Fabozzi Ch04 BMAS 7thed

Chapter 4
Bond Price Volatility
Copyright 2010
4-1
Learning Objectives
After reading this chapter, you will understand
the price-yield relationship of an option-free bond
the factors that affect the price volatility of a bond
when yields change
the price-volatility properties of an option-free bond
how to calculate the price value of a basis point
how to calculate and interpret the Macaulay duration,
modified duration, and dollar
duration of a bond
why duration is a measure of a bonds price sensitivity
to yield changes
Copyright 2010
4-2
Learning Objectives (continued)

After reading this chapter, you will understand
the spread duration measure for fixed-rate and floatingrate bonds
how to compute the duration of a portfolio and
contribution to portfolio duration
limitations of using duration as a measure of price
volatility
how price change estimated by duration can be adjusted
for a bonds convexity
how to approximate the duration and convexity of a bond
the duration of an inverse floater
how to measure a portfolios sensitivity to a nonparallel
shift in interest rates (key rate duration and yield curve
reshaping duration)
Copyright 2010
4-3
Review of the Price-Yield

Relationship for Option-Free Bonds
As illustrated in Exhibit 4-1 (See Overhead 4-5):
An increase in the required yield decreases the present
value of its expected cash flows and therefore decreases
the bonds price.
An decrease in the required yield increases the present
value of its expected cash flows and therefore increases
the bonds price.
As shown in Exhibit 4-2 (See Overhead 4-6):
The price-yield relation is not linear.
The shape of the price-yield relationship for any optionfree bond is referred to as a convex relationship.
Copyright 2010
4-4
Exhibit 4-1
PriceYield Relationship for Six Hypothetical Bonds
Required
Yield (%)
Price at Required Yield (coupon/maturity in years)
6.00
9% / 5
9% / 25
112.7953 138.5946
6% / 5
6% / 25
100.0000 100.0000
0% / 5
74.4094
0% / 25
22.8107
7.00
108.3166 123.4556
95.8417
88.2722
70.8919
17.9053
8.00
8.50
104.0554 110.7410
102.0027 105.1482
91.8891
89.9864
78.5178
74.2587
67.5564
65.9537
14.0713
12.4795
8.90
100.3966 100.9961
88.4983
71.1105
64.7017
11.3391
8.99
100.0395 100.0988
88.1676
70.4318
64.4236
11.0975
9.00
100.0000 100.0000
88.1309
70.3570
64.3928
11.0710
9.01
99.9604
99.9013
88.0943
70.2824
64.3620
11.0445
9.10
99.6053
99.0199
87.7654
69.6164
64.0855
10.8093
9.50
98.0459
95.2539
86.3214
66.7773
62.8723
9.8242
10.00
96.1391
90.8720
84.5565
63.4881
61.3913
8.7204
11.00
92.4624
83.0685
81.1559
57.6712
58.5431
6.8767
12.00
88.9599
76.3572
77.9197
52.7144
55.8395
5.4288
Copyright 2010
4-5
Exhibit 4-2
Shape of Price-Yield Relationship for an
Option-Free Bond
Price
Maximum
Price
Yield
Copyright 2010
4-6
Price Volatility Characteristics

of Option-Free Bonds
There are four properties concerning the price volatility of an
option-free bond:
(i) Although the prices of all option-free bonds move in the opposite
direction from the change in yield required, the percentage price
change is not the same for all bonds.
(ii)For very small changes in the yield required, the percentage price
change for a given bond is roughly the same, whether the yield
required increases or decreases.
(iii)For large changes in the required yield, the percentage price change is
not the same for an increase in the required yield as it is for a decrease
in the required yield.
(iv)For a given large change in basis points, the percentage price increase
is greater than the percentage price decrease.
An explanation for these four properties of bond price volatility

