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Lecture 4 - Fixed Income Risk

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17 views

Lecture 4 - Fixed Income Risk

Uploaded by

Tishal Bhantoo
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Lecture 4

Fixed Income Risk


Introduction
Two commonly used measures of interest rate risk are duration and convexity. They distinguish
between risk measures based on changes in a bond’s own yield-to-maturity (yield duration and
convexity) and those that affect the bond based on changes in a benchmark yield curve (curve duration
and convexity).

Macaulay duration
Macaulay duration is named after Frederick Macaulay, the Canadian economist who first wrote about
the statistic in 1938.

The duration of a bond measures the sensitivity of the bond’s full price (including accrued interest) to
changes in the bond’s yield-to-maturity or, more generally, to changes in benchmark interest rates.
Duration estimates changes in the bond price assuming that variables other than the yield-to-maturity
or benchmark rates are held constant. Most importantly, the time-to-maturity is unchanged.
Therefore, duration measures the instantaneous (or, at least, same-day) change in the bond price.

Duration is a useful measure because it represents the approximate amount of time a bond would
have to be held for the market discount rate at purchase to be realized if there is a single change in
interest rate. If the bond is held for the duration period, an increase from reinvesting coupons is offset
by a decrease in price if interest rates increase and a decrease from reinvesting coupons is offset by an
increase in price if interest rates decrease.

Consider first the 10-year, 8% annual coupon payment bond used in Examples 1–6 in the previous
lecture. The bond’s yield-to-maturity is 10.40%, and its price is 85.503075 per 100 of par value.

The Macaulay duration is 7.0029 years.


1
Now consider an example between coupon payment dates. A 6% semi-annual payment corporate
bond that matures on 14 February 2027 is purchased for settlement on 11 April 2019. The coupon
payments are 3 per 100 of par value, paid on 14 February and 14 August of each year. The yield-to-
maturity is 6.00% quoted on a street-convention semiannual bond basis. The full price of this bond
comprises the flat price plus accrued interest. The flat price for the bond is 99.990423 per 100 of par
value. The accrued interest is calculated using the 30/360 method to count days. This settlement date
is 57 days into the 180-day semiannual period, so t/T = 57/180. The accrued interest is 0.950000 (=
57/180 × 3) per 100 of par value. The full price for the bond is 100.940423 (= 99.990423 + 0.950000).

Microsoft Excel users can obtain the Macaulay duration using the DURATION financial function—
DURATION(DATE(2019,4,11),DATE(2027,2,14),0.06,0.06,2,0)— and inputs that include the settlement
date, maturity date, annual coupon rate as a decimal, annual yield-to-maturity as a decimal,
periodicity, and day count code (0 for 30/360, 1 for actual/actual).

The annualised Macaulay duration is reported as 6.31 years

In principle, duration is lower for (i) a shorter maturity date, (ii) a higher coupon rate, and (iii) a higher
yield.

Modified duration
Modified duration gives an idea of how the price of a bond will be affected should interest rates
change. A higher duration implies greater price volatility should rates move. Duration is quoted as the
percentage change in price for each given percent change in interest rates. For example, the price of a
bond with a duration of 2 would be expected to increase (decline) by about 2.00% for each 1.00%
move down (up) in rates.

Microsoft Excel users can obtain the modified duration using the MDURATION financial function using
the same inputs as for the Macaulay duration:

MDURATION(DATE(2019,4,11),DATE(2027,2,14),0.06,0.06,2,0).

The annualised modified duration is reported as 6.13 years.

Convexity
Modified duration measures the primary effect on a bond’s percentage price change given a change in
the yield-to-maturity. A secondary effect is measured by the convexity statistic, which is illustrated in
the exhibit below for a traditional (option-free) fixed-rate bond.

2
The true relationship between the bond price and the yield-to-maturity is the curved (convex) line
shown in the exhibit above. This curved line shows the actual bond price given its market discount
rate. Duration estimates the change in the bond price along the straight line that is tangent to the
curved line. For small yield-to-maturity changes, there is little difference between the lines. But for
larger changes, the difference becomes significant. The convexity statistic for the bond is used to
improve the estimate of the percentage price change provided by modified duration alone. The
equation below is the convexity-adjusted estimate of the percentage change in the bond’s full price.

The formula for approximate convexity is as follows:

Annualised convexity = ApproxCon/(preriodicity)^2

https://www.raymondjames.com/wealth-management/advice-products-and-services/investment-
solutions/fixed-income/bond-basics/duration-and-convexity

https://macrohive.com/hive-explainers/duration-and-convexity-in-bond-markets/

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