Basic Bond Analysis2

gcnath@hotmail.
com 1

BOND PRICE AND RISK DYAMICS
Golaka C Nath
1. Introduction
A student of Finance needs to understand few basic concepts on Bond Theory in order to
understand the relationship between price and yield, to design bond trading strategies, to
interpret yield curves movements, look at arbitrage opportunities, etc. A trader can deal
with various types of bonds. Bonds are issued by issuers with specific need and hence have
different risks associated with them. Rating agencies play a very important role in bond
issuances. Bond investment has many facets some regulatory and some pure investment.
Banks invest in Sovereign Bonds in many countries as a regulatory requirement known as
Statutory Liquidity Ration. This write-up helps to understand what kind of information one
can deduce from different bonds traded in the market, yield curves properties and theory
behind yield curves as well various properties of bonds.

2. Bond Pricing Mechanism
A bond is either a zero coupon bond or a coupon bearing bond regular inflow of future
stream of cash flows both equal and unequal. A zero coupon paper is a bullet payment by
the investor and repayment by the issuer. A coupon bearing bond is combination of many
zero coupon bonds as it a combination of many future cash flows. Hence, the price of a
bond is nothing but the present value of its expected future cash flows.

The present value (PV) of a bond will be lower than its future value primarily because having
100,000 three months from now is less valuable than having 100,000 at hand now. As we
move to the future, the value of a bond may deplete as the possibility of default increase,
inflation can also eat away part of the value, future interest rate scenario changes, etc.
There are many classes of bonds traded in the market. Sovereign bonds contribute the
largest chunk followed by corporate bonds. Sovereign bonds do not assume credit risk or
default risk while corporate bonds include default risk and rating information on such bonds
is very important to price the bond. An AAA rated bond will have a lesser chance of default
vis--vis a BB rated bond and accordingly credit spread is charged for the bonds. However,
gcnath@hotmail.com 2

sovereign bonds provide the starting basis to price a bond with credit risk. Most bond prices
are quoted in decimals (upto 4 decimals). However, the US market quotes in 32nds.

2.1 Pricing a Single Cash Flow
While calculating the future value of an investment, we require a rate of return for the term
of our investment. If we want a 10% p.a. return for our investment, then 100 invested now
will become 110 in one years time.
Future Value (FV) = 100 * (1 + 10/100) = 110
Alternatively, we can also write the same as: where PV is the
present value r is the rate of return. In general, we can write,

where n is the number of periods invested. If we want to calculate the price of a bond as a
function of its future value, we can rewrite this equation as

where P is the price of the bond which is nothing but the present value. And FV is the
future cash flow i.e. the repayment at redemption n periods ahead.

2.2 Discount Rate
The r is referred to as the yield or the discount rate, i.e. the rate used to discount all the
future cash flows in order to ascertain the current price or present value of the investment.
is the value of the discount function at period n. Multiplying the discount function
at period n by the cash flow expected to be received at period n gives the present value
of the cash flow today.
Pricing a bond with a semi-annual coupon follows the same principles as that of an annual
coupon. A 5 year bond with a FV of 100 and semi-annual coupons will have 10 periods, each
of six months maturity; and the price equation will be:

where c = annual coupon value and r is the redemption yield or discount rate (semi-annual
yield * 2 to make it annualized).

In practice, most bonds will have multiple cash flows before their maturity and therefore
each cash flow needs to be discounted in order to find the present value (current price). The
general price is given as follows:

The P here is the dirty price (inclusive of all interests accrued from the last coupon
payment date). The common practice in bond markets is to discount using a redemption
yield and all future cash flows are discounted using this rate. The yields are derived from the
yield curve in the market for a particular type of debt. The clean price is used by traders to
quote a bond in the market. The accrued interest is deducted from the dirty price to get the
quoted price of a bond.

In the bond price equation, r is the redemption yield the yield that an investor is likely to
get if he holds the security till maturity. This assumption may have problems as many fund
managers may have different portfolio holding periods and the same may vary dynamically
depending on market condition and movement of yield curve. In theory, each investor will
have a slightly different view of the rate of return required on the basis of opportunity cost
facing each of them. Their perception on future inflation, appetite for risk, nature of
liabilities, investment time horizon etc. will vary. The required yield for an investor needs to
reflect the above considerations. While dealing in the market, investors will figure out what
they consider to be a fair yield to enthuse them to invest. They can then compute the
corresponding price using the yield and compare this to the market price before deciding
whether and how much to buy or sell.
In general, the bond mathematics notation for expressing the price of a bond is given by

where PV(cf t ) is the present value of the cash flow at time t.
In the above example, we have used the same redemption yield to price the bond. However,
Time Value of Money makes us to consider different interest rates applicable to each cash
flow in terms of its arrival time. So using a single r to price a bond, we may consider
different series of rs to estimate the price. These yields are known as the spot yields or
zero coupon yields. Typically these yields are not observed in the market (unless you have

many Zeros trading in the market) and have to be estimated using various theories of yield
curve. In that case the bond price equation will be:

Here we have used different rs appropriate for each term.
2.3 Dirty Prices and Clean Prices

A bond has multiple coupon payment dates which starts with the issue of the bond and
ends with the maturity of the bond. On coupon payment dates, bonds are not typically
traded as it may go for a Shut period in order to make payment of the coupon to the last
recorded holder of the Bond. This is so as a bond is sold with accrued interest even if no
interest has been received by the seller at the time of selling the Bond. Interest will be paid
out by the issuer on the next designated coupon payment date (for example 8.79% GOI
2021 bond will pay coupon on 08-May and 08-Nov every year till 08-Nov-2021). Hence these
factors need to be taken into account while pricing a bond. The traders quote clean price
while trading a bond but the back office calculates the full price of the bond for invoicing to
the counterparty. If all other parameters like maturity, coupon and yield are constant, the
clean price remains more or less stable. That is the reason why clean price is important for a
trader and why the same is used while trading the bond.
When a bond is bought or sold during a coupon cycle (between last coupon date and next
coupon date), a certain amount of coupon interest will have accrued on the bond. Because
he may not have held the bond throughout the coupon period, he is required to pay the
previous holder some compensation for the amount of interest which accrued during his
ownership. In order to calculate the accrued interest, we need the basis of calculating the
days between coupon cycles. There are markets which follow Actual / 365 while some
markets follow 30/360 (each month is considered 30 days and year is considered 360 days)
and many other types of Basis is used in markets depending on the type of assets we value.
Coupon rate is already known at the time of issuing a bond. In most bond markets, accrued
interest is calculated on the following basis:


