Quotation of Bonds:

Bond Prices are in 1/32 nds; i.e.: 101:20 = 101 + 20/32

Coupons are given like 7,25s (s: semiannual payment)
Maturity is stated like 08/15/01 (mm/dd/yy)
Canada and Europe use decimal system and dd/mm/yy
Treasury Strips = Zero Coupon Bonds (=ZCB)
Bonds that make no payment till they mature. Strips are created by stripping
coupon (C-Strips) and principle payment (P-Strips) from regular Treasury.
Strips that mature on same date should have same price
Advantages of ZCB: only one payment, no reinvest. risk
The Discount Factor for a particular time period gives the value today or
the PV of $1 to be received at the end of that time, i.e.:
d(t) = discount factor for t years
Because of the time value of money the discount factors fall with maturity.
Discount factor can be obtained for each maturity date from respective
Strips (if enough strips are in the market)
Discount Factor =Strip Price / 100
To compute future values: 1/d(t), i.e., $1 invested for 6 months grows to
1/d(.5) = $1/.9825 =$1.02 in 6 months
Future Values (t) = 1/d(t)
Forward loan is an agreement made today to lend money at some future
date at an agreed upon rate called a forward rate.
The Expectations Hypothesis states that the forward rate is the market
consensus expectation of the future interest rate.
r(t) = semi-annual compounded rate earned on a six-month loan (t - 0.5
yrs) forward:
By definition:

r(.5) r(.5)

r(t)
1 2

2T

r(.5)
1
...
2

r(t)
1 2

Trading rich: The discounted CFs of a Bond are worth less than
quoted market price of bond
Trading cheap: The discounted CFs of a Bond are worth more than
quoted market price of bond
Replicating Portfolio: Needed for arbitrage
- Long cheap Bond and short Rep. Portfolio
or
- Short expensive Bond and long Rep. Portfolio
To set up replication portfolio, each of CFs of the Bond have to be
matched by a fair priced bond with exactly that maturity (mimic CFs!!)
Start from the last date, then the second last... and calculate the FVs
of different Bonds with the different coupons and maturities.Example:

6.25

% 105.37
F1 0 F2 0 F3 0 F4 100
2

FV4 =102.182

now the next one

6.375

6.25
F1 0 F2 0 F3 100 2 % F4 2 % 5.375

Spot (Interest) Rates (= Return on ZCB)

The spot rate is the rate on a spot loan: Only 2 exchanges of cash
(borrow(+) and repay principal and interest (-))

100 120

- 1 5.385%

58.779

r
$ X 1
2

2T

with T years

Example: 5% annual on a semi-annual bond with a $100 face value

corresponds to:
2

0.05
$100 x 1
$105.0625
2

YTM of 2-year bond will be below 2-year spot rate

- In a downward-sloping curve, any blend of the four rates will be above the
two-year spot rate
Coupon Effect on YTM, different YTM but no one is a better bond
(same credit risk) Example:

Term structure of Interest Rates (Spots):

Relationship between spot rate & maturity
Example: Monetary policy can influence short term, but
long term is controlled by market.

r(t) r(10) 2

A complete specification of return needs to detail:

(1) the annual rate, and (2) the number of times the rate will be
compounded during the year. Most bonds are semi-annual: the
annual rate divided by two is compounded twice.

r2 r1.5 r1 r.5

Bootstrapping: Obtaining discount factors from bonds.

Example:
1.) d(0,5): Quoted Price = [CF Coupon +
CF FV] * d(0,5)
d(0,5)
2.) d(1): Quoted Price = CF Coupon * d(0,5)
+ [CF Coupon + CF FV] * d(1)
d(1)
3.) d(1,5): Quoted Price = CF Coupon *
d(0,5) + CF Coupon * d(1) +
[CF Coupon + CF FV] * d(1,5) d(1,5)

(t)= semi-annually compounded return from investing in

STRIPS (ZCBs) that mature t years from now
Example: STRIP due 2/15/11 = $58.779. Today is 2/15/01, therefore
there are 20 six-month periods:

When the forward rate is above the spot rate, the spot rate curve
upward sloping (rising), since the spot rate [(t)=(t - 0,5) * r(t)] is a blend of
the previous spot rate and the respective forward rate. When the forward
rate is below the spot rate, the spot rate curve is falling or downward
sloping. Example: Upward sloping Spot curve and correspon. forward rates.

