BONDS MARKET

4.1 INTRODUCTION
A bond is a debt security, under which the issuer owes the holders a debt and,
depending on the terms of the bond, is obliged to pay them interest (the coupon) and/or
to repay the principal at a later date (the maturity date). Interest is usually payable at
fixed intervals (annually, semiannually, and sometimes monthly). Very often the bond
is negotiable, i.e. the ownership of the instrument can be transferred i n the secondary
market.

4.2 DEBTS AND STOCKS

Bonds and stocks are both securities, but the major difference between the two is that
stockholders have an equity stake in the company (i.e. they are investors), whereas
bondholders have a creditor stake in the company (i.e. they are lenders). Being a
creditor, bondholders have absolute priority and will be repaid before stockholders
(who are owners) in the event of bankruptcy. Another difference is that bonds usually
have a defined term, or maturity, after which the bond is redeemed, whereas stocks
are typically outstanding indefinitely. An exception is an irredeemable bond, such as
Consols, which is a perpetuity, i.e. a bond with no maturity.
The primary advantage of being a creditor is a higher claim on assets tha n that of
shareholders. That is, in the case of bankruptcy a bondholder will get paid before a
shareholder does. The bondholder, however, does not share in the profits if a company
does well he or she is entitled only to the principal plus interest. To sum it up, there
is generally less risk in owning bonds compared to owning stocks, but this comes at
the cost of a lower return.

4.3 BOND TERMINOLOGY

• The terms under which money is borrowed are contained in an agreement known
as the indenture. The indenture defines the obligations of and restrictions on the
borrower, and forms the basis for all future transactions between the
lender/investor and the issuer. These terms are known as covenants and include
both negative (prohibitions on the borrower) and affirmative (actions that the
borrower promises to perform) sections. In addition to the payment schedule, the
indenture also specifies a set of restrictions on the issuer (in terms of sinking
funds, further borrowing, dividend policy, and collateral) to protect the r ights of
the holders of the bonds.
• The term to maturity (or simply maturity) of a bond is the length of time until
the loan contract or agreement expires. It defines the (remaining) life of the bond.
• The maturity date is the represents the date on which the bond matures, i.e., the
date on which the face value is repaid. The last coupon payment is also paid on
the maturity date.

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 • The par value of a bond is the amount that the borrower promises to pay on or
before the maturity date of the issue.
• The coupon rate is the rate that, when multiplied by the par value of a bond,
gives the amount of interest to be paid annually by the borrower (coupon amount).
• The required return is the rate of return that investors currently require on a
bond.

4.4 BOND MARKET

The bond market is a financial market where participants buy and sell debt securities,
usually in the form of bonds. The classification of a bond depends on its type of issuer,
priority, coupon rate, and redemption features. The following chart outlines these
categories of bond characteristics:
Types of Bonds

Issuer Priority Features Coupon Features Embedded Option

Corporation Junior or Fixed income Callable
Municipality Subordinated Floater Convertible
Senior or Inverse floater Puttable
Government unsubordinated Zero coupons
Consols
International

Treasury Securities International Bond issues

Bond (10yrs +) Eurobond
Note (1-10 yrs) Foreign
Bill (< 1 yr) Global

4.4.1 Bond Issuers

Bond issuer is the major determiner of a bond's credit quality; the issuer is one of the
most important characteristics of a bond.

(i) Government (Treasury) Securities

In general, government securities are classified according to the length of time before
maturity. These are the three main categories:
▪ Bills - debt securities maturing in less than one year.
▪ Notes - debt securities maturing in one to 10 years.
▪ Bonds - debt securities maturing in more than 10 years.
Since the Treasury securities are “issued” by (and thus receive the full backin g of) the
government, they are considered to be one of the “safest” investments in the world.
This is why the Treasury securities are often used as a benchmark for measuring risk.
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(ii) Government Agency Bonds
There are a number of government agencies and government-sponsored agencies
(which are privately owned entities) that make loans to a certain class of borrowers.
The reason such agencies exist is because government believes that the supply of
credit can be too limited, too variable, or too expensive for cer tain class of borrowers.
As a result, these agencies are set up to provide dependable sources of credit at the
lowest possible cost. These agencies issue their own debt instruments to raise money
to make various types of loans.

