Fixed Income Continued

Portfolio Wealth Management: Role
of Fixed Income Securities

Suman Banerjee
March 2009

Life Cycle Hypothesis (LCH)
Young people and retirees are unable to save very much.
Most saving is done by middle-aged people.
Income follows a humped-shaped pattern over an
individual's lifetime.
There would be no problem is spending patterns followed
the same path with low consumption needs at beginning
and end of life and higher needs during peak earning
periods.
However, individuals prefer to spend at a steadier rate
over their lifetimes.

Diagram: LCH
Example 1: Bonds Total Return
Suppose an investor is considering purchasing a 7-year semi-
annual coupon bond selling at par and having a coupon rate of 9%.
Investor assumes that
The coupon re-investment rate is 9.4%, and
He is going to hold the bond for 5 years (his investment horizon).
Step 1: Total future earnings from this bond includes
1. Coupon payment of $45 every 6 month until the end of investment
horizon,
2. Interest earned on re-investing the semi-annual coupon payments
at 4.7% (half of the assumed annual reinvestment rate) until the
end of investment horizon, and
3. Expected price of the bond at the end of investment horizon.
Price at the End of Investment Horizon
Investor assumes that
The market interest rate for similar risk bonds at the end of his
investment horizon is 11.2%.
What is the price of the bond then?
Price = PV of coupons + PV of maturity value

=

Remember, it is a 7-year 9% coupon bond!
( )
( )
( )
4
4
1
1
1 .056
1000
45 $157.34 $804.16 $961.50
.056
1 .056
(
(
+
(
+ = + =
(
+
(
(

Example continued
Step 2: Calculate the future value of coupon interest plus interest on coupon
interest as follows:

Step 3: Compute the total dollar return

Step 4: Compute the following

Step 5: Doubling 4.27% gives the total return of 8.54%
Total return on effective rate basis: (1.0427)
2
-1 =8.72%.
( )| |
10
(1.047) 1
$45 $45 12.4032 $558.14
0.047
(
= =
(

Coupon interest and interest on coupon interest $ 558.14
Sell price after 5 years (assuming 11.2% required return) $961.50
Total dollar return $1,519.64
1
10
$1, 519.64
1 0.0427 4.27%
$1000
(
= =
(

Example 2 : Total Return
Suppose that an investor has 6 years investment horizon. The
investor is considering a 13-year semi-annual coupon bond selling
at par and having a coupon rate of 9%.
The investor expectations are as follows:
The first 4 semi-annual coupon payments can be reinvested from the
time of receipt to the end of the investment horizon at an annual
interest rate of 8%,
The last 8 semi-annual coupon payments can be reinvested from the
time of receipt to the end of the investment horizon at a 10% annual
interest rate, and
The required market interest rate on 7-year bonds at the end of the
investment horizon is 10.6%.
What is the total return?

Example 2: We just figure out.
Step 1: Total future earnings from this bond
includes
1. Coupon interest of $45 every six months for 6 years (the
investment horizon),
2. Interest earned from reinvesting the first 4 semi-annual coupon
interest payments at 4% (one-half the assumed annual
reinvestment rate) until the end of the investment horizon,
3. Interest earned from reinvesting the last 8 semi-annual coupon
interest payments at 5% (one-half the assumed annual
reinvestment rate) until the end of the investment horizon, and
4. Expected price of the bond at the end of investment horizon.

