Bond Price Volatility

Dr. Himanshu Joshi

FORE School of Management
New Delhi
Bond Price Volatility
To employ the effective bond portfolio
strategies, it is necessary to understand the
price volatility of bonds resulting from
changes in interest rate.
In this session we will discuss the price
volatility characteristics of a bond and to
present some measures to quantify price
volatility.
Review of the Price-Yield Relationship for Option Free Bonds C:\Documents and
Settings\himanshu\Desktop\SRPM June-Sept 12\price-yield-relationship.xlsx
Six hypothetical bonds, where the bond prices
are shown assuming a par value of $100 and
interest paid semiannually:
1. A 9% coupon bond with 5 years to maturity.
2. A 9% coupon bond with 25 years to maturity.
3. A 6% coupon bond with 5 years to maturity.
4. A 6% coupon bond with 25 years to maturity.
5. A zero coupon bond with 5 years to maturity.
6. A zero coupon bond with 25 years to maturity.

Price-Yield Relationship
The Inverse Relationship Between Bond Prices
and Yields
Price-Yield Relationship
Notice that as the required yield rises, the price of the
option-free bond declines. This relationship is not
linear, however. (i.e., it not a straight line). The shape
of the price-yield relationship for any option free bond
is referred to as convex.
The price-yield relationship that we have discussed
refer to an instantaneous change in the required yield.
The price of bond will change over time as a result of:
(1) a change in the perceived credit risk of the issuer.
(2) a discount or premium bond approaching the
maturity date, and
(3) a change in the market interest rates.
Price Volatility Characteristics of
Option Free Bond
Price Volatility Characteristics of
Option Free Bond
The Exhibit above shows, for six hypothetical
bonds, the percentage change in the bonds
price for various changes in the required yield,
assuming that the initial yield for all six bonds
is 9%. (for varying coupon rates of 9%, 6% and
0%.)
A close examination of exhibit above reveals
several properties concerning the price
volatility of an option free bond.
Price Volatility Characteristics of
Option Free Bond: Some Properties:
Property 1. although the prices of all option
free bonds move in the opposite direction
from the change in the yield required, the
percentage change is not the same for all the
bonds.
Property 2. for very small changes in the yield
required, the percentage price change for a
given bond is roughly the same, whether
required yield increases or decreases.
Price Volatility Characteristics of
Option Free Bond: Some Properties:
Property 3. for large changes in 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.
Property 4. for a given large change in basis
points, the percentage price increase (on
decrease on req. yield) is greater than the
percentage price decrease (on increase in req.
yield).
Price Volatility Characteristics of
Option Free Bond: Some Properties:
Implication of Property 4: (Convexity)
The implication of property 4 is that if an investor
owns a bond (i.e., long a bond), the price
appreciation that will be realized if the required
yield decreases is greater than the capital loss
that will be realized if required yield rises by the
same number of basis points.
For an investor who is short a bond, the reverse
is true: the potential capital loss is greater than
the potential capital gain if the required yield
changes by a given number of basis points.
Characteristics of a bond that affect its
price volatility
Characteristic 1: for a given term to maturity and
initial yield, the price volatility of a bond is
greater, lower the coupon rate.
(compare 9%, 6% and zero coupon bond with
same maturity.)
Characteristic 2: For a given coupon rate and
initial yield, the longer the term to maturity, the
greater the price volatility.
(compare five year bond with 25 year bond with
the same coupon say 9%, 6% and 0% bonds)

Characteristics of a bond that affect its
price volatility: An Implication
An implication of the second characteristic is that
investors who want to increase a portfolios price
volatility (they expect interest rate to fall), all
other factor being constant, they should hold
bonds with longer maturities in the portfolio.
To reduce a portfolios price volatility in
anticipation of a rise in interest rates, bond with
shorter-term maturities should be held in
portfolio.
Effects of Yield to Maturity
Holding other factors constant, does the YTM
affect a bonds price volatility?

Higher the yield to maturity at which bond
trades, the lower the price volatility.
Price Change for a 100 basis point change in
yield for 9%, 25 year Bond trading at different
Yield Levels
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 are commonly employed are:
(1) Price value of a basis point
(2) Yield value of a basis point
(3) Duration.
1. Price Value of a Basis Point
Bond Initial Price (9%
yield)
Price at 9.01% yield Price Value of a
Basis Point
9% Coupon/5 Year 100 99.9604 0.0396
9% Coupon/25 Year 100 99.9013 0.0987
6% Coupon/5 Year 88.1309 88.0945 0.0364
6% Coupon/25 Year 70.3570 70.2824 0.0746
0% Coupon/5 Year 64.3928 64.3620 0.0308
0% Coupon/25 Year 11.0710 11.0445 0.0265
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.
3. Duration
P =C/1+y + C/(1+y)
2
+ ----+C/(1+y)
n
+ M/(1+y)
n

First differentiation is duration.

