure of interest rate sensitivity. He called
this duration and defined it as a value-weighted average of
the timing of the cash flows.
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MACAULAY DURATION: SENSITIVITY
MEASURE (2)
Consider a six- year bond with face value of $1,000, and a
6.1% coupon rate (semi-annual payments). If the current
yield to maturity is 10%, the value of the bond is found by
discounting each of the semi-annual payments
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MACAULAY DURATION: SENSITIVITY
MEASURE (2)
Macaulay Duration takes the present value of each
payment and divides it by the total bond price, P. By
doing this, one has a percentage, w
t
, of the total bond
value that is received in each period, t.



The duration or effective maturity for the bond could then
be estimated by multiplying the weight, w
t
, times the time,
t and then summing all of the weighted values, or
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MACAULAY DURATION: SENSITIVITY
MEASURE (2)
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MACAULAY DURATION: SENSITIVITY
MEASURE (2)
The semi- annual duration for this bond is 10.014 six-
month periods. We usually use annual duration and we
annualize the semi-annual duration simply by dividing by 2
(the number of six month periods in a year). In this case,
the annualized duration would be 5.007 years.

Note that the Macaulay Duration for a 5- year zero coupon
bond is the same as the simple maturity, 5.0 years.

Hence, we can expect that the original 6-year, 6.1% coupon
bond when interest rates change to behave in a manner
similar to a 5-year zero coupon bond, since their effective
maturity (Macaulay Duration) is essentially the same.
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MODIFIED DURATION: SENSITIVITY
MEASURE (3)
If we want a more direct measure of the relationship
between changes in interest rates and changes in
bond prices, we can use Modified Duration. Modified
Duration, D, is defined as the following



where P is the bond price, P is the change in bond price
and y is the change in the required rate of return (yield to
maturity).
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MODIFIED DURATION: SENSITIVITY
MEASURE (3)
We know price of a bond is:



Taking the derivative of P with respect to y,


Inserting this into the formula for Modified Duration
yields

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MODIFIED DURATION: SENSITIVITY
MEASURE (3)
Rearranging the previous formula slightly




Comparing this to the definition of Macaulay
Duration and using that definition we can write
Modified Duration as
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MODIFIED DURATION: SENSITIVITY
MEASURE (3)
While it is easy calculate Modified Duration once you
have Macaulay Duration the interpretations of the
two are quite different.
Macaulay Duration is an average or effective
maturity.
Modified Duration really measures how small
changes in the yield to maturity affect the price of the
bond.
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MODIFIED DURATION: SENSITIVITY
MEASURE (3)
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MODIFIED DURATION: SENSITIVITY
MEASURE (3)
Modified Duration assumes that the price changes are
linear with respect to changes in the yield to
maturity.

From last table, the true relationship between the
bond's price and the yield to maturity is not linear.

The Column with the differences is always positive
and increases as we move away from a yield to
maturity of 10%. The actual relationship between the
bond price and the yield to maturity is:
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MODIFIED DURATION: SENSITIVITY
MEASURE (3)
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Non-linearity of relationship between bond prices and
yield:

The curved line is the actual price curve. The straight line is
the price relationship using Modified Duration. Everywhere
the actual price curve is above the Modified Duration
relationship. This is exactly what we saw in Table. The
difference was always positive, i.e., actual calculated price
was greater than the new price using the Modified Duration
relationship.

In addition, the percentage changes in price are not
symmetric. The percentage decrease in price for a given
increase in yield is always less than the percent increase for
the same decrease in yield. This property is referred to as
convexity.

Note that the two prices are quite close for small changes in
the yield to maturity but the difference grows as the change
in yield to maturity becomes bigger.
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CONVEXITY: SENSITIVITY MEASURE (4)
Modified Duration relationship does not fully capture
the true relationship between bond prices and yield to
maturity. In order to more fully capture this,
practitioners use Convexity. The definition of
Convexity is


The actual definition of Convexity that we can use is
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CONVEXITY: SENSITIVITY MEASURE (4)
We can annualize the semi-annual convexity of
110.88 by dividing it by 2
2
or 4. Here it would be
27.72.
Convexity is useful to practitioners in a number of
ways.
First it can be used in conjunction with duration to
get a more accurate estimate of the percentage price
change resulting from a change in the yield.
The formula is:
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Adjustment
factor
CONVEXITY: SENSITIVITY MEASURE (4)
Adding the convexity adjustment corrects for the fact
that Modified Duration understates the true bond
price.
For example, in our example, at a yield of 12% the
percentage price change using only Modified Duration
was -9.54%, while the actual was -9.01%. If we use
the Convexity value we just calculated, the predicted
percentage price change would be


This is -8.99%, which is much closer to the actual
percentage price change of -9.01%.
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CONVEXITY: SENSITIVITY MEASURE (4)
Convexity provides insight into how a bond will react
to yield changes.
Earlier we saw that the price reaction to changes in
yield is not symmetric.
For a given change in yield, bond prices drop less
for a given increase in yield and increase more
for the same decreases in yield. The downside is
less and the upside is more. This is clearly a desirable
property.
The higher the Convexity of a bond the more this is
true. Thus, bonds with high convexity are more
desirable.
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TERM STRUCTURE OF INTEREST RATES

Term structure is the relationship between time to
maturity and yields, all else equal
It is important to recognize that we pull out the effect of
default risk, different coupons, etc.

Yield curve graphical representation of the term
structure
Normal upward-sloping, long-term yields are higher than
short-term yields
Inverted downward-sloping, long-term yields are lower
than short-term yields
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FIGURE UPWARD-SLOPING YIELD CURVE
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FIGURE DOWNWARD-SLOPING YIELD CURVE
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FACTORS AFFECTING BOND YIELDS
Default risk premium remember bond ratings

Liquidity premium bonds that have more frequent
trading will generally have lower required returns

Anything else that affects the risk of the cash flows to the
bondholders will affect the required returns
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ASSIGNMENT
What is Effective Duration? Give an example to show
its calculation
What is the difference and similarity between
Modified Duration and Effective Duration?
Where it is appropriate to use Modified duration and
where Effective duration is more suitable?
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