Escolar Documentos
Profissional Documentos
Cultura Documentos
The price of a bond is equal to the present value of all coupon interest and
principal discounted at the required yield. The change in yield (y) as well as
failure to pay coupon interest (C=coupon rate*F) and or principal on a timely
basis adversely affects the value of the underlying bond and at the limit the bond
price will be equal to the recovery value in the state of bankruptcy. For an n year
balloon bond, the intrinsic value (P) is as follows in Equation 5.1.
P= C/(1+ y)^1+ C/(1+ y)^2+ C/(1+ y)^3+ C/(1+ y)^n+ F/(1+ y)^n (5.1)
Where coupon rate can be fixed or floating; F is the face value of the bond; y is
the required yield or yield to maturity of the bond; and n is the maturity of the
issue. An n year bond price in equation 1 can be considered as a portfolio of (n+1)
zero coupon bonds. For example, C/(1+ y)^1 is a 1-year zero, C/(1+ y)^2 is a 2-
year zero and so on.
Bond price can change for the following reasons:
Change in credit quality of a firm resulting a change in required yield;
Change in required yield due to changes in the market yield for comparable
bonds; and
Change in price of a bond without a change in required yield as bond approaches
its maturity (premium or discount bond).
The yield on a bond is affected by the following factors:
Base interest rate
Yields On the run Treasuries (the yield on newly issued versus the yield on the old
issue (off-the run)
Risk premium
Types of issuers
Credit worthiness of the issuer
Inclusion of options
Taxability of the interest
Expected liquidity of an issue
Term to maturity
Risk free interest rates such as the rate on the US Treasury securities set the base
interest rate. For risky issuers such as corporate, financials, utilities, etc, the yield is
adjusted upward by the risk premium (likelihood of default), types of collateral
securing the debt, credit quality of the issuer as AAA bonds yield is lower than a
comparable maturity rated AA. Inclusion of options (callable) increases the yield for
callable bond, as compared to a straight bond with no options. The yield on Putable
bonds is lower than the yield on comparable straight bonds as investors have the
option to put the bond back to issuer usually at the worst time. The yield is also
affected whether or not the coupon interest is taxable or tax exempt (Municipal
209
bonds). The yield is inversely related to the expected liquidity (highly liquid
treasuries/ little or no liquidity troubled loan assets on bank balance sheet) of the issue
and positively related to term to maturity.
For example, consider a 30-year zero coupon bond rated to yield 6 percent. The face
value of the bond is $100 million. Exhibit 5.1 shows the price yield relationship for
this bond assuming various yields. The price yield is non-linear convex demonstrating
inverse relationship between price and yield.
Exhibit 5.1:
Exhibit 5.2 demonstrates the price yield relationship for a 2 year 6 percent coupon
paying bond rated to yield in the range of 2 to 12 percent. While the price and
yield is inversely related, there is little or no convexity in the bond as the price
and yield appear to be linear.
210
Exhibit 5.2:
Price volatility is measured by the duration of a bond which is equal to the slope of the
price yield relationship in Exhibit 5.3 weighted by the market value of the bond.
Duration is the price sensitivity of the bond with respect to change in yield and
therefore can be considered as price elasticity. For that matter, some bonds are more
price elastic than others and offer the potential for enhancing yields in active
portfolio management. For example, consider bond A and B in Exhibit 5.3. Bond B
has greater convexity compared to bond A in Exhibit 5.3. The greater positive
convexity is associated with higher price change for a given change in yield when
yield is falling. However, when yield increases bond B price is expected to fall less
than bond A other things remaining the same. Bond B is likely to be a deep discount
bond or convertible bond whose value is equal to a straight bond plus a call option.
While rising yield adversely affects the value of straight bond, it positively affects
the intrinsic value of call option, therefore reducing the impact of the rising yield on
the value of positively convex bond such as convertibles.
