Bond Price Elasticity

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Business 4179

Bond Price Elasticity

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The sensitivity of bond prices (BP) to changes in the required rate of return (I) is commonly measured by bond price elasticity (BPe), which is estimated as

percent change in BP BP percent change in i

e

Example of Elasticity
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If the required rate of return changes from 10 percent to 8 percent, the bond price of a zero coupon bond will rise from $386 to $463. Thus the bond price elasticity is

$463 $386 19.9% $386 e BP .997 8% 10% 20% 10%

Example of Elasticity
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$463 $386 19.9% $386 e BP .997 8% 10% 20% 10%

This implies that for each 1 percent change in interest rates, bond prices change by 0.997 percent in the opposite direction.

Bond Price Elasticity and Bond Price Theorums

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The following table demonstrates how bond price elasticity measures the effects of a given change in interest rates on bonds with different coupon rates. Zero coupon or stripped bonds have the longest durations because there are no intermediate cash flows, hence they exhibit the greatest elasticity. The higher the coupon rate, the lower the elasticity all other things being equal.

Sensitivity of 10-year bonds with different coupon rates to interest rate changes
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Effects of a Decline in the Required Rate of Return
(1) Bonds with A Coupon Rate of: 0% 5 10 15 (2) Initial Price Of Bonds (When i=10%) $386 693 1,000 1,307 (3) Price of Bonds when i=8% $463 799 1,134 1,470 (4)=[(3)-(2)]/(2) Percentage Change in Bond Price +19.9% +15.3 +13.4 +12.5 (5) Percentage Change in i -20% -20% -20% -20% (6)=(4)/(5) Bond Price Elasticity (BPe)

Effects of an Increase in the Required Rate of Return:

(1) Bonds with a Coupon Rate of: 0% 5 10 15 (2) Initial Price Of Bonds (When i=10%) $386 693 1,000 1,307 (3) Price of Bonds when i=12% $322 605 887 1,170 (4)=[(3)-(2)]/(2) Percentage Change in Bond Price -16.6% -12.7 -11.3 -10.5

(5) Percentage Change in i +20% +20% +20% +20%

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(6)=(4)/(5) Bond Price Elasticity (BPe) -.830 -.635 -.565 -.525

1
-.997 -.765 -.670 -.624

Bond Price Sensitivity and Term to Maturity

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The following chart explores the impact of the term to maturity on bond price sensitivity clearly, the longer the term to maturity, the greater the bond price elasticity. When interest rates rise, the bond price will rise by a greater percentage, than the fall in bond price in response to an equal but opposite increase in interest rates.

Sensitivity of 10-year bonds with different coupon rates to interest rate changes
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Effects of a Decline in the Required Rate of Return on a 10% Coupon Rate Bond
(1) Bonds with a Term to Maturity of: 1 5 10 30 (2) Initial Price Of Bonds (When i=10%) $1,000 1,000 1,000 1,000 (3) Price of Bonds when i=8% $1,019.40 1,079.87 1,134.21 1,225.20 (4)=[(3)-(2)]/(2) Percentage Change in Bond Price +1.9% +8.0 +13.4 +22.5 (5) Percentage Change in i -20% -20% -20% -20% (6)=(4)/(5) Bond Price Elasticity (BPe) -.095 -.4 -.67

-1.126

Effects of an Increase in the Required Rate of Return on a 10% Coupon Rate Bond
(1) Bonds with a Term to Maturity of: 1 5 10 30 (2) Initial Price Of Bonds (When i=10%) $1,000 1,000 1,000 1,000 (3) Price of Bonds when i=12% $982.19 927.88 887.02 838.92 (4)=[(3)-(2)]/(2) Percentage Change in Bond Price -1.8% -7.2 -11.3 -16.0 (5) Percentage Change in i +20% +20% +20% +20%

