Price Volatility

Also called as Sensitivity Duration Macaulay and Modified Duration PV01 / PVBP / Dollar Duration / DV01 Convexity

Duration Weighted average maturity

Measure of average maturity / life of the bond
Weighted average life until cash flows are received Weight for each cash flow is the % of the Bond price contributed by that cash flow

Measure of interest rate risk

Approximation of price sensitivity of bond to change in underlying yield

 Distance from left-hand end to balance point represents Macaulay Duration

 To measure average maturity, we need to weight the Time to each payment. This is called Duration or more accurately, Macaulay Duration.
Suppose a bond pays $C each year. The yield of the bond is y. Assume annual compounding for now.

What we do here is weight the time to each payment by the present value of the payment and then divide the result by the sum of weights.

Duration
The denominator of the previous equation is just the price of a bond.

D= Macaulay Duration

Duration - recap

Duration Price Sensitivity

DurationMeasure of Price Sensitivity

Consider an annual coupon payment bond :

dp / dy : Change of Price wrt Yield

Duration - Sensitivity Measure

Duration - Price Sensitivity to Interest Rate

Previous dp/dy says that bond price sensitivity is directly related to duration. We can also express it in percentage price

This is called MD = Modified Duration We can see the inverse relationship between Price and Yield

Practical Uses of Duration

Duration as a measure of volatility to estimate price change due to change in interest rate:

MD = % change in price for a 100 bp change in yield MD of 3.5 = price of the bond is likely to move up/down by 3.5% from current levels for a 100 bps fall/increase in Interest Rates

Price change using MD

8.5% bond with 5 years to Maturity. Price at $103.2196 to yield 7.70%. MD = 3.9815 Estimate the change in price (dp) for following change in yield using duration estimate :

Example clearly suggest that Duration is just a linear estimate of price change due to yield movements.

DVO1 / PVBP/ Dollar Duration

Industry pays attention to DV01:
That is, how much the price of bond will change for 1 bp change in yield DV01 = (Modified Duration x Full Price) x 0.0001 for $100 face value bond DV01 = (Dollar Duration) x 0.0001 for $100 face value bond

Price Change from DV01 estimate :

dp=(-) dy * DV01

Duration - Properties
How coupon influences Duration ? How coupon payment influences Duration ? How yield influences Duration ?

Duration Properties
Duration is reduced when
coupons are increased yield increases frequency is higher

Duration is increased when

coupons are decreased (and is maximised for zero coupon Bonds) yield decreases frequency is lower

Duration is
Term to Maturity for zero coupon bonds not proportional to Term to Maturity

Convexity

What is Convexity?
Convexity measures the curvature (nonlinearity) in a price-yield curve Positive convexity indicates a bonds price rises more for a given decline in yield but fall less for a given increase in yield Convexity exists because of bond price-yield relationship

Convexity Effect on Price

From Dp/Dy to D2p/Dy2

Measure Convexity

Convexity of Zeros
Duration (Macaulay) of zero (T in full year)

Convexity of zero:

Rules of thumb for convexity of zero: Convexity increases as a square of Macaulay Duration (or maturity)

Approximating bond price change with duration & convexity

Taylor series expansion of bond price change:

Convexity Effect on Price

Change in Price : Example

Suppose Modified Duration is 4 years and convexity is 49, what is the % change of price for 100 bp shift in yield? = 4x0.01 + 0.5x49x(.01)2 = 0.04245 = 4.4245%

Factors effecting Convexity

Cash flow pattern :
Dispersed cash flows : Higher Convexity Concentrated cash flows : Lower Convexity

For given YTM and time to maturity Coupon rate

Higher coupon : Lower convexity Lower Coupon : Higher convexity

YTM increases Convexity decreases and vice versa For given yield and time to maturity ZCBs have highest convexity For given YTM & Modified Duration Lower Coupon : lower convexity ZCB will have the lowest convexity