2.0 - Part IV Fixed Income Securities

Bond Prices and Yields
Chapter 12
Part IV: Fixed Income Securities

Investment Management
Bond Characteristics
 Face or par value
 Coupon rate
 Coupon rate= annual coupon payment ($)/Face Value
 Zero coupon bond
 Indenture
A contract between the issuer and the bond holder
 Specifies: coupons rate, par value, maturity, and bond
provisions.

-2-
Provisions of Bonds
 Secured or unsecured
 Call provision
 Convertible provision
 Retractable and extendible bonds
 Known as putable bonds in the US
 Floating vs. fixed rate bond
 Sinking funds

-3-
Principal and Interest Payments for a 4% Real Return
Bond

-4-
Bond Pricing
T
Ct ParValue
PB = ∑ +
t =1 (1 + r ) t
(1 + r ) T
PB = price of the bond

Ct = interest or coupon payments
T = number of periods to maturity
r = the appropriate semi-annual discount rate

-5-
Bond Quotation (Nov. 17, 2011)
Rating
Issuer Name Symbol Coupon Maturity Moody's/S&P/ High Low Last Change Yield %
Fitch
MORGAN STANLEY MS.MHU 5.500% Jul 2021 A2/A/-- 93.946 89.884 90.394 -1.752 6.873
US CENTRAL CREDIT UNION USFD.GB 1.900% Oct 2012 Aaa/AA+/-- 101.563 101.484 101.484 -0.079 0.268
JPMORGAN CHASE & CO JPM.SEM 4.350% Aug 2021 Aa3/A+/-- 101.518 98.758 98.891 -0.545 4.491
AMERICAN EXPRESS CREDIT
AXP.NX 2.800% Sep 2016 A2/BBB+/A+ 102.646 100.043 100.088 -1.234 2.780
CORP
JPMORGAN CHASE & CO JPM.SCH 3.150% Jul 2016 Aa3/A+/AA- 100.900 99.203 99.300 -0.033 3.314
CITIGROUP FUNDING C.HTB 1.875% Oct 2012 Aaa/AA+/AAA 101.620 101.517 101.620 0.450 0.112
CITIGROUP C.ALY 4.500% Jan 2022 --/A/-- 99.814 96.364 99.550 2.520 4.554
GENERAL ELECTRIC CAPITAL
GE.HDS 5.250% Oct 2012 Aa2/AA+/-- 104.115 103.291 103.386 -0.289 1.493
CORP
BHP BILLITON FINANCE (USA) BHP.GH 4.800% Apr 2013 A1/A+/A+ 106.063 105.793 105.846 -0.026 0.600
ALLY FINANCIAL GMAC.IRI 2.200% Dec 2012 Aaa/AA+/AAA 102.280 101.346 101.591 -0.552 0.715
Fannie Mae Issues Federal Provincial Corporate
Maturity
Coupon Bid $ Yield %
Date
Rate Maturity Bid Asked Yield
Bell Canada 4.850 06/30/2014 106.56 2.25
6.13 3-12 101:31 102:00 ... Bell Canada 3.600 12/02/2015 103.71 2.62
4.88 5-12 102:13 102:14 0.04 Bell Canada 4.400 03/16/2018 106.45 3.26
Bell Canada 5.000 02/15/2017 109.66 2.99

5.25 8-12 103:14 103:15 0.29
Bell Canada 6.100 03/16/2035 108.02 5.49
4.38 9-12 103:14 103:15 0.16 Bank of Montreal 4.650 03/14/2013 104.08 1.52
4.38 3-13 105:14 105:15 0.26 Bank of Montreal 4.870 04/22/2015 107.88 2.45

-6-
Problem 12.1
A bond with semi-annual coupon payment:

• Annual coupon: 80
• Par value: 1000
• Years to maturity: 30 years
• Yield to maturity (annual rate): 10%
What is the price of the bond?