4
(6)=(4)/(5) Bond Price Elasticity (BPe) -.09 -.36 -.565 -.80

Bond Prices and Term to Maturity

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R e q u ire d re t u rn = 1 0 . 0 0 % C oupon R ate = 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 10.00% $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 T e rm t o M a t u ritB o n d P r i c e y 10.00% 8.00% B o n d P ric e $981.82 $965.29 $950.26 $936.60 $924.18 $912.89 $902.63 $893.30 $884.82 $877.11 $870.10 $863.73 $857.93 $852.67 $847.88 $843.53 $839.57 $835.97 $832.70 $829.73 $827.03 $824.57 $822.34 $820.31 $818.46 $816.78 $815.26 $813.87 $812.61 $811.46 10.00% 12.00% B o n d P ric e $1,018.18 $1,034.71 $1,049.74 $1,063.40 $1,075.82 $1,087.11 $1,097.37 $1,106.70 $1,115.18 $1,122.89 $1,129.90 $1,136.27 $1,142.07 $1,147.33 $1,152.12 $1,156.47 $1,160.43 $1,164.03 $1,167.30 $1,170.27 $1,172.97 $1,175.43 $1,177.66 $1,179.69 $1,181.54 $1,183.22 $1,184.74 $1,186.13 $1,187.39 $1,188.54 10.00% 6.00% B o n d P ric e $963.64 $930.58 $900.53 $873.21 $848.37 $825.79 $805.26 $786.60 $769.64 $754.22 $740.20 $727.45 $715.87 $705.33 $695.76 $687.05 $679.14 $671.94 $665.40 $659.46 $654.05 $649.14 $644.67 $640.61 $636.92 $633.56 $630.51 $627.74 $625.22 $622.92 10.00% 14.00% B o n d P ric e $1,036.36 $1,069.42 $1,099.47 $1,126.79 $1,151.63 $1,174.21 $1,194.74 $1,213.40 $1,230.36 $1,245.78 $1,259.80 $1,272.55 $1,284.13 $1,294.67 $1,304.24 $1,312.95 $1,320.86 $1,328.06 $1,334.60 $1,340.54 $1,345.95 $1,350.86 $1,355.33 $1,359.39 $1,363.08 $1,366.44 $1,369.49 $1,372.26 $1,374.78 $1,377.08
0 1 2 3 4 5 6 7 8 9 10 200 400 1200 1600

T e r m to M a tu r i ty a n d B o n d P r i c e

1400

1000

800

600

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12 13 14 15 16 17 18 19 20 21 22 23

Bo n d Pr ice ($)

Y e a r s L e f t t o M a t u r it y

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Duration
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An alternative measure of bond price sensitivity is the bonds duration. Duration measures the life of the bond on a present value basis. Duration can also be thought of as the average time to receipt of the bonds cashflows. The longer the bonds duration, the greater is its sensitivity to interest rate changes.

Duration and Coupon Rates

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A bonds duration is affected by the size of the coupon rate offered by the bond. The duration of a zero coupon bond is equal to the bonds term to maturity. Therefore, the longest durations are found in stripped bonds or zero coupon bonds. These are bonds with the greatest interest rate elasticity. The higher the coupon rate, the shorter the bonds duration. Hence the greater the coupon rate, the shorter the duration, and the lower the interest rate elasticity of the bond price.

Duration
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The numerator of the duration formula represents the present value of future payments, weighted by the time interval until the payments occur. The longer the intervals until payments are made, the larger will be the numerator, and the larger will be the duration. The denominator represents the discounted future cash flows resulting from the bond, which is the bonds present value.
DUR

t 1 t 1 n

Ct (t ) (1 i ) t Ct (1 i ) t

where : Ct the coupon or principal payment generated by the bond t the time at which the paymentsare provided i the bond ' s yield to maturity

Duration Example
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As an example, the duration of a bond with $1,000 par value and a 7 percent coupon rate, three years remaining to maturity, and a 9 percent yield to maturity is:

$70 $70(2) $1070(3) 1 2 (1.09) (1.09) (1.09) 3 DUR $70 $70 $1070 1 2 (1.09) (1.09) (1.09) 3 2.80 years

Duration Example ...

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As an example, the duration of a zero-coupon bond with $1,000 par value and three years remaining to maturity, and a 9 percent yield to maturity is:

$1000(3) (1.09) 3 DUR $1000 (1.09) 3 3.0 years

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Duration

is a handy tool because it can encapsule interest rate exposure in a single number. rather than focus on the formula...think of the duration calculation as a process... semi-annual duration calculations simply call for halving the annual coupon payments and discounting every 6 months.

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Duration Rules-of-Thumb

duration of zero-coupon bond (strip bond) = the term left until maturity. duration of a consol bond (ie. a perpetual bond) = 1 + (1/R) where: R = required yield to maturity duration of an FRN (floating rate note) = 1/2 year

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Other Duration Rules-of-Thumb

duration increases with maturity of a fixed-income asset, but at a decreasing rate.

Duration and Maturity

Duration and Yield

duration decreases as yield increases.

Duration and Coupon Interest

the higher the coupon or promised interest payment on the security, the lower its duration.

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Economic Meaning of Duration

duration is a direct measure of the interest rate sensitivity or elasticity of an asset or liability. (ie. what impact will a change in YTM have on the price of the particular fixed-income security?) interest rate sensitivity is equal to: dP P = - D [ dR/(1+R)]
Where: P=

Price of bond

C= R= N= F=

Coupon (annual) YTM Number of periods Face value of bond

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Interest Rate Elasticity

the percent change in the bonds price caused by a given change in interest rates (change in YTM)

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Economic Meaning of Duration

dP P = - D [ dR/(1+R)]

interest rate sensitivity is equal to:

dP/P = change in bond price [ dR/(1+R)] = change in interest rate

Obviously, the relationship is an inverse function of Duration (D)

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Example of Calculation of Interest Rate Sensitivity

given:
n = 6 years (Eurobond ... annual coupon payments) 8 percent coupon 8 YTM if yields are expected to rise by 10%, what impact will that have on the price of the bond?
If there were no coupon payments the duration would be = 6. since there are coupon payments the duration must be less than 6 years. D = 4.993 years

the first step is to calculate the duration of the bond.

the second step is to calculate the % change in price for the bond. = -(4.993)(.1/1.08) = - 0.4623 = - 46.23%

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Immunization

fully protecting or hedging an FIs equity holders against interest rate risk. elimination of interest rate risk by matching the duration of both assets and liabilities. (not their average lives or final maturities). when immunized:
the gains or losses on reinvestment income that result from an interest rate change are exactly offset by losses or gains from the bond proceeds on sale of the bond.