lies in the convex shape of the price-yield relationship.
Copyright 2010
4-7

of Option-Free Bonds (continued)
Characteristics of a Bond that Affect its Price
Volatility
There are two characteristics of an option-free bond that
determine its price volatility: coupon and term to maturity.
1) First, for a given term to maturity and initial yield, the price
volatility of a bond is greater, the lower the coupon rate.
This characteristic can be seen by comparing the 9%, 6%, and
zero-coupon bonds with the same maturity.
2) Second, for a given coupon rate and initial yield, the longer
the term to maturity, the greater the price volatility.
This can be seen in Exhibit 4-3 (See Overhead 4-9) by comparing
the five-year bonds with the 25-year bonds with the same
coupon.
Copyright 2010
4-8
EXHIBIT 4-3
Bonds
Instantaneous Percentage Price Change for Six Hypothetical
Six hypothetical bonds, priced initially to yield 9%:

9% coupon, 5 years to maturity, price = 100.0000
Yield (%)
Change to:
6.00
7.00
8.00
8.50
8.90
8.99
9.01
9.10
9.50
10.00
11.00
12.00
Change in
Basis Points
-300
-200
-100
-50
-10
-1
1
10
50
100
200
300

Percentage Price Change (coupon/maturity in years)

9% / 5 9% / 25
6% / 5
6% / 25
0% / 5 0% / 25
12.80
38.59
13.47
42.13
15.56
106.04
8.32
23.46
8.75
25.46
10.09
61.73
4.06
10.74
4.26
11.60
4.91
27.10
2.00
5.15
2.11
5.55
2.42
12.72
0.40
1.00
0.42
1.07
0.48
2.42
0.04
0.10
0.04
0.11
0.05
0.24
-0.04
-0.10
-0.04
-0.11
-0.05
-0.24
-0.39
-0.98
-0.41
-1.05
-0.48
-2.36
-1.95
-4.75
-2.05
-5.09
-2.36
-11.26
-3.86
-9.13
-4.06
-9.76
-4.66
-21.23
-7.54
-16.93
-7.91
-18.03
-9.08
-37.89
-11.04
-23.64
-11.59
-25.08
-13.28
-50.96
Copyright 2010
4-9

of Option-Free Bonds (continued)
Effects of Yield to Maturity
We cannot ignore the fact that credit considerations cause different bonds to
trade at different yields, even if they have the same coupon and maturity.
Holding other factors constant, the higher the yield to maturity at which a
bond trades, the lower the price volatility.
To see this, compare the 9% 25-year bond trading at various yield levels in
Exhibit 4-4 (See Overhead 4-11) .
The 1st column of Exhibit 4-4 shows the yield level the bond is trading at,
and the 2nd column gives the initial price.
The 3rd column of Exhibit 4-4 indicates the bonds price if yields change by
100 basis points.
The 4th and 5th columns of Exhibit 4-4 show the dollar price decline and the
percentage price decline.
The 4th and 5th columns of Exhibit 4-4 also show: higher the initial yield, the
lower the price volatility.
An implication of this is that for a given change in yields, price volatility is
greater (lower) when yield levels in the market are low (high).
Copyright 2010
4-10
EXHIBIT 4-4 Price Change for a 100-Basis-Point Change in Yield for a 9% 25Year Bond Trading at Different Yield Levels
Yield Level (%)
Initial Price
New Price a
Price Decline
Percent Decline
$123.46
$110.74
$12.72
10.30
110.74
100.00
10.74
9.70
100.00
90.87
9.13
9.13
10
90.87
83.07
7.80
8.58
11
83.07
76.36
6.71
8.08
12
76.36
70.55
5.81
7.61
13
70.55
65.50
5.05
7.16
14
65.50
61.08
4.42
6.75
110.74
100.00
10.74
9.70
As a result of a 100-basis-point increase in yield.
Copyright 2010
4-11
Measures of Bond Price Volatility

Money managers, arbitrageurs, and traders need
to have a way to measure a bonds price volatility
to implement hedging and trading strategies.
Three measures that are commonly employed:
1) price value of a basis point
2) yield value of a price change
3) duration
Copyright 2010
4-12