211
Exhibit 5.3: Price Yield Relationship
Price
A B
Y Actual Price
Forecast Price
Yield
5% 6% 7%
Duration can also be defined in terms of number of years, as is practiced on Wall Street,
as the sum of cash flows (multiplied by the present value of the time) in which each
cash flow is recognized weighted by the market value of the bond. In this context
duration measures the size and timing of the cash flows as seen in Equation 5.2
n
D = [ (t C)/(1+y)^t +(n. F)/ )/(1+y)^n] / P (5.2)
t =1
Where, all the parameters are as previously defined. The term in the bracket is the slope
of the price yield relationship P / Y, first derivative of bond price with respect to
change in yield and is also called dollar duration.
Duration of the three-year bond in Exhibit 5.1 is estimated using Equation 5.2 to be 2.83
years as follows:
212
Example: Consider a 6 percent coupon bond rated to yield 6 percent. This bond has a
maturity of 15 years and face value of $1000. The coupon is made once a year. Duration
of this bond is 10.21 year in table 5.1.
Table 5.1: McCauley Duration for a 15 year 6 percent bond rated to yield 6 percent
t
(1/
1+
y)^ tc*(1/1+
c tc t y)^t
0.94339
1 60 60 6 56.6037736
0.88999
2 60 120 6 106.799573
0.83961
3 60 180 9 151.131471
0.88999
2 60 120 6 106.799573
0.74725
5 60 300 8 224.177452
0.70496
6 60 360 1 253.785795
0.66505
7 60 420 7 279.323988
0.62741
8 60 480 2 301.157938
0.59189
9 60 540 8 319.62517
0.55839
10 60 600 5 335.036866
0.52678 (n*f)/ FIRST
11 60 660 8 347.679767 ((1+y)^n) DERIVATIVE
0.49696
12 60 720 9 357.817942 6258.975911 10211.68
0.46883
13 60 780 9 365.694437 Price Duration
0.44230
14 60 840 1 371.53281 ($1,000.00) 10.21
0.41726
15 60 900 5 375.538555
SUM 3952.70511
Table 5.2: Duration and yield for a 15 year 6 percent bond rated to yield 6%
213
Yield Duration
0.03 10.95
0.04 10.71
0.05 10.46
0.06 10.21
0.07 9.96
0.08 9.70
0.09 9.45
0.1 9.18
0.11 8.92
0.12 8.68
Duration is indicating that for every +/-100 basis points (1 percent) change in the yield
the bond price is expected to change symmetrically in the opposite direction by -/+ 9.63
percent. Assuming the bond pays coupons semi-annually, the number of periods is
doubled to 30, and the coupon is reduced by half in table 5.1. Therefore, the dollar
duration is adjusted
The price yield relationship in Exhibit 5.3 is a nonlinear convex set because the
percentage changes in bond or stock prices or the price of any asset, financial or real,
is non-symmetric, while duration as a measure of volatility is linear, additive, and
symmetric.
For example, the price of a stock is currently at $50. The price goes up to $75 for a
gain of 50 percent and the price drops to $50 from $75 for a loss of 33.33 percent.
The percentage changes are non-symmetric. The additive property of duration
implies that the duration of the portfolio is the simple weighted average of the
duration of individual assets in the portfolio as each asset is weighted by the market
value not the book value against the total market value of the portfolio. The
symmetric property of duration implies that the extent of the exposure to the bond
portfolio as a result of changes in the yield for plus or minus say 100 basis points
will be the same. The exposure is defined in Equation 5.3 as the changes in the
market value of the portfolio of assets or liabilities as P = Pt Pt-1 that is related
linearly to duration of the portfolio (Dp) as well as to the market value of the
portfolio (P) and to the changes in the yield ( Y) as follows:
P = - Dp P. Y (5.3)
Example: Horizon bond portfolio currently has a market value of $350 million with a
modified duration of 9.375 years. The portfolio manager is expecting rates to go up as the
214
outlook of higher growth for the economy is improving. Therefore the portfolio manager
is contemplating shortening the duration of its portfolio to seven years assuming the
portfolio manager is expecting a 50 basis point increase in the yield in the next three to
six months. The amount of the exposure for this portfolio is symmetrical to +/-
$16,406,250 as follows.
