Bond Theorem

By.Sanjay Tomar

Property 1
Although the price moves in the
opposite direction from the change in
yield, the percentage price change is
not the same for all bonds.

Property 2: For small changes in

the yield, the percentage price
change for a given bond is roughly
the same, whether the yield
increases or decreases.
YTM

0% 5 yrs 0% 25 Yrs 6% 5 yrs 6% 25 yrs 9% 5 yrs 9% 25 yrs

9.01%

-0.05%

-0.24%

-0.04%

-0.11%

-0.04%

-0.10%

9.00%

0.00%

0.00%

0.00%

0.00%

0.00%

0.00%

8.99%

0.05%

0.24%

0.04%

0.11%

0.04%

0.10%

Property 3: For large changes in yield, the

percentage price change is not the same for an
increase in yield as it is for a decrease in yield.
0% 25
6% 25
9% 25
YTM
0% 5 yrs Yrs
6% 5 yrs yrs
9% 5 yrs yrs
11.00% -9.08% -37.88% -7.91% -18.03% -7.53% -16.93%
9%
0%
0%
0%
0%
0%
0%
7.00% 10.09% 61.72% 8.75% 25.46% 8.31% 23.45%

Bond Theorem
Property 4: For a given large change
in yield, the percentage price
increase is greater than the
percentage price decrease.

The Impact of Maturity

All other factors constant, the longer the bonds
maturity, the greater is the bonds price sensitivity
to changes in interest rates. For example, for a 6%
20-year bond selling to yield 6%, a rise in the yield
required by investors to 6.5% will cause the bonds
price to decline from 100 to 94.4479, a 5.55%
price decline.
For a 6% 5-year bond selling to yield 6%, the price
is 100. A rise in the yield required by investors
from 6% to 6.5% would decrease the price to
97.8944. The decline in the bonds price is only
2.11%.

The Impact of Coupon Rate

A property of a bond is that all other factors constant,
the lower the coupon rate, the greater is the bonds
price sensitivity to changes in interest rates. For
example, consider a 9% 20-year bond selling to yield
6%. The price of this bond would be 134.6722. If the
yield required by investors increases by 50 basis points
to 6.5%, the price of this bond would fall by 5.13% to
127.7605. This decline is less than the 5.55% decline for
the 6% 20-year bond selling to yield 6%.
An implication is that zero-coupon bonds have
greater price sensitivity to interest-rate changes
than same-maturity bonds bearing a coupon rate
and trading at the same yield.

The Impact of Embedded

Options
Price of callable bond
= price of option-free bond price of
embedded call option

Bonds with Call and Prepay Options

Bonds with Embedded Put Options

DURATION
Price if yields decline - price if yields rise
2(initial price) (change in yield in decimal)

For example, consider a 9% coupon 20-year optionfree bond selling at 134.6722 to yield 6% (see
Excel). Lets change (i.e., shock) the yield down.
and up by 20 basis points and determine what the
new prices will be for the numerator. If the yield is
decreased by 20 basis points from 6.0% to 5.8%,
the price would increase to 137.5888. If the yield
increases by 20 basis points, the price would
decrease to 131.8439.

Thus
Duration = 137.5888 131.8439

2 (134.6722 )(0.002)
=10.66

10 bsp change
The initial price is 134.6722. For a 10 basis
point increase in yield, duration estimates
that the price will decline by 10.66%. Thus
the price will decline to
133.2366 (found by multiplying 134.6722 by
1 minus 0.1066). The actual price
from Exhibit 94 if the yield increases by 10
basis points is 133.2472. Thus the
price estimated using duration is close to the
actual price.

200 bsp change

Again, lets look at the use of duration in terms of
estimating the new price.
Since the initial price is 134.6722 and a 200 basis
point increase in yield will
decrease the price by 21.32%, the estimated new
price using duration is 105.9601
(found by multiplying 134.6722 by 1 minus
0.2132). From Exhibit 94 the actual
price if the yield is 8% is 109.8964. Consequently,
the estimate is not as accurate
as the estimate for a 10 basis point change in yield.

 The estimated new price

using duration for a 200 basis point
decrease in yield is 163.3843
compared with
the actual price (from Exhibit 94) of
168.3887.

Duration
Modified duration = Macaulay
duration

(1+ yield/k)
approximate percentage price
change = duration y 100
approximate percentage price
change = 10.66 (+0.001)100 =
1.066%

Duration as sensitivity
measure

What is Duration?
It is the approximate price change as
because of the 100 bsp change in
price.
It is the price sensitivity.

Duration
When the concept of duration was originally
introduced by Macaulay in 1938, he used it
as a gauge of the time that the bond was
outstanding. More specifically, Macaulay
defined duration as the weighted average
of the time to each coupon and principal
payment of a bond. Subsequently, duration
has too often been thought of in temporal
terms, i.e., years. This is most unfortunate
for two reasons.

Duration
First, in terms of dimensions, there is nothing
wrong with expressing duration in terms of
years because that is the proper dimension of
this value. But the proper interpretation is that
duration is the price volatility of a zero-coupon
bond with that number of years to maturity.
So, when a manager says a bond has a
duration of 4 years, it is not useful to think of
this measure in terms of time, but that the
bond has the price sensitivity to rate changes
of a 4-year zero-coupon bond.

Duration
Second, thinking of duration in terms of years makes it
difficult for managers and their clients to understand
the duration of some complex securities. Here are a few
examples. For a mortgage-backed security that is an
interest-only security (i.e., receives coupons but not
principal repayment) the duration is negative. What
does a negative number, say, 4 mean?
In terms of our interpretation as a percentage price
change, it means that when rates change by 100 basis
points, the price of the bond changes by about 4% but
the change is in the same direction as the change in
rates

Duration
As a second example, consider an
inverse floater created in the
collateralized mortgage
obligation (CMO)market. The
underlying collateral for such a
security might be loans with 25
years to final maturity. However, an
inverse floater can have a duration
that easily exceeds 25.

Duration
This does not make sense to a
manager or client who uses a
measure of time as a definition for
duration.

Duration
As a final example, consider derivative
instruments, such as an option that expires in
one
year. Suppose that it is reported that its
duration is 60. What does that mean?
To someone who interprets duration in terms of
time, does that mean 60 years, 60 days, 60
seconds? It doesnt mean any of these. It
simply means that the option tends to have the
price sensitivity to rate changes of a 60-year
zero-coupon bond.

Convexity

Mathematically, a portfolios duration can be

calculated
as follows:

= w1D1 +w2D2 +w3D3.+ wKDK

The different types of risk that an investor in fixed

income securities is exposed to are as follows:

Market, or interest-rate, risk

Reinvestment risk
Timing, or call, risk
Credit risk
Yield-curve, or maturity, risk
Inflation, or purchasing-power, risk
Liquidity risk
Exchange-rate, or currency, risk
Volatility risk
Political or legal risk