(continued)
Price Value of a Basis Point
The price value of a basis point, also referred to as the dollar value of an 01, is
the change in the price of the bond if the required yield changes by 1 basis
point.
Note that this measure of price volatility indicates dollar price volatility as
opposed to percentage price volatility (price change as a percent of the initial
price).
Typically, the price value of a basis point is expressed as the absolute value of
the change in price.
Price volatility is the same for an increase or a decrease of 1 basis point in
required yield.
Because this measure of price volatility is in terms of dollar price change,
dividing the price value of a basis point by the initial price gives the percentage
price change for a 1-basis-point change in yield.
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(continued)
Yield Value of a Price Change

Another measure of the price volatility of a bond used by
investors is the change in the yield for a specified price
change.
This is estimated by first calculating the bonds yield to
maturity if the bonds price is decreased by, say, X dollars.
Then the difference between the initial yield and the new
yield is the yield value of an X dollar price change.
Price volatility is the same for an increase or a decrease of 1
basis point in required yield.
The smaller this value, the greater the dollar price volatility,
because it would take a smaller change in yield to produce a
price change of X dollars.
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Duration
(continued)
The Macaulay duration is one measure of the approximate

change in price for a small change in yield:
1C
Macaulay duration
1 y
2C
1 y
+ . . .+
nC
1 y
nM
1 y
where P = price of the bond

C = semiannual coupon interest (in dollars)
y = one-half the yield to maturity or required yield
n = number of semiannual periods (number of years times 2)
M = maturity value (in dollars)

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Duration
(continued)
Investors refer to the ratio of Macaulay duration to 1 + y as the

modified duration. The equation is:
Macaulay duration
modified duration
1 y
where y = one-half the yield to maturity or required yield.
The modified duration is related to the approximate

percentage change in price for a given change in yield as given
by:
dP 1
dy P
modified duration
where dP = change in price, dy = change in yield, P = price of the bond.

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(continued)
Duration
Because for all option-free bonds modified duration is positive,
the modified duration equation, (dP/dy )(1/P), states that there is
an inverse relationship between modified duration and the
approximate percentage change in price for a given yield
change.
This is to be expected from the fundamental principle that bond
prices move in the opposite direction of the change in interest
rates.
Exhibit 4-5 (see Overhead 4-18) and Exhibit 4-6 (see Overhead
4-19) show the computation of the Macaulay duration and
modified duration of two five-year coupon bonds.
The durations computed in these exhibits are in terms of duration per
period.
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EXHIBIT 4-5 Calculation of Macaulay Duration and Modified

Duration for 5-Year 9% Bond Selling to Yield 9%
Coupon rate: 9.00%
Period, t
1
Term (years): 5
Cash Flow
$
4.50
Initial yield: 9.00%
PV of $1 at 4.5%
PV of CF
t PVCF
0.956937
4.306220
4.30622
4.50
0.915729
4.120785
8.24156
4.50
0.876296
3.943335
11.83000
4
5
6
7
8
9
10
4.50
4.50
4.50
4.50
4.50
4.50
$104.50
0.838561
0.802451
0.767895
0.734828
0.703185
0.672904
0.643927
3.773526
3.611030
3.455531
3.306728
3.164333
3.028070
67.290443
100.00000
15.09410
18.05514
20.73318
23.14709
25.31466
27.25262
672.90442
826.87899
Copyright 2010
4-18
EXHIBIT 4-6 Calculation of Macaulay Duration and Modified

Duration for 5-Year 6% Bond Selling to Yield 9%
Coupon rate: 6.00% Term (years): 5
Period, t
1
2
3
4
5
6
7
8
9
10
Total
Cash Flow
$
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
103.00
PV of $1 at 4.5%
0.956937
0.915729
0.876296
0.838561
0.802451
0.767895
0.734828
0.703185
0.672904
0.643927
Copyright 2010
PV of CF
2.870813
2.747190
2.628890
2.515684
2.407353
2.303687
2.204485
2.109555
2.018713
66.324551
88.130923
t PVCF
2.87081
5.49437
7.88666
10.06273
12.03676
13.82212
15.43139
16.87644
18.16841
663.24551
765.89520
4-19