Prices in the market are usually quoted on a clean basis but settled on a dirty basis or full
price. For 8.79% GOI 2021 maturing on 08-Nov-2021, the AI on 01-Jan-2012 will be =
(8.79/360)*53 days = 1.2941. Since the settlement is on 01-Jan-2012, the legal title of the
bond passes to the buyer from this date and he is eligible for all accruals from this date. The
previous holder of the bod is eligible for compensation till 31-Dec-2011 from 08-Nov-2011
(last coupon payment date) 23 days in November + 30 days in December making total 53
days.
The Dirty price of this bond on January 1, 2012 will be 102.5066. How this price is arrived?
The bond has been traded at an yield of 8.6021% by the trader. The computation of the
price on 01-Jan-2012 is given below (Table 1):
Table 1: Bond Price using Cash Flow Method
Settlement
Date
Cash flow
Date Cash flow Period
Period in
Years
Discount
Factors
Discounted
Cash Flow
Value Date
(The previous
holder ceases
and new one
takes over
legal
ownership)
Coupon
Payment
Dates
Money
Received
Days
from
Value
Date to
Next
Coupon
date
Period in
Years
(30/360
Basis)

R=8.6021%
DF * Cash
Flow
01-Jan-12 08-May-12 4.3950 127 0.3528 0.9707 4.2663
08-Nov-12 4.3950 307 0.8528 0.9307 4.0904
08-May-13 4.3950 487 1.3528 0.8923 3.9217
08-Nov-13 4.3950 667 1.8528 0.8555 3.7600
08-May-14 4.3950 847 2.3528 0.8202 3.6050
08-Nov-14 4.3950 1027 2.8528 0.7864 3.4563
08-May-15 4.3950 1207 3.3528 0.7540 3.3138
08-Nov-15 4.3950 1387 3.8528 0.7229 3.1771
08-May-16 4.3950 1567 4.3528 0.6931 3.0461
08-Nov-16 4.3950 1747 4.8528 0.6645 2.9205
08-May-17 4.3950 1927 5.3528 0.6371 2.8001
08-Nov-17 4.3950 2107 5.8528 0.6108 2.6846
08-May-18 4.3950 2287 6.3528 0.5856 2.5739
08-Nov-18 4.3950 2467 6.8528 0.5615 2.4678
08-May-19 4.3950 2647 7.3528 0.5383 2.3660
08-Nov-19 4.3950 2827 7.8528 0.5161 2.2684
08-May-20 4.3950 3007 8.3528 0.4949 2.1749
08-Nov-20 4.3950 3187 8.8528 0.4744 2.0852
08-May-21 4.3950 3367 9.3528 0.4549 1.9992
08-Nov-21 104.3950 3547 9.8528 0.4361 45.5293
Dirty Price 102.5066
AI 1.2941
Clean price 101.2125

The dirty price and clean price have different behavioral pattern. The clean price is stable
over time (a very decline in value as the time passes) if we have the maturity, yield and
coupon is held constant. The dirty price is maximum on one day before coupon payment
dates as on this day, the accrual is highest on this day. On coupon payment date, the dirty
price and clean price is same as there is no accrued interest on this date. Further, on coupon
payment dates, the price of the bond is equal to the FV (100) if yield and coupon is same.
But on any other day if we price the bond between two coupon payment dates), the said
rule does not hold good. For our own example, the theoretical value of the bond on 01-Jan-
2012 (if we make the yield as 8.79%), the price comes to 99.9804 and not 100 (Table 2).
Table 2: Bond Price using Cash Flow Method when Coupon equals Yield
Settlement
Date
Cash flow
Date Cash flow Period
Period in
Years
Discount
Factors
Discounted
Cash Flow
01-Jan-12 08-May-12 4.3950 127 0.3528 0.9701 4.2636
08-Nov-12 4.3950 307 0.8528 0.9293 4.0841
08-May-13 4.3950 487 1.3528 0.8901 3.9122
08-Nov-13 4.3950 667 1.8528 0.8527 3.7475
08-May-14 4.3950 847 2.3528 0.8168 3.5897
08-Nov-14 4.3950 1027 2.8528 0.7824 3.4386
08-May-15 4.3950 1207 3.3528 0.7494 3.2938
08-Nov-15 4.3950 1387 3.8528 0.7179 3.1552
08-May-16 4.3950 1567 4.3528 0.6877 3.0223
08-Nov-16 4.3950 1747 4.8528 0.6587 2.8951
08-May-17 4.3950 1927 5.3528 0.6310 2.7732
08-Nov-17 4.3950 2107 5.8528 0.6044 2.6565
08-May-18 4.3950 2287 6.3528 0.5790 2.5446
08-Nov-18 4.3950 2467 6.8528 0.5546 2.4375
08-May-19 4.3950 2647 7.3528 0.5313 2.3349
08-Nov-19 4.3950 2827 7.8528 0.5089 2.2366
08-May-20 4.3950 3007 8.3528 0.4875 2.1424
08-Nov-20 4.3950 3187 8.8528 0.4669 2.0522
08-May-21 4.3950 3367 9.3528 0.4473 1.9658
08-Nov-21 104.3950 3547 9.8528 0.4285 44.7287
AI 1.2941
Clean price 99.9804
The clean price is stable over period in time if we keep the parameters like yield, coupon
and maturity constant over time. When clean prices change, it is more for an economic
reason, for instance a change in interest rates or in the bond issuer's credit quality. Dirty
prices, on the other hand, change day to day depending on where the current date is in
relation to the coupon dates, in addition to any economic reasons. In our example, the clean

price of 8.79% GOI 2021 maturing on 08-Nov-2021 and trading at an yield of 8.6021% on
various days between 01-Jan-2012 and 31-Mar-2012 is plotted below (Chart -1). The chart
clears shows that the clean price change is about only 0.016 over a three month period.

The dirty price changes day to day as interest are accrued every day (Chart 2).

The bond price equation we used above can also be written as:

[ (
)]

The above equation has been derived from the original bond price equation. If we have
semi-annual bond, then the rate will be
and time will be 2*t. The above formula gives us

an approximate clean price of the bond. For our example, the bond will be priced as
101.194
101.199
101.204
101.209
30-Dec-11 19-Jan-12 08-Feb-12 28-Feb-12 19-Mar-12
Chart - 1: Clean Price
Clean Price
99.0000
100.0000
101.0000
102.0000
103.0000
104.0000
105.0000
106.0000
107.0000
23-Dec-11 06-May-13 18-Sep-14 31-Jan-16 14-Jun-17 27-Oct-18
P
r
i
c
e

Settlement Date
Chart - 2: Dirty Price vs Clean Price
Dirty Price Clean Price

(
) [
= 102.1844*0.5639+43.6125
= 101.2317
Price of the bond can also be found out by finding out the value the bond as of the last
coupon payment date and then taking that value forward to the current point in time
(settlement date). This is the total price that the buyer will actually pay. To get the quoted
or clean price, subtract the accrued interest. For example, the price for the bond in our
example on last coupon payment date (08-Nov-2011) is =102.1844*.5692+43.0751 =
101.2434. To take that value forward till settlement date, we need to divide the same by the
DF till settlement date
. This makes the Dirty Price =

101.2434/0.9877 = 102.5066. If we deduct the AI of 1.2941, we get the Clean Price of
101.2125 which is the CP we derived earlier.