(iii) Municipal bonds

In addition to the central government, there are other governmental units that can be
grouped as local government: municipalities, townships, and districts. Many of these
local governmental units raise money by issuing municipal bonds (or munis) 1, which
take on two general forms:
1. Revenue Bonds: These are bonds issued to finance a particular project.
Revenues generated by the project will be used to pay the interest payments
and repay the principal.
2. General Obligation Bonds: These are bonds that are backed simply by the full
faith and credit of the governmental units that they will make the interest
payments and repay the principal.

(iv) International bonds

International bonds (issued by government or corporate) get complicated because of
differing currencies. Here are some types of international bonds:
1. Eurobond: refers to any bond that is denominated in a currency other than that
of the country in which it is issued. Bonds in the Eurobond market are
categorized according to the currency in which they are denominated. As an
example, a Eurobond denominated in Japanese Yen but issued in the U.S. would
be classified as a Euroyen bond.
2. Foreign bonds: are denominated in the currency of the country into which a
foreign entity issues the bond. An example of such a bond is the Samura i bond,
which is a yen-denominated bond issued in Japan by an American company.
3. Global bonds: are structured so that they can be offered in both foreign and
Eurobond markets. Essentially, global bonds are similar to Eurobonds but can
be offered within the country whose currency is used to denominate the bond.

(v) Corporate bonds

In order to fuel its growth (whether through building a new plant or through mergers
and acquisitions), a company can choose to finance these business-related needs by
issuing bonds (especially when these are long-term needs). Corporate bonds are
characterized by higher yields because there is a higher risk of a company defaulting

1 The major advantage to munis is that the returns are free from tax.
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than a government. The company's credit quality is very important: the higher the
quality, the lower the interest rate the investor receives.

4.4.2 Priority Features

The priority indicates your place in line should the company default on payments.
1. Unsubordinated bond/debt is a loan or security that ranks above other loans or
securities with regard to claims on assets or earnings. If you hold an
unsubordinated (senior) security and the company defaults, you would be first
in line to receive payment from the liquidation of their assets. Therefore,
unsubordinated debt is less risky than subordi nated debt.
2. Subordinated bond/debt is debt which ranks after other debts should a company
fall into receivership or bankruptcy. In case you owned a subordinated/junior
debt security, you would get paid out only after the senior debt holders have
received their share.

4.4.3 Coupon Rate

Bond issuers may choose from a variety of types of coupons, or interest payments.
1. Fixed-rate bonds pay an absolute coupon rate over a specified period of time.
Upon maturity, the last coupon payment is made along with the par value of the
bond.
2. Floating rate debt instruments or floaters pay a coupon rate that varies
according to the movement of the underlying benchmark. These types of coupons
could, however, be set to be a fixed percentage above, below, or equal to the
benchmark itself. Floaters typically follow benchmarks such as the three, six, or
nine-month T-bill rate or LIBOR.
3. Inverse floaters pay a variable coupon rate that changes in direction opposite to
that of short-term interest rates. An inverse floater subtracts the benchmark from
a set coupon rate. For example, an inverse floater that uses LIBOR as the
underlying benchmark might pay a coupon rate of a certain percentage; say 6%,
minus LIBOR.
4. Zero coupon or accrual bonds do not pay a coupon. Instead, these types of bonds
are issued at a deep discount and pay the full face value at maturity.
5. Consols: These are perpetual bonds which make periodic interest payments
forever (has no final maturity date).

