LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

LM05 Understanding Fixed-Income Risk and Return

1. Introduction ......................................................................................................................................................2
2. Sources of Return ............................................................................................................................................2
3. Macaulay and Modified Duration ..............................................................................................................9
3.1 Macaulay, Modified, and Approximate Duration .........................................................................9
4. Approximate Modified and Macaulay Duration ............................................................................... 11
5. Effective and Key Rate Duration............................................................................................................. 14
5.1 Key Rate Duration ................................................................................................................................. 14
6. Properties of Bond Duration .................................................................................................................... 15
7. Duration of a Bond Portfolio .................................................................................................................... 20
8. Money Duration and the Price Value of a Basis Point .................................................................... 21
9. Bond Convexity ............................................................................................................................................. 23
10. Investment Horizon, Macaulay Duration and Interest Rate Risk ........................................... 27
10.1 Yield Volatility ...................................................................................................................................... 27
10.2 Investment Horizon, Macaulay Duration, and Interest Rate Risk ................................... 28
11. Credit and Liquidity Risk ........................................................................................................................ 29
12. Empirical Duration.................................................................................................................................... 30
Summary .............................................................................................................................................................. 32

This document should be read in conjunction with the corresponding reading in the 2023 Level I
CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright
2022, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights
reserved.

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

1. Introduction
This reading covers:
 Sources of return on a bond: reinvestment of coupon payments and receipt of
principal.
 How investors are exposed to different interest rate risk if the same bond is held for
different time periods.
 Duration and convexity as measures of interest rate risk.
 How duration and convexity can be used to predict a change in a bond’s price, and
assess credit and liquidity risks.
2. Sources of Return
The total return is the future value of reinvested coupon interest payments and the sale
price (or redemption of principal if the bond is held to maturity). The horizon yield (or
holding period rate of return) is the internal rate of return between the total return and the
purchase price of the bond.
Total return on a bond = reinvested coupon interest payments + sale/redemption of
principal at maturity
A bond investor has three sources of return:
 Receiving the full coupon and principal payments on the scheduled dates.
 Reinvesting the interest payments. This is also known as interest-on-interest.
 Potential capital gain or loss on sale of the bond, if the bond is sold before maturity
date.
Now, we will look at a series of examples that demonstrate the effect on two investors’
realized rate of returns when one of these variable changes: time horizon, interest rate at
which the coupons are reinvested, and market discount rates at the time of purchase and at
the time of sale.
In Examples 1 and 2, we look at the realized rate of return for two investors with different
time horizons for the same bond.
Example 1: Calculating the total return on a bond that is held until maturity
Investor 1: A “buy-and-hold” investor purchases a 5-year, 10% annual coupon payment bond
at 92.79 per 100 of par value and holds it until maturity. Calculate the total return on the
bond.

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

Solution:
10 10 10 10 110
92.79 = + + + +
(1 + r)1 (1 + r)2 (1 + r)3 (1 + r)4 (1 + r)5
Use the following keystrokes to calculate the bond’s yield to maturity:
N = 5; PV = -92.79; PMT = 10; FV = 100; CPT I/Y;
Hence, r = 12%.
This is the yield to maturity at the time of purchase. However, this holds good only if all of
the following three conditions are true:
 The bond is held to maturity.
 The coupon and final principal payments are made on time (no default or delay).
 The coupon payments are reinvested at the same rate of interest.
To calculate the total return on the bond, we first need to calculate the interest earned when
coupon payments are reinvested.
Coupon reinvestment:
 The investor receives 5 coupon payments of 10 (per 100 of par value) for a total of 50,
plus the redemption of principal (100) at maturity. The investor has the opportunity to
reinvest the cash flows. If the coupon payments are reinvested at 12% (i.e., yield to
maturity), the future value of the coupons on the bond’s maturity date is 63.53 per 100 of
par value.
[10 x (1.12)4 ] + [10 x (1.12)3 ] + [10 x (1.12)2 ] + [10 x (1.12)1 ] + 10 = 63.53
 The first coupon payment of 10 is reinvested at 12% for 4 years until maturity, the
second is reinvested for 3 years, and so on. The future value of the annuity is obtained
easily using a financial calculator: N = 5; PV = 0; PMT = 10; I/Y = 12; CPT FV. FV = -63.53
 The amount in excess of the coupons, 13.53 (= 63.53 – 50), is the ‘interest-on-interest’
gain from compounding.
 The investor’s total return is 163.53, the sum of the reinvested coupons (63.53) and the
redemption of principal at maturity (100). The realized rate of return is 12%.
163.53
92.79 = (1+r)5
, r = 12%

Example 2: Calculating the total return on a bond that is sold before maturity
Now let us consider investor 2 who buys the same 5-year, 10% annual coupon payment
bond but sells the bond after three years. Assuming that the coupon payments are reinvested
at 12% for three years, calculate the total return on the bond.
Solution:
The future value of the reinvested coupons is 33.74 per 100 of par value.