-7-
Bond Prices and Interest Rates
 Prices and market interest rates have an inverse relationship
 When interest rates get very high the value of the bond will be very low
 When rates approach zero, the value of the bond approaches the sum
of the cash flows

-8-
Bond Prices at Different Interest Rates (8% Coupon Bond,
Coupons Paid Semiannually)

-9-
Bond Valuation Between Coupon Payments
 When a bond is sold between coupon payments, part of the next coupon
payment (CP) belongs to the sellers. This is called accrued interest.
Entire Coupon Period
Most Recent CP Next CP

Settlement date
Interest earned Interest to be

by Seller earned by buyer
 In order to value a bond between coupon payment dates, we need to

incorporate the fractional coupon period into our bond value model.

-10-
Bond Valuation Between Coupon Payment
• The fractional period is
# days between settlement and next coupon
W=
# days in the coupon period
• And the valuation equation becomes

T
Ct Par
PB = ∑ +
(1+ y) (1+ y)
t −1+W T −1+W
t =1
• The above price is called invoice price (or dirty price, full price) which is the
actual price paid when buying the bond.
• Bond prices are quoted without the accrued interest. This is often referred to as
the clean price (or just price). To determine the clean price, we must compute
the accrued interest and subtract this from the dirty price. Conversely, if we know
clean price, we need to add accrued interest to determine the actual price we
need to pay.

-11-
Problem 12.2
 Consider A 3-year bond, with $1,000 par value, 6%
semiannual coupon bond, YTM=12%. Suppose that the
maturity of this bond is January 15, 2004, and you are valuing
the bond for settlement on April 20, 2001. The next coupon is
due July 15, 2001, and you will assume a 30E/360 day count
convention.
What is the dirty price, accrued interest and clean price of the
bond on the settlement date?

-12-
Yield to Maturity
 YTM: interest rate that makes the present value of the bond’s
payments equal to its price.
 It is the promised rate of return based on the current market
price if
 Bond is held to maturity
 Coupons are reinvested at the same rate
Solve the bond price formula for y
PB = ∑ Ct t + ParValue
T
T
t =1 (1+ y ) (1+ y)
T

-13-
Problem 12.3 Yield to Maturity
Consider a 10-year bond, with an 7% annual coupon
rate, making payments semiannually. The bond’s par
value is $1,000, and its quoted market price is $950.
Find the bond’s yield to maturity.
What is the yield to maturity (semi-annual rate)?

-14-
Yield Measures
 Bond Equivalent Yield (quoted yield): 3.86% x 2 = 7.72%
 Effective Annual Yield: (1+0.0386)2 − 1 = 7.88%
 Current Yield (=Annual Interest/Market Price): $70/$950 = 7.37%
 Yield to Call: Yield calculated using call price and # of periods to call
 For premium bonds

Coupon rate > Current yield > YTM
 For discount bonds, relationships are reversed
Coupon rate < Current yield < YTM

-15-
Callable Bonds
 The company (issuer) has an option to buy back (call) the
entire bond issue at the call price.
 The issuer has an incentive to call when the bond price
exceeds the call price.
 An equivalent argument: when interest rates fall, the issuer
can refinance its debt at a lower rate.
 The price of a callable bond is capped – a rational bondholder
will never agree to pay for the bond a price higher than the call
price

-16-
The Inverse Relationship between Bond Prices and Yields
for a Callable Bond

-17-
Yield to Call
• There is always a chance that the bond will be called before
maturity
• Yield to call may be more relevant to bondholders than yield
to maturity (especially if market price is close to the call
price)
• Solve the following formula for yC
TC
Ct Call Price
P=∑ +
t =1 (1 + y c ) (1 + y c )Tc
t
where yc = Yield To Call and Tc = expected time of call

-18-
Problem 12.4: Yield to Call
• Consider a 10-year callable Period
Call price
bond, with an 8% coupon rate, (years)
making payments
semiannually. The bond’s par 6-7 1,100
value is $1,000, and its
current quoted market price is 7-8 1, 050
$1,150
• The bond indenture indicates 8-10 1, 000
the call schedule. Find the
bond’s yield to first call

-19-
Problem 12.5
 Two bonds have identical times to maturity and
coupon rates. One is callable at 105, the other at 110.
Which should have the higher yield to maturity?