Example 2 continued
Step 2: Calculate the future value of coupon interest plus interest on
coupon interest as follows:

This gives the coupon interest plus interest on interest as of the end of
the second year (four periods). Reinvesting at 4% until the end of the
investment horizon, 4 years or 8 six-month periods later, $191.09 will
grow to

The coupon interest plus interest on interest for the last eight coupon
payments can be found as follows:

( )| |
4
(1.04) 1
$45 $45 4.2465 $191.09
0.04
(
= =
(

( )
8
$191.09 1.04 $261.52 =
( )| |
8
(1.05) 1
$45 $45 9.5491 $429.71
0.05
(
= =
(

Example 2 continued
Step 2 (continued): The coupon interest and interest on interest from
all 12 coupon interest payments is
$691.23 (= $261.52 + $429.71).
Step 3: Compute the expected price of the bond 6 years from today:

Step 4: Compute the total dollar return
( )
( )
( )
14
14
1
1
1 .053
1000
$45 $437.02 $485.29 $922.31
.053
1 .053
(
(
+
(
+ = + =
(
+
(
(

Coupon interest and interest on coupon interest $ 691.23
Sell price after 5 years (assuming 11.2% required return) $922.31
Total dollar return $1,613.54
Example 2 continued

Step 5: Doubling 4.07% gives the total return of
8.14% on bond equivalent basis.
1
12
1, 613.54
1 0.0407 4.07%
1000
(
= =
(

Analyzing a Callable Bond
An investor is considering bond C: 11% semi-annual coupon, 15
years to maturity and the price for this bond is $1,144.88. Then,
YTM is 9.2% (Please check!).
Suppose that this bond is callable in 3 years at $1,055 (this is
called the first call date).
What is the RTC (or YTC) of this bond ? RTC = 7.22%.
However, suppose that this investor's investment horizon is 5
years (a period extending beyond the first call date, but
shorter than the maturity of the bond).
Also assume that this investor believes that any proceeds can
be reinvested at a 6% annual interest rate.
Compute the total return of the bond on the assumption that the
bond is called in three years.
Cash flow of a Callable Bond
Time 0 1 3 4 5 6 ... ... 29 30

If the
bond
matures

$55

$55

$55

$55

$55

$55

...

...

$55

$55
$1000

If the
bond is
called

$55

$55

$55

$55

$55

$55
$1055
Callable Bonds: Return to Call
How do you calculate the RTC?
Determine the payoff, if the bond is called on the first call date:
Price (or your investment): $1144.88
Coupon interest received: 6 payments of $55 each
Call price (you receive): $1055
RTC is that interest rate that solves the following equation

Using the calculator: PV = -1144.88; CP (or FV) = 1055; N = 6; and
PMT = 55, compute I/Y = 3.6087% semi-annually => 7.22% annually.
6 6
) 1 (
1055
) 1 (
1
1
55
88 . 1144
) 1 ( ) 1 (
1
1
RTC RTC RTC
RTC
CP
RTC RTC
c
P
m m
+
+
(
+
=
+
+
(
+
=
Callable Bonds: Total Return
Step 1: Total future earnings from this bond includes
1. Coupon interest of $55 every six months for 3 years (1
st
call date),
2. Interest earned from reinvesting the first 6 semi-annual coupon interest
payments at 3% (one-half the assumed annual reinvestment rate of 6%)
until the 1
st
call date, and
3. Proceeds from reinvesting the call price plus (1) and (2) above for the two
years (end of the investment horizon) at 3% interest rate.
The coupon interest plus interest on interest for the last six coupon
payments can be found as follows:

76 . 355 $
03 .
1 ) 03 . 1 (
55
6
=
(

Callable Bonds: Total Return
Step 2 (continued): This gives the coupon interest plus interest on coupon
interest as of the end of the year 3 (six periods) when the bond is called. Adding
the call price of $1,055 gives the total proceeds that must be reinvested at 3%
until the end of the investment horizon, for two years or four periods.
Proceeds to be reinvested = $355.76 + $1,055 = $1,410.76.
Reinvesting $1,410.76 for four periods at 3%:


Doubling 3.335% gives the total return of 6.67% in bond equivalent basis.

