Duration and convexity for Fixed-Income Securities
RES9850 Real Estate Capital Market
Professor Rui Yao
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Duration and convexity: Outline
I. Macaulay duration
II. Modified duration
III. Examples
IV. The uses and limits of duration
V. Duration intuition
VI. Convexity
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A Quick Note
Fixed income securities’ prices are sensitive to changes in interest rates
This sensitivity tends to be greater for longer term bonds
But duration is a better measure of term than maturity Duration for 30-year zero = 30
Duration for 30-year coupon with coupon payment < 30
A 30-year mortgage has duration less than a 30-year bond with similar yield
Amortization
Prepayment option
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I. (Macauly) duration
Weighted average term to maturity Measure of average maturity of the bond’s promised cash flows
Duration formula:
where:
is the share of time t CF in the bond price
and t is measured in years
0
10
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)(PVP
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yCF
CF
CFw
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Duration - The expanded equation
For an annual coupon bond
Duration is shorter than maturity for all bonds except zero coupon bonds
Duration of a zero-coupon bond is equal to its maturity
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IV An Example – page 1
Consider a 3-year 10% coupon bond selling at $107.87 to yield 7%. Coupon payments are made annually.
87.10779.8973.835.9bond of Price
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2 *
8.73
107.87
3 *
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107.87
2.7458
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II. Modified duration (D*m)
Direct measure of price sensitivity to interest rate changes Can be used to estimate percentage price volatility of a bond
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Derivation of modified duration
So D*m measures the sensitivity of the % change in bond price to changes in yield
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An Example – page 2
Modified duration of this bond:
If yields increase to 7.10%, how does the bond price change? The percentage price change of this bond is given by:
= –2.5661 .1%
= –.2566%
5661.207.1
7458.2* mD
yDP
Pm
*
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An Example – page 3
What is the predicted change in dollar terms?
New predicted price: $107.87 – .2768 = $107.5932
Actual dollar price (using PV equation): $107.5966
2768$.
87.107$100
2566.100
2566.
PP
Good approximation!
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Summary: Steps for finding the predicted price change
Step 1: Find Macaulay duration of bond. Step 2: Find modified duration of bond. Step 3: Recall that when interest rates change, the change in a bond’s price
can be related to the change in yield according to the rule:
Find percentage price change of bond Find predicted dollar price change in bond Add predicted dollar price change to original price of bond
Predicted new price of bond
yDP
Pm
*
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V. Check your intuition
How does each of these changes affect duration?
1. Decreasing the coupon rate.
verify this with a 10-year bond with coupon rate from 5% to 15%, and ytm of 10%
2. Decreasing the yield-to-maturity.
verify this property with a 10-year bond with coupon rate of 10%, and ytm from 5% to 15%
3. Increasing the time to maturity.
verify this property with a par bond with a coupon rate of 10%, and term from 5 to 15 years
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V. Dollar Duration We have derived the following relationship between duration and price
changes (bond returns):
Hence
Note the term on the RHS of the equation above measures the (absolute value of) slope of the yield-price curve, which is also called dollar duration
We can then predict price changes using dollar duration:
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Pm
*
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yP
P
yduryPDP m $)( *
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Duration with intra-year compounding
In practice, lots of bonds do not pay annual coupon and we need to change the formula a bit to account for it
Some calculus (note: each step in summation is 1/m year so there are m*T terms in total)
So dollar duration
Duration
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V. Effective Duration– Numerical Approximation
Instead of calculating modified duration based on weighing the time of cash flow with the present value share of the CF, and then modify by dividing by (1+y), we can numerically approximate the modified duration from the slope of price-yield chart:
The slope of the yield-price curve is the dollar duration
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PDm
1*
PDy
Pm
*
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V. Effective Duration – Numerical Approximation
We can approximate the slope of the graph / dollar duration by averaging the forward and backward slope (“central difference method”)
The duration is then
The modified duration then can be estimated as
This approach directly uses the idea that the duration measures price sensitivity to interest rate Can duration be negative?
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VI. Duration and Convexity – Numerical Approximation
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yield
price
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VI. Convexity
Duration is the first order approximation for percentage change in bond prices for a one percent change in yield to maturity For a fixed rate non-callable bond, duration underestimates change when
yield falls and overestimates when yield rises The difference is captured by convexity Convexity is typically positive for bond
Is this good or bad?
Mortgage is a difficult product to evaluate due to embedded call options Duration tends to become shorter when interest becomes lower as borrower
prepays mortgage Duration becomes longer when interest rate becomes higher as borrower
holds on to his mortgage Negative convexity
Opposite to the case of a typical bond
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V. Convexity
The forecast of price response using dollar duration is
Essentially it is a linear projection using the slope measured at yo
However as soon as you move away from yo the slope will change
The rate of slope change is captured by dollar convexity
A little calculus yields (take first order derivative of dollar duration with respect to yield)
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V. Convexity – Numerical Approximation
What is the predicted dollar duration at y+ using dollar duration from yo and convexity measure at yo?
So the average of slopes at y+ and yo , which gives a better approximation of changes in prices when yield changes, is
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oyyyy
2
2
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Pddurdurdur
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V. Convexity
The forecast of price response using duration and convexity
In percentage term
The term
is referred to as convexity
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V. Convexity with intra-year coupons
Dollar convexity with intra-year coupons
Convexity with intra-year coupons
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V. Effective Dollar Convexity – Numerical Approximation
Instead of analytical formula, in practice $ convexity is frequently approximated using numerical methods based on price-yield relations
Numerical approximation is very useful when cash flow size and timing are uncertain due to built-in options in the bond payments
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V. Homework
30 year T-bond has a yield to maturity of 3.0% and price at par, and coupon is paid annually.
1. Find out analytically the following measure at 3.0%: A. duration B. modified duration C. dollar duration D. dollar convexity E. convexity
2. Also calculate B, C, D, and E using numerical approximations using a step (delta y) of 1 basis point. How accurate is the approximation compared with analytical solutions from part 1?
3. Use dollar duration measure to predict price when yields change from 1% to 5% at 0.5% interval.
4. Use both duration and convexity to predict bond price when yields change from 1% to 5% at 0.5% interval.
note: you can use either the analytical duration/convexity or their numerical approximation for question 3 and 4.
5. What do you conclude when comparing results from 3 and 4? Which one is more accurate and why?