MFE8812 Seminar Slide 01 (2pg)

Bond Prices and Yields
Measurement of Interest Rate Risk
MFE8812 Bond Portfolio Management
William C. H. Leon
Nanyang Business School
January 16, 2018
1 / 63 William C. H. Leon MFE8812 Bond Portfolio Management
Bond Prices and Yields

Measurement of Interest Rate Risk
1 Bond Prices and Yields

Overview
Valuation of Bond
Value of Cash Flows
Value of a Bond
Present Value Formula
Taxonomy of Rates
2 Measurement of Interest Rate Risk

Overview
Full Valuation Approach
Duration & Convexity Approach

Bond Prices and Yields Valuation of Bond
Measurement of Interest Rate Risk Taxonomy of Rates
Overview
Bond pricing is typically performed by taking the discounted value of the
bond cash flows.
We shall review the basics of the mathematics of discounting, including
time basis and compounding conventions, and introduce various types of
interest rates involved in the fixed-income world, including the notions of
coupon rate, current yield, yield to maturity, spot rate, forward rate and
bond par yield.

Present Value of a Cash Flow

Consider a cash flow CFT that occurs at time T :
Discount rate rT
Cash Flow CFT

Time t
0 1 2 3 ... T
Present Future
CFT
PV = CFT
(1 + rT )T

Present Value of a Stream of Cash Flows

Consider a stream of cash flow CF1 , CF2 , CF3 , . . . , CFT :
Discount rate rt for maturity t
CF1 CF2 CF3 ... CFT

Time t
0 1 2 3 ... T
Present Future
CF1 CF2 CF3 CFT CFt T

PV = + + + · · · + = .
1 + r1 (1 + r2 )2 (1 + r3 )3 (1 + rT )T t=1
(1 + r t)
t

Valuing a Bond
Valuing a bond can be viewed as a three-step process:
Step 1: obtain the cash flows the bondholder is entitled to.
Step 2: obtain the discount rates for the maturities corresponding to the
cash flow dates.
Step 3: obtain the bond price as the discounted value of the cash flows.

Obtaining Cash Flows of a Bond

If we are dealing with a straight default-free, fixed-coupon bond, the value
of cash flows paid by the bond are known with certainty ex ante, i.e., on
the date when pricing is performed.
In general, two parameters that are needed to fully describe the cash flows
on a bond.
The first is the maturity date of the bond, on which the principal or
face amount of the bond is paid and the bond retired.
The second parameter needed to describe a bond is the coupon rate.
For a non-standard bond, the following are some of the problems
associated with estimating cash flows:
The due date for the payment of the principal may be altered.
The coupon payments may be reset periodically.
There may be an option to convert or exchange one security for
another security.

Example
A Canadian Government bond issued in the domestic market pays one-half of
its coupon rate times its principal value every 6 months up to and including the
maturity date. Thus, a bond with an 8% coupon and $5,000 face value
maturing on December 1, 2xx5, will make future coupon payments of 4% of
principal value, that is, $200 on every June 1 and December 1 between the
purchase date and the maturity date.

Obtaining Discount Rates

Given that the cash flows are known with certainty ex ante, only the time-value
needs to be accounted for, using the present value rule, which can be written
as the follow
CFt
PV (CFt ) = t = B(0, t) CFt ,
1 + R(0, t)
where PV (CFt ) is the present value of the cash flow CFt received at date t,
R(0, t) is the annual spot rate (or discount rate) at date 0 for an investment up
to date t, and B(0, t) is the price at date 0 (today) of a zero-coupon bond (or
pure discount bond) paying $1 on date t.
Note that it would be easy to obtain B(0, t) if we can find zero-coupon bonds
corresponding to all possible maturities.

Obtaining Bond Price

The price of a bond

T
CFt
T
P0 = PV (Bond) = t = B(0, t) CFt .
t=1 1 + R(0, t) t=1
We must address the following important issues to turn the above simple
principle into sound practice:
Where do we get the discount factors B(0, t) from?
Do we use the equation to obtain bond prices or implied discount factors?
Can we deviate from this simple rule? Why?

Mathematics of Discounting
Suppose that all cash flows and all discount rates across various maturities are
identical and, respectively, equal to CF and y . Then
T
T
CF CF 1
PV CF = t = 1− T .
t=1 t=1 1 + y y 1 + y
For a bond, we have

C 1 N
P0 = 1− T + T .
y 1+y 1+y
where P0 is the present value of the bond, T is the maturity of the bond, N is
the nominal value of the bond, C = c × N is the coupon payment, c is the
coupon rate and y is the discount rate.