(continued)
Duration
In general, if the cash flows occur m times per year, the durations are
adjusted by dividing by m, that is,
duration in years
duration in m periods per year

m
We can derive an alternative formula that does not have the extensive
calculation of the Macaulay duration and the modified duration.
This is done by rewriting the price of a bond in terms of its present value of
an annuity and the present value of the par value, taking the first derivative,
and dividing by P:
modified duration
C
y2
1 1 y n
n 100 C / y
1 y
n1
where the price is expressed as a percentage of par value.

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(continued)
Properties of Duration
The modified duration and Macaulay duration of a coupon bond
are less than the maturity.
The Macaulay duration of a zero-coupon bond equals its maturity;
but a zero-coupon bonds modified duration is less than its
maturity.
Lower coupon rates generally have greater Macaulay and
modified bond durations.
There is a consistency between the properties of bond price
volatility and the properties of modified duration.
For example, a property of modified duration is that, ceteris paribus,
a bond with a longer maturity will have a greater modified duration.
Generally, a lower coupon rate implies a greater modified duration
and a greater price volatility.
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(continued)
Approximating the Percentage Price Change

The below equation can be used to approximate the percentage
price change for a given change in required yield:
dP
(modified duration) dy
P
where dP = change in price, P = price of the bond and dy = change in yield.
Suppose that the yield on any bond changes by 100 basis points.
Then, substituting 100 basis points (0.01) for dy into the above
equation, we get:
dP
(modified duration) 0.01 (modified duration ) 1%
P
Thus, modified duration can be interpreted as the approximate
percentage change in price for a 100-basis-point change in yield.
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(continued)
Approximating the Dollar Price Change

Modified duration is a proxy for the percentage change in price.
Investors also like to know the dollar price volatility of a bond.
For small changes in the required yield, the below equation does a
good job in estimating the change in price yield:
dP = (dollar duration)(dy)
where dP = change in price and dy = change in yield.
When there are large movements in the required yield, dollar
duration or modified duration is not adequate to approximate the
price reaction.
Duration will overestimate the price change when the required yield
rises, thereby underestimating the new price.
When the required yield falls, duration will underestimate the price
change and thereby underestimate the new price.
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(continued)
Spread Duration
Market participants compute a measure called spread duration.
This measure is used in two ways: for fixed bonds and floating-rate bonds.
A spread duration for a fixed-rate security is interpreted as the approximate
change in the price of a fixed-rate bond for a 100-basis-point change in the spread
bond.
Portfolio Duration
Thus far we have looked at the duration of an individual bond.
The duration of a portfolio is simply the weighted average duration of the
bonds in the portfolios.
Portfolio managers look at their interest rate exposure to a particular issue
in terms of its contribution to portfolio duration.
This measure is found by multiplying the weight of the issue in the portfolio by
the duration of the individual issue given as:
contribution to portfolio duration = weight of issue in portfolio duration of issue.
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(continued)
Portfolio Duration
Portfolio managers look at portfolio duration for sectors of the
bond market.
The procedure is the same for computing the contribution to
portfolio duration of a sector as it is for computing the
contribution to portfolio duration of an individual issue.
A spread duration for a portfolio of fixed-rate bonds can also be
computed.
In this case, the portfolio duration is divided into two durations.
The first is the duration of the portfolio with respect to changes in
the level of Treasury rates.
The second is the spread duration.
The above is illustrated in Exhibit 4-7 (see Overhead 4-26) for a
portfolio using six sectors.
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EXHIBIT 4-7 Calculation of Duration and Contribution to Portfolio
Duration for a Asset Allocation to Sectors of the Lehman