The YTM is in fact a blend of spot rates, and for a bond that pays most
value at maturity, the YTM of the bond will be close to the spot rate for the
same maturity
- In a flat term structure, all spot rates are the same and equal to the YTM
- In an upward-sloping curve,

The law of one price: same CF with same risk must

sell for same price.
Arbitrage (violation of law of one price):
Make money with no risk, and no equity (= 0 = square
position).
Reverse Repurchase Agreement:
Selling Short a Bond and lending the Cash received to
the original owner of the Bond and receiving the Bond
as collateral which is the bond sold in the first place.

250 130
HPR 2
- 1 6.2%
100

Yield-To-Maturity (YTM) = rate so that the discounted value of a

bonds CFs at that rate equal bonds price.
Example: T 6 1/4 due 2/15/03 with p = $102:18-1/8

3.125
1 y

3.125
(1 y ) 2
2

3.125
(1 y )3
2

103.125
(1 y ) 4
2

102 18.125 / 32

c
F
1

1 -
y 1 y/2 1 y 2

2T

P(T)

t 1

c/2

or

1 y 2t 1 y 22T

3 ways to compute Bond prices:

Example: As of 2/15/01, price of $100 face bond of Ts
14 1/4 due 2/15/02
1.) Returns of ZCB (discount factors):

108 31.5 / 32 7.125 x d(.5) 107.125 x d(1)

2.) Spot Interest Rates:

YTM is not the same as realized return nor a good measure of

relative value.
The uncertainty about the reinvestment rates for coupons is named
reinvestment risk There is no reason to assume that they will be
reinvested at initial YTM. Clearly, the realized return will depend on
the future rates. If rates are greater than YTM, the realized return will
be higher than the YTM, and vice-versa
YTM Formulas:
2T
2T

P(T)

Different rates for different CF maturities

Holding Period Return (=Realized Return)
Semiannually compounded return from investing $X for
T years and having $W at the end:

W 12T
1

d(t)
r 2
- 1
r(t) 2T
1 2
X

and
Example: initial investment $X = $100; at end of 15
years $W = $250. semi-annual HPR?

with

C=Coupon payment y=YTM

T=Years
P(T)= Price of Bond
F= Face Value of Bond
Useful YTM Formula:

108 31.5 / 32

7.125
107.125

r(.5) r(1) 2
1
2
1 2

3.) Spot and Forward Interest Rates

108 31.5 / 32

7.125
107.125

r(.5) r(.5) r(1)

1

2
2
2

Price increases whenever c>r over period of maturity

extension
Price decreases whenever c<r over
period of maturity extension
Pull to par effect (all yields are5,5%)
Premium bonds fall over time until they are worth
par at maturity Discount bonds rise over time until
they are worth par at maturity

P A[1 (c/2 - y/2) a(y/2, 2T)]

Yields across fairly priced securities of the same maturity vary with the cash
flow structure of the securities
1.) ZCB: YTM = spot rate for that maturity
2.) Par bond: P = FV which implies that c = y
3.) Non-prepayable Mortgage: CFs are all the same one each date
In an upward-sloping term structure, YTMZCB > YTMPAR since the
YTMPAR is blend of spot rates
Mortgages have lower YTMs because more of their total value
discounted at lower spot rates.
In downward-sloping term structure, the inverse will hold.

A= Face amount of the bond,

a(y/2, 2T)= annuity factor

The interest due to the seller is called Accrued Interest. The convention is
that, at the time of purchase, the buyer pays the seller accrued interest and
keeps the coupon when received later. Accrued Interest is used when sale
of bond coupon payment day. The system in bond markets is different to
the system in equity markets. The quoted price in bond markets is always
net of accrued interest.
P = PV(CFs) - AI
P = Quoted Price or Flat Price
PV(CFs) = Invoice Price or Full Price
AI = Accrued Interest
With constant yield, the quoted price of a bond does not fall as a result of a
coupon payment in contrast to what happens with stocks

When cash flows do not follow a semi-annual cycle, semi-annual

compounding is clearly not suitable
Money market convention is the actual/360 convention, or
actual/365 convention
Example:
Say that from 2/15/01 to 8/15/01 there are 181 days. So the final date
is 181/365 or .4959 years away. If the discount factor for d(.4959) is
.97561, then the market interest payment is

a( y / 2,2T )