2.4 Relationship between price and yield
There is a direct relationship between the price of a bond and its yield. Bond price and yield
move inversely. The price is the amount the investor will pay for the future cash flows; the
yield is a measure of return on those future cash flows. The price-yield relationship of a
standard non-callable coupon bearing bond shows a convex shape (Chart 3 and 3A).

When the required yield decreases, the discount factor also decreases and the price of the
bond rises. Hence the price increases as yield decreases.
60.0000
80.0000
100.0000
120.0000
140.0000
160.0000
180.0000
1.00% 5.00% 9.00% 13.00% 17.00%
P
r
i
c
e

Yield
Chart - 3: Price and Yield Relationship
Dirty Price Clean Price

3. Yields and yield curves
For Bonds, prices are derived for convenience of transferring value from buyer to sell. Since
we have bonds with different parameters like maturity and coupon, they can be compared
by means of their relative attractiveness which is found by comparing the yield of the bond.
It is not possible for an investor to compare the relative value of bonds by simply looking at
their traded prices as the different maturities and coupons will affect the traded price.
Hence to figure out the relative value of bonds, we need to compare bond yields. Yields are
usually quoted on an annual basis (semi-annual *2). In order to convert to a semi-annual
basis (and vice versa), we can apply the following formulae:
1
(

In general, the formula applied to convert from an annual to other period yield is

1) * n.

3.1 Money market yields
Money market yields are quoted on a different basis (Act/365) and therefore in order to
compare short-term bonds and money market instruments it is necessary to look at them
on a comparable basis. The price of a 91-day T-Bill is found out as follows:

96
98
100
102
104
106
108
110
112
114
7.10% 7.60% 8.10% 8.60% 9.10%
A
x
i
s

T
i
t
l
e

Axis Title
Chart - 3A: Price Yield Relationship
CP DP

If a 91-day TB is trading at 8.15%, then its price will be 98.0085.

3.2 Uses of Yield Curves and Yield Curve Theories
A yield curve (Chart 4) is a graphical representation of the term structure of yields for a
given market. It depicts how yields for a set of bonds with similar characteristics except
maturity vary with maturity. Yield curves are therefore constructed from a homogeneous
group of bonds. Bonds with different credit quality will have different yield curves.
Sovereign yield curves represent the yield on Government securities traded in a market.
Yield curves help us to price bonds whether they are traded or not. Yield curves represent a
continuous time domain.

Yield curve is the Bible for Bond market participants and have different uses for different
people. Sovereign yield curves tell us market participants expectation about the future.
Sovereign yield curves demonstrate the tightness (and expected tightness) of monetary
policy; it allows allow cross-country comparisons; assist pricing of new issues; assess relative
value between bonds; allow one to derive implied forward rates; and help traders/investors
understand risk; help in pricing illiquid and non-traded bonds. Different yield curves
(depending upon the class of bonds used) are used for different purposes.

Theories of the yield curve attempt to explain the shape of the curve, depending on
preferences/views of the market participants. The major theories behind yield curve
8.2000
8.3000
8.4000
8.5000
8.6000
8.7000
8.8000
8.9000
0.00 5.00 10.00 15.00 20.00 25.00 30.00
Y
i
e
l
d

%

Maturity
Chart - 4: Yield Curve
Indian_23-04-2012

construction are - Liquidity Preference Theory (risk premia increase with time so, other
things being equal, one would expect to see a rising yield curve); Pure Expectations
Hypothesis (forward rates govern the curve - these are simply expectations of future spot
rates and do not take into account risk premia); Segmented Markets Hypothesis (the yield
curve depends on supply and demand in different sectors and each sector of the yield curve
is only loosely connected to others); Preferred Habitat (again investors have a maturity
preference, but will shift from their preferred maturity if the increase in yield is deemed
sufficient compensation to do so).

Sovereign yield curves are very important tools for monetary policy. The shape and slop of
the curve helps to frame monetary policy as future expectations are inbuilt in the curve.
Central Banks around the world plan Open Market Operations (OMO) to moderate the
shape of the curve by buying and selling bonds through designated windows.

3.3 Flat Yield
This is the simplest measure of yield (also known as current yield, interest yield, income
yield or running yield). Before the onset of computers and Financial Calculators, buyers and
sellers used this form of yield to compare the bonds. It does not talk about time value of
money or compounding. It is a very crude measure of yield. It just maps the holding cost of a
Bond and compares bonds across time horizon. It just assumes one period holding till next
coupon date. It does not take into account accrued interest. It assumes that price is not
going to change during holding period. It is given by:
Flat Yield = Coupon Rate/Clean price
For a bond 8.79% GOI 2021 maturing on 08-Nov-2021 and trading at an yield of 8.6021% for
value date as on 01-Jan-2012, the clean price is 101.2125. The Flat Yield will be =
8.79/101.2125 = 8.6847%

It can only sensibly be used as a measure of value when the term to maturity is very long (as
coupon income will be more dominant in the total return than capital gain/loss).

3.4 Simple Yield

Simple Yield is a slightly more sophisticated measure of return than flat yield. This takes into
account the capital gain. But it assumes that capital gain accrues in a linear fashion over the
life of the bond. However, it does not allow for compounding of interest; nor does it take
into account accrued interest. It uses the clean price in the calculation.
(

)

For our Bond, the same will be (8.79 +
)/(
) = 8.8594%
When a bond reaches near its last coupon period is, in terms of its cash flows, it directly
comparable with a money market instrument as there is no intervening coupon. In this case
simple interest yield calculations are used.

3.5 Redemption Yield (Yield to Maturity)
A redemption yield or yield to maturity is that rate of interest (current interest rate
prevailing in the market for similar kind of bonds) at which the total discounted values of
future payments of income and capital equate to its price in the market.

where P =dirty price; C =coupon, R =redemption payment (typically 100); and n =no of
periods; r =redemption yield.

The redemption yield is also referred to as the Internal Rate of Return or the Yield to
Maturity (YTM). It assumes that investor is going to hold this bond till maturity. When
quoting a yield for a bond, it is the redemption yield that is normally used by traders. Yield
curve captures all the factors contributing to the expectation of return on investment in a
single number. The redemption yield takes into account the time value of money by using
the discount function: each cash flow is discounted to give its net present value. Obviously a
bond with near maturity is expected to be traded at a lower yield than a long maturity bond.
This measure gives only the potential return as an investor can sell of the bond before its
maturity or she may have her own investment period.