82 . 1587 $ ) 03 . 1 ( 76 . 1410
4
=
% 335 . 3 1
88 . 1144
82 . 1587
10
1
=
(
Comparing Coupon and Zero-Coupon Bonds:

Break-even Reinvestment Rate
As I have emphasized throughout my lectures, assessing the relative
value of any two coupon bonds on the basis of YTM may provide
misleading conclusions.
A manager of a tax-exempt portfolio who intends to hold a bond until
maturity has the advantage of having an analytical framework necessary
to determine the relative value of a zero-coupon bond and a coupon
bond.
Suppose that the manager of a tax-exempt portfolio is considering two 5-
year bonds: (1) a 9% semi-annual coupon bond selling at par ($1000),
and (2) a zero-coupon bond selling at $600. (per $1000 par value and
semi-annual compounding).
Suppose also that the bonds have the same credit quality rating and that the
portfolio manager plans to hold either bond until maturity.
What is the total return of the zero coupon bond?

Doubling 5.24% gives the total return of 10.48% in bond equivalent basis.
Note: a zero-coupon bond has no coupon reinvestment risk.
Hence, YTM = Total Return, given that the bond is held until maturity.
What is the total return of the coupon bond?
It depends on the coupon re-investment rate assumed by the portfolio
manager.
Can we determine the coupon reinvestment rate that will equalize the total
return of the 9% coupon bond and the zero-coupon bond?
If yes, this reinvestment rate called the Break-even reinvestment
rate.
600
) 1 (
1000
) 1 (
10
=
+
=
+
=
YTM YTM
M
P
N
Suppose instead of buying 3 coupon bonds by investing $3000 in the 9%
coupon bond, an investor invest $3000 in the zero-coupon bond and buy 5
bonds.
$3000 invested in the zero-coupon bond will grow to $5000 at the end of 10
periods (5 years).
An investor will be indifferent between the choice of the zero-coupon
bond and the 9% coupon bond if the latter produces a total future
amount of $5000.
The total future amount from holding a 12% bond to maturity will be
equal to the sum of (1) the coupon payments, (2) the maturity value, and
(3) the interest on coupon interest. For the 9% coupon bond, the investor
knows for certain that for each $3000 invested, the following future
amounts wi1l be received:
Maturity value = $3000.00
We need coupon interest plus interest on coupon interest = $2000 which
implies that we need $650 (=$2000 - $1350) worth of interest on coupon).
Maturity value = 3000.00
We need coupon interest plus interest on coupon interest = $2000
Coupon plus interest on coupon from each bond must equal ($2000/3)

Solving the above equation gives, the annual reinvestment rate i =
16.94%.
If the portfolio manager believes at least an 16.94% reinvestment rate can be
realized, the 9% coupon bond will provide more future dollars than the zero-
coupon bond. If the reinvestment rate is expected to be less than 16.94%, then
the zero-coupon bond is a better investment, as it will provide a higher total
return.
The analysis assumes that the portfolio manager could invest all the coupon
payments at a tax-free rate. If taxes on the coupon payments must be paid,
the analysis must take this into consideration.
( ) ( )
(
+
=
(
+
=
r
r
r
r
C FV
n
c
1 1
45 67 666
1 1
10
.
2000-09 Suman Banerjee
Bond Price-Interest Relation:
Convexity
The reason for this property lies in the convex shape of the
price/discount rate relationship. This is illustrated graphically
in figure below.
Price
discount rate
P
1

