Debt Markets

Duration

Topicstobecovered
ConceptofDuration MeasuringDuration g ModifiedDuration Eff ti D EffectiveDuration ti PortfolioDuration BenefitsofDuration Bond Portfolio Immunization BondPortfolioImmunization LimitationsofDuration NumericalQuestions

ConceptofDuration
Durationisameasurewhichconsidersbothpriceand

reinvestmentriskandplaysaverycrucialroleon understandingprice yieldrelationships Durationmeasuresthetimetakenbyabondtorepaythe originalpriceofthebondthroughitsinternalcashflows Durationisalwayslesserthanorequaltothematurityof y q y thebond.Itcanneverbegreaterthanthematurityofthe bond BondswhereDurationisequaltothematurityofthebond arecalledZeroCouponBonds,orDeepDiscountBonds p , p wherenocouponispaid

MeasuringDuration
Step1 Findthepresentvalueofeachannualcoupon

orprincipalpayment.UsetheprevailingYTMonthe bondasthediscountrate Step 2 Divide this present value by the current Step2 Dividethispresentvaluebythecurrent marketpriceofthebond Step 3 Multiply the relative value by the year in Step3 Multiplytherelativevaluebytheyearin whichthecashflowistobereceived Step4 Addupthevaluescalculatedinstep3

ModifiedDuration
ModifiedDuration=DurationinYears/(1+YTM) Todeterminethebondspercentagepricechange p g p g

resultingduetoincreaseinmarketinterestratesor decreaseinmarketinterestratescanbecomputedby decrease in market interest rates can be computed by thebelowmentionedformula:

%changeinpriceofabond=(1) Modified Duration % change in price of a bond = (1)*ModifiedDuration* %changeininterestrates
Bond prices and interest rates movement have an Bondpricesandinterestratesmovementhavean

inverserelationshipandthusifinterestratesgoup, bondpricesfallandviceversa b d i f ll d i

EffectiveDuration
EffectiveDurationisameasureofpricesensitivity

calculatedfromactualbondpricesassociatedwith differentinterestrates EffectiveDuration (Pa Pb)/(Po(Yb Effective Duration =(Pa Pb) / (Po (Yb Ya))

PortfolioDuration
Thedurationofaportfolioofbondscanbecomputed

intwoways:
Mapthecashflowsofthebondintovariousterm

buckets,whentheyaredue,andusingyieldofthe portfolio,discountthetotalcashflowsoftheportfolio. Computedurationwiththeusualformula,treatingthe aggregatecashflowssiftheywereasinglebond Computetheweighteddurationofaportfolio,usingthe marketvalueofthebondastheweightage

BenefitsofDuration
Durationisespeciallyusefulindeterminingthe

relativeriskinessoftwoormorebondswhenvisual inspectionoftheircharacteristicsmakesitunclear g g whichismostvulnerabletochanginginterestrates DurationhelpsinStructuringofbondportfolios Duration helps in bond portfolio immunization Durationhelpsinbondportfolioimmunization

LimitationsofDuration
Durationisnotastaticpropertyofabond.Durationofa

bondchangesovertime,andwithchangesinmarket yields.Anystrategybasedondurationvaluesofabond will,therefore,requirecontinuousandactiveevaluation Computingdurationinvolvesthediscountingcashflowsof abond.ItiscommontousetheYTMofthebond,asthe rateatwhichcashflowsarediscounted.Therefore,the limitationsofYTMextendtothecomputationofduration Theresultsobtainedbyusingdurationtomeasureprice changeareonlyanapproximationoftheactualpriceyield relationship,whichisnotlinear,butconvex

NumericalQuestions
E Example1 C l l l 1 CalculateMacaulayDurationandModified M l D i d M difi d

DurationofabondforcompanyA,ifthecouponrateis giventobe8%andYTMis6%andthetimetomaturityis5 given to be 8% and YTM is 6% and the time to maturity is 5 years.FaceValueofthebondisINR1,00,000andinterest paymentsaremadeannually.Also,calculate%changein thepriceofthebondiftheYTfallsby100basispointsof the price of the bond if the YT falls by 100 basis points of 1%from6%to5%.Also,calculate%changeinbondprice y ifYTMincreasesby2% Solution:
Step1 WehavetocalculatetheMarketPriceofthebond,

forwhichwewillusethefollowingformulaasthebondis f hi h ill th f ll i f l th b d i maturingatParvalue:

YTM=(((MaturityValue PurchasePrice)/YearstoMaturity)+ Coupon)/((MaturityValue*0.4+PurchasePrice*0.6) 0.06=(((100000 PurchasePrice)/5)+8000)/ ((100000*0.4+PurchasePrice*0.6) PurchasePrice=108475

NumericalQuestions
S l i Solution:
Step2 CalculationofDuration:
Year (1) 1 2 3 4 5 AnnualCash Flows (2) 8000 8000 8000 8000 108000 PresentValue ofINR1at6% (3) 0.94 0.89 0.84 0 84 0.79 0.75 Present Valueof AnnualCashFlows (4)=(2)*(3) 7,520 7,120 6,720 6 720 6,320 81,000 Duration PresentValueofAnnualCashFlows dividedbyCurrentMarketPrice (5)=(4)/1,08,696 0.0692 0.0655 0.0618 0 0618 0.0581 0.7452 TimeRelative orDuration (6)=(5)*(1) 0.0692 0.1310 0.1855 0 1855 0.2326 3.726 4.3442