4.4.4 Embedded Option

Both investors and issuers are exposed to interest rate risk since they are locked into
either receiving or paying a set coupon rate over a specified period of time. For this
reason, some bonds offer additional benefits to investors or more fle xibility for
issuers:

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1. Callable or a redeemable bond feature gives the bond issuer the right but not
the obligation to redeem their issue of bonds before the bond's maturity the
issuer, however, must pay the bond holders a premium. There are two
subcategories of these types of bonds: American callable bonds and European
callable bonds. American callable bonds can be called by the issuer any time
after the call protection period while European callable bonds can be called by
the issuer only on pre-specified dates.
2. Puttable bonds give bondholders the right but not the obligation to sell their
bond back to the issuer at a predetermined price and date. These bonds generally
protect investors from interest-rate risk. If the prevailing bond prices are lower
than the exercise par of the bond, resulting from interest rates being higher than
the bond's coupon rate, it is optimal for investors to sell their bond back to the
issuer and reinvest their money at a higher interest rate.
3. Convertible bonds give bondholders the right but not the obligation to convert
their bonds into a predetermined number of shares at predetermined dates prior
to the bond's maturity.
An embedded option that benefits the issuer will increase the yield required by bond
buyers. An embedded option that benefits the bondholder will decrease the yield
required on the bond.

4.5 BOND CREDIT RATING

In investment, the bond credit rating represents the credit worthiness of corporate or
government bonds. The ratings are published by Credit rating agencies and used by
investment professionals to assess the likelihood the debt will be repaid.
The rating of a bond is simply the grade it received based on its likelihood of not
meeting any of its payments: the higher (or better) the grade, the less likely the
company will default on its bond payments. The following table shows the ratings
available from Moody’s and S&P:
Moody’s S&P Description
Aaa AAA Capacity to pay interest and repay principal is extremely strong
Aa AA Very strong capacity to pay interest and repay principal; only slightly
less safe than debt rated triple A
A A Strong capacity to pay interest and repay principal, though somewhat
susceptible to adverse changes in financial and economic conditions
Baa BBB Adequate capacity to pay interest and repay principal, though more
susceptible to adverse changes in economic and financial conditions

The first four categories of bond ratings are considered as investment grade bonds,
which generally means that they are “safer” bonds and thus more attractive to
investors. Some regulated institutional investors are only allowed to invest in
investment grade points.

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The following categories of bond ratings are considered as speculative grade (or junk)
bonds, which generally means that they are “risky” bonds and thus less attractiv e to
investors.
Moody’s S&P Description
Ba BB Speculative; faces ongoing uncertainties or exposure to adverse
conditions which could lead to the inability to pay interest or repay
principal
B B Vulnerable to default, but currently has the capacity to meet interest
and principal obligations
Caa CCC Currently identifiable vulnerability to default and is dependent on
favorable conditions to meet obligations
Ca CC More vulnerable to default and highly speculative
C C Extremely speculative; poor prospects for attaining any real
investment standing
D D Currently in default

The rating of a bond reflects the financial health of the issuer. The rating companies
determine the ratings based on set of the issuer’s financial ratios. There are five
financial ratios that they look at: (1) Coverage (or asset turnover) ratios; (2) Leverage
ratios; (3) Liquidity ratios; (4) Profitability ratios; and (5) Cash flow to debt ratios.

4.6 BOND VALUATION

Bonds are valued using time value of money concepts. When you invest in a bond,
you are expected to receive a steady stream of fixed interest payments from the bond
known as coupon amount (C ) , these payments are treated like an equal cash flow
stream (annuity). Their face value is treated like a lump sum. You are expected to
reinvest them in the market at the nominal market interest rate (i ) .
Nominal market interest rate is made up of three parts: (a) a real risk-free rate of
return, (b) a compensation for expected inflation, and (c) a compensation for bond-
specific characteristics (such as ratings, call features, liquidity, etc.). This means that
there will be a different market interest rate for each bond that reflects the risks
associated with that bond.
To determine the intrinsic value of a bond, we simply apply the concept of time value
of money to determine the present values of all the cash flows (i.e. interest payments
and principal) generated by the bond throughout its lifetime. In other words, the
intrinsic value of a bond is simply the present value of all its interest payments plus
the present value of its principal, which is expressed by the formula below:
C1 C2 Cn Par
P0 = + 2
+ ... + n
+ (0.1)
(1 + i) (1 + i) (1 + i) (1 + i) n