Duration Calculation.

Macaulay Duration and Modified
Duration for Six Hypothetical Bonds
Bond Macaulay Duration Modified Duration
9%, 5 Year 4.13 3.96
9%, 25 Year 10.33 9.88
6%, 5 Year 4.35 4.16
6%, 25 Year 11.10 10.62
0%, 5 Year 5.00 4.78
0%, 25 Year 25.00 23.92
Properties of Duration
As can be seen from the various durations
computed for the six hypothetical bonds, the
Modified duration and Macaulay Duration of a
coupon bond are less than the maturity.
It is obvious from the formula that Macaulay
Duration of the zero coupon bond is equal to its
maturity.
A zero coupon bonds modified duration is
however, less than its maturity.
Also, lower the coupon, generally higher the
modified and Macaulay duration of the bond.
Properties of Duration..
There is a consistency between the properties
of bond price volatility we discussed earlier
and the properties of modified duration:
1. We showed earlier that when all other
factors remain unchanged, the longer the
maturity, the greater the price volatility.
A property of Modified Duration is that when
all other factors are constant, the longer the
maturity, the greater the Modified Duration.
Properties of Duration..
2. We also showed that the lower the coupon
rate, all other factors being constant, the
greater the bond price volatility.
In case of duration, the lower the coupon rate,
the greater the Modified Duration, the greater
the Price Volatility.
Properties of Duration..
3. Finally, as we noted earlier, another factor
that will influence price volatility is YTM.
All other factors being constant, the higher the
yield level, the lower the price volatility.
The same property holds for modified duration,
as can be seen in the following table, which
shows the modified duration of a 25 year 9%
coupon bond at various yield levels:
Properties of Duration..
Yield (%) Modified Duration
7 11.21
8 10.53
9 9.88
10 9.27
11 8.70
12 8.16
13 7.66
Approximating the Percentage Price
Change..
dP/dy* 1/P = - Modified Duration
Multiplying both the side with dy (change in
the required yield)
dP/P = - Modified Duration * dy
This equation can be used to approximate the
percentage change for a given change in
required yield.
Approximating the Percentage Price
Change..
Example: Consider the 25 year 6% bond selling
at 70.3570 to yield 9%. The modified duration
for this bond is 10.62. if yield increase
instantaneously from 9% to 9.10%, a yield
change of (.0910-.09) = +0.001 (10 Basis
Points)
Portfolio Duration
The duration of the portfolio is simply the
weighted average of the bonds in the
portfolios.

Bond Market Value Portfolio
Weight
Duration
A $10 million 0.10 4
B $40 million 0.40 7
C $30 million 0.30 6
D $20 million 0.2 2
Portfolio Duration
0.1*4 + 0.4*7 +0.3*6+ 0.2*2 = 5.4
The portfolio duration is 5.4 and interpretation is as
follows:
If all the yields affecting the four bonds in the portfolio
change by 100 basis points, the portfolios value will
change by approximately 5.4%.
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
duration of the individual issue:
Portfolio Duration
Contribution to portfolio Duration = weight of
issue in portfolio * duration of issue.

A = 0.10* 4 = 0.40
B= 0.40* 7 = 2.8
-----
Portfolio Duration
Moreover, portfolio managers look at portfolio
duration for sectors of the bond market.
Sector Portfolio
Weight
Sector
Duration
Contribution to
Portfolio
Duration
Treasury 0.00 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
Total 1.00 4.52
Convexity
The relationship between bond prices and yields
is not linear
Duration rule is a good approximation for only
small changes in bond yields
Bond Price Convexity: 30-Year Maturity, 8% Coupon; Initial
Yield to Maturity = 8%
Correction for Convexity

=
(

+
+ +
=
n
t
t
t
t t
y
CF
y P
Convexity
1
2
2
) (
) 1 ( ) 1 (
1
Correction for Convexity:
2
1
[ ( ) ]
2
P
D y Convexity y
P
A
= -A + A

Example. Convexity
Bond in the figure has a 30 year maturity, an
8% coupon, and sells at an initial yield to
maturity of 8%.
Because coupon rate equals YTM, the bond
sells at par value $1000.
Modified duration for the bond is 11.26 years,
and convexity is 212.4.
If the bonds yield increases from 8% to 10%,
bond price will fall to $811.46.
Example
Change of 18. 85%
The duration rule P/P = -D* y
=-11.26 * .02 = -22.52%.
Duration with Convexity:
P/P = -D
*
y +1/2 * Convexity* (y)
2

=11.26*.02 +1/2 * 212.4 * (.02)
2

=
-18.27%.