DV01 can be estimated using Equation 5.3 for a bond or portfolio of credits. For
example, DV01 for the above portfolio is:
The portfolio value is expected to change by +/-$328,125 for every 1 basis point change
in the yield. DV01 conveys useful information to a portfolio manager as some of the
proprietary web sites such as Bloomberg and Reuters report this statistics for their
member clients. The portfolio duration for the Treasury sector is equal to 6.56 year as
individual duration is value weighted by the respective duration in Table 5.3.
Table 5.3: A Few Key Statistics for Treasury and Corporate Sector
Issuer Coupon Maturity YTM Modified DV01 Par Full S&P
% % Duration $ Amount Price Credit
(Year) (million) (000) Rate
Treasury 6.5 2/15/10 4.55 6.56 50,109.87 67 76,387
Treasury 5.625 5/15/08 4.64 5.48 54,121.57 92 98,762
Treasury 5 8/15/11 4.57 7.77 203,838.95 84 87,192
Treasury 6.56 172,095.69 262,341
Sector
Time Warner 8.18 8/15/07 5.47 4.72 44,231.12 82 93,710 BBB+
Enterprise
Texas 6.375 1/1/08 6.19 5.06 15,523.06 30 30,678 BBB
Utilities
Rockwell 6.15 1/15/08 6.04 5.13 26,735.52 52 52,837 A
International
Transamerica 9.375 3/1/08 6.34 4.93 8,600.38 15 17,445 AA-
215
Corporation
Coastal 6.5 6/1/08 6.76 5.25 15,830.32 30 30,153 BBB
Corporation
United 6.831 9/1/08 5.99 5.51 22,011.89 38 39,949 A-
Airlines
Source: Bloomberg Financial
In the Treasury sector all three bonds are premium bond as the respective coupon is
higher than the yield. In the corporate sector all bonds are premium bonds, except for the
bond issued by Coastal Corporation with face value of $30 million, and full price of
$30.153 million that is a typo error. The full price (market value has to be below $30
million face value as yield is higher than coupon of 6.5 percent). Duration of portfolio is
defined as follows in equation 5.4:
Dp= Wi*Di (5.4)
Where wi and Di are respectively the proportion and duration of the i-th bond in the
portfolio. For the Treasury sector duration of the portfolio Dp is as follows:
Dp = 76,387/262,341*6.56+98762/262,341*5.48+87192/262,341*7.77
= 6.56
Consider the three bonds in Exhibit 5.4 the forecasted percentage price changes based on
duration and actual percentage price changes for plus or minus 100 basis points change in
the yield.
Exhibit 5.4: Actual and Forecasted Percentage Price Changes Based on Duration
Maturity Coupon Yield Price Modified Duration Actual% price change for
+ 100 - 100 a
bps bps
The 20-year pure zero coupon bond has the highest price volatility as reflected in the
modified duration of 18.87 years. The actual percentage price change for this bond is
17.60 and +21.49 percent respectively for +/- 100 basis points change in the yield as seen
in Exhibit 5.4. The forecast based on duration is predicting that the price is expected to
change by +/-18.51 percent for every 1 percent change in the yield. The duration alone is
not sufficient to capture the percentage change in price of bond due to convexity of this
bond.1
Similarly, the 20-year bond in Exhibit 5.4 has more convexity than the other two bonds
as reflected in the actual price changes for +/-100 basis points change in the yield when
compared to the other two bonds. The convexity captures the curvature of the price yield
relationship as bond B in Exhibit 5.2 enjoys higher convexity (positive) as compared to
216
bond A. The price of the positively convex bond is expected to increase more for a
decrease in yield, while the price is expected to drop less in the event of an increase in the
yield than a bond with smaller or no convexity.