P
P
2

i-2% i i+2%
Portfolio Managers Problem
What market participants would like to have is a measure that can be used to
quantify the price volatility of a bond.
For example, suppose a portfolio manager expects that interest rates will fall and is
considering purchasing one of the following two bonds: (1) Bond A, 7%, 22-year
bond selling to yield 8%, and (2) Bond B, a zero-coupon, 15-year bond, selling to give
8.40% as required return.
With interest rates expected to decline, the portfolio manager will want to purchase
the bond that offers the greater price volatility. Which has higher price volatility?
On the one hand, Bond B has a lower coupon than Bond A, so it would seem that
Bond B has a greater price volatility.
On the other hand, Bond A has a longer maturity than Bond B, so it would seem that
Bond A has more price volatility.
Complicating further, the two bonds are trading at different required return.
Next two lectures discuss the measures of bond price volatility appropriate for such a
situation.
One of the things we do know is that any measure of price volatility should take into
consideration the three factors that affect price volatility: coupon rate, maturity, and
level of discount rate.
Role of Duration
We explained that the bond return that is realized by
investing in a coupon security will depend on the
interest rate earned on the reinvestment of the coupon
payments.
When interest rates rise, interest on interest from the
reinvestment of the coupon payments will be higher, but if the
investment horizon is shorter than the maturity of the bond, a
loss will be realized upon the sale of the bond.
The reverse is true if interest rates fall: price appreciation will be
realized when the bond is sold, but interest on interest from
reinvesting the coupon payments will be lower. Because of
these two risks, the investor cannot be assured of locking in the
return at the time of purchase.
Role of Duration: Important
Question
Because the interest rate risk and
reinvestment risk tend to offset each other,
Is it possible to select a bond or a portfolio of
bonds that will lock in the return at the time
of purchase regardless of interest rate changes
in the future?
Is it possible to immunize the bond or bond
portfolio against interest rate changes?
Important Question: Answer
Fortunately, under certain circumstances, the answer is
YES.
This can be accomplished by buying a bond or by
constructing a portfolio of bonds such that its duration is
equal to the length of the investment horizon of the
manager.
Thus, a portfolio manager with an investment horizon of
5 years who wants to lock in a return over that time
period, should select a portfolio with a Macaulay
duration of 5 years.
We will demonstrate this with an example later, but first
we need to learn how to compute duration?.
Duration of a Bond
Duration is the weighted average time to
maturity, where the weights are the
relative PV of cash flows.
It is a measure of the elasticity of an assets or
liabilitys value to small changes in the interest
rate.
The percentage in bonds fair value (or PV) for
a given change in interest rates can be more
directly measured by duration.
Computing Macaulay Duration
Macaulay duration (in periods)

where
t = the period when the cash flow is expected to
be received (t = 1, ...,n);
n = number of years until maturity;
PVCF1+PVCF2+..+PVCF2n = PV of all future
cashflows = price of a bond
(1) PVCF1 + (2) PVCF2 + (3) PVCF3 + ...+ (n) PVCFn
PVCF1 + PVCF2 + PVCF3 + ...+ PVCFn
Duration of a Bond
For an option-free bond with semi-annual
payments,
the cash flow for periods 1 to n -1 is one-half the
annual coupon interest.
the cash flow in period n is the semiannual coupon
interest plus the maturity value.
Since the bond's price is equal to its cash flow
discounted at the prevailing YTM, (PVCF1+
PVCF2+ PVCF3++ PVCF2n) is the current
market price.
Duration of A Bond: Example 1
Duration of a 4-year bond with a 10% coupon paid semi-annually, selling
at 8% YTM.

Duration =0.5*(7291.19/1067) = 3.42 years
3 4 5
t CF
t
1
1 50 0.96154 48.08 48.077
2 50 0.92456 46.23 92.456
3 50 0.88900 44.45 133.349
4 50 0.85480 42.74 170.961
5 50 0.82193 41.10 205.482
6 50 0.79031 39.52 237.094
7 50 0.75992 38.00 265.971
8 1050 0.73069 767.22 6137.798
6.733 1067 7291.19
( )
1
1.04
t
( )
1.04
t
t
CF
( )
1.04
t
t
CF t
Mathematically, Macaulay duration for a semi-annual pay
bond can be shown to be equivalent to:

i = semi-annual YTM;

c = semi-annual coupon rate.
n = number of compounding periods
Macaulay Duration: Algebra
1
(1 )
i i c
Dur H n H
i i
+
= +
bond the of Price
payments coupon all of lue Present va
H =
Duration
Consider a 15-year, 8% semi-annual coupon bond selling at 84.63 to give
YTM=10%. Find the duration of the bond?