1
1

y 2 y 2 (1 y 2) 2T

- c = y, P = 1, bond sells at face value Par Bond

- c < y, p < 1, bond sells at discount Disc. Bond
- c > y, p > 1, bond sells at premium Prem. Bond
If T , P = c/y = price of perpetuity

1
1
1
1 2.50%
d .4959
.97561

If YTM remains unchanged over a 6-month period, the

YTM equals the annual return. Volatility of Bond
reduces towards maturity
The market interest payment of 2.50% is unique.
Depending on the compounding conventions, we will
obtain different rates:
6

rmonthly
1 12 1 2.50% rmonthly 4.9487%

rsemi annual
2.50% rsemi annual 5%
2
181rsimple
360

2.50% rsimple 4.9724%

181

rdaily
1

365

The convention is to discount the next coupon payment at a semi-annual

comp. rate even though the payment does not occur in six-month intervals:
1
2.75
2.75
P

....
1 y / 2166 /181 to.. full (1 y 2)166/ 181 (1 y 2)166/ 1811

Curve fitting: The set of traded bond prices from which the discount
factors are extracted are limited. Therefore, it is necessary to
construct an entire, continuous discount function to price cash flows
at any interval in the future. A common but unsatisfactory technique
is linear yield interpolation.

1 2.50% rdaily 4.9798%

Bad Days refers to the fact that some of the days in

which coupon payments are due are not business days.
Market convention uses a distinction between
conventional yields and true yields, which adjusts for
the discrepancy in dates

Formula for Discounting (when coupon payment date sales date):

= fraction of semi-annual period before next coupon,
N = number of semi-annual periods until maturity after next coupon
C= Coupon
and
y = YTM

N1

c
1
1

(1 y/2)
t
N
1 y 2 2
t 1 (1 y/2) (1 y 2)

with annuity formula:

N 1

1
(1 y ) n 1
A
(1 y / 2)
t
y (1 y) n
t 1 (1 y / 2)

DV01: Dollar Value of a Basis Point (0,01%) change in interest rate yield:

1
P
1
dP( y )
DV01

10.000 y
10.000 d ( y)

It involves par bonds and it entails connecting the chosen points with
straight lines. Knowing the par yield curve, it is possible to extract the
discount factors. Problems: Unrealistic kinks in the spot curve
because slope is different before and after a point. Convex regions
are often an artifact of the technique used, beyond a certain point,
curves should be concave. The forward curve is extremely irregular
and has major jumps. It is therefore better not to force a curve to
price bonds exactly and attempt to fit a smooth curve to the data
A callable bond is a bond that the issuer may repurchase or call at
some fixed set of prices on some fixed set of dates. A callable bond
is negatively convex (concave) in all but the highest rates
Hedging with DV01:
DV01 is expressed in a fixed face amount
FA = Face Amount of A to be hedged
FB = Face Amount of B to be used for hedge

Derivative of the price-rate function at that point slope of the line

connecting the two points used.
Usage: Determine the $ amount to hedge

Duration (= risk measure similar to for equities):

It measures the percentage change in value of a security for a unit change
in rates (or 10.000 basis point). When an explicit formula for the price-rate
function is available, the derivative may be used.

1 P
1 dP
D-
-
P y
P dy

D approx

P P
2Po y

or
If Duration is given, a change yield will lead to % price change!

- D y P%

P
P

Usage: Sensitivity analysis and risk assessment

From Duration to DV01 for change in yield

- D y

P
P% P DV01
P

Paradigms: parallel yield shifts & fixed CFs

Yield based DV01 (yield = interest factor, FV=100):
1
1 2T t
c/2

DV 01

10,000 1 y/2 t 1 2 1 y 2t
1 y 22 T

DV01

c
1
1
1 10,000 y 2 (1 y / 2) 2T

100

T
100 c

2T 1
y
(1 y / 2)

DV01 is the sum of the time-weighted PVs of a bonds CFs divided by

10,000 multiplied by one plus half yield The meaning is as follows:
a one-basis point decline in the bonds yield changes its price by DV01
Modified Duration (P=Invoice Price)

1 1 2T t
c/2
100
DMod
T

t
2
T
P 1 y/2 t 1 2 1 y 2
1 y 2

1c
1
DMod 2 1 P y (1 y / 2) 2T

T
100 c

2T 1
y
(1 y / 2)