For example, for 3 and 25-year coupon paying bonds, the actual percentage price
changes and the forecast of the percentage price changes based on their respective
duration are approximately close as shown in Exhibit 5.4. For example, the price of a 25-
year coupon paying bond is expected to change by +/-10.62 percent as reflected in its
duration. However, the actual percentage price changes of this bond are respectively
-9.76 and +11.6 percent for +/-100 basis point change in the yield as seen in Exhibit 5.4.
For duration based active bond portfolio management see the following excerpt taken
from Bondweek:
Indiana Farm Bureau Insurance will look to swap out of financials into triple-B utilities
on the view that utilities are oversold as a result of Enron-related worries. The
Indianapolis-based insurer has an effective duration of approximately 5.58 years. It does
not follow a benchmark, but does not like to let duration fall below 5.5 years. It allocates
56.7 percent to corporates, 13.6 percent to utilities, 9.5 percent to CMOs, 8.6 percent to
collateralized debt obligations, 3.1 percent to Treasuries, 3 percent to taxable municipal
bonds, 2.8 percent to Fannie Mae Delegated Underwriting and Servicing pools, 1.5
percent to asset-backed securities, 7 percent to agency pools, and 0.3 percent to agencies.
Approximate Duration: When the yield changes are small the forecast price based on
duration is nearly the same as the actual price as is evidenced in Exhibit 5.4.
However, the forecast error increases as the changes in yield becomes substantial.
The changes in the yield in reality are relatively small in the market and approximate
duration (Da) in Equation 5.5 provides a reasonable estimate of the exposure to bond
or bond portfolio as follows:
Da = (P+- P -) / (2 Pi Y) (5.5)
Where P+ is the new price of bond when yield increases, P - is the new price of the bond
when yield decreases, and Pi is the initial price of the bond. The approximate duration
estimated using Equation 5.5 for bonds are shown in Exhibit 5.5.
217
25 6 9 703.57 10.62 10.68
With the exception of the long-term 20-year pure zero coupon bond, the approximate
duration provides a reasonable estimate of the volatility of bond. This procedure will be
employed throughout the remainder of the book. When the yield changes are relatively
high duration and convexity combined can be used to measure the exposure to the bond
or the bond portfolio. The percentage change in price due to duration and convexity is
defined in Equation 5.6.
Where C is the convexity of the bond and other parameters are as defined previously.
Convexity is defined as the second derivative of the bond with respect to change in yield
weighted by the market value of the bond P as (dP2/ dy2) (1/ P). The convexity can be
calculated as follows in equation 5.7:
n
[dP / dy ]*1/ P = [ (t) (t+1). C) / (1+y) ^t+2 + (n) (n+1)*F / (1+y) ^ n+2] / P
2 2
(5.7)
t =1
The convexity of the bond in table 5.1 is estimated as follows in table 5.4.
Table 5.4: Estimate of Convexity for a 15 year 6 percent bond rated to yield 6 percent
1/
t*(t+1) (1+y)^t+ t*(t+1)*C*1/ (n) (n+1)*F / (1+y) ^
t C *C 2 (1+y)^t+2 n+2
0.839619 15*16*1000/
1 60 120 283 100.754314 (1+0.06)^17
0.792093
2 60 360 663 285.1537188 89127.46046
0.747258
3 60 720 173 538.0258845
0.704960
4 60 1200 54 845.9526485
0.665057
5 60 1800 114 1197.102805
0.627412
6 60 2520 371 1581.079176
0.591898
7 60 3360 464 1988.778837
0.558394
8 60 4320 777 2412.265436
0.526787
9 60 5400 525 2844.652637
0.496969
10 60 6600 364 3279.9978
218
0.468839
11 60 7920 022 3713.205056
0.442300
12 60 9360 964 4139.937027
0.417265 126918.491
13 60 10920 061 4556.534463 Second derivative 1
0.393646
14 60 12600 284 4959.943175 Price 1000
0.371364 126.9
15 60 14400 419 5347.647628 Convexity 1
SUM 37791.03061
Assuming the coupon is paid semi-annually; the convexity in half a year has to be
converted into convexity in years as follows:
P/P = - Dp. Y + C. ( Y) 2
=- 9.63(+/- .01) + *126.91*(+/-.01)2
= +/- .0963+.0063=.1026 or -.09
The actual percentage change in price of bond in Exhibit 5.4 for +/- 100 basis points is
equal to +11.03 percent or -9.08 percent. Approximating percentage price change based
on duration alone produces +/- 9.93 percent. As is evidenced from the example, inclusion
of convexity improves forecasts. This improvement is far more significant for deep
discount bond as compared to coupon paying bonds.