The limitations of using the YTM yield to discount future cash flows are:

- It assumes that a bond is held to maturity. (i.e. the YTM is only achieved if a bond is
held to maturity);
- It discounts each cash flow at the same rate irrespective of its time of arrival in the
hands of the investor and hence against the principle of Time Value of Money;
- Since we discount using the same YTM throughout its life, YTM assumes a
bondholder can reinvest all coupons received at the same rate (i.e. assumes a flat
yield curve), whereas in reality coupons will be reinvested at the market rate
prevailing at the time they are received (it assumes no reinvestment risk);
- The discount rate used for a cash flow in, say, three years time from a 10 year bond
will be different from the rate used to discount the three year payment on a 30 year
bond.
The YTM curve suffers from these above limitations. We use the curve for simple analysis,
and it can also be used when there are insufficient bonds available to construct a more
sophisticated yield curve. In an illiquid market, this is the best we can have. Approximate
YTM is found out by using IRR function (Table 3). Here we need to use only the clean price
as first Cash outflow and all coupons and Principal as inflows in future dates. For our Bond,
the same is working out as 8.6067% (this is little higher than actual yield).
Table 3: Yield Using IRR
Settlement
Cash flow
Date
Maturity to
CF
Years Cash flow DF DCF
-101.2125
01-Jan-12 08-May-12 127 0.35 4.395 0.9707 4.2663
08-Nov-12 307 0.85 4.395 0.9307 4.0904
08-May-13 487 1.35 4.395 0.8923 3.9217
08-Nov-13 667 1.85 4.395 0.8555 3.7600
08-May-14 847 2.35 4.395 0.8202 3.6050
08-Nov-14 1027 2.85 4.395 0.7864 3.4563
08-May-15 1207 3.35 4.395 0.7540 3.3138
08-Nov-15 1387 3.85 4.395 0.7229 3.1771
08-May-16 1567 4.35 4.395 0.6931 3.0461
08-Nov-16 1747 4.85 4.395 0.6645 2.9205
08-May-17 1927 5.35 4.395 0.6371 2.8001
08-Nov-17 2107 5.85 4.395 0.6108 2.6846
08-May-18 2287 6.35 4.395 0.5856 2.5739
08-Nov-18 2467 6.85 4.395 0.5615 2.4678
08-May-19 2647 7.35 4.395 0.5383 2.3660

08-Nov-19 2827 7.85 4.395 0.5161 2.2684
08-May-20 3007 8.35 4.395 0.4949 2.1749
08-Nov-20 3187 8.85 4.395 0.4744 2.0852
08-May-21 3367 9.35 4.395 0.4549 1.9992
08-Nov-21 3547 9.85 104.395 0.4361 45.5293
DP 102.5066
AI 1.2941
CP 101.2125
IRR 8.6067%
The Bond price equation used in this section looks at gross returns, but bond investors are
likely to be subject to tax: possibly both on income and capital gain. The net yield, if taxed
on both coupon and redemption payments, is given by:

P = Dirty price; C = Coupon; R = Redemption payment; r = net redemption yield and t =
applicable Tax rate

The above equation changes and becomes more complicated if withholding tax is imposed
(as a percentage of tax will be imposed at source with the remainder being accounted for
after the payment has been received). As tax rules can materially affect the price of bonds,
their effects need to be taken into account in any yield curve 14odeling process in order to
avoid distortions in the estimated yield curve.
Yield can also be approximated using the following formula:

For our Bond, we can approximate the YTM as

3.6 Spot Rate and the Zero Coupon Curve

Given the limitations of the YTM we discussed above, it would seem more logical to
discount each cash flow by a discount rate appropriate to its maturity; that is, using a spot
rate or a zero rate.

where P =Price (dirty); C =Coupons; n =Number of periods; ri =Spot rate for period I; and R =
Redemption payment

Each spot rate above is the specific zero coupon yield related to that maturity. Hence, it will
give a more accurate rate of discount at that maturity than the usual YTM we used in earlier
equations. Reinvestment risk is taken care of in the above equation. Zero rates take into
account current spot rates, expectations of future spot rates, expected inflation, liquidity
premia and risk premia. The zero coupon yield curve or spot yield curve is also referred to as
the Term Structure of Interest Rates; the plot of appropriate spot rates of varying
maturities against those maturities. The spot yield curve gives us an unambiguous
relationship between yield and maturity. This curve is used for pricing all kinds of products.

A spot yield coupon curve can be estimated using the coupon bearing traded bonds in the
market or by using actual zero coupon papers like STRIPS in the market. If we know the spot
rate (r1) of a 6-month bond, then we can determine the one-year spot rate (r2). Then, r3,
the third period spot rate, can be found from looking at a 3 year bond. We can use the
following series of equation to solve for different rates:

We need to plug in the rates found in previous periods to find the spot rate for next period.
This method is known as the Bootstrapping method of extracting spot rates from the bond
price information. However, this assumes to have traded bonds at every 6-month period to
bootstrap the future spot rates. This may not be the case.


Further, an YTM curve can also be used to derive the spot yield curve. Assuming the
sovereign yield curve to be the most representative and efficiently estimated, it will
represent the market participants expectation of all economic variables. If suppose
Government comes to market to borrow money by issuing new bonds in all time spectrum
(6-month, 12-month, 1.5years,say upto 30 years), then it will issue at Par (FV=100).
Hence all coupons on those bonds will be nothing but the YTMs applicable to the respective
maturities. Assuming yield as coupon, we can bootstrap the spot rates for each term.

However, traders may choose to use more sophisticated models like Nelson Siegel, Nelson
Siegel and Svensson, Splines, etc. to create the zero curve. However, evidence suggests that
the zero curve constructed from bootstrapping and the zero curve constructed from a more
sophisticated model are very similar.

The main uses of the zero coupon curve are finding relatively mis-priced bonds, valuing
swap portfolios and valuing new bonds at auction. The advantage of this curve is that it
discounts all payments at the appropriate rate, provides accurate present values and does
not need to make reinvestment rate assumptions.

3.7 Forward Zero Coupon Yield
Forward spot yields indicate the expected spot yield at some date in the future. These can
be derived simply from spot rates:
- The 6 month spot rate is the rate available now for investing for 6-month (rate = r1 )
- The 1-year spot rate is the rate available now for investing for one years (rate = r2 )
- The two year spot rate is the rate available now for investing for n years (rate = rn )
Hence, there is a rate implied for investing for a one-year period in one years time (f12,).
We can write:

i.e. the forward rate,
is such that an investor will be indifferent to investing for two

years or investing for one year and then rolling over the proceeds for a further year. For
example, if the investor has 100 to invest and he has two options: (a) investing for 6 months
@10% p.a. or (b) invest for first 3 months @9% p.a. and then agreeing to reinvest the

proceeds for 3 more months from the date of maturity of first 3 months @10.76%. The
implied forward in this case is 10.76%p.a. The same is calculated as follows if we invest for
3 months we get 102.25 which needs to be reinvested for next 3 months to yield 2.75 more
to make it 105 which we would have received if we had agreed to invest for 6 months at the
beginning. The investor is indifferent between two options given to him and the implied
forward rate is risk neutral arbitrage free one. Now the trader has to apply all his
expectation about future to quote the rate in the market. The forward zero rate curve is
thus derived from the spot yield curve by calculating the implied one period forward rates.
Expressing the price of the bond in terms of these rates gives:

= f
i
is the I period forward rate for one further period (i.e. the one-year rate in I years time)
All forward yield curves can be calculated in this way. However, the above formula assumes
the expectations hypothesis i.e. the implied forward rate equals the spot rate that prevails
in the future. However, the liquidity premium hypothesis suggests that the implied forward
rate equals the expected future spot rate plus a risk premium.