Example
Consider the problem of valuing a bond with a 5% coupon rate, annual coupon
payments, a 10-year maturity and a $1,000 face value; assuming all discount
rates equal to 6%.
Step 1: The cash flows of the bond is
CF1 = CF2 = · · · = CF9 = $50 and CF10 = $1, 050.
Step 2: The discount rate y = 0.06.

Step 3: The value of the bond is
9
50 1050 50 1 1000
P0 = t
+ 10
= 1− 10
+
t=1
1.06 1.06 0.06 1.06 1.0610
= $926.39913.

Priced at Par
When the coupon rate is equal to the discount rate (i.e., c = y or equivalently
C = y N), then the bond value is equal to its face value.

cN 1 N
P0 = 1− T + T
y 1+y 1+y

yN 1 N
= 1− T + T = N.
y 1+y 1+y

Premium, Par & Discount

More generally, depending on the relation between coupon rate, c, and
discount rate, y , a bond may be priced:
at a premium, P0 > N;
at par, P0 = N; or
at a discount, P0 < N.

c 1 1
P0 = N 1− T + T ,
y 1+y 1+y
c>y P0 > N, i.e., at a premium

c=y P0 = N, i.e., at par
c<y P0 < N, i.e., at a discount

Perpetual Bond
A bond paying a given coupon amount every year over an unlimited horizon is
known as a perpetual bond. The price of such bond is

T
C C 1
P0 = lim t = lim 1− T
T →∞ 1 + y T →∞ y 1 + y
t=1
C
= .
y

Annual vs. Semiannual Coupons

Consider a bond with a coupon rate c, a maturity T year, a face value N, and
a discount rate y .
If the bond delivers coupon annually, its price

T
cN N cN 1 N
P0 = t + T = 1− T + T .
t=1 1 + y 1 + y y 1 + y 1 + y
If the bond delivers coupon semiannually, its price

2T
c N/2 N
P0 = t + 2T
t=1 1 + y /2 1 + y /2

cN 1 N
= 1− 2T + 2T .
y 1 + y /2 1 + y /2

Time Basis & Compounding Frequency Conventions

To apply present value formulas, one must have information about both the
time basis (usually interest rates are expressed on an annual basis) and the
compounding frequency.
Careful attention needs to be paid to the question of how an interest rate is

defined: An amount $x invested at the T -year interest rate RT ,n expressed on
an annual basis and compounded n times per year grows to the amount
nT
RT ,n
x 1+
n
after T years.

Example
If you invest $100 at a 6% 2-year annual rate with semiannual
compounding, you would get:

$100 1 + 6% after 6 months,
2
2
$100 1 + 6% after 1 year,
2
3
$100 1 + 6% after 1.5 year,
2

6% 4
$100 1 + 2 after 2 years.
If you invest $100 at a 4% 3-year semiannual rate with semiannual

$100 (1 + 4%) after 6 months,
$100 (1 + 4%)2 after 1 year,
$100 (1 + 4%)3 after 1.5 year,
..
.
$100 (1 + 4%)6 after 3 years.

Example
If you invest $100 at a 3% 1-year semiannual rate with monthly

$100 1 + 3% after 1 month,
6
2
$100 1 + 3% after 2 months,
6
3
$100 1 + 3%6
after 3 months,
..
. 12
$100 1 + 3%6
after 1 year.

Effective Annual Yield

The effective equivalent annual (i.e., compounded once a year) yield R is
defined as the solution to
nT
RT ,n
x 1+ = x (1 + R)T
n
or
n
RT ,n
R= 1+ − 1.
n
Bond yields are often expressed on a yearly basis with semiannual

compounding in the United States and in the United Kingdom, they are
expressed on a yearly basis with annual compounding in France or
Germany.
To compare bond yields, one can always turn a bond yield into an
effective annual yield (EAY), that is, an interest rate expressed on a yearly
basis with annual compounding.