The approximate convexity (Ca) is defined in Equation 5.8.
The approximate convexity for a 20-year zero-coupon bond assuming yield changes by
+/-100 basis points is as follows:
The percentage change in price due to duration and convexity in Equation 5.7 for the 20-
year zero-coupon bond will be equal to
219
The actual convexity of the above bond is equal to 386.47. 2 The percentage price changes
due to duration and convexity combined are respectively +.2045 and -.1657, which is a
substantial improvement over the estimates provided by duration alone in Exhibit 5.4.
Assuming the Treasury yields for various maturities are upward sloping (i.e., long-term
rates are higher than their short-term counterparts). The forward rates will be greater than
their spot counterpart. However, if the spot rate curve or the term structure of the spot
rates is inverted then the forward rate derived from the spot rates will be below their spot
counterpart. Exhibit 5.6 shows the behavior of the yield to maturity, spot rates and the
forward rates.
When the yield is upward sloping the spot rate is over and above the yield to maturity and
the forward rates is greater than the spot rates. However, in an inverted yield market the
reverse is true. That is, the forward rates will be below the spot rates and spot rates below
the yield to maturity.
Spot Rate: The spot rate or theoretical spot is the rate that equates the present value of
cash flows from a portfolio of zero coupon bonds to the market value of the coupon
paying debt instrument. For example, any coupon paying debt instrument can be defined
as a portfolio of zero coupon bonds with a maturity corresponding to the maturity of the
coupon that is discounted at a portfolio of spot rates. The yield to maturity and spot rate
are the same for any zero coupon bond of any maturity. In the treasury spot market, the
zero coupon bonds are the securities with a maturity of one year or less (i.e., 90 and 180
days). When the yields are up ward sloping, the yield to maturity, spot rate and forward
rate are as follows in Exhibit 5.6. The forward rate is higher than the spot rate and the
spot rate is higher than the yield to maturity. However, in an inverted market, the
behavior of the three yields is reversed in the order shown in Exhibit 5.7.
Exhibit 5.6: Behavior of the Various Yields over Time (Normal Market)
Yield to Maturity, Spot and Forward Rates
Forward Rate
Spot Rate (Zero Coupon)
Yield to Maturity
Time
220
Exhibit 5.7: Behavior of the Various Yields over Time (Inverted Market)
Yield
Yield to Maturity
Spot Rate (Zero Coupon)
Forward Rate
Time
Example: Consider one, two, and three-year bonds rated to yield 5, 5.5, and 6 percent,
respectively. The first bond is a pure discount issue, and the last two bonds are priced at
par (the coupon and yield are identical). All three bonds have $1,000 face values as
shown in Exhibit 5.8.
The unknown rate is the two-year spot rate that equates the present value of the cash flow
from the coupon-paying instrument to the portfolio of zeros. Solving for the unknown the
two-year spot rate is equal to 5.51 percent. The first coupon (one-year zero coupon bond)
was discounted at a one-year spot rate of 5 percent as opposed to 5.5 percent yield to
maturity. The second coupon and the principal in two years are discounted at the two-year
spot rate of 5.51 percent, preventing risk-less arbitrage from stripping coupons. The
above procedure is known as bootstrapping for estimation of the spot rates.