-20-
Realized Yield versus YTM
 Reinvestment Assumptions Growth of Invested Funds
 Holding Period Return
 Changes in rates affects
returns
 Reinvestment of coupon
payments
 Change in price of the bond

-21-
Problem 12.6
 Bonds of Zello Corporation with a par value of $1,000 sell for
$960, mature in five years, and have a 7 percent annual
coupon rate paid semiannually.
a) Calculate
I. Current yield
II. Yield to maturity
III. Realized compound yield for an investors with a three-
year holding period and a re-investment rate of 6 percent
over the period; at the end of three years the 7 percent
coupon bonds with two years remaining will sell to yield 7
percent
b) Discuss one major shortcoming for each of the three yield
measures.
-22-
Price Paths of Coupon Bonds
Price
Premium bond
1,000
Discount bond
Time
0 Maturity date

-23-
Taxation on Bond Investment
 Ordinary income component:
 Assuming yield remains constant, discount bond prices rise over
time and premium bond prices decline over time.
 For bonds originally issued at a discount/premium, the price
appreciation/depreciation (based on unchanged yield) is taxed as
ordinary income/loss.
 Capital Gain Component:

 Price changes stemming from yield changes are taxed as capital
gains/loss if the bond is sold.

-24-
Problem 12.7
 Consider a 30-year bond with 4% coupon rate (paid
annually), issued at an 8% YTM. Calculate the tax
payment, if sold one year later, when YTM=7%.
Income tax rate is 36%.

-25-
Problem 12.8
 Assume you have a one-year investment horizon and are trying to choose
among three bonds. All have the same degree of default risk and mature in
10 years. The first is a zero-coupon bond that pays $1000 at maturity. The
second has an 8 percent coupon rate and pays the $80 coupon once per
year. The third has a 10 percent coupon rate and pays the $100 coupon
once per year.
a) If all three bonds are now priced to yield 8 percent to maturity, what are
their price?
b) If you expect their yield to maturity to be 8 percent at the beginning of
next year, what will their price be then? What is your before-tax holding
period return on each bonds? If your tax bracket is 30 percent on ordinary
income and 20 percent on capital gain income, what will your after-tax
rate of return be on each?
c) Recalculate your answer to b) under the assumption that your expect the
yields to maturity on each bond to be 7 percent at the beginning of next
year.
-26-
Default Risk and Ratings
 Rating companies
 Moody’s Investor Service
 Standard & Poor’s
 DBRS
 Rating Categories
 Investment grade
 Speculative grade

-27-
Definitions of Each Bond Rating Class

-28-
Factors Used by Rating Companies
 Coverage ratios
 Leverage ratio
 Liquidity ratios
 Profitability ratios
 Cash flow to debt

-29-
Financial Ratios and Default Risk by Rating Class, Long-
Term Debt

-30-
Default Risk and Bond Pricing: Bond Indentures
 Sinking funds: A way to call bonds early
 Subordination of future debt: Restrict additional
borrowing
 Dividend restrictions: Force firm to retain assets
rather than paying them out to shareholders
 Collateral: A particular asset bondholders receive if
the firm defaults

-31-
Default Risk
 Corporate bonds are subject to default risk
 Promised or stated yield may be different from realized yield
 The state yield is the maximum possible yield to maturity of the bond
 To compensate for the possibility of default, corporate bonds must offer a default
premium
 Default premium = Promised yield – Yield of an otherwise-identical
government bond
 Credit Default Swaps (CDS)
 Acts like an insurance policy on the default risk of a corporate bond or loan
 Buyer pays annual premiums
 Issuer agrees to buy the bond in a default or pay the difference between par
and market values to the CDS buyer
 Institutional bondholders, e.g. banks, used CDS to enhance creditworthiness of
their loan portfolios, to manufacture AAA debt
 Can also be used to speculate that bond prices will fall

-32-
Yields on Long-Term Bonds

-33-
Default Risk and Bond Pricing
 Credit Risk and Collateralized Debt Obligations
(CDOs)
 Major mechanism to reallocate credit risk in the fixed-
income markets
 Loans are pooled together and split into tranches with
different levels of default risk
 Mortgage-backed CDOs were an investment disaster in
2007-2009