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 n
Ct Par
P0 = å n
+ n
(0.2)
t= 1 (1 + i) (1 + i )

é é 1 ùù
ê1- ê úú
ê ê(1 + i ) n úúú
ê ë ûû+ Par
P0 = C ´ ë (0.3)
i (1 + i ) n
Where P0 is the intrinsic value of a bond, C is the coupon (or interest) payment from
period t , and i is the nominal market interest rate.
A simple modification of the above formula will allow you t o adjust interest rates and
coupon payments to calculate a bond price for any payment frequency:
é é ùù
ê ê úú
ê ê 1 úú
ê1- ê úú
ê êæ i ön´ F úú
ê êç1 + ÷ úú
ê êççè F ø ÷
÷ úú
C ê êë ú
ûú Par
P0 = ´ ë û+
n´ F
(0.4)
F i æ iö
çç1 + ÷÷
F çè F ÷ø
Notice that the only modification to the original formula is the addition of “ F,” which
represents the frequency of coupon payments, or the number of times a year the
coupon is paid. Therefore, for bonds paying annual coupons, F would have a value of
1. Should a bond pay quarterly payments, F would equal 4, and, if the bond paid semi -
annual coupons, F would equal 2.
Example 1
Calculate the price of a bond with a par value of TZS 1,000 to be paid in ten years, a
coupon rate of 10%, and a required yield of 12%. In our example we'll assume that
coupon payments are made semi-annually to bond holders, and that the next coupon
payment is expected in six months. Here are the steps we have to take to calculate the
price:
1. Determine the number of coupon payments: Since two coupon payments will
be made each year for ten years, we will have a total of 20 coupon payments.
2. Determine the value of each coupon payment: Since the coupon payments are
semi-annual, divide the coupon rate in half. The coupon rate is the percentage
off the bond's par value. As a result, each semi-annual coupon payment will be
TZS 50 (TZS 1,000 X 0.05).
3. Determine the semi-annual yield: Like the coupon rate, the required yield of
12% must be divided by two because the number of periods used in the
calculation has doubled. (If we left the required yield at 12%, our bond price

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 would be very low and inaccurate.) Therefore, the required semi -annual yield
is 6% (0.12/2).
4. Plug the amounts into the formula:

é é 1 ùù
ê1-ê úú
ê ê(1 + 0.06) 20 úú
ê ë ûú
û+ 1, 000 = 50´ 1- 0.3118 + 1, 000
P0 = 50´ ë
0.06 1.0620 0.06 3.207
= 50´ 11.47 + 311.82 (0.5)
= TZS 885.32
From the above calculation, we have determined that the bond is selling at a discount:
the bond price is less than its par value because the required yield of the bond is
greater than the coupon rate. The bond must sell at a discount to attract investors, who
could find higher interest elsewhere in the prevailing rates . In other words, because
investors can make a larger return in the market, they need an extra in centive to invest
in the bonds.
Pricing Zero-Coupon Bonds
So what happens when there are no coupon payments? For the aptly-named zero-
coupon bond, there is no coupon payment until maturity. Because of this, the present
value of annuity formula is unnecessary. You simply calculate the present value of
the par value at maturity. Here's a simple example:
Example 2
Let's look at how to calculate the price of a zero -coupon bond that is maturing in five
years, has a par value of TZS 1,000, and a required yield of 6%.
1. Determine the number of periods: Unless otherwise indicated, the required
yield of most zero-coupon bonds is based on a “semi-annual coupon payment.”
Here's why: the interest on a zero-coupon bond is equal to the difference
between purchase price and maturity value, but we need a way to compare a
zero-coupon bond to a coupon bond, so the 6% required yield must be adjusted
to the equivalent of its semi-annual coupon rate. Therefore, the number of
periods for zero-coupon bonds will be doubled, so the zero coupon bond
maturing in five years would have ten periods (5 x 2).
2. Determine the yield: The required yield of 6% must also be divided by two
since the number of periods used in the calculation has doubled. The yield for
this bond is 3% (6% / 2).
3. Plug the amounts into the formula:
Par 1, 000
P0 = n
= = TZS 744.09 (0.6)
(1 + i) (1 + 0.03)10