3.8 Par Yield
The par yield is a hypothetical yield typically used to figure out the coupon of a new security
going to be auctioned. The spot yields are used to find out the coupon of a Bond is it has to
be sold at Par (100). We use the same equation to figure out the Coupon.

Suppose we have the following spot yields and we would like to find out the expected
coupon of a new bond to be issued at Par.

Year 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Spot
Rate 8.15% 8.26% 8.35% 8.42% 8.48% 8.56% 8.62% 8.71% 8.74% 8.80%
DF 0.9608 0.9222 0.8845 0.8479 0.8125 0.7777 0.7442 0.7110 0.6805 0.6501

Then the expected Coupon will be:

The par yield curve is used for determining the coupon to set on new bond issuances, and
for assessing relative value.
3.9 STRIPS
A STRIP is a zero coupon bond which has been created by separating the coupons and
principal of a coupon bearing bond into different zeros and trade the same in the market as
zero coupon papers. For example, a 10-year bond with an semi-annual coupon could be
separated into 21 zero-coupon bonds, 20 representing coupons and one relating to the
principal repayment. If STRIPS market is liquid, then spot yield curve can be easily
constructed using simple bootstrapping techniques. The STRPS will be priced and traded
using the simple formula:

A trader can compare the STRIPS traded with the bond and see if it is valuable to buy all
STRIPS parts to construct the bond.

For example, we are on 09-Sep-2011 and dealing with a Bond 7.80% GOI 2021 issued on 11-
Apr-2011 for 10 years maturity that has been permitted for stripping (Table 4). The bond is
trading at 96.35. The spot rates for the appropriate coupon maturity dates are as follows:


Table 4: STRIP PRICING USING SPOT YIELD
Date: Cash Flows Zeros Rates
STRIPS Rate
(%) PV Cash Flow:
11-10-11 3.9 0.078 7.8 3.7536
11-04-12 3.9 0.0792 7.92 3.7256
11-10-12 3.9 0.0795 7.95 3.5822
11-04-13 3.9 0.0799 7.99 3.4435
11-10-13 3.9 0.0802 8.02 3.3088
11-04-14 3.9 0.0807 8.07 3.1777
11-10-14 3.9 0.0811 8.11 3.0505
11-04-15 3.9 0.0816 8.16 2.9269
11-10-15 3.9 0.0819 8.19 2.8085
11-04-16 3.9 0.082 8.2 2.6965
11-10-16 3.9 0.0823 8.23 2.5862
11-04-17 3.9 0.0825 8.25 2.4816
11-10-17 3.9 0.0826 8.26 2.3817
11-04-18 3.9 0.0829 8.29 2.2831
11-10-18 3.9 0.0832 8.32 2.1875
11-04-19 3.9 0.0827 8.27 2.1081
11-10-19 3.9 0.0829 8.29 2.0210
11-04-20 3.9 0.0836 8.36 1.9292
11-10-20 3.9 0.0839 8.39 1.8467
11-04-21 103.9 0.0842 8.42 47.0925
Dirty Price 99.3912

If we buy all the parts and use the zero rates applicable for the day, we get a value of
99.3912 (zero rates have been derived from the market trades on the said date). The bond
has an accrued interest of 3.2067. Hence the dirty price using trading information works out
to be 99.5567 while the STRIPS give us a dirty price of 99.3912. STRIPS are cheaper than the
Bond. Can we buy the bond and sell the STRIPS? This is a common situation: The On-the-Run
Bonds sell at a premium to its "intrinsic value" measured by STRIPS, or even other Treasury
papers. Whether this creates an arbitrage opportunity is another question, as that must
include the costs of shorting the overvalued paper. It is common for recently issued papers
to trade on special in the repo market, which means the costs of borrowing the paper to
short it may well offset the apparent price differential.
4. Bond Risk Measures
Bond risk measure concentrates on Duration and Convexity concepts. Duration is a
sophisticated measure of finding out the payback period of a bond as it takes into account

all cash flows and the time value of money.The duration of a bond is a measure of how long,
on average, the holder of the bond has to wait before receiving cash payments. A zero-
coupon bond that matures in n years duration of n years. However, a coupon-bond
maturing in n years will have a duration of less than n years. This is because some of the
cash payments are received by the holder prior to year n. Duration is therefore the
weighted average of the net present values of the cash flows where the weights, w
t
, are the
present values of the payments in each period. It allows us to compare the riskiness of
bonds with different maturities, coupons etc. For coupon bonds, duration is less than time
to maturity because some of the coupons are received in years prior to maturity of the
bond. For zero-coupon bonds, duration equals time to maturity.

For estimating duration, we not only consider the maturity over which cash flows are
received but also the time pattern of interim cash flows. Hence the of a bond without
embedded options is a measure of the sensitivity of its market price to a change in interest
rates. Bond having higher duration would mean a higher sensitivity to changes in interest
rate.

We can write the bond price equation as

A specific formula for computing duration may be obtained by taking the derivative of price
with respect to r. If we differentiate both sides of above equation:

Multiplying the above by (1 + r), we get:

Finally, divide the above equation by P and get:

+ =
n
t
t
t
r C P
1
) 1 (
=

+ =
n
t
t
t
r tC
dr
dP
1
1
) 1 (
+ = +
n
t
t
t
r tC
dr
dP
r
1
) 1 ( ) 1 (
D
P
r C
t
r dr
P dP
n
t
t
t
=
(
+
=
+

=
1
) 1 (
) 1 /(
/

where the expression in the square bracket is defined as weight. This is the Macauley
duration (D):

Duration is therefore the
weighted average of the net present values of the cash flows. It allows us to compare the
riskiness of bonds with different maturities, coupons etc. we can rewrite is as

From the above equation, the negative of duration, -D, can be interpreted as the percentage
change in the bond price, dP/P, induced by a change in the bond's yield, dr, scaled by
1/(1+r). In other words, we can say that duration not only measures the weighted average
pay back period for the bond; it also approximates the elasticity of the value (price, or P) of
the bond with respect to a change in one plus the bonds yield to maturity. Macaulays
duration is approximately equal to the negative of the elasticity with respect to a change in
one plus the internal yield to maturity.