Continuous Compounding
It seems desirable to have a homogeneous convention in terms of compounding
frequency. This is where the concept of continuous compounding is useful.
Let the compounding frequency increase without bound,

nT
RT ,n c
lim x 1 + = x eR T
n→∞ n
where R c expressed on an annual basis is a continuously compounded rate.
Note that
n
c RT ,n
R = lim RT ,n = lim ln 1 + .
n→∞ n→∞ n

Continuous Compounding: Proof

Since

n ln 1 +
RT ,n
− ln 1
RT ,n RT ,n n
ln 1 + = n ln 1 + = RT ,n ,
n n RT ,n
n
RT ,n ln(1+y )−ln 1
and limn→∞ n
= 0 and limy →0 y
= 1, we have
n
RT ,n
lim ln 1 + = lim RT ,n = R c .
n→∞ n n→∞

Future & Present Value Using Continuous Compounding

The future and present value of any cash flow are, respectively,
c
FVt (CF0 ) = CF0 eR t ,
c
PV (CFt ) = CFt e−R t ,
where FVt (CF0 ) is the future value at date t of a cash flow CF0 invested at
date 0 at a R c continuously compounded rate, and PV (CFt ) is the present
value at date 0 of a cash flow CFt received at date t.

Effective Annual Yield Using Continuous Compounding

The effective equivalent annual (i.e., compounded once a year) rate R is the
solution to
c
x eR T
= x (1 + R)T
or
c
R = eR − 1.
Note that the difference R − R c is positive and it is actually small when R is

small. Indeed, we know from numerical analysis that
y2 y3 yk
ey = 1 + y + + + ··· + + ··· ,
2! 3! k!
so that R ≈ R c as a first-order approximation.

Different Types of Rates & Yields

There are a host of types of interest rates involved in the fixed-income jargon.
Coupon rates.
Current yields.
Yields to maturity.
Spot zero-coupon rates.
Forward rates.

Coupon Rates
The coupon rate is the stated interest rate on a security, referred to as an
annual percentage of face value.
It is called the coupon rate because bearer bonds carry coupons for
interest payments. Each coupon entitles the bearer to a payment when a
set date has been reached. Today, most bonds are registered in holders
names, and interest payments are sent to the registered holder, but the
term coupon rate is still widely used.
Coupon or interest payment is commonly made twice a year (in the United
States, for example) or once a year (in France and Germany, for example).
The coupon rate is essentially used to obtain the cash flows and shall not
be confused with the current yield.

Current Yield
The current yield yc is obtained using the following formula
cN
yc = ,
P
where c is the coupon rate, N is the nominal value and P is the current price.
For example, a par $1,000 bond has an annual coupon rate of 7%, so it
pays $70 a year.
If you buy the bond for $900, your actual current yield is
$70
7.78% = .
$900
If you buy the bond for $1,100, your actual current yield is
$70
6.36% = .
$1, 100

Yield to Maturity
The yield to maturity (YTM) is the single rate that sets the present value of
the cash flows equal to the bond price, i.e., the YTM y solves the equation

T
CFt
t = P,
t=1 1+y
where CFt is the cash flow at time t, T is the number of cash flows, and P is
the current price.

Yield to Maturity
(Continue)
More precisely, the bond price P is found by discounting future cash flows back
to their present value as indicated in the two following formulas depending on
the coupon frequency:
When coupons are paid annually,

T
CFt
P= t ,
t=1 1+y
where the yield denoted by y is expressed on a yearly basis with annual

compounding, and T is the number of annual periods.
When coupons are paid semiannually,

2T
CFt
P=
y2 t
,
t=1 1+ 2
where the yield denoted by y2 is expressed on a yearly basis with

semiannual compounding, and 2T is the number of semiannual periods.

Exercise
Consider a $1,000 face value 3-year bond with 10% annual coupon, which
sells for 101. What is the yield to maturity of this bond?
Consider a $1,000 nominal value 2-year bond with 8% coupon paid

semiannually, which sells for 103–23 (i.e., 103 23
32
). What is the yield to
maturity of this bond?

Answer

Yield to Maturity & Internal Rate of Return

The YTM is the internal rate of return (IRR) of the series of cash flows.
Hence, each cash flow is discounted using the same rate. We implicitly
assume that the yield curve is flat at a point in time.
An IRR is an average discount rate assumed to be constant over the
different maturities. It is equivalently the unique rate that would prevail if
the yield curve happened to be flat at date t (which of course is not
generally the case). It is computed by trial and error, but may be easily
determined by using built-in functions in financial calculators or
spreadsheet softwares (e.g., the IRR function in Microsofts Excel).