The three-year bond which can be defined as a portfolio of three zero coupon bonds of
one, two, and three years maturity whose present values discounted at respective spot
rates must be equal to the present value of the three-year coupon-paying bond as follows:
P = $1000 = 60 + 60 + 1060
(1+. 05) (1+. 0551) 2 (1+?) 3
221
The three-year spot rate can be found by solving for the unknown. The three-year spot
rate turned out to be equal to 6.04 percent. The relationship between an n-year spot rate
(R (0, n)) prevailing at time zero and forward rates ((1, n)), the rate prevailing between
time (1 and n) are demonstrated schematically in Exhibit 5.9.
0 R (0, 3) = .06 3
Forward Rate: The forward rate is the rate that is expected to prevail in the future
between any two adjacent periods. For example, from Exhibit 5.9 the forward rate
between periods 1 and 2 as well as the forward rate between periods 2 and 3 can be
inferred from the market data. The number of forward rates in the n periods will be equal
to n (n-1) /2. In Exhibit 5.9 there are three forward interest rates: (1,2), (2,3), and
(1,3), which are defined as forward rates between years 1 and 2, years 2 and 3, and years
1 and 3.
The above scenario exposes investors to reinvestment rate risk, which is assumed to be
equal to zero under the expectation hypothesis.
Option 3: Buy the three year bond and sell the bond at the end of two years. There is
interest rate risk associated with this option and the longer the maturity the greater is the
interest rate risk. The expectation theory is plagued with two fundamental flaws namely
interest rate risk and reinvestment rate risk are assumed to be zero, therefore, bonds of
varying maturities are a perfect substitute for one another.3
222
Assuming the forward interest rate is greater than 6 percent it pays-off to invest in a one-
year bond and rollover the proceeds into another one-year security. A riskless arbitrage
profit can be realized following this strategy. However, as demand for a one-year forward
bond increases, the price goes up and the yield drops.
Likewise, if the forward interest rate is less than 6 percent, it pays off to invest in a two-
year bond and as demand for two-year bonds increases, the demand will push its price
higher and its yield down until the pay-off from either option is identical and arbitrage
profit disappears.
The forward rate [ (2,3)] can also be estimated from the observed rates in two and
three year bonds. Let us define any long-term interest rates as the geometric average of
the short-term rates. For instance, define the two-year rate as the geometric average of
two one-year rates; one that is observed and the other is an unobservable one-year
forward rate. Similarly, let us define the n-year rate as the geometric average of n one-
year rates as shown in Equation 5.9.
(1+R (0, n)) n = (1+R (0, 1)) (1+ (1,2)) (1+ (2,3)) ++ (1+ (n-1, n)) (5.9)
For n equal to 3
(1+R (0, 3))3 = (1+R (0, 1)) (1+ (1,2)) (1+ (2,3))
Plugging the numbers from Exhibit 5.2 for three and one-year spots and one-year forward
rate ((1,2)), and solving for the (1+ (2,3)) produces:
The one-year forward rate prevailing between years two and three are equal to 7.01
percent. This result can be obtained using the observed yield for two and three-year bonds
as seen in Equation 5.10.
(1+ (2,3)) = [(1+R (0, 3)) 3]/ [(1+R (0, 2))2] (5.10)
(1+ (2,3)) = (1.06)3/ (1.055)2 = 1.0701, (2,3) = .0701
The forward rates are the market consensus and are assumed to be unbiased predictors of
the future spot rates.
Various theories have been advanced to explain the shape of the yield curve:4
Expectation theories and market segmentation theory
223
Expectations theories can take several forms: pure expectation theory, liquidity
premium theory, and preferred habitat theory. Various forms of expectation theories
assume the forward rates are the market consensus of the future interest rates and embody
no risk premium over time.5 For example, based on the pure expectation theory the long-
term rate is the geometric average of the portfolio of short-term rates that is expected to
prevail in the future. A falling term structure such as Exhibit 5.11 indicates that the
market expects forward interest rates to continue to fall in the near future, as witnessed in
the past due to falling inflationary expectations producing an inverted yield curve that
was observed in the last business day in August 1981. Likewise, a flat term structure
reflects future short term interest rates that will be expected to remain constant, and a
rising term structure hints that the short term interest rates (the forward rates) are
expected to go up, producing an upward sloping scenario for U.S. treasury securities as of
October 1982 (see Exhibit 5.10).