Portfolio managers use the measure of duration which is simply the percentage change in
bond price, dP/P, induced by a change in yield, dr, rather than to think of it as an elasticity
measure. To find this expression, we divide the equation by (1 + r), and get:

D
m
is called modified duration and is used to measure interest risk. It is simply the Macaulay
duration as defined divided by (1 + r). If we have semi-annual cash flows from coupon, then
the same will be (1+r/2) instead of (1+r). For our Bond 8.79% GS 2021 maturing on 08-Nov-
2021 and trading at an yield of 8.6021% on January 1, 2012, the Duration (6.7262)
calculation is as follow (Table 5):

,
) 1 (
1
+
=
n
t
t
t
P
r C
t D
.
) 1 /(
/
1
D tw
r dr
P dP
n
t
t
= =
+

=
.
) 1 (
) 1 (
) 1 ( /
1
m
n
t
t
t
D
r
D
r P
r C
t
dr
P dP

+
=
(
+
+
=

=

The Duration of the bond is 6.7262 and the Modified Duration of the bond is 6.4488 which is
nothing but

The modified duration computed in this example predicts that if interest rates increase by
100 basis points, the bond price will drop by 6.4488%. Conversely, a decrease in yield of 100
basis points implies a 6.4488% increase in the bond price. This shows that the percentage
change in a bond price is equal to its modified duration multiplied by the size of the parallel
shift in the yield curve. From the duration equation, we can also say that the change in price
of a bond (dP) is equal to negative of Modified Duration multiplied by Price of the Bond and
Table 5: BOND DURATION
Settlement
Date
Cash flow
Date
Cash flow Period
Period in
Years
Discount
Factors
Discounted
Cash Flow Duration
Value Date
(The
previous
holder
ceases and
new one
takes over
legal
ownership)
Coupon
Payment
Dates
Money Received
on each Coupon
Date
Days from
Value Date
to Next
Coupon
date
(investment
time)
Period in
Years (30/360
Basis)
r=8.6021%
DF * Cash
Flow
(DCF*
Price)/
Time
01-Jan-12 08-May-12 4.395 127 0.3528 0.9707 4.2663
0.0147
08-Nov-12 4.395 307 0.8528 0.9307 4.0904
0.0340
08-May-13 4.395 487 1.3528 0.8923 3.9217
0.0518
08-Nov-13 4.395 667 1.8528 0.8555 3.76
0.0680
08-May-14 4.395 847 2.3528 0.8202 3.605
0.0827
08-Nov-14 4.395 1027 2.8528 0.7864 3.4563
0.0962
08-May-15 4.395 1207 3.3528 0.754 3.3138
0.1084
08-Nov-15 4.395 1387 3.8528 0.7229 3.1771
0.1194
08-May-16 4.395 1567 4.3528 0.6931 3.0461
0.1293
08-Nov-16 4.395 1747 4.8528 0.6645 2.9205
0.1383
08-May-17 4.395 1927 5.3528 0.6371 2.8001
0.1462
08-Nov-17 4.395 2107 5.8528 0.6108 2.6846
0.1533
08-May-18 4.395 2287 6.3528 0.5856 2.5739
0.1595
08-Nov-18 4.395 2467 6.8528 0.5615 2.4678
0.1650
08-May-19 4.395 2647 7.3528 0.5383 2.366
0.1697
08-Nov-19 4.395 2827 7.8528 0.5161 2.2684
0.1738
08-May-20 4.395 3007 8.3528 0.4949 2.1749
0.1772
08-Nov-20 4.395 3187 8.8528 0.4744 2.0852
0.1801
08-May-21 4.395 3367 9.3528 0.4549 1.9992
0.1824
08-Nov-21 104.395 3547 9.8528 0.4361 45.5293
4.3762
6.7262
AI 1.2941
6.4488
Clean price 101.2125


change in interest rate. For this bond, if our expected change in interest rate is 1bps
increase, the expected change in price will be -6.4488*102.5066*.01% = 0.0661in opposite
direction (fall). This equation enables a hedger to assess the sensitivity of a bond to
infinitesimally small changes in its yield (discount or interest rate).

The duration price sensitivity or elasticity depends on the maturity, coupon, and yield
to maturity. The longer maturity bonds likely to have greater the duration, ceteris paribus
(Chart 5).

Higher coupon bonds are likely to have smaller duration (Chart 6) as larger part of the cash
flows will be received in early stages. Coupon payments cause weight to be put on the early
years in the duration formula.

0.0000
2.0000
4.0000
6.0000
8.0000
10.0000
12.0000
0.00 5.00 10.00 15.00 20.00 25.00
D
U
R
A
T
I
O
N

Maturity
Chart - 5: Duration and Maturity
Duration
6.0000
6.5000
7.0000
7.5000
8.0000
8.5000
9.0000
9.5000
0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00%
D
U
R
A
T
I
O
N

Coupon
Chart - 6: Duration and Coupon
Duration

Third, duration decreases with increases in Yield to Maturity (Chart 7). This occurs
because an increase in the yield (interest rate) has a greater damping effect on the present
value of a distant coupon than on the present value of a nearby coupon.

For a standard bond, duration is not infinite and the duration for a 30-year bond and a
perpetual will be similar. This can be understood by looking again at the mathematics: the
net present value of cash flows 30 years away are small, and the longer out, will get smaller.
So, in calculating the duration, these terms will become negligible. The maximum duration
for a standard bond depends on the yield environment.
PV01 of a bond is defined as the price change in the bond if the yield changes by 1bps. This
can be approximated by

. For our bond, the same is equal to

(6.4488*102.5066)/10000 = -0.0661.

Duration is used as a hedging tool. If we do a Principal Component Analysis using the
historical yield curves (CCIL yield curves from 01-Jan-2004 to 27-Apr-2012), we find that at
least 52% of shifts in the curve is parallel, while 30% shifts are slope related and only 7%
shifts are curvature related ones. Parallel shifts in the term structure imply that the change
in yield is the same for all maturities.

Duration is derived from the first derivative of the Bond price equation. Mathematically,
duration is a first approximation of the price/yield relationship. Modified duration is an
approximation of the percentage change in bond price for a given change in yield. In fact, it
4.5000
5.0000
5.5000
6.0000
6.5000
7.0000
7.5000
8.0000
0.00% 5.00% 10.00% 15.00% 20.00% 25.00%
D
U
R
A
T
I
O
N

Yield
Chart - 7: Duration and Yield
Duration

is accurate only for very small and parallel shifts in the yield curve. Duration can
approximate price changes if the yield changes are small but when the yield changes are
large, the duration does not approximate the price changes accurately. This is so because of
bonds have different degree of convex shapes. When considering moderate - or large -
changes in interest rates, a factor known as convexity is important. That is, duration
attempts to estimate a convex relationship with a straight line (the tangent line). The above
can be explained with the example of our Bond.
Table 6: Price Change and Modified Duration
Interest Rate
shock
Actual Price
Change
Price Change
implied by MD Difference (Error)
0.10% -0.6421 -0.6610 0.0189
-0.10% 0.6477 0.6610 0.0134
0.20% -1.2787 -1.3221 0.0434
-0.20% 1.3009 1.3221 0.0211
0.30% -1.9099 -1.9831 0.0733
-0.30% 1.9599 1.9831 0.0232
0.40% -2.5356 -2.6442 0.1085
-0.40% 2.6246 2.6442 0.0196
0.50% -3.1560 -3.3052 0.1492
-0.50% 3.2950 3.3052 0.0102
0.60% -3.7712 -3.9663 0.1951
-0.60% 3.9713 3.9663 -0.0050
0.70% -4.3810 -4.6273 0.2463
-0.70% 4.6534 4.6273 -0.0261
0.80% -4.9857 -5.2884 0.3027
-0.80% 5.3416 5.2884 -0.0532
0.90% -5.5852 -5.9494 0.3642
-0.90% 6.0357 5.9494 -0.0863
1.00% -6.1797 -6.6105 0.4308
-1.00% 6.7359 6.6105 -0.1254
1.50% -9.0771 -9.9157 0.8385
-1.50% 10.3298 9.9157 -0.4142
2.00% -11.8543 -13.2209 1.3666
-2.00% 14.0846 13.2209 -0.8637