PV of all coupons = = $61.49

Hence, H = $61.49/$84.62 = 0.726596

Duration =

=

= 16.90 half years or 8.45 years

(
(
+

1
1
(1 )
n
c
i i
+
+
1
(1 )
i i c
H n H
i i
+
1.05 .05 .04
(.726596) 30(1 0.726596)
.05 .05
Macaulay Duration: Par Value Bond
For a par value bond, the semi-annual coupon rate is equal to
semi-annual yield; thus c and i are equal. The Macaulay
duration for a par value bond in six-month periods is;

1
(1 )
1
half-years
1 1
years
2
i i c
Dur H n H
i i
i
H
i
i
H
i
+
= +
+
=
+
(
=
(

Macaulay Duration: ZC Bond
For a zero coupon bond, the coupon rate is zero; that is, c =0.
Hence, H = 0. The Macaulay duration for a par value bond in
six-month periods is;

+
= +
=
=
1
(1 )
(1 0) half-years
half years
= n/2 years
i i c
Dur H n H
i i
i
n
i
n
Duration
Consider a 15-year, 8% semi-annual coupon
bond selling at 84.63 to give YTM=10%. Find the
duration of the bond?
Suppose interest rate increases, such that the
bond coupons can be reinvested at 11% and the
discount rate for the bond is also 11%. What
happens to the investors total return?
Assume that the investors investment horizon is 8.5
years (or 17 periods)
Next, assume that the investors investment horizon
is 7 years (or 14 periods)?

t CF
t
P VCF P VCF*t
1 4 0 . 9 5 2 3 . 8 10 3 . 8 10
2 4 0 . 9 0 7 3 . 6 2 8 7 . 2 5 6
3 4 0 . 8 6 4 3 . 4 5 5 10 . 3 6 6
4 4 0 . 8 2 3 3 . 2 9 1 13 . 16 3
5 4 0 . 7 8 4 3 . 13 4 15 . 6 7 1
6 4 0 . 7 4 6 2 . 9 8 5 17 . 9 0 9
7 4 0 . 7 11 2 . 8 4 3 19 . 8 9 9
8 4 0 . 6 7 7 2 . 7 0 7 2 1. 6 5 9
9 4 0 . 6 4 5 2 . 5 7 8 2 3 . 2 0 6
10 4 0 . 6 14 2 . 4 5 6 2 4 . 5 5 7
11 4 0 . 5 8 5 2 . 3 3 9 2 5 . 7 2 6
12 4 0 . 5 5 7 2 . 2 2 7 2 6 . 7 2 8
13 4 0 . 5 3 0 2 . 12 1 2 7 . 5 7 7
14 4 0 . 5 0 5 2 . 0 2 0 2 8 . 2 8 4
15 4 0 . 4 8 1 1. 9 2 4 2 8 . 8 6 1
16 4 0 . 4 5 8 1. 8 3 2 2 9 . 3 19
17 4 0 . 4 3 6 1. 7 4 5 2 9 . 6 6 8
18 4 0 . 4 16 1. 6 6 2 2 9 . 9 17
19 4 0 . 3 9 6 1. 5 8 3 3 0 . 0 7 6
2 0 4 0 . 3 7 7 1. 5 0 8 3 0 . 15 1
2 1 4 0 . 3 5 9 1. 4 3 6 3 0 . 15 1
2 2 4 0 . 3 4 2 1. 3 6 7 3 0 . 0 8 3
2 3 4 0 . 3 2 6 1. 3 0 2 2 9 . 9 5 3
2 4 4 0 . 3 10 1. 2 4 0 2 9 . 7 6 7
2 5 4 0 . 2 9 5 1. 18 1 2 9 . 5 3 0
2 6 4 0 . 2 8 1 1. 12 5 2 9 . 2 4 9
2 7 4 0 . 2 6 8 1. 0 7 1 2 8 . 9 2 8
2 8 4 0 . 2 5 5 1. 0 2 0 2 8 . 5 7 0
2 9 4 0 . 2 4 3 0 . 9 7 2 2 8 . 18 2
3 0 10 4 0 . 2 3 1 2 4 . 0 6 3 7 2 1. 8 9 8
8 4 . 6 3 14 3 0 . 11
Duration
Duration of the bond =
0.5*(1430.11/84.63) = 8.45 years
Next, we will demonstrate the
process of immunization!
Duration
What is the FV of coupon + interest on coupons at the
end of 8.5 years if the interest rate stays put?