-34-
The Term Structure of Interest
Rates
Chapter 13

The Yield Curve
 The yield curve is a graph that displays the relationship
between YTM and time to maturity
 Information on expected future short-term rates can be implied
from the yield curve
Yields
Upward Sloping
Flat
Downward Sloping
Maturity
-36-
Short Rate
0 1 2 ………… t-1 t
r0,1 r1,2 rt-1,t
 Short rate: interest rate for one unit of time

 Notation rt-1,t=interest rate from t-1 to t
 Revealed only at time t-1
 e.g., r0,1 = interest rate from time 0 to time 1
r1,2 = interest rate from time 1 to time 2
…
rt-1,t = interest rate from t-1 to t

-37-
Spot Rates
 A spot rate (or zero rate) for maturity T is the rate of interest earned on an
investment that provides a payoff only at T.
 Spot rate equals the yield to maturity of a zero coupon bond.
 Notation: yt = YTM for t-year zero coupon bond.
 E.g., y1 = YTM for a 1-year zero coupon bond
y2 = YTM for a 2-year zero coupon bond
…
yt = YTM for a t-year zero coupon bond
FT
P0 =
(1 + yT ) T
where, FT is the principal payment at time T and yT is the spot rate for
maturity T.
-38-
Short Rate and Spot Rate
0 1 2 3 …….. t-1 t
r2,3 rt-1,t
r0,1 r1,2
reveal at time 2
reveal at time t-1
y1 reveal at time 1
Known at
time 0 y2
y3
yt …..

-39-
Derive Spot Rates using Short rates
• If we know future short rates, we could easily derive spot rate.
• The following equation must holds
1 1
PVt = =
(1 + r0,1 )(1 + r1, 2 )...(1 + rt −1,t ) (1 + yt ) t
1
⇒ yt = [(1 + r 0,1)(1 + r1, 2 )...(1 + rt −1,t )] − 1
t
where PVt = the present value of $1 paid at time t

r0,1 = one year short rate for year 1
r1,2 = one year short rate for year 2
…
rt-1,t = one year short rate for year t
yt = spot rate with a maturity year t
However, in a world with uncertainty, we usually do not know what

the short rate will be in the future.
-40-
Problem 13.1
• A 2-year zero coupon bond priced at $896.47,
the year 1 short rate is 5% and the year 2 short
rate is 6%. What is the 2-year spot rate?

-41-
Spot Rate Curve
A spot curve is a graph of spot rates as a function of maturity.
14
12 11.76
10
9.3
Annualized Spot 8
Rate 7.14
(%) 6
5.13 5.3
4
0
0.5 yr 1 yr 1.5 yr 2 yr 2.5 yr
Maturity
The spot rate curve for the spot rates in Example 12.2

-42-
The Yield Curve and
Future Interest Rates
• Short Rates and Yield Curve Slope
 When next year’s short • When next year’s

rate, r2 , is greater than short rate, r2 , is less
this year’s short rate, r1, than this year’s short
the yield curve slopes up rate, r1, the yield
 May indicate rates are
curve slopes down
expected to rise – May indicate rates
are expected to fall

-43-
Yield Curve: Bond Pricing
 Yields on different maturity bonds are not all equal
 We need to consider each bond cash flow as a stand-
alone zero-coupon bond
 Bond stripping and bond reconstitution offer
opportunities for arbitrage
 The value of the bond should be the sum of the
values of its parts

-44-
Problem 13.2 Valuing Coupon Bonds
Yields and Prices to Maturity on Zero-Coupon Bonds
($1,000 Face Value):
Value a 3 year, 10% coupon bond using discount

rates In the table.

-45-
Forward Rate
• In reality, future short rates are uncertain and only spot rates
are available to investor (y1, y2,..yt are reported in the
newspaper).
• The forward rate is the future spot rate implied by today’s
term structure of spot rates.
• Definition (1 + y 2 ) 2
= (1 + y1 )(1 + f1, 2 )
• More distant forward rates are calculated in a similar way:
(1 + y n ) n = (1 + y n −1 ) n −1 (1 + f n −1, n )
where fn-1, n is one year forward rate in year n

-46-
Problem 13.3: Forward Rate
4 yr spot rate= 9.993; 3yr spot rate= 9.660;
 f3,4 =?