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You should note that zero-coupon bonds are always priced at a discount: if zero -
coupon bonds were sold at par, investors would have no way of making money from
them and therefore no incentive to buy them.
Lessons Learned from Valuing a Bond
In the previous example, we know that the characteristics of a bond (e.g. coupon rate,
term to maturity, and payment schedule) will have an impact on the intrinsic value
(i.e. fair market price) of the bond. What are some of the lessons we learned from
valuing a bond?
Lesson 1: There is an inverse relationship between the market interest rate and the
price of a bond, i.e. if the market interest rat e goes up (down), then the price of a
bond will go down (up).
Lesson 2: The price of a bond is affected by the relationship between its coupon
rate and the market interest rate.
Coupon rate > Market interest  Price of bond > Par  Sold at premium
Coupon rate = market interest  Price of bond = Par  Sold at par
Coupon rate < market interest  Price of bond < Par  Sold at discount

4.7 BOND YIELDS

The term yield is generally used to represent the return of an investment. However,
do you know that there are different types of yield associated with a bond, each
representing a different way to measure the return of the bond? In this section, we
will look at (a) normal yield, (b) current yield, (c) yield to maturity, and (d) yield to
call.

4.7.1 Normal yield

The normal yield of a bond is simply the quoted coupon rate of the bond. For example,
a bond with an 8% coupon rate has a normal yield of 8%. Keep in mind that the normal
yield of a bond is fixed (in general) and does not take into consideration the current
market condition, which means that you should not rely on the normal yield to help
you determine the return of a bond. The normal yield is simply the coupon payment
(C) as a percentage of the par value (Par).
C
Normal Yield = (0.7)
Par
Coupon yield is also called nominal yield.

4.7.2 Current Yield

The current yield of a bond does take the current market condition into consideration
by incorporating the current market price into its calculation. A bond’s current yield
is determined as follows:
Annual Coupon Payment
Current Yield = (0.8)
Current Bond Price

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Example 3
If you purchased a bond with a par value of $100 for $95.92 and it paid a coupon rate
of 5%, this is how you'd calculate its current yield:
0.05´ $100
Current Yield = ´ 100% = 5.21%
$95.92

4.7.3 Yield to Maturity

Yield to Maturity (YTM) is the rate of return that an investor would earn if he bought
the bond at its current market price and held it until maturity. Alternatively, it
represents the discount rate which equates the discounted value of a bond's future cash
flows to its current market price. To determine the yield to maturity of a bond, you
need to solve the following equation:
n
C Par
P0 = å t
+ n
(0.9)
t= 1 (1+ YTM ) (1+ YTM )
1
1-
(1 + YTM ) n Par
P0 = C ´ + (0.10)
YTM (1 + YTM ) n
You can solve for the YTM using a financial calculator or estimate it with the
following formula:
Par Value - Market Price
Annual Coupon Payment +
Years Until Maturity
YTM @ (0.11)
(0.4´ Par Value)+ (0.6´ Market Price)
It is important to understand that the yield to maturity of a bond is computed with the
assumption that the coupon payments received are reinvested at the YTM rate. In
situations when the market interest rates are fluctuating, you will not get the promised
yield to maturity because each coupon payment is reinvested at a different rate .
Another thing you need to understand is that the yield to maturity of a bond is
generally treated as the same as the market interest rate of that bond. In other words,
the YTM is generally used as the measurement of a bond’s return.