Step3 CalculationofModifiedDuration:

ModifiedDuration=Durationinyears/(1+YTM) ModifiedDuration=4.3442/1.06 ModifiedDuration=4.0983 Modified Duration = 4 0983

NumericalQuestions
Solution: Step4 Calculating%changesinPriceifYTMchanges
%changeinbondprices=(1)*ModifiedDuration*%changein

YTM IfYTMfallsby1% =(1)*4.0983*1% =4.0983%orbondpricewillincreaseby4.0983% 4 0983% b d i ill i b 4 0983% IfYTMincreasesby2% =(1) 4 0983 2% = ( 1) *4.0983*2% =8.1967%orbondpricewilldecreaseby8.1967%

NumericalQuestions
Example2 Mr.Lakshya isconsideringthepurchaseofthe

followingdebenture: ParValue IN 100 V l INR100 Maturity 3years Coupon 11%

a)IftheinvestorrequiresaYTMof13%ondebenturesof

equivalentriskandmaturity,whatdoeshebelieveisafair i l t i k d t it h td h b li i f i marketprice? b)IfthedebentureissellingforapriceofINR97.59,whatis b) If the debenture is selling for a price of INR 97 59 what is itspromisedYTM? c)Whatisthedurationofthisdebenture? d)Ifaninvestorhasahorizondateof4years,whyisthis debenturerisky? e)Ifaninvestorhasahorizondateof2years,whyisthis ) If i h h i d f2 h i hi debenturerisky?

NumericalQuestions
Example3 Mr.Guptarecentlypurchaseda10%bond

withFVINR1000and4yearstomaturity.Interest paymentsarepaidannuallybythecompany.Mr. p p GuptapaidINR1032.40forthebond.

a)WhatisbondsYTM?

Solution Solution
a)YTM=(((1000 1032.40)/4)+100)/(1000*0.4+

1032.40*0.6) 1032 40*0 6) =9.01%

NumericalQuestions
Example4 Calculatedurationofa5year,11%bondataYTMof9%(coupon f f (

paymentsarereceivedsemiannually).CurrentmarketpriceofthebondisINR 107.91 Solution

Period (1) 1 2 3 4 5 6 7 8 9 10 SemiAnnual CashFlows (2) 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 105.5 PresentValue ofINR1 at4.5%(YTM/2) (3) 0.9569 0.9158 0.8763 0.8386 0.8024 0.7679 0.7348 0.7032 0.6729 0.6439 Present ValueofSemi AnnualCashFlows (4)=(2)*(3) (4) (2) * (3) 5.26 5.04 4.82 4.61 4.41 4.22 4.04 3.87 3.70 67.93 Duration PresentValueofSemiAnnualCash FlowsdividedbyCurrentMarketPrice (5)= (4)/107.91 (5) (4) / 107 91 0.049 0.047 0.045 0.043 0.041 0.039 0.037 0.036 0.034 0.630 TimeRelative orDuration (6)=(5)*(1) (6) (5) * (1) 0.049 0.093 0.135 0.171 0.205 0.234 0.259 0.288 0.306 6.300 8.04 8 04

Duration=8.04halfyearsor4.02years

NumericalQuestions
Example5 XLtdissueda5year10%bond(face

valueINR100).Yieldtomaturityofthebondis12%. Calculatethemarketpriceofthebond.Also,calculate y y durationofthebond.Iftheyieldfallsby100basis points,calculatethechangeinthebondprice Solution Solution

Step1 WehavetocalculatetheMarketPriceofthe

bond,forwhichwewillusethefollowingformulaasthe bond for which we will use the following formula as the bondismaturingatParvalue:
YTM=(((MaturityValue PurchasePrice)/YearstoMaturity)+ YTM = (((Maturity Value Purchase Price)/ Years to Maturity) + Coupon)/((MaturityValue*0.4+PurchasePrice*0.6) 0.12=(((100 PurchasePrice)/5)+10)/((100*0.4+Purchase Price*0.6) PurchasePrice=92.65

NumericalQuestions
S l i Solution:
Step2 CalculationofDuration:
Year (1) 1 2 3 4 5 Annual CashFlows (2) 10 10 10 10 110 PresentValue ofINR1at12% (3) 0.89 0.80 0.71 0 71 0.64 0.57 Present Valueof AnnualCashFlows (4)=(2)*(3) 8.93 7.97 7.12 7 12 6.36 62.42 Duration PresentValueofAnnualCashFlows dividedbyCurrentMarketPrice (5)=(4)/92.65 0.10 0.09 0.08 0 08 0.07 0.67 TimeRelative orDuration (6)=(5)*(1) 0.10 0.17 0.23 0 23 0.27 3.37 4.14

Step3 CalculationofModifiedDuration:

ModifiedDuration=Durationinyears/(1+YTM) ModifiedDuration=4.14/1.12 ModifiedDuration=3.70 Modified Duration = 3 70

NumericalQuestions
Solution: Step4 Calculating%changesinPriceifYTMchanges
%changeinbondprices=(1)*ModifiedDuration*%changein

YTM IfYTMfallsby1% =(1)*3.70*1% =3.70%orbondpricewillincreaseby3.70%oritwillbecome 3 70% b d i ill i b 3 70% it ill b 96.08from92.65