Yield to Maturity as a Total Return Rate

A YTM may also be seen as a total return rate.
Consider a bond with a 3-year maturity and a YTM of 10% selling for
$875.66. The bond pays an annual coupon of $50 and a principal of
$1,000 at maturity.
If we buy the bond today, we will receive $50 at the end of the first
year, $50 at the end of the second year and $1,050 after 3 years.
Assuming that we reinvest the intermediate cash flows, i.e., the
coupons paid after 1 year and 2 years, at an annual rate of 10%.
The total cash flows we receive at maturity are
$50 × (1 + 10%)2 + $50 × (1 + 10%) + $1, 050 = $1, 165.50.
Our investment therefore generates an annual total return rate y

over the period, such that
1, 165.50
(1 + y )3 = =⇒ y = 10%.
875.66

Yield to Maturity & Price

Under certain technical conditions, there exits a one-to-one
correspondence between the YTM and the price of a bond. Thus, giving a
YTM for a bond is equivalent to giving a price for the bond. It should be
noted that this is precisely what is actually done in the bond market,
where bonds are often quoted in YTM, i.e., YTM is just a convenient way
of reexpressing bond price.
A bond YTM is not a very meaningful number. This is because there is
no reason one should discount cash flows occurring on different dates with
a unique discount rate. Unless the term structure of interest rates is flat,
there is no reason one would consider the YTM on a T -year bond as the
relevant discount rate for a T -year horizon. The relevant discount rate is
the T -year pure discount rate. In other words, YTM is a complex average
of pure discount rates that makes the present value of the bonds
payments equal to its price.

Spot Zero-Coupon Rate

The spot zero-coupon rate R(0, t) is implicitly defined by
1
B(0, t) =
t
1 + R(0, t)
where B(0, t) is the market price at date 0 of a bond paying off $1 at date t.

Note that such a bond may not exist in the market.
The yield to maturity and the zero-coupon rate of a strip bond (i.e., a
zero-coupon bond) are identical.
In practice, when we know the spot zero-coupon yield curve t → R(0, t),
we are able to obtain spot prices for all fixed-income securities with known
future cash flows.
Zero-coupon rates make it possible to find other very useful forward rates
and par yields.

Forward Rate
If R(0, t) is the rate at which you can invest today in a t period bond, we can
define an implied forward rate (or forward zero-coupon rate) between years t1
and t2 as
⎛
t 2 ⎞ t 1
2 −t1
⎜ 1 + R(0, t2 ) ⎟
F (0, t1 , t2 − t1 ) = ⎝
t 1 ⎠ − 1.
1 + R(0, t1 )
It is the forward rate as seen from date t = 0, starting at date t = t1 , and

with residual maturity t2 − t1 .
Basically, it is the rate at which you could sign a contract today to borrow
or lend between periods t1 and t2 .
In practice, it is very common to draw the forward curve τ → F (0, t, τ )
with rates starting at date t.
Denote its continuously compounded equivalent as F c (0, t1 , t2 − t1 ).

Forward Rate: A Rate That Can Be Guaranteed

The forward rate is the rate that can be guaranteed now on a transaction
occurring in the future.
Suppose we simultaneously borrow and lend $1 repayable at the end of 2
years and 1 year, respectively. The cash flows generated by this
transaction are as follows:
Today In 1 Year In 2 Year

2
Borrow (2 Year) 1 − 1 + R(0, 2)
Lend (1 Year) −1 1 + R(0, 1)
2
Net Cash Flow 0 1 + R(0, 1) − 1 + R(0, 2)
This is equivalent to borrowing 1 + R(0, 1) in 1 year, repayable in 2 years

2
at the amount 1 + R(0, 2) .

Forward Rate: A Rate That Can Be Guaranteed

(Continue)
2
Borrowing 1 + R(0, 1) in 1 year and repaying 1 + R(0, 2) in 2 years has
the implied rate on the loan given by
2
1 + R(0, 2)
− 1 = F (0, 1, 1).
1 + R(0, 1)
Thus, F (0, 1, 1) is the rate that can be guaranteed now for a loan starting
in 1 year and repayable after 2 years.

Spot Zero-Coupon Rate & Forward Rate

The spot zero-coupon rate R(0, ·) and forward rates F (0, ·, ·) are related as
follow:

R(0, t) = 1 + R(0, 1) 1 + F (0, 1, 1) 1 + F (0, 2, 1) . . .