1. If a bond's current yield is less than its YTM, then the bond is selling at a discount.
2. If a bond's current yield is more than its YTM, then the bond is selling at a premium.
3. If a bond's current yield is equal to its YTM, then the bond is selling at par.

Example 4
Assume you have 15 year pays TZS 110 per year (11%) in interest and TZS 1,00 0
after 15 years in principal payment. The current price of bond is TZS 932.21. We wish
to determine YTM, or discount rate, that equates future flow with the current price.
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 1,000 - 932.21 67.79
110 + 110 +
YTM = 15 = 15 = 110 + 4.52 = 114.52 = 11.94%
0.6(932.21) + 0.4(1,000) 559.33 + 400 959.33 959.33

The answer of 11.94% is a reasonably good approximation of the exact YTM of 12%.

4.7.4 Yield to call

The yield to maturity measures the annual return of a bond if it is held until maturity.
However, this is not always possible for a bond with an embedded call feature.
Callable bonds have the potential to be recalled (or retired) prior to their maturities,
especially when the interest rate is falling. As a result, it is important for holders for
such bonds to determine the bonds’ yields to call (in addition to their yields to
maturity).
Calculating the yield to call is very similar to calculating the yield to maturity: you
simply (a) replace the original term to maturity with the time until first call and (b)
replace the principal with the call price.

4.8 MANAGING BOND PORTFO LIOS

Bond portfolio manager can pursue passive or active investment management strategy.
A passive investment strategy takes market prices of securities as fairly set. Rather
than attempting to beat the market by exploiting superior information or insights,
passive managers act to maintain an appropriate risk-return balance given market
opportunities.
In contrast, an active investment strategy attempts to achieve returns greater than
those commensurate with the risk borne. In the context of bond management this style
of management can take number of forms, the active managers either use interest rate
forecasts to predict movements in the entire fixed income market, or they employ
some form of intramarket analysis to identify particular sectors of the fixed income
market or particular bonds that are relatively mispriced.
The interest rate risk is crucial to formulating both active and passive strategies. For
that reason we begin our discussion with an analysis of the sensitivity of bonds prices
to interest rate fluctuations. This sensitivity is measured by the durations of the bond.

4.8.1 Risks Associated with Investing in Bonds

The m o s t important risks associated with investing in bonds are interest r a t e risk,
reinvestment risk, and credit risk.
1. Interest rate risk. As the interest rates go up (down), bond p r i c e s go down
( up). This is the source of interest r a t e risk, which is approximated by
duration.
2. Call risk. Call protection reduces call risk. When interest r a t e s are more
volatile, callable bonds have more call risk.
3. Prepayment risk. If rates fall, causing p r e p a y m e n t s to increase, the
investor m u s t reinvest at the new lower rate.

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 4. Yield curve risk. Changes in the shape of the yield curve mean that yields
change by different a m o u n t s for bonds with different maturities.
5. Reinvestment risk. Reinvestment risk occurs when interest r a t e s decline and
investors are forced to reinvest bond cash flows at lower yields.
Reinvestment risk is the greatest for bonds that have embedded call
options, prepayment options, or high coupon rates, and is greater for
amortizing securities t h a n for non-amortizing securities.
6. Credit risk. Credit risk comes in three forms-default risk, credit spread risk,
and downgrade risk.
7. Liquidity risk. Since investors prefer more liquidity to less, a decrease in
a security's liquidity will decrease its price, and the required yi e l d will be
higher.
8. Exchange-rate risk. This is the uncertainty about t h e value of foreign
currency cash flows to an investor in terms of his home country currency.
9. Volatility risk.This risk is present f o r fixed- income securities that have
embedded options-call options, prepayment options, or put options.
Changes in interest rate volatility affect the value of these options a n d
thus affect the value of securities with embedded o p tions.
10. Inflation risk. This is the risk of unexpected inflation, also called purchasing
power risk.
11. Event risk. Risks outside t h e risks of financial m a r k e t s (i.e., natural
dis ast ers , corporate takeovers).