What is the expected sell price at the end of date 8.5
after interest rate stays put?

Total dollars earned? $103.36+$90.56=194.47

( )
17
17
1.05 1 (1 ) 1
4 $103.36
0.05
n
r
r
i
FV c
i
(
( +
= = =
(
(
(

17
13 13
1 1 100
1 4 1 $90.56
(1 ) (1 ) (1.05) (1.05)
n n
M
PV c
i i
( (
= + = + =
( (
+ +

Duration
end of 8.5 years after the interest rate changes?

after interest rate changes?


( )
17
17
1.055 1 (1 ) 1
4 $107.99
0.055
n
r
r
i
FV c
i
(
( +
= = =
(
(
(

17
13 13
1 1 100
1 4 1 $86.32
(1 ) (1 ) (1.055) (1.055)
n n
M
PV c
i i
( (
= + = + =
( (
+ +

Duration: Horizon 7 years
end of 7 years if the interest rate stayed put?

What is the expected sell price at the end of date 7 after
interest rate stayed put?


( )
14
14
1.05 1 (1 ) 1
4 $78.39
0.05
n
r
r
i
FV c
i
(
( +
= = =
(
(
(

14
16 16
1 1 100
1 4 1 $89.16
(1 ) (1 ) (1.05) (1.05)
n n
M
PV c
i i
( (
= + = + =
( (
+ +

Duration: Horizon 7 years
end of 7 years after the interest rate changes?

after interest rate changes?


( )
14
14
1.055 1 (1 ) 1
4 $81.17
0.055
n
r
r
i
FV c
i
(
( +
= = =
(
(
(

14
16 16
1 1 100
1 4 1 $84.31
(1 ) (1 ) (1.055) (1.055)
n n
M
PV c
i i
( (
= + = + =
( (
+ +

Duration and Change in Price
A securitys price changes for a given change in interest
rates is given by:

The approximation works best when there are just small
changes (Ai is small) in interest rates.
We call

where i is the semi-annual YTM.
( )( )
Approximate percentage change in price
1

1
Duration Interest rate Change
i
=
(
(
+

duration Modified
i) (1
Duration
=
+
Duration And Change In Price
Consider a 15-year, 8% semi-annual coupon bond selling at 84.63
to give YTM=10%. Duration of the bond is 8.45 years.

Modified Duration = (8.45/1.05) = 8.05

Suppose the interest rate increases from 10% to 10.10%, then

Interest rate change = 0.1% = .0010
Approximate % price change = - (8.05)(0.0010)
= - 0.81%.
Actual Price change = -0.80%.
For a small change in yield, modified duration provides a
good approximation of price change.
Duration And Change In Price: Large
Interest Rate Change
A 15-year, 8% semi-annual coupon bond selling at 84.63 to
yield 10%. Duration of the bond is 8.45 years (Check!).
Modified Duration = (8.45/1.05) = 8.05

Suppose the interest rate increases from 10% to 13%, then
Interest rate change = 3.0% = .03
Approximate % price change = - (8.05)(0.03)
= - 24.15%
Actual Price change = -20.41% (Check!)

For a large change in yield, modified duration does not
provides a good approximation of price change.
Convex Function and Price Change
For a large change in yield, modified duration does
not provides a good approximation of price
change.
This is because, duration assumes that the relation between price
and interest rate (or discount rate) is linear.
We argued that for a small change in interest rate assuming a
linear relationship does not make a big difference.
The true relation price and interest rate is convex.
Thus, for large change in interest rate, assuming a linear
relationship will give a large error.
We need to add a correction factor
The correction factor is called convexity.

