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Class Business. Upcoming Homework. Duration. A measure of the effective maturity of a bond The weighted average of the times (periods) until each payment is received, with the weights proportional to the present value of the payment Duration is equal to maturity for zero coupon bonds - PowerPoint PPT Presentation
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Class Business
Upcoming Homework
Duration A measure of the effective maturity of a bond
The weighted average of the times (periods) until each payment is received, with the weights proportional to the present value of the payment
Duration is equal to maturity for zero coupon bonds
Duration of a perpetuity is (1+r)/r
Duration Formula
(YTM) rateinterest
maturity
t'' periodin flowcash
occurs flowcash when period
11*
11
i
T
CF
t
i
CF
i
CFtDUR
t
T
tt
tT
tt
t
Duration FormulaAnother Perspective
Pi
CF
wi
CFP
where
twtP
i
CF
i
CF
ti
CF
DUR
t
t
tT
t t
t
T
tt
T
t
t
t
T
t T
t t
t
t
t
1 ,
1
* *1
1
*1
1
111
1
Workout Problem-Duration
Calculate the duration of an asset that makes nominal payments of $120 one year from now, $140 two years from now, and $160 three years from now. Assume the YTM is 10%. Calculate the duration of another asset that makes nominal payments of $160 one year from now, $140 two years from now, and $120 three years from now, also with an YTM of 10%.
– Spreadsheet
Duration Properties
The longer the term to maturity of a bond, everything else being equal, the greater its duration.
When interest rates rise, everything else being equal, the duration of a coupon bond falls. (convexity)
The higher the coupon rate on the bond, everything else being equal, the shorter the bond’s duration.
Duration is additive: The duration of a portfolio of securities is the weighted average of the durations of the individual securities, with the weights reflecting the proportion of the portfolio invested in each.
Algebraic Duration Relations
Where D* is modified Duration, D* = D/(1+y) But, using some algebra
P-D
Py1
D - y P/
*
y D- P/P *
Immunization Example
Insurance co must make $19,487 in 7 years, market rates are 10%, PV of payment is $10,000. Using 4 year zero coupon bonds and perpetuities, immunize this obligation against interest rate risk.
Duration of Liabilities = 7 yearsDuration of zero-coupon bonds = 4Duration of perpetuities = 1.1/.1 = 11
Solve: x*4 + (1-x)*11 = 7
x = 57%, therefore buy $5,700 worth of zero coupon bonds and $4,300 worth of perpetuities
Pricing Error from Convexity
Price
Yield
Duration
Pricing Error from
Convexity
Correction for Convexity
)(21 2* yConvexityyD
P
P
Modify the pricing equation:
Convexity is Equal to:
Convexity
How does convexity affect the approximation error of the bond return when we match only the modified duration?
As an investor, do we like convexity?
In general, the higher the coupon rate, the lower the convexity of the bond.
Example
Annual coupon paying bond– matures in 2 years, par=1000, – coupon rate =10%, y=10%
Price=$1000 Time when cash is received:
– t1=1 ($100 is received), t2=2 ($1100 is received)
Find approximate percentage change in bond price using both duration and convexity if yields increase by 100bps
Example
Using D* only (D* = 1.7355)
Using both D* and convexity (4.6583)
Differences can be meaningful
Convexity of a Portfolio
The convexity of a portfolio is the weighted sum of the convexity’s of each bond in the portfolio where weights are the fraction of your investment equity in each
Therefore, we can match convexity of portfolio similar to matching modified duration
1 1 2 2 ...p j jC w C w C w C
Active Bond Management: Swapping Strategies
Substitution Intermarket Rate anticipation Pure yield pickup Tax Others
Interest Rate Swaps
Interest rate swap basic characteristics– One party pays fixed and receives variable– Other party pays variable and receives fixed– Principal is notional (not exchanged)
Growth in market– Started in 1980– Estimated over $60 trillion today
Hedging applications – Banks Speculative applications – Fixed Income Asset
Management
A and B Transform Assets
A B
LIBOR
5%
LIBOR+0.8%
5.2%
Existing Asset
Existing Asset
Swap{
Assume Portfolio manager A thinks interest rates are going up while manager B thinks interest rates will stay level or go down
Swap Example:Financial Institution is Involved
A F.I. B
LIBOR LIBORLIBOR+0.8%
4.95% 5.05%
5.2%