Worksheet 2 Ans - Managing Bond Portfolios

WORKSHEET TWO
MANAGING BOND PORTFOLIOS

(TOPIC 5)
SUMMARY OF TOPIC 4- BOND VALUATION
 Bonds can be valued by discounting future cash flows at the yield to
maturity R
CT + PT PT
P0 =
C1
+
C2
+ .... P0 =
(1 + R )
1
(1 + R )
2
(1 + R )T (1 + R ) T
 Coupon Rate > R bond trades above par
 Coupon Rate = R bond trades at par
 Coupon Rate < R bond trades below par
 Bond prices change inversely with R; As R increases (decreases) the
present value of the bond will fall (rise)
 Bond price P0 response to interest rate changes depends on maturity
and coupon
 Less sensitive bonds: shorter maturity bonds with higher
coupon payments
 More sensitive bonds: longer maturity bonds with lower
coupon payments
SUMMARY OF TOPIC 5 - SECTION A
C1 C2 C3 CT + PT
D = 1 + 2 + 3 + .... + T 
P0 ( 1 + R )1
P0 ( 1 + R ) 2
P0 ( 1 + R ) 3
P0 ( 1 + R )T
 The longer a bond’s duration the more sensitive the bond
 Shorter maturity bonds with higher coupon payments- Low
Macaulay duration; Less sensitive bond
 Longer maturity bonds with low coupon payments-
High Macaulay duration; More sensitive bond.
 If interest rates are expected to rise (Fall): hold Low (high) Macaulay
duration bond.
 Modified D = D / (1+R) ΔP0 = P0 × ΔR × -MD
 The inverse relationship between bond price and yield is convex.
Duration is a linear approximation. Convex is above the linear, so
price estimated using duration will be lower than actual
EXERCISE 1- WS TWO
Consider the following three bonds:
Bond 1 Bond 2 Bond 3

Par Value £1,000 £1,000 £1,000
Coupon 0% 7% 11%
Time to Maturity 5 yrs 3yrs 3yrs
Required Yield 9% 9% 9%
I. Calculate the Present values of each bond

II. Calculate the Macaulay Duration for each bond
III.Calculate the Modified Duration for each bond
IV.If required yield fell to 8%, use duration to calculate the price
changes for each bond
V. An investor decides to reduce the holding of Bond 1 and to
increase the holding of Bond 3. Comment on the investor
action and his expectation for future interest rate changes?.
EXERCISE 1 - WS TWO
ANSWERS
I. Answer- BOND 1:
Par value: £1000; 0% coupon; 5 years to maturity; R =

9%
PT
P0 =
(1 + R ) T
1,000
P0 = = £649.93
( 1 + 0.09 ) 5
(Bond 1 trades below par as Coupon Rate < R)

EXERCISE 1 - WS TWO
ANSWERS C1 C2 CT + PT
P0 = + + ....
(1 + R )1 (1 + R )2 (1 + R )T
BOND 2
Par value: £1000; 7% coupon; 3 years to maturity; R=9%
70 70 1070
P0 = + +
(1 + 0.09 )1 (1 + 0.09 )2 (1 + 0.09 )3
= 64.22 + 58.92 + 826.24 = £949.38
Bond 2 trades below par as Coupon Rate < R
BOND 3
Par value: £1000; 11% coupon; 3 years to maturity; R=9%
110 110 1110
P0 = + +
(1 + 0.09)1 (1 + 0.09)2 (1 + 0.09)3
= 100.92 + 92.58 + 857.12 = £1050.62
Bond 3 trades above par as Coupon Rate > R
EXERCISE 1- WS TWO - ANSWER II
C1 C2 Ct CT + PT
D=1 +2 + .... + t + ... + T
P0 ( 1 + R )
1
P0 ( 1 + R ) 2
P0 ( 1 + R ) t
P0 ( 1 + R )T
BOND 1: D1 = 5 Years (Zero coupon bond, duration = time to maturity)
BOND2
70 70 1070
D2 = 1  + 2 + 3
949.38(1 + 0.09 )1 949.38(1 + 0.09 )2 949.38(1 + 0.09 )3
 64.22   58.92   826.24 

D2 =  1   + 2  + 3  = 2.80 Years
 949.38   949.38   949.38 
BOND3
110 110 1110
D3 = 1  + 2 + 3
1050.62(1 + 0.09 )1 1050.62(1 + 0.09 )2 1050.62(1 + 0.09 )3
 100.92   92.58   857.12 

D3 =  1  +
  2  +
  3   = 2.72 Years
 1050.62   1050.62   1050.62 
EXERCISE 1 – WS TWO
ANSWER III – MODIFIED DURATION
 D1 = 5 Years, D2 = 2.80 Years, D3 = 2.72 Years
 modified D = D / (1+R)
Bond 1 D 5
 MD1 = = = 4.59 %
(1 + R ) (1 + 0.09 )
D 2.80
 Bond 2 MD2 = = = 2.57 %
(1 + R ) (1 + 0.09 )
D 2.72
Bond 3 MD3 = = = 2.49 %

(1 + R ) (1 + 0.09 )
EXERCISE 1- WS TWO - ANSWER IV
 P1: £649.93; P2: £949.38; P3: £1050.62
 MD1: 4.59%; MD2: 2.57%; MD3: 2.49%
 Yield fell from 9% to 8% thus price will increase.
 Expected ΔP0 for a 1% decrease in R :

