F303 – Intermediate Investments

Interest Rate Sensitivity and

Bond Duration

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 Outline of This Subject
Interest rate risk.

Interest rate sensitivity.

Concept of Duration.

Calculating Durations.

Rules of Duration. 2
 Interest Rate Risk
There is an inverse relationship between bond
prices and yields – high yields imply low prices.

This relationship becomes fundamental when

considering that interest rates fluctuate
substantially.

The capital gains or losses that result from these

interest rate movements, make investment risky.

This is true even if the coupon and principal

payments are guaranteed. 3
 Interest Rate Sensitivity
• Bond prices and yields are inversely related;
• Not symmetric relationship: An increase in a bond’s yield to maturity
results in smaller price decline than the price gain associated with a
decrease of equal magnitude in yield; For a 1-year zero coupon bond
P = 1000/(1+Y):

Yield 10% 15% 20%

Price 909.09 869.57 833.33
Change in Price 39.53 36.23

• Prices of long-term bonds tend to be more

sensitive to interest rate changes than prices of
short-term bonds;
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 Interest Rate Sensitivity
As maturity increases, price sensitivity to
yield changes increases at a decreasing
rate;

Interest rate risk is inversely related to the

bond’s coupon rate;

Bond prices are more sensitive to changes

in yields when the bond is selling at a lower
initial yield to maturity.
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 Changes in Bond Prices
% Change in Bond Price Bond A:
Coupon: 11% Maturity: 5 years Initial YTM: 9%
Bond B:
Coupon: 11% Maturity: 30 years Initial YTM:9%
Bond C:
Coupon: 4% Maturity: 30 years Initial YTM: 9%
Bond D:
Coupon: 4% Maturity: 30 years Initial YTM: 6%

Change in Yield to Maturity

A
B
C
6
D
Coupon Rate and Interest Rate Sensitivity
Example 1: Prices of 8% Coupon Bond (semi-annual payments)

Yield to Maturity T = 1 Year T = 10 Years T = 20 Years

8% 1,000 1,000 1,000
9% 990.64 934.96 907.99
Change in Price 0.94% 6.50% 9.20%

Example 2: Prices of Zero-Coupon Bond (semi-annual compounding)

Yield to Maturity T = 1 Year T = 10 Years T = 20 Years

8% 924.56 456.39 208.29
9% 915.73 414.64 171.93

Change in Price 0.96% 9.15% 17.46%

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 Duration
Look at the effective maturity of a bond.

Investors can do so by looking at the

promised cash flows; these provide a
summary statistic of the effective maturity.

Concept of duration: the weighted

average of the times to each coupon or
principal payment made by the bond.
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 Duration
The cash flow weights are related to the
importance of every single payment to the
value of the bond.

The weight applied to each payment time is

the proportion of the total value of the bond
accounted by that payment.

The proportion is the present value of the

payment divided by the bond price.
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 Duration
The weight, w, associated with the cash flow
(CF) made at time t is given by
CF / (1 + y ) t
w = t
t Pr ice
Where y is the bond’s yield to maturity.
The Macaulay’s duration is then obtained as:
T
D = ∑ t×w
t =1 t
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Calculating Duration – Coupon Paying Bond

Example 1: Prices of 8% Coupon Bond (semi-annual payments)

Time Until Payment Payment Discounted Weight (1) X (4)

(Years) Payments
(at 5%)
0.5 $40 $38.095 0.0395 0.0198
1.0 $40 $36.281 0.0376 0.0376
1.5 $40 $34.553 0.0358 0.0537

2.0 $1,040 $855.611 0.8871 1.7742

SUM $964.54 1.00 1.8853

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Calculating Duration – Zero-Coupon Bond

Example 1: Prices of Zero-Coupon Bond

Time Until Payment Payment Discounted Weight (1) X (4)

(Years) Payments
(at 5%)
0.5 – 1.5 $0 $0 0 0
2.0 $1,000 $822.70 1.0 2
SUM $822.70 1.00 2.0

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 Duration – Its Importance
Duration is a key concept in fixed income portfolio
management.

It is a simple summary statistic of the effective

average maturity of the portfolio;

It is an essential tool in immunizing portfolio

from interest rate risk;

It is a measure of the interest rate sensitivity of

the portfolio.

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 Bond Price Changes
Long-term bonds are more sensitive to
interest rate movements than are short-term
bonds.

The duration measure enables us to

quantify this relationship.

When interest rates change, the proportional

change in a bond’s price can be related to
the change in its yield to maturity.
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 Bond Price Changes
Bond price volatility is proportional to the
bond’s duration.

Duration becomes a natural measure of

interest rate exposure.

∆P  ∆(1 + y ) 
= −D ×  
P  1+ y 
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 Bond Price Changes
Let us refer to the examples shown before.

The coupon-paying bond sells for $964.54

at the initial semiannual interest rate of 5%.

If the bond’s semiannual yield increases by

1 basis point (i.e. 0.01%) to 5.01%, its price
will fall to $964.19, a percentage decline of
0.0359%.
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 Duration – Basic Rules
The duration of a zero-coupon bond equals its
time to maturity;

Holding maturity constant, a bond’s duration is

higher when the coupon rate is lower;

Holding the coupon rate constant, a bond’s

duration generally increases with its time to
maturity. Duration always increases with maturity
for bonds selling at par or at a premium to par;
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 Duration – Basic Rules
• Holding other factors constant, the duration of a coupon
bond is higher when the bond’s yield to maturity is lower;

• The duration of a level perpetuity is (1+y)/y. For example,

at a 10% yield, the duration of a perpetuity that pays $100
once a year for ever will equal 1.10/.10=11 years;

• The duration of a coupon bond equals:

1 + y (1 + y ) +T ( c − y )
y
−
[T
c (1 + y ) −1 + y ] 18
 Key Points to Remember
Interest rate risk and interest rate sensitivity
and the implications to investors.

Meaning of Duration; duration of coupon-

paying bonds and duration of zero-coupon
bonds.

Calculating Durations for various bonds and

the implication of duration to a bond’s interest
rate sensitivity.

Rules of Duration.
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