Bond Price Volatility

Joel R. Barber
Joel R. Barber () Chapter 4 1 / 29
Price-yield curve for noncallable bonds
1
example: CR = 6%, T = 20 years, M = $100
2
value: P(y) = 3A(y/2, 40) +
100
(1+y /2)
40
3
declining
4
convex
0.02 0.04 0.06 0.08 0.10 0.12 0.14
60
80
100
120
140
160
yield
P
Joel R. Barber () Chapter 4 2 / 29
Bond price properties
1
prices are inversely related to yield
2
for a small yield change (either or up or down) the price sensitivity
can be measured by the slope
3
for a large change in yield the price sensitivity is greater when yields
decrease
4
sensitivity is negatively related to the yield
Joel R. Barber () Chapter 4 3 / 29
Characteristics of a bond that explain price volatility
1
positively related to maturity
2
price versus yield for coupon rate of 6% with 5, 15, and 30 year
maturities
0.02 0.04 0.06 0.08 0.10 0.12 0.14
50
100
150
200
yield
P
Joel R. Barber () Chapter 4 4 / 29
Characteristics of a bond that explain price volatility
1
negatively related to coupon rate
2
value per dollar invested (assuming yield initial yield of 6 percent)
versus yield for coupon rate of 0, 6, and 12 percent
0.02 0.04 0.06 0.08 0.10 0.12 0.14
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
yield
P
Joel R. Barber () Chapter 4 5 / 29
Duration analysis
1
modied duration
MD =
1
P

dP
dy

y =y
0
-

%P
y

for small y
2
Macaully Duration:
D =
1 +y
P

dP
dy

3
formula:
D =
1
P
_
C
1
(1 +y)
+
2C
2
(1 +y)
2
+ +
NC
N
(1 +y)
N
_
4
for semi-annual bonds substitute
y
2
for y and multiply D by
1
2
5
relationship
D = (1 +y) MD
Joel R. Barber () Chapter 4 6 / 29
Duration as measure of a bonds eective life
1
dene present value cash ow weight for cash ow promised at date i :
w
i
=
C
i
/(1 +y)
i
P
2
weights sum to one
3
then
D = w
1
+w
2
2 + ... +w
N
N
4
so duration is a weighted average of cash ow payment dates
Joel R. Barber () Chapter 4 7 / 29
Properties of Macaully duration
1
measures price sensitivity to interest rate change:
%P -
_
D
1 +y
_
y
2
in units of time (years)
3
measures eective life of bond
4
duration of zero equals maturity (w
N
= 1)
5
duration of coupon bond less than zero with same maturity
6
duration increases in maturity
7
for a coupon bond duration increases with maturity at a decreasing
rate
8
duration decreases with CR
Joel R. Barber () Chapter 4 8 / 29
Duration increases with maturity
CR = 0, 2, 6, and 10 percent:
0 10 20 30
0
10
20
30
time to maturity (years)
D
Joel R. Barber () Chapter 4 9 / 29
Duration decreases with yield
5, 15, and 30 year maturity bond with CR = 6%
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10
0
2
4
6
8
10
yield
D
Joel R. Barber () Chapter 4 10 / 29
Duration analysis
Example
CR = 6%, T = 20 years, M = $100
1
if y = 6%,then
P = $100 and D = 11. 904 years
2
suppose = +50 bps
3
%P -
11. 904
1.03
(.5) = 5. 779%
4
suppose = 50 bps
5
%P -
11. 904
1.03
(.5) = +5. 779%
Joel R. Barber () Chapter 4 11 / 29
Duration analysis
Example continued
1
approximate new price at y = 5.5%
100(1 + .05779) = 105. 78
2
actual price at
P = 3A(.055/2, 40) +
100
(1 + .055/2)
40
= 106.02
3
approximate new price at
100(1 .05779) = 94. 221
4
actual price at y = 6.5%
P = 3A(.065/2, 40) +
100
(1 + .065/2)
40
= 94. 448
Joel R. Barber () Chapter 4 12 / 29
Convexity
1
actual price always greater then duration approximation
2
why?
3
because price-yield curve is convex, linear approximation at initial
yield is a supporting line
0.04 0.06 0.08 0.10
60
80
100
120
140
yield
P
Joel R. Barber () Chapter 4 13 / 29
Convexity
1
convexity adjustment:
%P -
_
D
1 +y
_
y +
1
2
CX(y)
2
where CX measures convexity at y
2
note convexity adjustment is always positive
3
denition:
CX =
1
P
d
2
P
dy
2
4
formula (do not need to know):
CX =
1
(1 +y)
2
_
N

