Duration

Riccardo Colacito

Motivational example
Two bonds sell today with the same payment schedule
Time 1: $10 Time 2: $20

However one has a YTM of 1% and the other one has a YTM of 99% What is the temporal distribution of the payments?
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Example (contd)
Time Payment PV (YTM=1%) PV (YTM=99%) 1 10 9.9 (33.6%) 5.025 (49.9%) 2 20 19.6 (66.4%) 5.050 (50.1%)

Effective maturity?
Both bonds have maturity 2 years But they differ in the temporal distribution of the (present value of) payments Their effective maturities should differ, i.e. the second one should have shorter maturity
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Duration
A measure of the effective maturity of a bond The weighted average of the times until each payment is received, with the weights proportional to the present value of the payment Duration is always shorter or equal to maturity for all bonds
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Duration: Calculation
Duration is

D = t wt
t =1

where

wt =

CFt

(1+ y ) t

Bond Price
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Duration: an example
Consider the following bond
Maturity: 4 years Par: $500 Coupon: $80 (once per year) YTM: 38.5%

Price is $287.205 (remember how to compute this?)

Compute the duration

Year 1 2 3 4 CF 80 80 80 580 Present Value CF 57.76 41.71 30.11 157.63 weight 0.20 0.15 0.10 0.55
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Duration is
Just use the formula
D = 1 .20 + 2 .15 + 3 .10 + 4 .55 = 3

or three years

Cash flows and their present values

700 600

500

400 CF Dicounted CF 300

200

100

0 1 2 3 4

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Question
What happens if the YTM decreases? Would you expect the duration to increase or decrease? Why?

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Duration: another example

Consider the following bond
Maturity: 4 years Par: $500 Coupon: $80 (once per year) YTM: 15.6% 38.5%

Price is $505.641 $287.205

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How are the weights affected?

700

600

500

400

300

200

100

0 1 2 3 4

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What happens to the duration?

You now attach a relatively higher weight to cash flows that happen further in the future That is: the duration goes up! Can verify that the duration is now 3 years and a quarter.
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Question
What is the duration of a zero coupon bond? The duration of a zero coupon bond is equal to its maturity

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A perpetuity
Definition: a security that pays a constant coupon forever Its maturity is infinite! Its duration is

1+ y D= y
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Duration vs maturity
Holding the coupon rate constant, a bonds duration generally increases with time to maturity

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Duration vs maturity
35

30

Zero-coupon bond

25

20

15

10

Par=$1,000, Coupon=$30 (yearly), YTM=5%

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0 0 5 10 15 20 25 30 35

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Duration vs Maturity (contd)

35

30

Zero-coupon bond

25

20

15

Par=$1,000, Coupon=$30 (yearly), YTM=15%

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Perpetuity
0 0 5 10 15 20 25 30 35

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Why does this happen?

As the YTM increases, the present value of the face value at high maturities gets smaller and smaller. That is the bond starts looking as a perpetuity with a very high yield to maturity.

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Figure 10.3 Duration as a Function of Maturity

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Uses of Duration
1. Summary measure of length or effective maturity for a portfolio 2. Measure of price sensitivity for changes in interest rate 3. Immunization of interest rate risk (next class)

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Duration/Price Relationship
Take derivative of price wrt YTM
T P C Par = t T t +1 T +1 (1 + y ) ( 1 + y ) ( 1 + y ) t =1

1 T C Par = t + T t T 1+ y ( 1 + y ) ( 1 + y ) t =1 1 = DP 1+ y

Hence the following holds as an approximation

P (1 + y ) = D P 1+ y
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Modified Duration
More compact formula

P * = y D P
where

D D = 1+ y
*
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Fact #1
Prices of long-term bonds are more sensitive to interest rate changes than prices of short term bonds

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500

1000

1500

2000

2500

3000

3500

4000

0 0 0.01 0.01 0.02 0.02 0.03 0.03 0.04 0.04 0.05 0.05 0.06 0.06 0.07 0.07 0.08 0.08 0.09 0.09 0.1 0.1 0.11 0.11 0.12 0.12 0.13 0.13 0.14 0.14 0.15 0.15 0.16 0.16 0.17 0.17 0.18 0.18 0.19 0.19 30 10

Fact #1

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Intutition
The higher the maturity, the higher the duration The higher the duration, the higher the price sensitivity Higher maturity implies higher price sensitivity to interest rate risk
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Fact #2
The sensitivity of bond prices to changes in yields increases at a decreasing rate as maturity increases. Equivalently, interest rate risk is less than proportional to bond maturity.

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1000

2000

3000

4000

5000

6000

0 0 0.01 0.01 0.02 0.02 0.03 0.03 0.04 0.04 0.05 0.05 0.06 0.06 0.07 0.07 0.08 0.08 0.09 0.09 0.1 0.1 0.11 0.11 0.12 0.12 0.13 0.13 0.14 0.14 0.15 0.15 0.16 0.16 0.17 0.17 0.18 0.18 0.19 0.19 50 30 10

Fact #2

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Intuition
Duration increases less than proportionally with maturity (e.g. see slide 18) Hence price sensitivity to interest rate risk increases less than proportionally with maturity.

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Fact #3
Prices of high coupon bonds are less sensitive to changes in interest rates than prices of low coupon bonds. Or equivalently, interest rate risk is inversely related to the bonds coupon rate

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100

300

500

700

900

1100

1300

1500

-100 0 0.01 0.01 0.02 0.02 0.03 0.03 0.04 0.04 0.05 0.05 0.06 0.06 0.07 0.07 0.08 0.08 0.09 0.09 0.1 0.1 0.11 0.11 0.12 0.12 0.13 0.13 0.14 0.14 0.15 0.15 0.16 0.16 0.17 0.17 0.18 0.18 0.19 0.19 10 100

Fact #3

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Intuition
The higher the coupon, the lower the duration Lower duration implies lower price sensitivity. The higher the coupon, the lower the price sensitivity to interest rate risk
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Fact #4
The sensitivity of a bonds price to a change in its yield is inversely related to the yield to maturity at which the bond currently is selling.

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Fact #4
2000 1800 Percentage Price change =(1341-1000)/1000=34.1%

1600

1400

1200 Percentage Price change =(769-610)/610=26%

1000

800

600

400

200

0 0.001 0.011 0.021 0.031 0.041 0.051 0.061 0.071 0.081 0.091 0.101 0.111 0.121 0.131 0.141 0.151 0.161 0.171 0.181 0.191

Busi 580 - Investments

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Intuition
The higher the YTM, the lower the duration The lower the duration, the lower the price sensitivity High YTM implies low price sensitivity

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Convexity
The formula

P * = y D P
is an approximation of the more precise relation

P 1 2 * = y D + convexity ( y ) P 2
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Figure 10.6 Bond Price Convexity

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The higher the convexity, the better it is for the investor

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Yet another fact

An increase in a bonds yield to maturity results in a smaller price change than a decrease in yield of equal magnitude
2000 1800 1600

1400

1200

1000

800

600

400

200

0 0.001 0.011 0.021 0.031 0.041 0.051 0.061 0.071 0.081 0.091 0.101 0.111 0.121 0.131 0.141 0.151 0.161 0.171 0.181 0.191

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