Duration

Bond Price Changes, Convexity and Immunization

http://www.tinyurl.com/BrackerDuration2

Duration and Changes in the Bond Price [ ( ) ]( )

You have a 10-year 8% coupon bond and the current market rate of interest is 7.25%. This bond will have a duration of 7.32 years. If interest rates fall by 80 basis points, what will happen to the bond price?

Convexity Note that duration says the bond price will rise by 5.46%. Assuming annual coupon payments, the bond was originally valued at $1052.07, so duration predicts a price of $1109.51. However, if we recalculate the bond price at the new rate (6.45%), we get $1111.69. What happened?

Convexity 30-Year 14% Coupon

$2,500.00

$2,300.00

$2,100.00

$1,900.00

$1,700.00

The actual bond price falls less than predicted by duration when interest rates go up and rises more than predicted by duration when interest rates fall. Note that the actual bond shape exhibits a convex relationship to interest rates. Hence the term convexity.
Duration Prediction Actual Bond Price

$1,500.00

$1,300.00

$1,100.00

$900.00

$700.00 -5% -4% -3% -2% -1% 0% 1% 2% 3% 4% 5%

Convexity 5-year 14% Bond

$1,450.00

$1,350.00

$1,250.00

$1,150.00

Duration Prediction Actual Bond Price

$1,050.00

$950.00

$850.00 -5% -4% -3% -2% -1% 0% 1% 2% 3% 4% 5%

Convexity All else equal, the higher the duration (longer time to maturity or lower coupon payment), the more error (convexity) there will be All else equal, the bigger the change in interest rates, the more error there will be

Convexity and Call Provisions

Duration and Immunization In addition to helping us estimate how sensitive a bond is to interest rates, duration can tell us an approximate holding period where price risk and reinvestment rate risk offset. Holding a bond to duration immunizes us from interest rate changes.

Duration and Portfolios The duration for a bond portfolio is just equal to the weighted average of each individual bonds duration.
Mkt Value Bond A Bond B Bond C $1 Million $3 Million $4 Million $8 Million Duration 10.5 years 8 years 5 years Weight 0.125 0.375 0.500 1.000 Weighted Duration 1.3125 3.0000 2.5000 6.8125 years

Immunization Example
Consider the Bond in this example. It's duration is approximately 12 years when the required return is 8.5%. While this tells us about the price sensitivity, it also tells us that an investor with a 12-year holding period should expect to have the same total proceeds if interest rates increase/decrease. The extra interest made from reinvesting the coupon payments is almost exactly offset by the lower selling price of the bond when interest rates rise to 9.5% as opposed to falling to 7.5% FV@9.5% $189.96 $173.48 $158.43 $144.68 $132.13 $120.67 $110.20 $100.64 $91.91 $83.93 $76.65 $70.00 $788.22 FV@7.5% $155.09 $144.27 $134.21 $124.84 $116.13 $108.03 $100.49 $93.48 $86.96 $80.89 $75.25 $70.00 $951.47

PMT 1 PMT 2 PMT 3 PMT 4 PMT 5 PMT 6 PMT 7 PMT 8 PMT 9 PMT 10 PMT 11 PMT 12 Selling Price

$70.00 $70.00 $70.00 $70.00 $70.00 $70.00 $70.00 $70.00 $70.00 $70.00 $70.00 $70.00 $788.22

$70.00 $70.00 $70.00 $70.00 $70.00 $70.00 $70.00 $70.00 $70.00 $70.00 $70.00 $70.00 $951.47

$2,240.87 $2,241.13 Note: This is a 30-year 7% Coupon Bond with a duration of 12 Years and an original market rate of interest of 8.5%. We are looking at what happens to our ending net cash flows if interest rates drop by 1% or increase by 1% after we buy the bond.