-47-
Forward Contract
 A forward contract: A contract today to borrow/lend at
later date, at a rate pre-specified in the contract
(forward rate).
 In the previous example, an investor today could
have a forward contract that allows him to
borrow/lend at beginning of year 4 for one year at
rate 10.998%.
 A forward contract is used to hedge interest rate risk
since future short rate is uncertain.

-48-
Synthetic Forward Loan
Time Action CF
0 Buy 1 3-year zero -1000/(1+9.66%)3 = -758.32
Sell (1+f4) 4-year zero (1+10.998%)x1000/(1+9.993%)4 = 758.32
3 3-year zero matures +1,000
4 4-year zero matures -(1+10.998%)x1,000

-49-
Forward Rate Curve
 A forward curve is a graph of forward rates all for the
same maturity but with different forward period
(different from spot rate curve!!).

-50-
Problem 13.4: Forward Rate Curve
Zero-Coupon Rates Bond Maturity

12% 1
11.75% 2
11.25% 3
10.00% 4
9.25% 5
 Calculate 1 year forward rates

-51-
Problem 13.4: Forward Rate Curve
 Note that both the spot and forward curves provide identical
information. If you have either one, you can construct the
other.
14
12
10
8 Spot Rate
%
6 One Year Forward Rate
0
1 2 3 4 5
Year

-52-
Theories of Term Structure
 The Expectations Hypothesis: f n −1, n = E[rn −1, n ]
The upward sloping yield curve (y2>y1) means the expect future short

rate is to be higher than current short rate.
 The downward sloping yield curve (y2<y1) means the expect future short
rate is to be lower than current short rate.
 Liquidity Preference: f n −1, n = E (rn −1, n ) + L n -1, n
 Short-term investors dominate the market and they will demand a
liquidity premium for the resale value risk associated with long-term
bonds.
 Yield curve has an upward bias built into the long-term rates because of
the liquidity (resale value ) risk premium
 Segmented Market Hypothesis
 Yields for a maturity segment is a function of demand within that
maturity segment.

-53-
Interpreting the Term Structure
 The yield curve reflects expectations of future interest rates
 The forecasts of future rates are clouded by other factors,
such as liquidity premiums
 An upward sloping curve could indicate:
 Rates are expected to rise and/or
 Investors require large liquidity premiums to hold long term bonds
 The yield curve is a good predictor of the business cycle
 Long term rates tend to rise in anticipation of economic expansion
 Inverted yield curve may indicate that interest rates are expected to fall
and signal a recession

-54-
Yields on Long-Term Versus Short-Term Government
Securities: Term Spread, 1980-2012

-55-
Problem 13.5
 The current yield curve for default-free zero-coupon bonds is
as follows:
Maturity (year) YTM(%)
1 10
2 11
3 12
a) What are the implied one-year forward rate?
b) If market expectations are accurate, what will be the pure yield curve?
c) If you buy a two-year zero-coupon bond now, what is the expected total
rate of turn over the next year?
d) What should be the current price of a three-year-maturity bond with a 12
percent coupon rate? If you purchase at that price, what would your total
expected rate of return be over the next year?

-56-
Managing Bond Portfolios
Chapter 14

Bond Pricing Relationships
1. Inverse relationship between price and yield
2. Convexity: An increase in a bond’s yield to maturity results in a
smaller price decline than the gain associated with a decrease in yield.
Price The first relationship says that, for a

increase of yield ∆y, the price of bond
will decrease by ∆P2. For a decrease
of yield ∆y, the price of bond will
P+∆P1 increase by ∆P1.
P
P-∆P2 The second relationship says that
∆P2<∆P1 for a given ∆y
Y-∆Y y Y+∆Y YTM