Price Change: Effect of Convexity

The last term on the RHS is the effect of convexity, where

2
) )( (convexity
2
1
i) ( duration) modified ( P % i A + A = A
Price ) (1 2
1))) (CF(t(t of
Convexity
m m
m i
PV
+
+
=
How to Calculate Convexity
Coupon rate 8% Initial YTM 10% Price = 92.28
Term (years) 5 Par Value 100
Period CF t(t+1) (CF)(t(t+1) PVCF*(t(t+1) PVCF*t
1 4 2 8 7.6190 3.8095
2 4 6 24 21.7687 7.2562
3 4 12 48 41.4642 10.3661
4 4 20 80 65.8162 13.1632
5 4 30 120 94.0231 15.6705
6 4 42 168 125.3642 17.9092
7 4 56 224 159.1926 19.8991
8 4 72 288 194.9297 21.6589
9 4 90 360 232.0592 23.2059
10 104 110 11440 7023.1676 638.4698
Total 7965.404669 771.4084
How to Calculate Convexity

Using the table in the last slide we get

Price ) (1 2
1))) (CF(t(t of
Convexity
m m
m i
PV
+
+
=
7965.4047 1))) (CF(t(t of PV = +
57 . 19
28 . 92 ) 05 . 1 ( 2
4047 . 7965
2 2
= = Convexity
Adjustment Due to Convexity
A 5-year, 8% semi-annual coupon bond selling at 92.28 to
yield 10%. Duration of the bond is 4.55 years and Modified
Duration = (4.18/1.05) = 3.98. Also, the convexity of the
bond is reported to be 19.57.
Annual yield change = 3.0% = .03
Approximate % price change due to duration=-
(3.98)(0.03) = - 11.94%

Convexity of the bond = 19.57
% price change due to convexity
= (0.5)(19.57)(0.03)
2
= .881%
Price Change: Duration & Convexity
A5-year, 8% semi-annual coupon bond selling at
92.28 to yield 10%.
Annual yield change = 3.0% = .03
Actual Price change = -11.11%
Total price change (duration & convexity)
= -11.94% + .881%
= -11.06%
Portfolio Duration
Bond Price YTM Modified
duration
A: 5 years, 10% coupon $4,000,000 10% 3.861
B: 15 years, 8% coupon $4,231,375 10% 8.047
C: 30 years, 14% coupon $1,378,586 10% 9.168
Total $9,609,962
All three bonds are semi-annual coupon bonds.
The portfolio consist of one bond A, one bond B and
one bond C.
Portfolio Duration
The portfolios modified duration is
0.416(3.861) + 0.440(8.047) +0.144(9.168) = 6.47
A portfolio modified duration of 6.47 means that for a
100-basis-point change in the yield for all three bonds,
the market value of the portfolio will change by
approximately 6.47%.
But the YTM on all three bonds must change by 100
basis points for the modified duration of the portfolio
measure to be useful.