1% change in yield leads to DMod% change in P of Bond

Macaulay duration is a transformation of modified duration

y
DMac 1 DMod
2

1 y/2 c
1
1
P y 2 (1 y / 2) 2T

T
100 c

y (1 y / 2) 2T 1

Zero Coupon Bonds and a Reinterpretation of Duration:

A convenient property of Macaulay duration is that the Macaulay duration of
a T-year zero coupon bond equals T;

DMacc 0 T

hence the Macaulay duration of a 6-month zero is 0,5 while that of a 10year zero is 10. Longer-maturity zeros have larger durations and thus
greater price sensitivity. Interpretation: its price sensitivity is that of a
zero coupon bond with the same duration equal to its maturity. Furthermore,
since a coupon bond can be seen as a portfolio of ZCBs, the D MAC of a
coupon bond equals duration of its repl. portfolio of zeros. The PV of CFs in
the calculation of the DMAC is weighted by its years to receipt bcs. years to
receipt are the duration of the corresponding zero in the repl. portfolio.

DModc 0

T
(1 y / 2)

DV01c 0

T
100(1 y / 2) 2T 1

Zero Coupon Bonds and their Yield-Based Convexity

Cc 0

T(T .5)

(1 y/2)

FA DV 01A
DV 01B

The security with the higher DV01 is traded in smaller quantity than
security with the lower DV01. DV01 hedging is due to differences in
convexity local; as a result, rehedging the position is necessary.
Convexity: measures how interest rate sensitivity (slope line
duration) changes with rates.

1 d2P
P dy 2

C approx

P P 2 P0

Clearly, longer-term maturity ZCBs have greater convexity, as convexity

increases with the square of maturity. Hence, the price-yield function of a
longer-term ZCB will be more curved than that of a shorter-maturity ZCB.
Moreover, since a coupon bond is a portfolio of ZCBs, longer-maturity
coupon bonds will tend to have greater convexity than shorter-maturity
coupon bonds. Clearly, the convexity formula may be viewed as the
convexity of the portfolio of zeros making up the coupon bond
The Barbell versus the Bullet:
Barbelling refers to the use of a portfolio of short- and long-maturity bonds
rather than intermediate-maturity bonds. Need of a liability with duration
equals to 9. Two Options: Buy several bonds with durations approximately
equal to 9 (bullet portfolio) Buy, say, 2- and 30-year securities with
combine duration equal to 9 (barbell portfolio) Assume the yield curve is
flat at 5%. 9-year ZCB will have a duration of 9 and a convexity given by:
2 2.5
30 30.5
9 (9.5)
.75
.25
221.30
81.38
( 1 0.05/2)2
( 1 0.05/2)2
(1 0.05/2)2
In contrast, the duration of a portfolio constructed with 75% of 2-year ZCBs
and 25% of 30-years ZCBs is .75x2+.25x30=9, and its convexity is:

Estimating Price Changes and Returns with DV01,

Duration, and Convexity
A second-order Taylor approximation for the price of a
security after a small change in rate:

P
1
- D y C (y)2
P
2

In words, the percentage change in the price of a

security (i.e., its return) is approx. equal to minus the
duration multiplied by the change in the rate plus half the
convexity multiplied by the change in rate squared. In
general, the duration term is much larger than the
convexity one, thus the duration effect dominates. Hence
a first-order approximation for the change in price:

P
- D y
P

DV01 of a portfolio:

i
DV 01 DV 01i

Duration of a portfolio:

P
D i Di
P
Convexity of a portfolio:

P
C i Ci
P

Par Bonds and Perpetuities:

The DV01s and durations of par bonds and perpetuities are given
by:

DMacP 100

d (t ) 1 at bt 2 ct 3
where a, b, and c are constant to be estimated. A more
advanced technique is piecewise cubic splines, which
knits several cubic polynomials so that the spot curve is
continuous.