1t
. . . 1 + F (0, t − 1, 1) −1
and

F (0, t1 , t2 − t1 ) = 1 + F (0, t1 , 1) 1 + F (0, t1 + 1, 1) 1 + F (0, t1 + 2, 1) . . .

t2 −t
1
. . . 1 + F (0, t2 − 1, 1) 1
− 1.

Forward Rate as a Break-Even Point

The forward rate may be considered as the break-even point that equalizes the
rates of return on bonds (which are homogeneous in terms of default risk)
across the entire maturity spectrum.
Suppose that a zero-coupon yield curve today from which we derive the
forward yield curve starting in 1 year is as follow:
Zero-coupon Rate Forward Rate Starting in 1 Year

R(0,1) 4.00% F(0,1,1) 5.002%
R(0,2) 4.50% F(0,1,2) 5.504%
R(0,3) 5.00% F(0,1,3) 5.670%
R(0,4) 5.25% F(0,1,4) 5.878%
R(0,5) 5.50%

Forward Rate as a Break-Even Point

(Continue)
The rate of return for the coming year of the 1-year zero-coupon bond is
of course 4%, while the return on the 2-year bond depends on the selling
price of the bond in 1 year. What is the level of the 1-year zero-coupon
rate in 1 year that would ensure that the 2-year bond also has a 4% rate
of return?
The answer is 5.002%. With this rate, the price of the 2-year bond
will rise from the initial 91.573 (= 100/1.0452 ) to 95.236 (=
100/1.05002) in 1 year, generating a return of 4% over the period.
The forward rate F (0, 1, 1) at 5.002% is the future level of the 1-year
zero-coupon rate that makes the investor indifferent between the
1-year and the 2-year bonds during the year ahead.
If the forward rate F (0, 1, 2) is 5.504%, a zero-coupon bond with a 3-year
maturity also returns 4% for the coming year.
Consequently, all the bonds have the same 4% return rate for the year
ahead. Breakeven is therefore the future scenario that balances all bond
investments.

Instantaneous Forward Rate

The instantaneous forward rate f (t, s) is the forward rate seen at date t,
starting at date s and maturing an infinitely small instant later on. It is a
continuously compounded rate. The instantaneous forward rate is defined
mathematically as follow:
f (t, s) = lim F c (t, s, τ ).

τ →0
Note that f (t, t) = r (t) is the short-term interest rate at date t.

Typically, this is the rate with a 1-day maturity in the market.
By varying s between 1 day and 30 years, it is possible to plot the level of
instantaneous forward rates at dates that are staggered over time. This is
what is called the instantaneous forward yield curve.
In practice, the market treats the instantaneous forward rate as a forward
rate with a maturity of between 1 day and 3 months. It is especially useful
for modeling purposes.

Bond Par Yield

A par bond is a bond with a coupon identical to its YTM, and its price is equal
to its principal. We define the par yield c(T ) so that a T -year maturity bond
paying annually a coupon rate of c(T ) with a $100 face value quotes par, i.e.,

c(T ) × $100 c(T ) × $100 1 + c(T ) × $100
+ 2 + · · · + T = $100.
1 + R(0, 1) 1 + R(0, 2) 1 + R(0, T )
Hence,
1
1− T
1 + R(0, T ) 1 − B(0, T )
c(T ) = = T .

T
1 t=1 B(0, t)
t
t=1 1 + R(0, t)

Bond Par Yield

(Continue)
In practice, the YTM curve suffers from the coupon effect. Two bonds
having the same maturity but different coupon rates do not necessarily
have the same YTM.
In the case of an upward sloping curve, the bond that pays the
highest coupon has the lowest YTM.
To overcome this coupon effect, it is customary to plot the par yield
curve. We can extract the par yield curve t → c(t), 0 < t ≤ T , when we
know the zero-coupon rates R(0, 1), R(0, 2), . . . , R(0, T ).
Typically, the par yield curve is used to determine the coupon level of a
bond issued at par.

Bond Prices and Yields Full Valuation Approach
Measurement of Interest Rate Risk Duration & Convexity Approach
Overview
The value of a bond moves in the opposite direction to a change in
interest rates. If interest rates increase (decrease), the price of a bond will
decrease (increase).
A key to measuring the interest rate risk is the accuracy in estimating the
value of the position after an adverse interest rate change. A valuation
model determines the value of a position after an adverse interest rate
move. Consequently, if a reliable valuation model is not used, there is no
way to properly measure interest rate risk exposure.
There are two approaches to measuring interest rate risk:
1 the full valuation approach, and
2 the duration & convexity approach.