The error in approximating the bond price changes using modified duration gets larger as
the interest shocks become larger. Further, the increase in interest rate has a relatively
lesser impact on bond price changes that the fall in interest rate. Hence, duration
underestimates the price change in case of interest rate fall and over estimates the price
change in case of an increase in interest rate (Chart 8).

The actual price change curve looks more convex vis--vis the linear line suggested by
modified duration. Hence, we need to look at the effect of convexity on the price change to
figure out better precision.
Further, effective duration can also be approximated using a uniform change in interest rate
on both sides (positive and negative) and generally given by

In our example, if we shock the present yield of 8.6021% by 20bps in either direction and
use their resultant prices, we can approximate duration. The same is:

In our actual calculation, we arrived at -6.4488 for modified duration (effective convexity).
This is so as the above was an approximation.
60.0000
65.0000
70.0000
75.0000
80.0000
85.0000
90.0000
95.0000
100.0000
105.0000
110.0000
115.0000
120.0000
125.0000
130.0000
5.00% 7.00% 9.00% 11.00% 13.00% 15.00%
P
r
i
c
e

Yield
Chart - 8: Price Change & Duration
Price Price suggested by Duration

Greater precision in measuring the bond's sensitivity to yield changes can be achieved by
taking into account the bond's convexity. To understand convexity, we have to remember
that a fundamental property of calculus is that a mathematical function can be
approximated by a Taylor (or Maclaurin) series. The more terms of a Taylor series used, the
better the approximation. We expand the bond price equation used earlier into a Taylor
series (using only the first two terms):

The error term recognizes the fact that we have used only the first two terms of the Taylor
series expansion. (the number two in second part of the equation is in fact 2!, i.e., two
factorial.) Now,
ignoring the error
term and divide both
sides by P.

0
5
-
0
8
-
1
2
0
5
-
0
8
-
1
4
0
5
-
0
8
-
1
6
0
5
-
0
8
-
1
8
0
5
-
0
8
-
2
0
0
5
-
0
8
-
2
2
0
5
-
0
8
-
2
4
0
5
-
0
8
-
2
6
0
5
-
0
8
-
2
8
0
5
-
0
8
-
3
0
0
5
-
0
8
-
3
2
0
5
-
0
8
-
3
4
0
5
-
0
8
-
3
6
0
5
-
0
8
-
3
8
0
5
-
0
8
-
4
0
0
5
10
15
20
25
30
0
0
.
0
2
5
0
.
0
5
0
.
0
7
5
0
.
1
Maturity Date
Modified Duration
Coupon Rate
Chart - 9: Effects of Coupon and Maturity on Duration of High-Yield Bond
2
2
2
) (
1
2
1
) ( dr
P dr
P d
dr
dr
P
dP
P
dP
+ =

The fact that duration is the first term of the Taylor series can be seen by comparing the first
right-hand side of equation above with other equations. The second term of the Taylor
series expansion requires the calculation of the second derivative of the bond price
function. Using the above analogies, we can define convexity as

The convexity measure
is an approximation of the curvature. Hence, using both duration and convexity, we can
approximate the price change in the bond as:
dP/P = - D
m
* dr + Convexity * (dr)
2

We obtain the value of the second derivative of the bond price (dP) with respect to a change
in yield (dr) by differentiating bond price equation again:

Convexity varies with maturity. A longer bond is likely to be more convex than a short
duration bond (Chart 10).

50.0000
60.0000
70.0000
80.0000
90.0000
100.0000
110.0000
120.0000
6.00% 7.00% 8.00% 9.00% 10.00% 11.00% 12.00% 13.00% 14.00% 15.00% 16.00%
P
R
I
C
E

YIELD
Chart - 10: Convexity of Bonds
PRICE2017 PRICE2020 PRICE2023 PRICE2027
PRICE2030 PRICE2034 PRICE2037 PRICE2040
P dr
P d
Convexity
1
! 2
1
2
2
.
) 1 (
) 1 (
2
1
2
2
(
+
+ =
+
=
t
t
n
t
r
C
t t
dr
P d

For our Bond 8.79% GS 2021, the Convexity works out to be 55.5712 as detailed below
(Table 7):

If we use the approximation, effective convexity will be written as

Using our example, the same works out to

To complete our illustration, we now use convexity in conjunction with modified duration to
arrive at a more accurate estimate of the percentage change in bond price attributable to a
100 basis point (1%) fall in yield.
dP/P = - D
m
* dr + .5* Convexity * (dr)2
= - 6.4488 * (-0.01) + .5 *55. 5712* (-0.01)^2 = 6.727 %
Table 7: Bond Convexity
SDATE
Next
Coupon
Date Coupon Years*2
Discount
Function DCF
Share
of CF in
Price DUR
Share
*(t(t+1))
1 /(1+y%/2)
^2 CONVX
1-Jan-
12 8-May-12 4.395 0.71
0.9707 4.2663
4.16%
0.0294
0.0501 0.9192 0.0460
8-Nov-12 4.395 1.71
0.9307 4.0904
3.99%
0.0681
0.1841 0.9192 0.1693
8-May-13 4.395 2.71
0.8923 3.9217
3.83%
0.1035
0.3836 0.9192 0.3526
8-Nov-13 4.395 3.71
0.8555 3.7600
3.67%
0.1359
0.6396 0.9192 0.5879
8-May-14 4.395 4.71
0.8202 3.6050
3.52%
0.1655
0.9442 0.9192 0.8679
8-Nov-14 4.395 5.71
0.7864 3.4563
3.37%
0.1924
1.2900 0.9192 1.1858
8-May-15 4.395 6.71
0.7540 3.3138
3.23%
0.2168
1.6704 0.9192 1.5354
8-Nov-15 4.395 7.71
0.7229 3.1771
3.10%
0.2388
2.0791 0.9192 1.9112
8-May-16 4.395 8.71
0.6931 3.0461
2.97%
0.2587
2.5108 0.9192 2.3080
8-Nov-16 4.395 9.71
0.6645 2.9205
2.85%
0.2765
2.9603 0.9192 2.7212
8-May-17 4.395 10.71
0.6371 2.8001
2.73%
0.2924
3.4231 0.9192 3.1466
8-Nov-17 4.395 11.71
0.6108 2.6846
2.62%
0.3066
3.8951 0.9192 3.5804
8-May-18 4.395 12.71
0.5856 2.5739
2.51%
0.3190
4.3725 0.9192 4.0193
8-Nov-18 4.395 13.71
0.5615 2.4678
2.41%
0.3299
4.8521 0.9192 4.4602
8-May-19 4.395 14.71
0.5383 2.3660
2.31%
0.3394
5.3309 0.9192 4.9003
8-Nov-19 4.395 15.71
0.5161 2.2684
2.21%
0.3476
5.8061 0.9192 5.3372
8-May-20 4.395 16.71
0.4949 2.1749
2.12%
0.3544
6.2756 0.9192 5.7687
8-Nov-20 4.395 17.71
0.4744 2.0852
2.03%
0.3602
6.7371 0.9192 6.1930
8-May-21 4.395 18.71
0.4549 1.9992
1.95%
0.3648
7.1890 0.9192 6.6083
8-Nov-21 104.395 19.71
0.4361 45.5293
44.42%
8.7524
181.2236 0.9192 166.5856
DP 102.5066 13.4523
Semi-annual
Convexity 222.285
AI 1.294 DUR 6.73 A Convexity 55.5712
CP 101.213 MDUR 6.4488