n=1
w
n
_
n
2
_
2
+D
_
Joel R. Barber () Chapter 4 14 / 29
Convexity measures cash ow dispersion about duration
1
bullet (zero coupon)
2
ladder (annuity)
3
barbell (use your imagination)
Joel R. Barber () Chapter 4 15 / 29
Convexity measures cash ow dispersion about duration
Example 1
compare CR = 6%, T = 20 years, M = $100
to zero with T = 11.904 years and P = $100
1
both bonds have same duration and same price
2
need to solve for M:
100 =
M
(1.03)
11.9042
solution is : M = 202. 13
3
so
P
ZC
(y) =
202. 13
(1 +y/2)
11.9042
Joel R. Barber () Chapter 4 16 / 29
Convexity measures cash ow dispersion about duration
Example 1: price yield curve for coupon bond and zero
0.02 0.04 0.06 0.08 0.10 0.12
60
80
100
120
140
160
180
yield
P
Joel R. Barber () Chapter 4 17 / 29
Convexity measures cash ow dispersion about duration
Example 2
compare bullet, barbell, and ladder
same price and duration
term structure: at 6%
1
ladder is 20 year $6 annuity, semiannual payment
2
price of ladder:
3A(.03, 40) = 69. 344
3
duration of ladder equals 8.325 years
4
zero coupon bond promises 113.440 dollars in 8.325 years
5
price of zero coupon:
P =
113.440
(1 + .03)
28.325
= $69.344
6
duration by construction equals 8.325 years
Joel R. Barber () Chapter 4 18 / 29
Convexity measures cash ow dispersion about duration
Example 2 continued
barbell makes two payments at 2 and 20 years of 50.622 and 79.485
dollars
1
price
50.622
(1.03)
4
+
79.485
(1.03)
40
= 69.344
2
duration
D =
_
50. 622 2
(1.03)
4
+
79. 485 20
(1.03)
40
__
69. 344
= 8. 325
Joel R. Barber () Chapter 4 19 / 29
Convexity measures cash ow dispersion about duration
Example 2: price-yield curve for zero, ladder, and barbell
0.02 0.04 0.06 0.08 0.10 0.12 0.14
40
50
60
70
80
90
100
yield
P
Joel R. Barber () Chapter 4 20 / 29
Convexity measures cash ow dispersion about duration
Example 2: price minus linear approximation
0.02 0.04 0.06 0.08 0.10 0.12 0.14
0
5
10
15
20
yield
Joel R. Barber () Chapter 4 21 / 29
Eective (approximate) duration and convexity
1
approach for dealing with bonds with embedded options
2
based upon valuation model estimate the slope of price-yield curve
about market yield
3
currently observed market price is P
0
4
compute the price P
+
for a small yield increase y +y
5
compute the price P

for a small yield decrease y y

2y
7
approximate duration
1
P
0
dP
dy
-
1
P
0
[slope[
=
P
+
P

2P
0
y
Joel R. Barber () Chapter 4 22 / 29
Eective (approximate) duration and convexity continued
approximate convexity
1
P
0
d
2
P
dy
2
-
1
P
0
_
(P
+
P
0
)
y

(P
0
P

)
y
__
y
=
(P
+
+P

2P
0
)
P
0
(y)
2
Joel R. Barber () Chapter 4 23 / 29
Eective (approximate) duration and convexity
Example
1
P
0
= 90 and y = 6%
2
25 bps shock: y
+
= 6.25% =P(y
+
) = 88
3
up percentage change = (88 90)/90 =
1
45
= 2.22%
4
y

= 5.75% =P(y

) = 92.75
5
down percentage change = (92.7 90)/90 = 3.00%
6
approximate duration
92.7 88
90 .005
= 10.44
7
approximate convexity
92.7 + 88 180
90 .0025
2
= 1244.4
Joel R. Barber () Chapter 4 24 / 29
Yield curve risk
1
above analysis assumed parallel shift
2
risk of change in the shape of yield curve
3
rate duration - sensitivity of bond to change in given spot rate
4
set (or vector) key rate durations
5
overall duration is weighted sum of rate durations
Joel R. Barber () Chapter 4 25 / 29
Yield curve risk
Example
barbell that promises $100 and $200 in 3 and 10 years
at term 6% term structure
1
suppose 3 year rate decreases by 50 bps
2
and 10 year rate increases by 50 bps
3
steepening of yield curve
4
initial price:
100
1.03
6
+
200
1.03
20
= 83. 748 + 110.74
= 194.48
5
duration:
83. 748 3 + 110.74 10
194.48
= 6. 986
Joel R. Barber () Chapter 4 26 / 29
Yield curve risk
contintued
1
key rate durations
3 and 10 years
2
based upon rate durations
P = 83. 748
_
3
1.03
_
(.005) 110.74
_
10
1.03
_
(.005)
= 4. 156 1
3
or a new price of
194.48 4. 156 1 = 190. 32
4
actual new price:
100
(1 + .055/2)
6
+
200
(1 + .065/2)
20
= 190. 47
Joel R. Barber () Chapter 4 27 / 29
Key rate durations
1
each payment date has a rate duration
2
idea: pick out a small set of key maturities
3
for example: 3 months, 1, 2, 3, 5, 7, 10, 15, 20, 25, 20 years
4
key rates are spot rates with key maturities
5
key rate duration is sensitivity of a bond portfolio to a given change in
a key rate
Joel R. Barber () Chapter 4 28 / 29
Multifactor duration
1
based upon historical term structure changes, identify key term
structure shifts
2
dene a duration measure with respect to each key shift
3
advantages
4
considers interrelationships between spot rate changes
5
fewer key durations (2 or 3 rather than 11)
6
gives guidance as to what type of shifts are likely to occur
7
and what types of shifts you are protected against
Joel R. Barber () Chapter 4 29 / 29