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Prepared By: Deveshree Raut Debjani Singha Jagruti Chauhan

The document discusses the concept of duration in bonds. It defines duration as the number of years required to receive the present value of future payments of interest and principal for a bond. It then discusses different factors that affect bond duration such as time to maturity, coupon rate, and modified duration. Modified duration accounts for changing interest rates and measures the price sensitivity of a bond to changes in yield. The document provides examples to illustrate how duration is calculated for individual bonds and bond portfolios. It also discusses the limitations of using duration and introduces the concept of convexity, which provides a more accurate measure of price changes due to yield fluctuations.

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45 views

Prepared By: Deveshree Raut Debjani Singha Jagruti Chauhan

The document discusses the concept of duration in bonds. It defines duration as the number of years required to receive the present value of future payments of interest and principal for a bond. It then discusses different factors that affect bond duration such as time to maturity, coupon rate, and modified duration. Modified duration accounts for changing interest rates and measures the price sensitivity of a bond to changes in yield. The document provides examples to illustrate how duration is calculated for individual bonds and bond portfolios. It also discusses the limitations of using duration and introduces the concept of convexity, which provides a more accurate measure of price changes due to yield fluctuations.

Uploaded by

arunj49
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Prepared By:

DEVESHREE RAUT
DEBJANI SINGHA
JAGRUTI CHAUHAN
WHAT IS DURATION?

 The number of years required to receive the


present value of future payments, both of interest
and principle, of a bond.

 Macaulay Duration: Developed in 1938 by


Frederic Macaulay.
EXAMPLE
 5 Year Bond, Coupon Rate-5%, FV- Rs. 1000

1st Year 2nd Year 3rd Year 4th year 5th year
(Interest) (Interest) (Interest) (Interest) (Interest + Face Value)

How to calculate Duration :


FACTORS AFFECTING BOND
DURATION
1). TIME TO MATURITY:
Consider 2 Bonds
A B
Face Value - 1000 1000
Interest Rate - 5% 5%
Maturity - 1 year 10 year

• Therefore, everyone would prefer Bond A as it will


repay its true cost quickly than Bond B.
• Hence, shorter duration maturity bond would have
lower duration and less price risk.
FACTORS AFFECTING BOND
DURATION
 2). COUPON RATE

• A Bond’s payment is the key factor in calculating


duration. Bonds with higher coupon will payback
its original cost quicker than the lower yielding
bonds.

• Therefore, higher the coupon, the lower will be


the duration.
UNDERSTANDING BOND DURATION

• You may think a 30 year treasury is your safest


investment, but if you don’t understand the dynamics
of Bond duration you could be taking a big risk.

• ONE RISK IN BOND MARKET= Interest Rate Risk-


which is easy to determine through the concept
of---------MODIFIED DURATION. (1966, Larry
Fisher)

• It is defined as the percentage change in price for a


100 basis point change in interest rates.
MODIFIED DURATION

• It is the modified version of the Macaulay


Model that accounts for change in interest
rates.
• Fluctuating interest rates will affect duration.

MODIFIED DURATION FORMULA

MD = Macaulay Duration
1 + YTM
no. of coupon per year
EXAMPLE OF MACAULAY AND MODIFIED

• Betty hold a 5 year bond with a par value of


1000 and coupon rate- 5%. ( Macaulay
Duration).
Solution -

1(50/1250)+2(50/1250)+3(50/1250)+4(50/1
250)+5(50/1250)+5(1000/1250)= 4.6 years.

Continue with same Eg for Modified Duration.


Md= (4.55/ (1+0.05/1))= 4.33.
EXAMPLE
• 2 bonds with similar maturity but with
different coupon rates and cash flow patterns
will have different duration.

• 1st Bond = 5 year maturity, 8.5% rate ,1000


face value , YTM=10%

• 2nd Bond =5 year maturity,11.5%


rate,1000FV, YTM=10.6%.
Duration of 8.5% Bond
YEAR CASH FLOW PV @ 10% BOND PRICE BOND PRICE*
PROPORTION TIME

1 85 77.27 0.082 0.082

2 85 70.25 0.074 0.149

3 85 63.86 0.068 0.203

4 85 58.06 0.062 0.246

5 1085 673.70 0.0714 3.572

943.14 1.000 4.252


Duration of 11.5% Bond
YEAR CASH FLOW PV @ 10.6% BOND PRICE BOND PRICE*
PROPORTION TIME

1 115 103.98 0.101 0.101

2 115 94.01 0.091 0.182

3 115 85.00 0.082 0.247

4 115 76.86 0.074 0.297

5 1115 673.75 0.652 3.259

1033.60 1.0000 4.086


COMPARISION OF BOTH THE BONDS
• Duration of 1st bond=4.252 years
• Duration of 2nd bond=4.086years

Now, if we calculate the volatility of both the bonds i.e.