The actual price change for the fall of 1% interest for our Bond works out to be 6.7359%
which is very close to the actual change. Hence Convexity helps in accurate approximation
of price change in a bond. The error gets reduced when we use convexity along with the
duration. If the interest rate rises by 1%, then the bond price will fall by
= - 6.4488 * (0.01) + .5 *55. 5712* (-0.01)^2 = 6.171 %
In the above example, the contribution from convexity in price change is about 0.28%. Since
convexity is positive for a non-callable bond, it always helps the trader as it either reduces
the risk or increases the return. After considering the convexity factor, the price change
approximation is more accurate (Chart 11).

For a long position in bond portfolios, a high-convexity bond portfolio with a certain
duration is always more attractive than a low-convexity portfolio with the same duration.
Investors use duration and convexity for hedging their exposure to possible adverse changes
in interest rates. In many cases, institutional investors endeavor to immunize their bond
portfolios such that their duration is equal to the duration of their liabilities. Such portfolios
tend to be devoid of interest rate risk and they should be able to provide guaranteed return
over their horizon interval. It is true that portfolios should be re-immunized with each
change in interest rates, because as interest rates change, durations change as well.
60.0000
65.0000
70.0000
75.0000
80.0000
85.0000
90.0000
95.0000
100.0000
105.0000
110.0000
115.0000
120.0000
125.0000
130.0000
5.0000% 7.0000% 9.0000% 11.0000% 13.0000% 15.0000%
P
r
i
c
e

Yield
Chart - 11: Price Change _ Duration and Convexity
Price Price suggested by Duration Price suggested by D and C

For bonds having embedded options like Call and Put features, the behavior of duration and
convexity will be different. In fact for a bond having call option, the convexity may be
negative. Suppose our bond in the example has a Call option when the price reaches (dirty
price for simpilicity) 103.50 (yield falls so that the issues can replace the bond with a lower
interest rate bond). Our duration and convexity calculation becomes:

and

For this callable bond, convexity is not the friend of the trader anymore as the negative
convexity will reduce the profit for the trader or increase his loss when interest rate
changes. This happens when yields drop and prices increase above par: that is, when prices
approach or exceed the redemption price of a security, the price-yield relationship becomes
non-convex so although the price of a callable bond will still increase in response to a fall
in yields, it will do so at a decreasing rate. This is because the chances that the security will
be called increases.
0
0
.
0
1
0
.
0
2
0
.
0
3
0
.
0
4
0
.
0
5
0
.
0
6
0
.
0
7
0
.
0
8
0
.
0
9
0
.
1
0
.
1
1
0
.
1
2
0
.
1
3
0
.
1
4
0
.
1
5
0
20
40
60
80
100
120
0.01
0.045
0.08
0.115
0.15
0.185
Coupon Rate
Convexity
Yield
Chart - 12: Effects of Coupon Rate and Yield on Convexity

Convexity is generally thought of as desirable and traders may give up yield to have
convexity. This is because, in general, a more convex bond will outperform in an
environment of falling yields, and will underperform less as yields rise. Furthermore, the
convexity effect is asymmetric; for a specified fall in yields, the price rise on account of
convexity will be greater (in magnitude) than the price fall related to the convexity factor for
the same rise in yields. Convexity can therefore be associated with a bonds potential to
outperform. However, convexity is a good thing if the yield change is sufficient that the
greater convexity leads to outperformance.

Duration and Convexity are used for immunizing portfolios by fund managers. Suppose we
have the following bonds of 1 year maturity in the portfolio:
Bonds Coupon Yield Price Duration Convexity
FV Investment
Bond 1 0% 5% 95.2381 1 1.8141
16832 -16030
Bond 2 4.939% 5% 99.9419 0.9639 1.4048
100000 99942
Bond 3 5.939% 5% 100.9058 0.9616 1.4004
83158 83911
We buy 9.939% bond and sell the other two bonds with 16.04% of zero coupon bond and
83.96% of 5.939% bond. If the interest rate moves by 50bps (rise) after our purchase, the
portfolio is immunized to a very large extent:
Bonds New price New Investment Value
% change by
Duration and
Convexity
change by
Duration and
Convexity Actual change
Bond 1 94.7867 -15955 0.50% 79.79 -75.97
Bond 2 99.4620 99462 0.48% -479.92 479.87
Bond 3 100.4224 -83509 0.48% 401.98 -401.99

0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
0.00
10.00
20.00
30.00
40.00
50.00
60.00
70.00
80.00
1.13 2.13 3.13 4.13 5.13 6.13 7.13 8.13 9.13 10.13 11.13
C
o
n
v
e
x
i
t
y

Maturity
Chart - 13: Duration and Convexity
CONVEXITY MDURATION

Risk in sovereign bond markets is predominantly interest rate risk. Duration matching is
used to reduce this risk. Since daily interest rate changes are not large, duration works fine
for short horizon investments. Of course, there are many other risks that an investor will
take into account when buying a bond - in liquidity risk. Since investors have different risk
appetite, it helps create a liquid market.

5. Concluding Remarks
The document has concentrated on various issues on Bond price and yield and its practical
implications for the traders. The document has been written to explain the Indian market
conventions.

Basic Bond Analysis2

Hochgeladen von

Dokumentinformationen

Originalbeschreibung:

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

Basic Bond Analysis2

Hochgeladen von

Copyright:

Verfügbare Formate

gcnath@hotmail.

and time will be 2*t. The above formula gives us

. This makes the Dirty Price =

is such that an investor will be indifferent to investing for two

. For our bond, the same is equal to

Das könnte Ihnen auch gefallen