-58-
Initial New ∆ Price
Bond C M YTM Price ∆ YTM (%) YTM New Price (%)
A 12% 5 10.00% 1,075.82 5.00% 15.00% 899.44 -16.40%
B 12% 30 10.00% 1,188.54 5.00% 15.00% 803.02 -32.44%
C 3% 30 10.00% 340.12 5.00% 15.00% 212.08 -37.64%
D 3% 30 6.00% 587.06 5.00% 11.00% 304.50 -48.13%
3. Long-term bonds tend to be more price sensitive than short-tem

bonds (A vs. B)
4. As maturity increases, price sensitivity to yield to maturity
increases at a decreasing rate. (A vs. B)
5. Price sensitivity is inversely related to a bond’s coupon rate for a
given maturity (B vs. C)
6. Price sensitivity is inversely related to the yield to maturity at
which the bond is selling (C vs. D)

-59-
200%
150%
100%
A
B
50%
C
D
0%
-5% -4% -3% -2% -1% 0% 1% 2% 3% 4% 5%
-50%
-100%

-60-
Bond Maturity
Bond AA
$1,000
$1,000
 Consider cash flows of
bonds AA and BB
 Both bond stop paying $500
cash after 5th year. The

stated maturity are both 5 $0
$10 $10 $10 $10
years, but the cash flow 1st Yr 2nd Yr 3rd Yr 4th Yr 5th Yr
patterns are quite Bond BB

different. $1,000
$1,000
 What relevant is the

effective maturity of cash
$500
flow.
$10 $10 $10 $10

$0
1st Yr 2nd Yr 3rd Yr 4th Yr 5th Yr

-61-
Macaulay Duration
 Duration is a measure of the effective maturity of a bond.
 It is the weighted average of the times until each payment is
received. T
D = 1× w1 + 2 × w2 + 3 × w3 + ... + T × wT = ∑ t × wt
t =1
 The weight in the duration measure is the proportion of the
PV of cash flows relative to the entire present value of the
bond (bond price). CF (1 + y)
t
wt =
t
P r ice
 Duration is shorter than maturity for all bonds except zero
coupon bonds
 Duration is equal to maturity for zero coupon bonds

-62-
Duration Calculation: An Example
10 year coupon bond with 4% annual coupon rate (assume a 8% market Yield)
(1) (2) (3) (4) (5) (6)

Year Cash Flow PV ($1) (2)x(3) (4)÷731.58 (1)×(5)
1 $ 40 $ 0.9259 $ 37.04 0.0506 0.0506

2 40 0.8573 34.29 0.0469 0.0938
3 40 0.7938 31.75 0.0434 0.1302
4 40 0.7350 29.40 0.0402 0.1608
5 40 0.6806 27.22 0.0372 0.1860
6 40 0.6302 25.21 0.0345 0.2070
7 40 0.5835 23.34 0.0319 0.2233
8 40 0.5403 21.61 0.0295 0.2360
9 40 0.5002 20.01 0.0274 0.2466
10 1,040 0.4632 481.73 0.6585 6.5850
Sum $ 731.58 1.0000 8.1193

-63-
Duration Calculation (Continued)
Cash Flow Present Value of Cash flow
1 2 3 4 5 6 7 8 9 10
Duration=8.12
Modified Duration=8.12/(1+0.08)=7.52
A 1 percentage point increase in interest rate, Bond price falls by 7.52×1%=7.52%

-64-
Duration/Price Relationship
ΔP Δ(1 + y)
= −Duration ×
P (1 + y)
 Modified Duration: A measure of percentage change in
bond price to change in the interest rate.
Modified Duration = Macaulay Duration / (1+y)

ΔP
= −Modified Duration ⋅ ∆(1 + y )
P
= − Modified Duration ⋅ ∆y
where
∆P
= % chang in bond price
p
∆y = change in interest rate

-65-
Why is duration a key concept?
 It’s a simple summary statistic of the effective
average maturity of the portfolio;
 It is an essential tool in immunizing portfolios from
interest rate risk;
 It is a measure of interest rate risk of a portfolio