The full valuation approach approach requires the re-valuation of a bond or
bond portfolio for a given interest rate change scenario.
The full valuation approach is a straightforward approach but can be very
time consuming.
If one has a good valuation model, assessing how the value of a bond will
change for different interest rate scenarios measures the interest rate risk
of the bond.
This approach is sometimes referred to as scenario analysis because it
involves assessing the exposure to interest rate change scenarios.

Example
Consider a $10 million par value position in a 20-year bond with 9% semiannual
coupon. The current price of the bond is 134.67216 with a yield to maturity of
6%. The market value of the position is $13,467,216 (= 134.67216% × $10
million). Suppose that yields change instantaneously for the following three
scenarios:
1 50 basis point increase;
2 100 basis point increase; and
3 200 basis point increase.
The following table shows what will happen to the bond position if the yield on
the bond increases from 6% to (1) 6.5%, (2) 7%, and (3) 8%:
Yield New New New Percentage

Scenario Change (bp) Yield Price Value ($) Change
1 50 6.5% 127.76054 12,776,054 −5.13%
2 100 7.0% 121.35507 12,135,507 −9.89%
3 200 8.0% 109.89639 10,989,639 −18.40%


(Continue)
A common question that often arises when using the full valuation
approach is which scenarios should be evaluated to assess interest rate risk
exposure.
There may be specified scenarios established by regulators for
regulated entities.
It is common for regulators of depository institutions to require
entities to determine the impact on the value of their bond portfolio
for a 100, 200, and 300 basis point instantaneous change in interest
rates.
Risk managers tend to look at extreme scenarios to assess exposure
to interest rate changes. This practice is referred to as stress testing.
The state-of-the-art technology involves using a complex statistical
procedure (such as principal component analysis) to determine a
likely set of interest rate scenarios from historical data.
The full valuation approach can also handle scenarios where the yield
curve does not change in a parallel fashion.

Duration
Duration is a measure of the approximate price sensitivity of a bond to interest
rate changes. More specifically, duration of a bond, D, is the approximate
percentage change in price for a change in rates, i.e.
ΔP/P P− − P+
D=− = , (1)
Δy 2 P Δy
where
P is the current price,
Δy is the change in the yield,
P − is the price when yield decreases by Δy , and
P + is the price when yield increases by Δy .

Price-Yield Relationship for an Option-Free Bond


Duration
(Continue)
Duration is the linear approximation of the percentage price change.

To improve the approximation provided by duration, an adjustment
for “convexity” can be made. Combining duration with convexity to
estimate the percentage price change of a bond caused by changes in
interest rates is called the duration & convexity approach.
Duration is interpreted as the approximate percentage change in price for
a 100 basis point change in rates.
A common question asked about this interpretation of duration is the
consistency between the yield change that is used to compute
duration using equation (1) and the interpretation of duration.
Note that regardless of the yield change Δy used to estimate
duration in equation (1), the interpretation is the same. i.e., if we
used a 25 basis point change in yield to compute the prices used in
the numerator of equation (1), the resulting duration is still
interpreted as the approximate percentage price change for a 100
basis point change in yield.

Modified Duration & Effective Duration

Modified duration is the approximate percentage change in a bonds price
for a 100 basis point change in yield assuming that the bonds expected
cash flows do not change when the yield changes.
This means that in calculating the values of P − and P + for the
value of duration, the same cash flows used to calculate P are used.
Therefore, the change in the bonds price when the yield is changed is
due solely to discounting cash flows at the new yield level.
Effective duration is the approximate percentage change in a bonds price
for a 100 basis point change in yield taking into account how the expected
cash flows may change when the yield changes.
Some valuation models for bonds with embedded options take into
account how changes in yield will affect the expected cash flows.
Thus, when P − and P + are the values produced from these
valuation models, the resulting duration takes into account both the
discounting at different interest rates and how the expected cash
flows may change.

Exercise
Consider a 20-years standard par bond with a 6% annual coupon.
What is the duration, assuming the yield increases or decreases 10 basis
points?