4.8.2 Interest Rate Sensitivity (Bonds Price Volatility)

Bond price volatility is measured in terms of percentage changes in bond prices. Bond
with high price volatility or high interest rate sensitivity is one that experiences a
relatively large percentage price change for a given change in yields.
Relationships between yield (interest rate) changes and bond price behavior:
1. Bond prices move inversely to bond yields (interest rates): as yield increase,
bond prices fall; as yields fall, bond prices raise.
2. Prices of long-term bonds tend to be more sensitive to interest rate changes
than prices of short term bonds: thus, bond price volatility is directly related
to term to maturity.
3. The sensitivity of bond prices to changes in yields increases at a decreasing
rate as maturity increases. In other words, interest rate risk is less than
proportional to bond maturity.
4. Bond price movements resulting from equal absolute increases or decreases in
yield are not symmetrical. An increase in a bond’s yield to maturity results in
a smaller price decline than the price gain associated with a decrease of equal
magnitude in yield.
5. Interest rate risk is inversely related to the bond’s coupon rate. Prices of high
coupon bonds are less sensitive to changes in interest rates than prices of low
coupon bonds.

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 6. The sensitivity of bond’s price to a change in its yield is inversely related to
the yield to maturity at which the bond currently is selling. 2
These six propositions confirm that maturity is a major determinant of interest rat e
risk. However, they also show that maturity alone is not sufficient to measure interest
rate sensitivity. Bonds may have same maturity, but the higher coupon bond has less
price sensitivity to interest rate change. Obviously, we need to know more than a
bond’s maturity to quantify its interest rate risk.

4.8.3 Duration
To deal with the ambiguity of the maturity of a bond making many payments, we need
a measure of the average maturity of the bond’s promised cash flows to serve as a
useful summary statistic of the effective maturity of the bond. Frederick Macaulay
termed the effective maturity concept the duration (D) of the bond.
Duration differs from maturity as a measure of interest rate sensitivity because
duration takes into account the time of arrival and the rate of reinvestment of all cash
flows during the bond’s life. Technically, duration is the weighted-average time to
maturity using the relative present values of the cash flows as the weights . Duration
is more complete measure of bond’s interest rate sensitivity than maturity because it
considers the time of arrival of all cash flows as well as the bond’s maturity.
n n n
t.CFt
å (1 + i )
t å t.CFt DFt å t.PVt
t= 1 t= 1 t= 1
D= n
= n
= n
(0.12)
CFt
å (1 + i )
t å CFt DFt å PVt
t= 1 t= 1 t= 1

Where,
t = the time period in which the coupon or principal payments occurs
CF t = the interest or principal payment that occur in period t
i = the yield to maturity on the bond
 = summation sign for addition of all items from t = 1 to n.
n = last period in which cash flow is received
DF t = the discount factor using the current market interest rate.
PV t = Present value of the cash flow at the end of period t (CFt  DFt )
The large the value of D that is calculated for the bond, the more sensitive is the
price of that bond to changes or shocks in interest rates.

4.8.4 ECONOMIC MEANING OF DURATION

Besides being a weighted-average measure of maturity (average life of a bond),
Duration is also a direct measure of interest rate sensitivity (interest rate risk).The

2
A bond with a high yield to maturity will display lower price volatility than a bond
with a lower yield to maturity, but a similar coupon rate and term to maturity
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higher the duration, the higher the bond's price risk, ceteris paribus. Formula, for
annual PMTs:
DP di
%P = =- D (0.13)
P (1 + i)
%P = Percentage change in the price of the bond (ΔP / P)
di = the change in interest rates
i = original level of interest rates
For semi-annual payments:
DP di
=- D (0.14)
P 1+ i ( 2 )
For small changes in interest rates, bond prices move in an inversely proportional
(linear) direction, according to the length of duration. The higher the duration, the
greater the price change (in %), the greater the capital loss (gain), and the gr eater the
price risk.
Example 6
Calculate the duration of a $1,000, 6% coupon bond with three years to maturity.
Assume that all market interest rates are 7%.