Brothers U.S. Aggregate Index: October 26, 2007
Portfolio Sector
Weight Duration
Sector
Contribution to
Portfolio
Duration
Treasury
0.000
4.95
0.00
Agency
0.121
3.44
0.42
Mortgages
0.449
3.58
1.61
Commercial Mortgage-Backed Securities
0.139
5.04
0.70
Asset-Backed Securities
0.017
3.16
0.05
Credit
0.274
6.35
1.74
1.000
Total
2.000
Copyright 2010
4.52
26.52
9.04
4-26

(continued)
Portfolio Duration
Exhibit 4-8 (see Overhead 4-28) shows the size of each sector in the
Lehman Brothers U.S. Aggregate Index.
You can see the importance of each sector.
The duration for each sector is shown in the third column and uses the
same values as in Exhibit 4-7.
The duration for the portfolio is shown in the last row of the third
column.
The calculation of the spread duration for the recommended
portfolio allocation and the Lehman Brothers U.S. Aggregate Index
are shown in Exhibit 4-9 (see Overhead 4-29) and Exhibit 4-10 (see
Overhead
4-30), respectively.
While the portfolio and the index have the same duration, the spread
duration for the recommended portfolio is 4.60 vs. 3.49 for the index.
The larger spread duration for the recommended portfolio is expected
given the greater allocation
to non-Treasury
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2010 Pearson sectors.
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EXHIBIT 4-8 Calculation of Duration and Contribution to the Lehman

Brothers Aggregate Index Duration: October 26, 2007
Weight
Sector
in Index Duration
Sector
Contribution to
Index Duration
Treasury
0.230
4.95
1.14
Agency
0.105
3.44
0.36
Mortgages
0.381
3.58
1.36
0.056
5.04
0.28
0.010
3.16
0.03
Credit
0.219
6.35
1.39
1.000
Total
2.001
Copyright 2010
4.56
26.52
9.12
4-28
EXHIBIT 4-9 Calculation of Spread Duration and Contribution to
Portfolio Spread Duration for an Asset Allocation to

Sectors of the Lehman Brothers U.S. Aggregate Index:
October 26, 2007
Portfolio
Weight
Sector
Sector
Contribution to
Spread Portfolio Spread
Duration
Duration
Treasury
0.000
0.00
0.00
Agency
0.121
3.53
0.43
Mortgages
0.449
3.62
1.63
0.139
5.04
0.70
0.017
3.16
0.05
Credit
0.274
6.35
1.79
1.000
Total
2.000
Copyright 2010
4.60
21.88
9.20
4-29
EXHIBIT 4-10
Calculation of Spread Duration and Contribution

to the Lehman Brothers Aggregate Index Spread
Duration: October 26, 2007
Weight
in Index
Sector
Spread
Duration
Contribution to
Index Spread
Duration
Treasury
0.230
0.00
0.00
Agency
0.105
3.53
0.37
Mortgages
0.381
3.62
1.38
0.056
5.04
0.28
0.010
3.16
0.03
Credit
0.219
6.53
1.43
Sector
1.000
Total
2.001
Copyright 2010
3.49
21.88
6.98
4-30
Exhibit 4-11
Measures of Bond Price Volatility and
Their Relationships to One Another
Notation:
D = Macaulay duration
D* = modified duration
PVBP = price value of a basis point
y = yield to maturity in decimal form
Y = yield to maturity in percentage terms ( Y = 100 y)
P = price of bond
m= number of coupons per year
Copyright 2010
4-31
Exhibit 4-11
Measures of Bond Price Volatility and Their
Relationships to One Another (continued)
Relationships:
D
D*
by definition
1 y m
P P
D to a close approximation for a small y
y
P Y slope of price-yield curve to a close approximation for a small y
D* P
PVBP
to a close approximation
10, 000
For B onds at or near par :
PVBP D * 100 to a close approximation

