Chapter 4

Bond Price Volatility

Introduction

Bond volatility is a result of interest rate

volatility:

When interest rates go up bond prices go down and

vice versa.

Goals of the chapter:

To understand a bonds price volatility

characteristics.
Quantify price volatility.

Price-Yield Relationship - Maturity

Consider two 9% coupon semiannual pay bonds:

Bond A: 5 years to maturity.

Bond B: 25 years to maturity.

Yield

5 Years

25 Years

1,127.95

1,385.95

1,083.17

1,234.56

1,040.55

1,107.41

1,000.00

1,000.00

10

961.39

908.72

11

924.62

830.68

12

889.60

763.57

The long-term bond price is more

sensitive to interest rate changes than
the short-term bond price.

Price-Yield Relationship - Coupon Rate

Consider three 25 year semiannual pay bonds:

9%, 6%, and 0% coupon bonds

Notice what happens as yields increase from 6% to 12%:

Yield

9%

6%

0%

9%

6%

0%

6%

1,127.95

1,000.00

228.11

0%

0%

0%

7%

1,083.17

882.72

179.05

-4% -12% -22%

8%

1,040.55

785.18

140.71

-8% -21% -38%

9%

1,000.00

703.57

110.71

-11% -30% -51%

10%

961.39

634.88

87.20

-15% -37% -62%

11%

924.62

576.71

68.77

-18% -42% -70%

12%

889.60

527.14

54.29

-21% -47% -76%

Bond Characteristics That Influence

Price Volatility

Maturity:

For a given coupon rate and yield, bonds with longer maturity
exhibit greater price volatility when interest rates change.

Coupon Rate:

For a given maturity and yield, bonds with lower coupon rates
exhibit greater price volatility when interest rates change.

Shape of the Price-Yield Curve

If we were to graph price-yield changes for bonds
we would get something like this:

Price

What do you notice about

this graph?

Yiel
d

It isnt linearit is convex.

It looks like there is more
upside than downside
for a given change in yield.

Price Volatility Properties of Bonds

Properties of option-free bonds:

All bond prices move opposite direction of yields, but the

percentage price change is different for each bond,
depending on maturity and coupon
For very small changes in yield, the percentage price
change for a given bond is roughly the same whether
yields increase or decrease.
For large changes in yield, the percentage price increase
is greater than a price decrease, for a given yield change.

Measures of Bond Price Volatility

Three measures are commonly used in practice:

1. Price value of a basis point
(also called dollar value of an 01)
2. Yield value of a price change
3. Duration

Price Value of a Basis Point

The change in the price of a bond if the required yield

changes by 1bp.
Recall that small changes in yield produce a similar
price change regardless of whether yields increase or
decrease.

Therefore, the Price Value of a Basis Point is the same for yield
increases and decreases.

Yield Value of a Price Change

Procedure:

Calculate YTM.
Reduce the bond price by X dollars.
Calculate the new YTM.
The difference between the YTMnew and YTMold is the
yield value of an X dollar price change.

Duration
The concept of duration is based on the slope of the
price-yield relationship:
What does slope of a
curve tell us?

Price

Yiel
d

How much the y-axis changes

for a small change in the x-axis.
Slope = dP/dy
Durationtells us how much
bond price changes for a given
change in yield.
Note: there are different types
of duration.

Two Types of Duration

Modified duration:

Dollar duration:

Tells us how much a bonds price changes (in percent)

for a given change in yield.
Tells us how much a bonds price changes (in dollars) for
a given change in yield.

We will start with modified duration.

Duration, cont

Therefore we get:
Modified Duration

Macaulay Duration
1 y

Modified duration gives us a bonds approximate percentage

price change for a small (100bp) change in yield.

Duration is measured on a per period basis. For semiannual cash flows, we adjust the duration to an annual
figure by dividing by 2:
Duration over a single period
Duration in years

Duration

duration is less than (coupon bond) or equal to (zero

coupon bond) the term to maturity
all else equal,

the lower the coupon, the larger the duration

the longer the maturity, the larger the duration
the lower the yield, the larger the duration

the longer the duration, the greater the price volatility

Convexity

Duration is a good approximation of the price

yield-relationship for small changes in y.

For large changes in y duration is a poor

approximation.

Why? Because the tangent line to the curve cant capture

the appropriate price change when y is large.

The Value of Convexity

Suppose we have two bonds with the same duration and the same
required yield:

Price

Notice bond B is more curved (i.e., convex) than bond A.

If yields rise, bond B will fall less than bond A.
If yields fall, bond B will rise more than bond A.
That is, if yields change from y0, bond B will always be
worth more than bond A!
Convexity has value!
Investors will pay for convexity (accept a lower yield) if
large interest rate changes are expected.
Bond B
Bond A

y0

Yiel
d

Properties of Convexity

All option-free bonds have the following

properties with regard to convexity.
Property 1:

As bond yield increases, bond convexity decreases (and

vice versa). This is called positive convexity.

Property 2:

For a given yield and maturity, the lower the coupon the
greater a bonds convexity.