-66-
Duration and Interest Rate Risk
 Two bonds have duration of 1.8852 years
 One is a 2-year, 8% semi-annual coupon bond with YTM=10%
 The other bond is a zero coupon bond with maturity of 1.8852 years
 Duration of both bonds is 1.8852 x 2 = 3.7704 semiannual periods
 Modified D = 3.7704/1 + 0.05 = 3.591 periods
 Suppose the semiannual interest rate increases by 0.01%. Bond prices fall
by ∆P
= − D * ∆y = -3.591 x 0.01% = -0.03591%
P
 Bonds with equal D have the same interest rate sensitivity
 The coupon bond, which initially sells at $964.540, falls to $964.1942, when its
yield increases to 5.01%, its price declines 0.0359%
 The zero-coupon bond initially sells for $1,000/1.053.7704 = $831.9704. At the
higher yield, it sells for $1,000/1.053.7704 = $831.6717, therefore its price also
falls by 0.0359%

-67-
Problem 14.1
 You will be paying $10,000 a year in education expenses at
the end of the next two years. Bonds currently yield 8 percent.
a) What is the present value and duration of your obligation?
b) What maturity zero-coupon bond would immunize your
obligation?
c) Suppose you buy a zero-coupon bond with value and
duration equal to your obligation. Now suppose that rates
immediately increase to 9 percent. What happens to your net
position? What if rate fall to 7 percent?

-68-
Convexity
 Duration assumes that the price change is a linear function of
changes in YTM.
 Predicting bond price changes based on duration is only the

first-order approximation.
 The actual true relationship is convex function.
 The error is small only for small changes in YTM.

-69-
Duration and Convexity
Price
Pricing error from
P+∆P1 convexity
P+∆P1’
P+∆P2
P+∆P2’
y-∆y y y+∆y Yield
Yield change Linear Relationship Convexity Price error

-∆y P+∆P1’ P+∆P1 ∆P1-∆P1’
+∆y P+∆P2’ P+∆P2 ∆P2-∆P2’

-70-
Duration: Corrected for Convexity
• A more exact approximation of price changes is a second-order
approximation, which involves measures of convexity.
1 n
 CFt 
Convexity =
P × (1 + y) 2
∑  (1 + y) t ( t + t )
t =1 
2
Correction for Convexity:

∆P
= − D ∗ ∆y + 1 ⋅ Convexity ⋅ ( ∆y ) 2
P 2

-71-
Problem 14.2
 There are two bonds: 1) 12.75-year-to-maturity zero-coupon
bond at yield of 8%, convexity of 150.3, and modified duration
of 11.81 years; 2) 30-year-to-maturity 6 percent annual coupon
bond at yield of 8%, convexity of 231.2, and modified duration
of 11.79 years.
a) Suppose yield to maturity on both bonds increases to 9%.
What will be the percentage capital loss on each bond?
b) What if the yield to maturity decreases to 7%?
c) Explain the attraction of convexity
d) Do you think it would be possible for two bonds with equal
duration but different convexity to be priced initially at the
same yield to maturity if the yields on both bonds always
increase or decrease by equal amount?
-72-

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2.0 - Part IV Fixed Income Securities

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Bond Prices and Yields

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

PB = price of the bond

Part IV: Fixed Income Securities

Fannie Mae Issues Federal Provincial Corporate

Bell Canada 5.000 02/15/2017 109.66 2.99

Part IV: Fixed Income Securities

A bond with semi-annual coupon payment:

What is the price of the bond?

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

Entire Coupon Period

Most Recent CP Next CP

Interest earned Interest to be

 In order to value a bond between coupon payment dates, we need to

Part IV: Fixed Income Securities

• And the valuation equation becomes

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

What is the yield to maturity (semi-annual rate)?

Part IV: Fixed Income Securities

 For premium bonds

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

where yc = Yield To Call and Tc = expected time of call

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

 Capital Gain Component:

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

r0,1 r1,2 rt-1,t

 Short rate: interest rate for one unit of time

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

where PVt = the present value of $1 paid at time t

However, in a world with uncertainty, we usually do not know what

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

 When next year’s short • When next year’s

Part IV: Fixed Income Securities

Part IV: Fixed Income Securities

Value a 3 year, 10% coupon bond using discount

Part IV: Fixed Income Securities

where fn-1, n is one year forward rate in year n

Part IV: Fixed Income Securities