Years Cashflow PVIF 7% PV of Cashflow Time Weighted PV of Cashflow

1 60 0.935 56.07 56.07
2 60 0.873 52.41 104.81
3 1060 0.816 865.28 2595.83
Total 973.76 2756.71
Duration = 2.83
Time weighted PV of Cashflows
Duration = = 2.83
PV of Cashflows
Consider the bond in the above question. (i) Calculate the expected rate of price
changes when interest rates drop to 6.75% using the duration approximation. (ii)
Calculate the actual price change using discounted cash flows.
P i
= − DUR  = 0.006615 = 0.6615%
P 1+ i
i −0.0025
P = −DUR   P = −2.83   973.76 = 6.44.
1+ i 1.07
So the new price is 973.76+6.44 = 980.20. The approximation is very good in this
instance (short maturity and a small change in yield).

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4.8.5 Bond convexity
Convexity is a measure of the sensitivity of the price of a bond to changes in interest
rates. It is related to the concept of duration. Duration is a linear measure of how the
price of a bond changes in response to interest rate changes. As interest rates change,
the price is not likely to change linearly, but instead it would change over some curved
function of interest rates. The more curved the price function of the bond is, the more
inaccurate duration is as a measure of the interest rate sensitivity.
Convexity is a measure of the curvature of how the price of a bond changes as the
interest rate changes, i.e. how the duration of a bond changes as the interest rate
changes. Specifically, duration can be formulated as the first derivative of the price
function of the bond with respect to the interest rate in question. Then the convexity
would be the second derivative of the price function with respect to the interest rate.
Price approximation using duration
Price
Actual price

Error in estimating price based only on

duration

Error in estimating price

based only on duration

Tangent line at y*
estimated price

Yield

Notice that dP/ di line is tangent to the price yield curve at a given yield as shown in
the above figure. For small changes in yields (i.e. from y * to either y1 or y 2 ), this
tangent straight line gives a good estimate of the actual price changes. In contrast, for
larger changes in yields (i.e. from y * to either y 3 or y 4 ), the straight line will estimate
the new price of the bond at less than the actual price shown by the price -yield curve.
Thus, duration allows us to estimate bond price changes for a change in interest rates.
However, the equation we are using is accurate only for very small changes in market
yield. The accuracy of the estimate of the price change deteriorates with larger
changes in yields because the modified duration calculation is a linear approximation
of a bond price change that follows a curvilinear (convex) function.

15
Determinants of Convexity
Convexity is a measure of the curvature of the price yield relationship. Because
duration is the slope of the curve at a given yield, convexity indicates changes in
duration. Mathematically, convexity is the second derivative of price with respect to
yield ( d 2 P / di 2 ) divided by price.
d 2P
Convexity = di 2 (0.15)
P
Computation of convexity:
 n CF 
d 2P
di 2
=
1
(1 + i )2
 t
(
 t =1 (1 + i )t
t2 + t ) (0.16)
 
Remember
Example: 3 year Bond, Face value 1000, 12% coupon rate, 9% required return
(1) (2) (3) (4) (1)x(4) (5) (4)x(5)
Year CFt PV@9% Pvt  CFt PV  t t +t
2

1 120 0.917 110.092 110.092 2 220.18

2 120 0.841 101.002 202.003 6 606.01
3 1120 0.772 864.845 2594.537 12 10378.15
Sum: 1075.939 2906.631 11204.34

Duration: 2.70
1 =
(1 + 0.09)2 0.84168
11204.34 x 0.84168= 9430.468

Convexity = 8.764874

Price changes due to convexity

dP di 1
+  convexity  ( di )
2
= −D (0.17)
P (1 + i ) 2
 di  1
P +  P  convexity  ( di )
2
dP =  − D  (0.18)
 
(1 + i )  2

Price change due to convexity is
1
 P  convexity  ( di )
2

2 (0.19)

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