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Example of Bond Price

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The Canada 10.25 1 Feb 04 is quoted at 123.95 yielding 5.27%. This means that for a $1,000 par value bond, these bonds are trading a premium price of $1,239.50 The figure represents bond prices as of June 17, 1998. This bond has 5 years and 8 months (approximately) until maturity = 5+(8/12) = 5.7 years

Bond Price = $102.50(PVIFAn=5.7 ,r=5.27%) + $1,000 / (1.0527)5.7 = $102.50(PVIFAr=5.27%%, n= 5.7) + $746.21 = $102.50(4.8156653) + $746.21 = $493.61 + $743.42 = $1,237.03 Can you explain why the quoted price might differ from your answer?
K. Hartviksen

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Example of a Duration Calculation

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Example Assume a 10% coupon bond with three years left to maturity and a required return of 8%. Coupon Rate = 10.00% Required Return = 8.00% Time Weighted Time Cashflow PVIF Present Value Weight CFs 0 0.5 50 0.96225 $48.11 4.55% 0.022767679 1 50 0.925926 $46.30 4.38% 0.043816419 1.5 50 0.890973 $44.55 4.22% 0.063243554 2 50 0.857339 $42.87 4.06% 0.081141517 2.5 50 0.824975 $41.25 3.90% 0.097598077 3 1050 0.793832 $833.52 78.89% 2.36662759 Bond Price = $1,056.60 100.00% 2.675194837 =Duration

Sensitivity Analysis of Bonds

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Coupon Bond Bond X R a te 7.0% 7.0% 7.0% 7.0% 7.0% Bond Y 5.0% 5.0% 5.0% 5.0% 5.0% T i m e to m a tu r i ty 13 12 10 5 1 13 12 10 5 1 Y i e l d to M a tu r i ty 6.0% 6.0% 6.0% 6.0% 6.0% 8.0% 8.0% 8.0% 8.0% 8.0% P V IF A 8.852683 8.383844 7.360087 4.212364 0.943396 7.903776 7.536078 6.710081 3.99271 0.925926 P V IF 0.468839 0.496969 0.558395 0.747258 0.943396 0.367698 0.397114 0.463193 0.680583 0.925926 B o n d P rice $1,088.53 $1,083.84 $1,073.60 $1,042.12 $1,009.43 $762.89 $773.92 $798.70 $880.22 $972.22

K. Hartviksen

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Prices over time

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Bond Price

Time To Maturiy X Bond Bond Y Bond $762.89 13 $1,088.53Prices over Time 12 $1,083.84 $773.92 10 1500 $1,073.60 $798.70 5 $1,042.12 $880.22 1000 $1,009.43 $972.22 1 0 1000 1000 500 0 13 12 10 5 1 Years Left Until Maturity 0

K. Hartviksen

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Duration of a Portfolio
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Bond portfolio mangers commonly attempt to immunize their portfolio, or insulate their portfolio from the effects of interest rate movements.
For example, a life insurance company knows that they need $100 million 30 years from now cover actuarially-determined claims against a group of life insurance policies just no sold to a group of 30 year olds. The insurance company has invested the premiums into 30-year government bonds. Therefore there is no default risk to worry about. The company expects that if the realized rate of return on this bond portfolio equals the yield-to-maturity of the bond portfolio, there wont be a problem growing that portfolio to $100 million. The problem is, that the coupon interest payments must be reinvested and there is a chance that rates will fall over the life of the portfolio.

Duration of a Portfolio ...

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The life insurance company example illustrates a keep risk in fixed-income portfolio management - interest rate risk. The portfolio manager, before-the-fact calculates the bond portfolios yield-to-maturity. This is an ex ante calculation. As such, a nave assumption assumption is made that the coupon interest received each year is reinvested at the yield-to-maturity for the remaining years until the bond matures. Over time, however, interest rates will vary and reinvestment opportunities will vary from that which was forecast.

Duration of a Portfolio ...

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The insurance company will want to IMMUNIZE their portfolio from this reinvestment risk. The simplest way to do this is to convert the entire bond portfolio to zero-coupon/stripped bonds. Then the ex ante yield-to-maturity will equal ex post (realized) rate of return. (ie. the ex ante YTM is locked in since there are no intermediate cashflows the require reinvestment). If the bond portfolio manager matches the duration of the bond portfolio with the expected time when they will require the $100 m, then interest rate risk will be eliminated.