P0 × ΔR × -modified D
Bond 1
Expected ΔP0 = £649.93 × (-1%) × (-4.59) = £29.83
Bond 2
Expected ΔP0 = £949.38 × (-1%) × (-2.57) = £24.40
Bond 3
Expected ΔP0 = £1050.62 × (-1%) × (-2.49) = £26.16
EXERCISE 1 - WS TWO
(V) An investor decides to reduce the holding of Bond 1
and to increase the holding of Bond 3. Comment on
the investor action and his expectation for future
interest rate changes?.
 Switching from zero coupon to coupon paying bond.
 Switching to a shorter maturity bond.
 The investor will be switching to a bond with a lower
duration
 Switching to less sensitive bond.
 Common strategy if interest rate expected to increase.
 Protecting himself from expected fall in bond price that will
accompany the rise in interest rates.
Consider the following three bonds:
Par Value £1,000 £1,000 £1,000
Coupon 6% Zero Zero
Time to Maturity 3 years 3 years 4 years
(i) Calculate the present values of each bond.

(ii) Calculate the Macaulay Duration of each bond
(iii) Calculate the Modified Duration of each bond
(iv) If required yield increases to 9.1%, what is the approximate price
change?
(v) Explain the relevance of convexity when using bond duration.
(vi) An investor decides to reduce the holding of Bond 1 and to increase
the holding of Bond 3. Comment on the investor action and his
expectation for future interest rate changes?.
Par Value £1,000 £1,000 £1,000
Coupon 6% Zero Zero
Time to Maturity 3 years 3 years 4 years
 Bond 1
£60 £60 £1,060
P0 = + + = £924.06
(1 + 0.09 ) (1 + 0.09 ) (1 + 0.09 )
1 2 3
 Bond 2
£1,000
P0 = = £772.18
(1 + 0.09 )
3 All Bonds trade below
par as Coupon Rate < R
 Bond 3
£1,000
P0 = = £708.43
(1 + 0.09 )4
EXERCISE 2 - WS TWO
(ii) Calculate the Macaulay Duration
C1 C2 Ct CT + PT
D=1 +2 + .... + t + ... + T
P0 ( 1 + R ) 1
P0 ( 1 + R ) 2
P0 ( 1 + R ) t
P0 ( 1 + R )T
£60 £60 £1,060
D1 = 1  + 2 + 3 = 2.83 Years
£924.06 (1 + 0.09 ) 1
£924.06 (1 + 0.09 ) 2
£924.06 (1 + 0.09 ) 3
 £55.05   £50.50   £818.51 

D1 = 1   + 2   + 3   = 2.83 year
 £924.06   £924.06   £924.06 
D2 = 3 Years D3= 4 years
Duration is the same as maturity for zero coupon

bonds
EXERCISE 2 - WS TWO
(iii) Calculate the Modified Duration for each bond.
D1 = 2.83 Years D2 = 3 Years D3= 4 years
Modified D = D / (1+R)
MD1= 2.83/1.09 = 2.6%
MD2= 3/1.09 = 2.75%
MD3= 4/1.09 = 3.67%

EXERCISE 2 - WS TWO
(iv) If required yield increases to 9.1%, what is the
approximate price change?
 P1: £ 924.06; P2: £ 772.18; P3: £ 708.43
 MD1: 2.6%; MD2: 2.75%; MD3: 3.67%
 Because we know the modified duration of this bond, we can
calculate the approximate change in this bond's price, given an
increase in R of 0.1%.
Approximate change in bond price = P0 × ΔR × -MD
 The approximate change in the price of the bond if the
required yield increases by 0.1% to 9.1 % is given as:
 Price Change in Bond 1 = £924.06 × (0.001) × (-2.6) = -£2.4
 Since the yield was rising, this will be a fall in price.
EXERCISE 2 - WS TWO
(v) Explain the relevance of convexity when using bond
duration.
 The duration result is imprecise for larger interest rate
movements
 Using duration to estimate interest rate sensitivity is only
precise for small interest rate movements.
 The inverse relationship between bond price and yield is convex
 Duration is a linear approximation. Convex is above the linear,
so price estimated using duration will be lower than actual
1600
1400
Bond Price
1200
1000
800
600
400
5%
7%
9%
%
11
13
15
17
19
21
23
YTM
EXERCISE 2 - WS TWO
(VI) An investor decides to reduce the holding of Bond
1 and to increase the holding of Bond 3. Comment
on the investor action and his expectation for
future interest rate changes?.
 Switching from coupon paying to zero coupon bond.

 Switching to a longer maturity bond.
 The investor will be switching to a bond with a higher
duration
 Switching to more sensitive bond.
 Common strategy if interest rate expected to fall.
 Positioning himself favourably for the expected rise in bond
price that will accompany the fall in interest rates.

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WORKSHEET TWO

MANAGING BOND PORTFOLIOS

Bond 1 Bond 2 Bond 3

I. Calculate the Present values of each bond

Par value: £1000; 0% coupon; 5 years to maturity; R =

(Bond 1 trades below par as Coupon Rate < R)

 64.22   58.92   826.24 

 100.92   92.58   857.12 

 Yield fell from 9% to 8% thus price will increase.

 Expected ΔP0 for a 1% decrease in R :

(i) Calculate the present values of each bond.

 £55.05   £50.50   £818.51 

D2 = 3 Years D3= 4 years

Duration is the same as maturity for zero coupon

(iii) Calculate the Modified Duration for each bond.

D1 = 2.83 Years D2 = 3 Years D3= 4 years

MD1= 2.83/1.09 = 2.6%

MD2= 3/1.09 = 2.75%

MD3= 4/1.09 = 3.67%

 Switching from coupon paying to zero coupon bond.

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