11.50
11.00
10.50
10.00
9.50
9.00
8.50
8.00
7.50
7.00
th
th
r
r
ea
ea
ea
ea
ea
ea
on
on
-Y
-Y
-Y
Y
Y
M
2-
1-
5-
10
20
30
3-
6-
The pure expectation theory has been criticized by assuming that the bonds of varying
maturities are a perfect substitute for one another. Clearly this is not the case and longer-
term bonds as compared to short-term bonds are more prone to higher price and
reinvestment rate risk.
224
Exhibit 5.11:
Exhibit 6.4 U.S. Treasury Securities (August
1981)
17.00
16.50
16.00
15.50
15.00
14.50
14.00
r
r
r
r
ea
ea
ea
ea
ea
ea
ea
ea
-Y
-Y
-Y
Y
Y
3-
5-
1-
2-
7-
10
20
30
Liquidity Preference Theory: Given the uncertainty about future interest rates and the
greater price and reinvestment rate risk associated with long term bonds, investors
are likely to demand higher risk premiums that are expected to increase uniformly as
the maturity of the bond increases.6 Based on this theory, long-term interest rates are
greater than the geometric average of short-term rates expected to prevail in the
future. An investors aversion to risk and uncertainty of long-term bond and
preference for greater liquidity of the short-term bills and notes increases demand for
short-term debt, pushing their yields down and price up.7 Similarly, the supply of
long-term debt tends to exceed the demand depressing the price and pushing the
yield higher producing an upward sloping yield curve. Investors will be enticed to
invest in the long end of the bond market if they are compensated by higher rates.
The forward interest rate is expected to be a biased predictor of the future short-term
interest rates as advocated by the liquidity preference theory.
Preferred Habitat Theory: This theory was advanced by Modigliani and Sutch (1966)
and assumes that the term structure embodies an expectation of future interest rates as
well as risk premium. However, risk premium is not expected to rise or fall uniformly as
maturity increases or decreases as advocated by the proponents of the liquidity preference
theory. Preferred investment or financing horizon is dictated by the nature of the assets
and liabilities of the financial institutions in making asset allocation decisions.
Institutions will only be enticed to shift from their preferred horizon only if sufficient
compensation in the form of higher yield is offered.
For example, life insurance companies have a long-term investment horizon since their
liabilities are long-term. Property casualty, however, invests in the intermediate segment
of the market and will only be induced to move into the long end of the market if a higher
225
risk premium offered mitigates aversion to interest rate and price risk associated with
long-term bonds.
226
prices of a MBS. Assume the coupon curve of prices for Ginnie Mae in June 2001 is
as follows: 6% at 92. 7% at 94. and 8% at 96.5. What is the estimated convexity of
the 7s?
a) 53
b) 26
c) 13
d) -53
227
c) Duration is usually higher for higher yields to maturity.
d) Duration is higher as the number of years to maturity for a bond selling at
par or above increases.
228
a) Decrease by $11,430
b) Decrease by $21,330
c) Decrease by $12,573
d) Decrease by $23,463
EndNotes
229
1
See Chicago Board of Trade Publications 1989.
2
Convexity is defined as second derivative of the bond with respect to change in yield weighted by the market value of
the bond as (dP2/ dR2) (1/ P). The convexity can be calculated as follows:
n
[dP2/ dR2]1/ P = [ (t) (t+1). C) / (1+R) t+2 + (n) (n+1)F / (1+R) n+2 ] / P
t =1
Where C is the coupon interest, F is the face value of the bond, R is the yield to maturity and n is the maturity of the
bond.
3
See Lutz (1940).
4
See Homer et al. (1971).
5
Fama (1976).
6
See Hicks (1946)
7
See Cox et al. (1981).
8
See Culbertson (1957).