Answer

Application of Duration
To approximate the percentage price change, ΔP/P, for a given change in
yield, Δy (in decimal), and a given duration, D, we may use the following
formula:
ΔP
= −D Δy .
P
The negative sign on the right-hand side of the equation is due to the
inverse relationship between price change and yield change (e.g., as yields
increase, bond prices decrease).

Exercise
Consider a 20-years standard par bond with a 6% annual coupon. The duration
of the bond is 11.47050 (as computed earlier).
1 Suppose the yield increases by 20 basis points. What is the approximate
percentage price change using duration?
2 How accurate is the approximation?
3 Repeat the analysis when the yield increases by 200 basis points.

Answer

Error Using Duration

The duration measure indicates that the approximate percentage price change
is the same regardless of whether interest rates increase or decrease. While for
small changes in yield the percentage price change will be the same for an
increase or decrease in yield, for large changes in yield this is not true. This
suggests that duration is only a good approximation of the percentage price
change for small changes in yield.

Convexity Adjustment
Duration is a first-order linear approximation for a small change in yield. The
approximation can be improved by using a second approximation called the
convexity adjustment. It is used to approximate the change in price that is not
explained by duration. The formula for the convexity adjustment to the
percentage price change is
ΔP 1 2
Convexity Adjustment to = C Δy ,
P 2
where Δy is the change in yield for which the percentage price change is
sought and
P− + P+ − 2 P
C = 2 .
P Δy
To calculate the convexity adjustment, we may assume that, when the

yield changes, the expected cash flows either do not change or they do
change. In the former case, the resulting convexity is referred to as
modified convexity adjustment; and in the later case, as effective
convexity adjustment.
Duration & Convexity Adjustment

The following formula provides a better approximation of the percentage price
change, ΔP/P, for a given change in yield, Δy (in decimal), and a given
duration, D, and convexity, C :
ΔP 1 2
= −D Δy + C Δy .
P 2

Exercise
Consider a 20-years standard par bond with a 6% annual coupon. The duration
of the bond is 11.47050 (as computed earlier).
1 Using a 10 basis points change in the yield, compute the convexity of the
bond.
2 Suppose the yield increases by 200 basis points. What is the approximate
percentage price change using duration and convexity?
3 How accurate is the approximation?

Answer

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Bond Prices and Yields

Measurement of Interest Rate Risk

MFE8812 Bond Portfolio Management

Nanyang Business School

January 16, 2018

1 / 63 William C. H. Leon MFE8812 Bond Portfolio Management

Bond Prices and Yields

1 Bond Prices and Yields

2 Measurement of Interest Rate Risk

2 / 63 William C. H. Leon MFE8812 Bond Portfolio Management

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Bond Prices and Yields Valuation of Bond

Present Value of a Cash Flow

Cash Flow CFT

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Present Value of a Stream of Cash Flows

Discount rate rt for maturity t

CF1 CF2 CF3 ... CFT

CF1 CF2 CF3 CFT CFt T

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Bond Prices and Yields Valuation of Bond

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Obtaining Cash Flows of a Bond

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Bond Prices and Yields Valuation of Bond

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Obtaining Discount Rates

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Bond Prices and Yields Valuation of Bond

Obtaining Bond Price

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For a bond, we have

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Bond Prices and Yields Valuation of Bond

CF1 = CF2 = · · · = CF9 = $50 and CF10 = $1, 050.

Step 2: The discount rate y = 0.06.

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Bond Prices and Yields Valuation of Bond

Premium, Par & Discount

c>y P0 > N, i.e., at a premium

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Bond Prices and Yields Valuation of Bond

Annual vs. Semiannual Coupons

If the bond delivers coupon semiannually, its price

16 / 63 William C. H. Leon MFE8812 Bond Portfolio Management

Time Basis & Compounding Frequency Conventions

Careful attention needs to be paid to the question of how an interest rate is

17 / 63 William C. H. Leon MFE8812 Bond Portfolio Management

Bond Prices and Yields Valuation of Bond

If you invest $100 at a 4% 3-year semiannual rate with semiannual

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Bond Prices and Yields Valuation of Bond

Eﬀective Annual Yield

Bond yields are often expressed on a yearly basis with semiannual

20 / 63 William C. H. Leon MFE8812 Bond Portfolio Management

Let the compounding frequency increase without bound,

where R c expressed on an annual basis is a continuously compounded rate.

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Bond Prices and Yields Valuation of Bond

Continuous Compounding: Proof