PASSIVE BOND PORTFOLIO
MANAGEMENT STRATEGIES: Indexing


PASSIVE BOND PORTFOLIO MANAGEMENT
STRATEGIES: Immunization

In contrast to indexing strategies many institutions try to
insulate their portfolios from interest rate risk altogether.
The net worth of the firm or ability to meet future
obligations fluctuate with interest rates.
Immunization refers to strategies used by such investors to
shield their overall financial status from interest rate
fluctuations.
Example: Pension Funds (Fixed Future obligation) and
Banks (asset Liability maturity mismatch).
The lesson is that funds should match the interest rate
exposure of assets and liabilities so that the value of assets
will track the value of liabilities whether rate rises or falls.
Immunization

The notion of immunization was introduced
by F. M. Redington, an actuary for a life
insurance company.
The idea behind immunization is that duration
matched assets and liabilities let the assets
portfolio meet the firms obligations despite
interest rate movements.

Immunization..
The procedure is termed immunization because it
immunizes the portfolio value against interest
changes.
The procedure and its refinements, is in fact one
of the most widely used analytical techniques of
investment science, shaping portfolios consisting
of billions of dollars of fixed income securities
held by pension funds, insurance companies, and
other financial institutions.

Immunization..
Let us more fully consider its purpose first. A portfolio can not be
structured meaningfully without a statement of its purpose.
Suppose you wish to invest in money now that will be used next
year for a major household expense. If you invest in 1 year T-bills
you know exactly how much money these bills will be worth in a
year, hence there is no relative risk to your purpose.
Conversely if you invest your money in 10 year T-
Bill, value of this T-Bill after one year will be quite variable. (Price
Risk)
The situation will be reversed if you were saving to pay off an
obligation that was due in 10 years, then a 10 year zero coupon
bond would provide completely predictable returns, but 1 year T-
Bill would impose (Reinvestment Risk).
Immunization..
Now suppose that you face a series of cash obligations and you wish to
acquire a portfolio that you will use to pay these obligations as they arise.
(LICs).
One way to do this is to purchase a set of zero-coupon bonds that have
maturities and face values exactly matching the separate obligations.
Not applicable with Corporate Bonds.
If perfect matching is not possible, you may instead acquire a portfolio
having a value equal to the present value of the stream of obligations.
You can sell some of your portfolio whenever cash is needed to meet
particular obligation; or if portfolio delivers more cash than needed at a
given time, you can buy more bonds.
Hence you will meet the obligations exactly.

What is the limitation of this method?
Immunization..
A problem with this value matching technique arises if the
yield change. The value of your portfolio and Present Value of
Stream of cash flows both will change, but differently.
Your portfolio will no longer be matched.
Immunization solves this problem- at least approximately-by
matching duration as well as present values.
Immunization..
If the duration of the portfolio matches that of the obligation
stream, then the cash value of the portfolio and the present
value of the obligation stream will respond identically to a
change in yield.

If yield increase present value of the asset portfolio will
decrease, but the present value of the obligations will
decrease by approximately the same amount, so the value of
portfolio will still be adequate to cover the obligation.
Pension Funds Lost Ground Despite
Broad Market Gains
With the S&P 500 providing a rate of return in
excess of 25%, 2003 was a banner year for the
stock market. Not surprisingly, this performance
showed up in the balance sheets of US pension
funds: assets in these funds rose by more than
$100 billion.
Despite this boost, the pension funds actually lost
the ground in 2003, the gap between assets and
liabilities growing by about $45 billion..
How could this happen?
Immunization
ExampleImmunizationBsheet.xlsx
Consider an example, an insurance company that
issues a guaranteed investment contract for
$10,000. if the GIC has five year maturity and a
guaranteed interest rate is 8%, the insurance co.
is obliged to pay = $10,000*(1.08)
5
= $14,693.
Suppose that insurance company chooses to fund
its obligation with $10,000 of 8% annual coupon
bonds, selling at par value, with 6 years to
maturity.
Immunization

If portfolio maturity is chosen appropriately, price
risk and re-investment rate risk will cancel out
exactly.
When the portfolio duration is set equal to the
investors horizon date, the accumulated value of
the investment fund at the horizon date will be
unaffected by interest rate fluctuations.
For a horizon equal to the portfolios duration,
price risk and reinvestment risk exactly cancel
out.
Immunization

If the obligation was immunized, why is there
any surplus in the fund?
Convexity.
Coupon bond has greater convexity than the
obligation it funds.
Immunization..
Limitations..
The method assumes that all yield are equal,
whereas in fact they usually are not. Indeed it
is quite unrealistic to assume that both long
term and short term bonds can be found with
identical yields.
Also in practice more than two bonds will be
used, partly to diversify default risk if the
bonds included are not Treasury bonds.

Figure 16.10 Immunization
Table 16.5 Market Value Balance Sheet