P (y ) 2

o
or
where d P/dy is the 2nd derivative of the price-rate function. Positive
convexity is a basic feature of most fixed-income securities; There
are securities that, at certain rates, need not be convex and exhibit
negative convexity.Example:Callable bonds, mortgage-backed secur.
2T t t 1 c / 2

1
100
C
T(T .5)

P(1 y/2)2 t 1 2 2 1 y 2t
1 y 22 T yield based
Short Convexity: The hedged pos. loses whether rates rise or fall
sell volatility
Long Convexity: The hedged position wins whether rates rise or fall
buy volatility
Convexity in Investmt & Asset-Liability Context Duration of very
convex security change dramatically as rates change exposure of
a portfolio to interest rates may change quite sudden. Exposure to
convexity is an exposure to volatility. Since y2 is always positive,
positive convexity increases return so long as interest rate move: the
bigger the move, the bigger the gain; vice-versa for negative
convexity. Greater protection against interest rate changes by setting
duration and convexity of assets equal to those of liabilities less
need for rehedging
Value of a portfolio: P
P
2

1 y / 2
1
1
y (1 y/2)2T

1
1

DModP 100 1 y (1 y/2)2T

1 2T t
c/2
100
DMac
T
2T
P t 1 2 1 y 2t
1 y 2
DMac

FB

Piecewise cubics
The first step is to assume a functional form for the
discount function., for instance a polynomial:

DV01P 100

1
1
1
100 y (1 y / 2) 2T

The graph of the approximation shows a good

improvement reached with the second-order
approximation. For less convex securities, both
approximations work quite well
Par Bonds and Perpetuities:
The DV01s, and durations of par bonds and
perpetuities are given by:

1
1

DModP 100 1 y (1 y/2)2T

1 y / 2
1
1
DMacP 100
y (1 y/2)2T
DV01P 100

Duration, DV01, Maturity, and Coupon: A Graphical Analysis:

The following figure assumes that all yields are fixed at 5%.
Duration: At this yield, the duration of a perpetuity is a horizontal
line. This line is a benchmark for the duration of any coupon bond
with a sufficiently long maturity. The Macaulay duration of a ZCB is a
450 line since its duration equals its maturity. The premium curve is
constructed assuming a coupon of 9%; the discount curve with a
coupon of 1%. Duration falls as coupon increases
Results: Higher-coupon bonds have a higher fraction of their value
paid earlier, hence the higher the weights on the duration terms of
earlier years relative to those of later years: they are like shorterterm bonds For very deep discount bonds, duration rises above that
of a perpetuity and then falls. The major difference between DV01
and duration is that the former is an absolute change in price
whereas the latter measures a % change

P DMod
P DMac
DV01

10,000
10,000(1 y / 2)

n
For a given duration, bonds with higher prices tend to have higher
absolute price sensitivities. While duration almost always increases
with maturity, the behavior of DV01s depends on how price changes
with maturity. The duration effect tends to increase DV01 with
maturity while the price effect can either increase or decrease DV01
with maturity. As yields increase, the derivative and the DV01 fall;
duration also falls: increasing yields lowers the present value of all
payments, but lowers the present value of the longer payments most,
those with higher duration. Vice-versa, decreasing yields, increases
DV01 and duration
The two have the same duration but the different convexities, since
duration increases linearly and convexity increases with the square
of maturity; the convexity of the 30-year ZCB compensates for the
lower convexity of the two-year zero. The graph on the right shows
the price-yield curve of the bullet and barbell portfolios
Note that the values of the two portfolios are equal at a yield of 5%.
As rates rise and fall, the barbell portfolio with greater convexity will
outperform the bullet portfolio Again, the barbell portfolio does not
dominate the bullet portfolio; the latter outperforms if rates move by a
small amount up or down, while the barbell outperforms if rates move
by a large amount Finally, spreading out the cash flows of a portfolio
(without changing its duration) raises its convexity

The DV01 and duration expressions of a perpetuity

provide a limiting case for any coupon bond: if the
maturity of a coupon bond is extended long enough, its
DV01 and duration will approximately equal the DV01
and duration of a perpetuity with the same coupon

DV01T

1
1
1
100 y (1 y / 2) 2T

PT

c
y

c
10,000 y 2

DMod T
DMac T

1
y

1 y / 2
y

DV01 Results/Description (no graph):

The DV01 of par bond always increases with maturity;
since price is always 100, the price effect does not
come into play. In general, extending the maturity of a
prem. bond increases its price; price and duration
effects combine to make the DV01 of premium bonds
increase with maturity faster than the DV01 of a par
bond. The opposite holds for a disc. bond: the duration
effect dominates first and DV01 increases then the
price effect catches up and the DV01 declines with
maturity. The DV01 of a ZCB behaves like that of disc.
bond and finally falls to zero, as its PV does with longer
and longer maturity. Unlike duration, the DV01 rises
with coupon: higher coupons higher $ prices and
absolute price sensitivity.