Managing Interest Rate Risk
Managing Interest Risk: Assets
The first step in assessing interest-rate risk is for the bank
manager to decide which assets and liabilities are rate-sensitive,
that is, which have interest rates that will be re-priced within the
year.
Note that rate-sensitive assets or liabilities can have interest rates
re-priced within the year either because the debt instrument
matures within the year or because the re-pricing is done
automatically, as with variable-rate mortgages.
For many assets and liabilities, deciding whether they are rate-
sensitive is straightforward.
In our example, the obviously rate-sensitive assets are securities
with maturities of less than one year ($5 million), variable-rate
mortgages ($10 million), and commercial loans with maturities
less than one year ($15 million), for a total of $30 million.
Managing Interest Risk: Assets
However, some assets that look like fixed-rate assets whose
interest rates are not re-priced within the year actually have a
component that is rate-sensitive.
For example, although fixed-rate residential mortgages may
have a maturity of 30 years, homeowners can repay their
mortgages early by selling their homes or repaying the
mortgage in some other way.
This means that within the year, a certain percentage of these
fixed-rate mortgages will be paid off, and interest rates on this
amount will be re-priced.
From past experience the manager knows that 20% of the fixed-
rate residential mortgages are repaid within a year, which
means that $2 million of these mortgages (20% of $10 million)
must be considered rate-sensitive.
YOU have to be careful in estimating your exposure!
Managing Interest Risk: Liabilities
Similarly, determine the total amount of rate-sensitive liabilities.
Obvious rate-sensitive liabilities are money market deposit accounts
($5 million), variable-rate CDs and CDs with less than one year to
maturity ($25 million), federal funds ($5 million), and borrowings
with maturities of less than one year ($10 million), for a total of $45
million.
Checkable deposits and savings deposits often have interest rates
that can be changed, although financial institutions often like to
keep their rates fixed for substantial periods.
Thus these liabilities are partially but not fully rate-sensitive. The
bank manager estimates that 10% of checkable deposits ($1.5
million) and 20% of savings deposits ($3 million) is considered rate-
sensitive.
Adding the $1.5 million and $3 million to the $45 million figure
yields a total for rate-sensitive liabilities of $49.5 million.
Managing Interest Rate Risk
Now the manager can analyze what will happen if interest rates
rise by 1 percentage point, say, on average from 10% to 11%.
The income on the assets rises by $320,000 (= 1% x $32 million of
rate-sensitive assets), while the payments on the liabilities rise by
$495,000 (= 1% x $49.5 million of rate-sensitive liabilities).
The First National Banks profits now decline by $175,000 =
($320,000 $495,000).
Conversely, if interest rates fall by 1%, similar reasoning tells us
that the First National Banks income rises by $175,000 and its net
interest margin rises by 0.175%.
Thus, if a financial institution has more rate-sensitive liabilities
than assets, a rise in interest rates will reduce the net interest
margin and income, and a decline in interest rates will raise the
net interest margin and income.

IRM: Income Gap Analysis
Example: Gap Analysis
The manager of notices that the bank balance sheet produces a
more refined maturity bucket that allows him to estimate the
potential change in income over the next one to two years.
Rate-sensitive assets in this period consist of $5 million of securities
maturing in one to two years, $10 million of commercial loans
maturing in one to two years, and an additional $2 million (20% of
fixed-rate mortgages) that the bank expects to be repaid.
Rate-sensitive liabilities in this period consist of $5 million of one-
to two-year CDs, $5 million of one- to two-year borrowings, $1 .5
million of checkable deposits (the 10% of checkable deposits that
the bank manager estimates are rate-sensitive in this period), and
an additional $3 million of savings deposits (the 20% estimate of
savings deposits).
For the next one to two years, calculate the gap and the change in
income if interest rates rise by 1%.

Example continued
More to Interest Rate Risk Mgmt.
The gap analysis we have examined so far focuses only on the
effect of interest- rate changes on income.
Clearly, owners and managers of financial institutions care not
only about the effect of changes in interest rates on income but
also about the effect of changes in interest rates on the market
value of the net worth of the financial institution.
An alternative method for measuring interest-rate risk, called
duration gap analysis, examines the sensitivity of the market
value of the financial institutions net worth to changes in interest
rates.
Duration analysis is based on Macaulays concept of duration,
which measures the average lifetime of a securitys stream of
payments.
Duration Gap Analysis
Duration of Assets and Liabilities
Example: Duration Gap
The manager wants to know what
happens to the institutions net worth
when interest rates rise from 10% to
11%. The total asset value is $100
million and total liability value is $95
million
Note that total liabilities excludes buffer
capital and are thus, $95 million.
Example continued

Fixed Income Continued

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Portfolio Wealth Management: Role

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Comparing Coupon and Zero-Coupon Bonds:

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