Modified Duration

• Volatility of 8.5% bond = 4.252/(1.100)= 3.87


• Volatility of 11.5% bond= 4.086/(1.106)= 3.69

• Which indicates that 8.5% bond has higher volatility.

• If YTM increase by 1%, this will result in 3.87% decrease


in the price and 3.69% decrease in case of 11.5% bond.
PRESENT VALUE (IN RUPEES)

DISCOUNT RATE 5 YEAR BOND 10-YEAR BOND PERPETUAL BOND


(In %)

5 1216 1386 2000

10 1000 1000 1000

15 832 749 667

20 701 581 500

25 597 464 400


WHAT COULD BE THE REASON?

• The reason for this differential responsiveness


is not difficult to understand.

• In case of 10 year bond, one would get just


Rs.100 even if interest rate rises to say 15
percent. Incase of 5 year bond, one can at least
sell the bond after 5 years and reinvest money
to receive Rs.150 for the next five years.
WHAT IS PORTFOLIO DURATION?

 A portfolio's duration is equal to the


weighted average of the durations of
the bonds in the portfolio. The weight
is proportional to how much of the
portfolio consists of a certain bond.
EXAMPLE
Portfolio Duration = w1D1 + w2D2 ...+ wkDk
Let's take 3 bonds:
• 6,000 market value of ABC ltd 7% of 10 with duration of 5.5
• 3,400 market value of XYZ 5% or 15 with duration of 7.8
• 1,535,market value of CDS 9% or 20 with duration of 12

Total market valve of 10,935.


Solution:
First let's find the weighted average of each bond:
• ABC LTD weighted average is 6,000/ 10,935= .548
• XYZ LTD weighted average is 3,400 / 10,935 = .311
• CDS LTDweighted average is 1,535/ 10935, = .14

So the Portfolio Duration = .548(5.5) + .311(7.8) + .14 (12) 


                                      = 7.119
LIMITATION OF THE PORTFOLIO
DURATION MEASURE

• Each of the bonds in the portfolio


must change by the 100 or 50bps, or
there must be a parallel shift in the
yield curve for the duration measure
to be useful.
EFFECTIVE DURATION

• The modified duration formula discussed above assumes


that the expected cash flows will remain constant, even if
prevailing interest rates change; this is also the case for
option-free fixed-income securities.

• On the other hand, cash flows from securities with


embedded options or redemption features will change when
interest rates change.

• For calculating the duration of these types of bonds,


“Effective Duration” is the most appropriate.

• EG - CALLABLE BONDS.
WHAT IS CONVEXITY?
Why duration is inaccurate in measuring the effect of yield changes
on price?
• Duration and YTM are inversely related.

• As yields rise, duration falls. Thus, the next yield increase has less
of a negative effect on price since duration is lower.

• As yields fall, duration rises. Thus, the next yield decline has more
of a positive effect on price since duration is higher.

• Using the duration method to calculate the new price of a bond


following a yield change – negative or positive – will, therefore,
be inaccurate (and always too low) since the bond’s original
duration is used in the calculation and the duration itself changes .
The more Convex a Bond, the more
attractive.
• Bond A has a higher convexity than Bond B, which
means that all else being equal, Bond A will always have
a higher price than Bond B as interest rates rise or fall.
WHAT IS NEGATIVE CONVEXITY?
• For a non-callable bond, there is an inverse relationship between
duration and yield.

• Negative convexity means that as market yields decrease, duration


decreases as well.

• Since this is an unfavorable characteristic of a bond, investors


demand a higher yield.

• Negatively convex bonds (such as callable corporate and mortgages)


thus yield more than otherwise equivalent non-callable, or positively
convex, bonds.

• Investors expecting stability in yields are attracted to such bonds.


THANK YOU

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