D* P Y to a close approximation for a small y
Copyright 2010
4-32
Convexity
Because all the duration measures are only approximations
for small changes in yield, they do not capture the effect of
the convexity of a bond on its price performance when
yields change by more than a small amount.
The duration measure can be supplemented with an
additional measure to capture the curvature or convexity of a
bond.
In Exhibit 4-12 (see Overhead 4-34), a tangent line is drawn
to the priceyield relationship at yield y*.
The tangent shows the rate of change of price with respect to a
change in interest rates at that point (yield level).
Copyright 2010
4-33
Exhibit 4-12
Line Tangent to the Price-Yield
Relationship
Price
Actual Price
Tangent Line at y*
(estimated price)
p*
Yield
y*
Copyright 2010
4-34
Convexity (continued)
If we draw a vertical line from any yield (on the horizontal axis), as in
Exhibit 4-13 (see Overhead 4-36), the distance between the horizontal
axis and the tangent line represents the price approximated by using
duration starting with the initial yield y*.
The approximation will always understate the actual price.
This agrees with what we demonstrated earlier about the relationship
between duration (and the tangent line) and the approximate price
change.
When yields decrease, the estimated price change will be less than the
actual price change, thereby underestimating the actual price.
On the other hand, when yields increase, the estimated price change
will be greater than the actual price change, resulting in an
underestimate of the actual price.
Copyright 2010
4-35
Exhibit 4-13. Price Approximation Using Duration

Actual Price
Price
Error in Estimating Price

Based only on Duration
Error in Estimating Price
Based only on Duration
p*
Tangent Line at y*
(estimated price)
y1
y2
y* y3
y4
Copyright 2010
Yield
4-36
Measuring Convexity
Duration (modified or dollar) attempts to estimate a convex

relationship with a straight line (the tangent line).
The dollar convexity measure of the bond:
The approximate change in price due to convexity is:
dP
d P
dollar convexity measure
2
dy
dollar
convexity measure dy
The percentage change in the price of the bond due to convexity or the
2
convexity measure is:
d P 1
convexity measure
2
dy P
The percentage price change due to convexity is:
dP 1
2
convexity measure dy
P 2

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Measuring Convexity
Exhibit 4-14 (see Overhead 4-39) and Exhibit 4-15 (see Overhead 440) demonstrate how to calculate the second derivative , annualized
dollar convexity measure, and annualized convexity measure for the
two five-year coupon bonds.
The convexity measure is in terms of periods squared.
In general, if the cash flows occur m times per year, convexity is
adjusted to an annual figure as follows:
convexity measure in year

convexity measure in m period per year
m2

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EXHIBIT 4-14
Calculation of Convexity Measure and Dollar Convexity

Measure for Five-Year 9% Bond Selling to Yield 9%
Period, t
Cash Flow
1/(1.045)t+2
1
2
3
4
5
6
7
8
9
10
4.50
4.50
4.50
4.50
4.50
4.50
4.50
4.50
4.50
104.50
0.876296
0.838561
0.802451
0.767895
0.734828
0.703185
0.672904
0.643927
0.616198
0.589663
Copyright 2010
t(t + 1)CF
9
27
54
90
135
189
252
324
405
11,495
12,980
Price: 100
t(t + 1)CF
(1.045) t+2
7.886
22.641
43.332
69.110
99.201
132.901
169.571
208.632
249.560
6,778.186
7,781.020
4-39
EXHIBIT 4-15
Calculation of Convexity Measure and Dollar Convexity

Measure for Five-Year 6% Bond Selling to Yield 9%
Period, t
Cash Flow
1/(1.045)t+2
1
2
3
4
5
6
7
8
9
10
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
103.00
0.876296
0.838561
0.802451
0.767895
0.734828
0.703185
0.672904
0.643927
0.616198
0.589663
Copyright 2010
t(t + 1)CF
6
18
36
60
90
126
168
216
270
11,330
12,320
Price: 88.1309
t(t + 1)CF
(1.045) t+2
5.257
15.094
28.888
46.073
66.134
88.601
113.047
139.088
166.373
6,680.891
7,349.446
4-40
Approximating Percentage Price Change Using Duration and
Convexity Measures
Using duration and convexity measures together gives a better
approximation of the actual price change for a large movement in the
required yield.
Some Notes on Convexity
Three points to know for a bonds convexity and convexity measure.
i. Convexity refers to the general shape of the price-yield relationship, while
the convexity measure relates to the quantification of how the price of the
bond will change when interest rates change.
ii. The approximation percentage change in price due to convexity is the
product of three numbers: , convexity measure, and square of the
change in yield.
iii.In practice different vendors compute the convexity measure differently
by scaling the measure in dissimilar ways.
Copyright 2010
4-41
Value of Convexity
Up to this point, we have focused on how taking convexity
into account can improve the approximation of a bonds price
change for a given yield change.
The convexity of a bond, however, has another important
investment implication, which is illustrated in Exhibit 4-16
(see Overhead 4-43).
The exhibit shows two bonds, A and B. The two bonds have
the same duration and are offering the same yield; they have
different convexities, however, Bond B is more convex
(bowed) than bond A.
Copyright 2010
4-42
Exhibit 4-16
Comparison of Convexity of Two Bonds
Price
Bond B Has Greater

Convexity Than Bond A
Bond A
Bond B
Bond B
Bond A
Yield
Copyright 2010
4-43
Value of Convexity
The market considers a bonds convexity when pricing it.
If investors expect that market yields will change by very little,
investors should not be willing to pay much for convexity.
If the market prices convexity high, investors with expectations of
low interest rate volatility will probably want to sell convexity.
Properties of Convexity
All option-free bonds have the following convexity properties.
i. As portrayed in Exhibit 4-17 (see Overhead 4-45), the required yield
increases (decreases), the convexity of a bond decreases (increases). This
property is referred to as positive convexity.
ii. For a given yield and maturity, lower coupon rates will have greater
convexity.
iii. For a given yield and modified duration, lower coupon rates will have
smaller convexity.
Copyright 2010
4-44
Exhibit 4-17
Change in Duration as the
Required Yield Changes
Price
As yield
Slope (duration)
As yield
Slope (duration)
2
3
Yield
Copyright 2010
4-45
Additional Concerns when

Using Duration
Relying on duration as the sole measure of the price
volatility of a bond may mislead investors.
There are two other concerns about using duration that
we should point out.
i. First, in the derivation of the relationship between modified
duration and bond price volatility, we assume that all cash
flows for the bond are discounted at the same discount rate.
ii. Second, there is misapplication of duration to bonds with
embedded options.
Copyright 2010
4-46
Dont Think of Duration as a

Measure of Time
Market participants often confuse the main purpose of duration by
constantly referring to it as some measure of the weighted average
life of a bond.
Certain CMO bond classes are leveraged instruments whose price
sensitivity or duration, as a result, are a multiple of the underlying
mortgage loans from which they were created.
Thus, a CMO bond class with a duration of 40 does not mean that it has
some type of weighted average life of 40 years.
Instead, it means that for a 100-basis-point change in yield, that bonds
price will change by roughly 40%.
Like a CMO bond class, we interpret the duration of an option in the
same way.
Copyright 2010
4-47
Approximating a Bonds Duration

and Convexity Measure
A simple formula can be used to calculate the approximate duration
of a bond or any other more complex derivative securities or options.
The formula shows the percentage price change of a bond when
interest rates change by a small amount:
P _ P
approximate duration
2 P0 y
where y is the change in yield used to calculate the new prices.
The above formula measures the average percentage price change (relative
to the initial price) per 1-basis-point change in yield.
The convexity measure of any bond can be approximated using the

following formula:
P P 2 P0
approximate convexity measure
2
P0 y
Copyright 2010
4-48
Approximating a Bonds Duration

and Convexity Measure
Duration of an Inverse Floater
The duration of an inverse floater is a multiple of the duration of the
collateral from which it is created.
Assuming that the duration of the floater is close to zero, it can be
shown that the duration of an inverse floater is as follows:
duration of an inverse floater

collateral prices
1
L
duration
of
collateral
inverse prices
where L is the ratio of the par value of the floater to the par value
of the inverse floater.
Copyright 2010
4-49
Measuring a Bond Portfolios

Responsiveness to Nonparallel Changes in
Interest Rates
Yield Curve Reshaping Duration
The yield curve reshaping duration approach focuses on the
sensitivity of a portfolio to a change in the slope of the yield
curve.
Key Rate Duration

The most popular measure for estimating the sensitivity of a
security or a portfolio to changes in the yield curve is key rate
duration.
The basic principle of key rate duration is to change the yield for a
particular maturity of the yield curve and determine the sensitivity
of a security or portfolio to that change holding all other yields
constant.
Copyright 2010
4-50
All rights reserved. No part of this publication may be reproduced,

stored in a retrieval system, or transmitted, in any form or by any means,
electronic, mechanical, photocopying, recording, or otherwise, without
the prior written permission of the publisher. Printed in the United
States of America.
Copyright 2010
4-51

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Chapter 4

Bond Price Volatility

Learning Objectives (continued)

Review of the Price-Yield

PriceYield Relationship for Six Hypothetical Bonds

Price at Required Yield (coupon/maturity in years)

Price Volatility Characteristics

An explanation for these four properties of bond price volatility

Price Volatility Characteristics

Instantaneous Percentage Price Change for Six Hypothetical

Six hypothetical bonds, priced initially to yield 9%:

6% coupon, 25 years to maturity, price = 70.3570

Percentage Price Change (coupon/maturity in years)

Price Volatility Characteristics

Yield Level (%)

As a result of a 100-basis-point increase in yield.

Measures of Bond Price Volatility

Measures of Bond Price Volatility

Measures of Bond Price Volatility

Yield Value of a Price Change

Measures of Bond Price Volatility

The Macaulay duration is one measure of the approximate

where P = price of the bond

Copyright 2010 Pearson

Measures of Bond Price Volatility

Investors refer to the ratio of Macaulay duration to 1 + y as the

The modified duration is related to the approximate

where dP = change in price, dy = change in yield, P = price of the bond.

Measures of Bond Price Volatility

EXHIBIT 4-5 Calculation of Macaulay Duration and Modified

Initial yield: 9.00%

EXHIBIT 4-6 Calculation of Macaulay Duration and Modified

Initial yield: 9.00%

Measures of Bond Price Volatility

duration in m periods per year

where the price is expressed as a percentage of par value.

Measures of Bond Price Volatility

Measures of Bond Price Volatility

Approximating the Percentage Price Change

Measures of Bond Price Volatility

Approximating the Dollar Price Change

Measures of Bond Price Volatility

Measures of Bond Price Volatility

EXHIBIT 4-7 Calculation of Duration and Contribution to Portfolio

Duration for a Asset Allocation to Sectors of the Lehman

Commercial Mortgage-Backed Securities

Measures of Bond Price Volatility

EXHIBIT 4-8 Calculation of Duration and Contribution to the Lehman

Commercial Mortgage-Backed Securities

EXHIBIT 4-9 Calculation of Spread Duration and Contribution to

Portfolio Spread Duration for an Asset Allocation to

Commercial Mortgage-Backed Securities

Calculation of Spread Duration and Contribution

Commercial Mortgage-Backed Securities

PVBP D * 100 to a close approximation

Exhibit 4-13. Price Approximation Using Duration

Error in Estimating Price

Duration (modified or dollar) attempts to estimate a convex

The dollar convexity measure of the bond:

The approximate change in price due to convexity is:

The percentage price change due to convexity is:

Copyright 2010 Pearson

convexity measure in year