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

[10 ∗ (1.12)2 ] + [10 ∗ (1.12)1 ] + 10 = 33.74

The interest-on-interest gain from compounding is 3.74 (= 33.74 – 30). After three years,
when the bond is sold, it has two years remaining until maturity. If the yield to maturity
remains 12%, then the sale price of the bond is 96.62.
10 110
+ = 96.62
(1.12)1 (1.12)2
The total return is 130.36 (= 33.74 + 96.62) and the realized rate of return is 12%.
130.36
92.79 = , r = 12%
(1 + r)3
This ‘r’ is called the horizon yield, the internal rate of return between the total return and the
purchase price of the bond. Horizon yield is equal to the original yield to maturity if:
 Coupon payments are reinvested at the same yield to maturity calculated at the time
of purchase of the bond. In our case, it is 12% as calculated in Example 1.
 There are no capital gains or losses when the bond is sold. It is sold at a price on the
constant-yield price trajectory. We arrive at the price 96.62 by taking 12% as the
constant yield for the remaining two years. If the yield is more than 12%, then losses
occur. Similarly, if the yield is less than 12%, then capital gains occur. This concept is
elaborated below:
Constant-yield price trajectory for a 5-year, 10% annual payment bond
The price of the bond at different time periods for a yield of 12% is plotted in the graph
below:

The calculations for determining the price are shown below:

Year Price Calculation
0 92.79 N = 5 ; I/Y = 12 ; PMT = 10 ; FV = 100 ; CPT PV
1 93.93 N = 4 ; I/Y = 12 ; PMT = 10 ; FV = 100 ; CPT PV
2 95.19 N = 3 ; I/Y = 12 ; PMT = 10 ; FV = 100 ; CPT PV
3 96.62 N = 2 ; I/Y = 12 ; PMT = 10 ; FV = 100 ; CPT PV
4 98.21 N = 1 ; I/Y = 12 ; PMT = 10 ; FV = 100 ; CPT PV

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

5 100
Observation:
There will be a capital gain if the bond is sold at a price above the trajectory at any point in
time during the bond’s life. This will happen if the yield is below 12%. Remember a bond’s
price and interest rates are inversely related. Similarly, there will be a capital loss if the bond
is sold at a price below the trajectory at any point in time during the bond’s life. This will
happen if the yield is above 12%. Any point on the trajectory represents the carrying value
of the bond at that time.
Next, we analyze what happens to the investors’ realized rate of return if interest rates go up
after the bond is purchased.
Example 3: Calculating an investor’s realized return when interest rates go up and
bond is held until maturity
The buy-and-hold investor purchases the same 5-year, 10% annual payment bond at 92.79.
After the bond is purchased and before the first coupon is received, interest rates go up to
15%.
Calculate the investor’s realized rate of return.
Solution:
Use the following keystrokes to calculate the future value of the reinvested coupons at 15%
for 5 years:
[10 x (1.15)4 ] + [10 x (1.15)3 ] + [10 x (1.15)2 ] + [10 x (1.15)1 ] + 10 = 67.42
The total return is 167.42 (= 67.42 + 100).
167.42
92.79 = ; r = 12.53%
(1 + r)5
The investor’s realized rate of return is 12.53%.
Observation:
Compared to the investor in Example 1 (12%), the realized return of this investor is higher
because the coupons are reinvested at a higher rate. There is no capital gain or loss because
the bond is held to maturity and the principal of 100 is redeemed.
Example 4: Calculating an investor’s realized return when interest rates go up and
bond is sold before maturity
The second investor buys the same 5-year, 10% annual payment bond at 92.79 and sells it in
three years. After the bond is purchased, interest rates go up to 15%. Calculate the investor’s
realized gain.
Solution:
The future value of the reinvested coupons at 15% after three years is:

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

[10 x (1.15)2 ] + [10 x (1.15)1 ] + 10 = 34.73

N = 3; PV = 0; PMT = 10; I/Y = 15; CPT FV; FV = -34.73
The sale price of the bond after three years is 91.87.
10 110
+ = 91.87
(1.15)1 (1.15)2
The total return is 126.60 (= 34.73 + 91.87), resulting in a realized three-year horizon yield
of 10.91%.
126.60
92.79 = , r = 10.91%
(1 + r)3
N = 3; PV = 92.79; FV = 126.60; CPT I/Y
Hence, r = 10.91%.
Observation:
Compared to the investor in Example 2 with a similar time horizon (12%), the realized
return to this investor is lower at 10.91% because there is a capital loss. Even though the
coupons are reinvested at a higher rate, the capital loss is greater than the gain from
reinvesting coupons.
Increase in the value of reinvested coupons = 34.73 − 33.74 = 0.99
Capital loss = 91.87 - 96.62 = -4.75. Capital gain or loss is always calculated relative to the
carrying value at that point in time.
Next, we look at the effect of realized returns when interest rates go down after the bond is
issued.
Example 5: Calculating an investor’s realized return when interest rates go down
The buy-and-hold investor purchases the same 5-year, 10% annual payment bond at 92.79
and holds the security until it matures. After the bond is purchased, and before the first
coupon is received, interest rates go down to 8%. Calculate the investor’s realized return.
Solution:
The future value of reinvesting the coupon payments at 8% for 5 years is 58.67 per 100 of
par value.
[10 ∗ (1.08)4 ] + [10 ∗ (1.08)3 ] + [10 ∗ (1.08)2 ] + [10 ∗ (1.08)1 ] + 10 = 58.67
The total return is 158.67 (= 58.67 + 100), the sum of the future value of reinvested coupons
and the redemption of par value.
158.67
92.79 = , r = 11.33%
(1 + r)5
The investor’s realized rate of return is 11.33%.
Observation:
The realized return is lower than that in Example 1 (12%) because the coupons are

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

reinvested at a lower rate of return. Since the bond is held to maturity, there is no capital
gain or loss.
Decrease in the value of reinvested coupons = 58.67 - 63.53 = - 4.86
Example 6: Calculating an investor’s realized return when interest rates go down
The second investor buys the same 5-year, 10% annual payment bond at 92.79 and sells it
after three years. After the bond is purchased, interest rates go down to 8%. Calculate the
investor’s realized return.
Solution:
The future value of the reinvested coupons at 8% after three years is:
[10 ∗ (1.08)2 ] + [10 ∗ (1.08)1 ] + 10 = 32.46
This reduction in the future value of coupon reinvestments is offset by the higher sale price
of the bond, which is 103.57 per 100 of par value.
10 110
+ = 103.57
(1.08)1 (1.08)2
The total return is 136.03 (= 32.46 + 103.57), resulting in a realized three-year horizon yield
of 13.60%.
136.03
92.79 = , 𝑟 = 13.60%
(1 + 𝑟)3
Observation:
The realized return is greater than that of the investors in Examples 2 and 4 with a similar
time horizon. It is primarily due to the capital gains.
Capital gain = 103.57 - 96.62 = 6.95
Decrease in the value of reinvested coupons = 32.46 - 33.74 = -1.28
As you can see, the capital gain is far greater than the decrease in the value of reinvested
coupons.
Interest rate risk affects the realized rate of return for any bond investor in two ways:
coupon reinvestment risk and market price risk. But, what is interesting is that these are
offsetting types of risk. Two investors with different time horizons will have different
exposures to interest rate risk. From the examples above, let us sum up what happens when
interest rates go up or down:
When interest rates go up or down:
 Reinvestment income is directly proportional to interest rate movements. The value
of reinvested coupons increases when the interest rate goes up.
 Bond price is inversely proportional to interest rate movements. Bond price
decreases when the interest rate goes up.

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

When does coupon reinvestment risk matter?

 Coupon reinvestment risk matters when an investor has a long-term horizon. If the
investor buys a bond and sells it before the first coupon payment, then this risk is
irrelevant. But a buy-and-hold investor as in Examples 1, 3, and 5 has only coupon
reinvestment risk.
When does market price risk matter?
 Market price risk matters when an investor has a short-term horizon relative to the
time to maturity. If the investor buys a bond and sells it before the first coupon
payment, then he is exposed to market price risk only. But a buy-and-hold investor
such as those in Examples 1, 3, and 5 has only coupon reinvestment risk, and no
market price risk.
Example 7: Calculating the purchase price of the bond for various YTM
An investor buys a five-year, 10% annual coupon payment bond priced to yield 8%. The
investor plans to sell the bond in three years once the third coupon payment is received.
Calculate the purchase price for the bond and the horizon yield assuming that the coupon
reinvestment rate after the bond purchase and the yield to maturity at the time of sale are
(1) 7%, (2) 8%, and (3) 9%.
Solution:
The purchase price is:
10 10 10 10 110
+ + + + = 107.99
(1.08)1 (1.08)2 (1.08)3 (1.08)4 (1.08)5
N = 5; PMT = 10; FV = 100; I/Y = 8; CPT PV, PV = -107.99.
Solution to 1:
With YTM at sale = 7%:
N = 3; PV = 0; PMT = 10; I/Y = 7; CPT FV, FV = -32.15.
The future value of the reinvested coupons after three years is 32.15.
10 110
(1.07)1
+ (1.07)2
= 105.42.
N = 2; I/Y = 7; PMT = 10; FV = 100; CPT PV, PV = 105.42.
The sale price of the bond after three years is 105.42.
The total return after three years is 137.57 (= 32.15 + 105.42).
The realized return calculated using the keystrokes: N = 3; PMT = 0; PV = 107.99; FV =
137.57; CPT I/Y,
r = 8. 4%.
137.57
107.99 = (1+r)3
, r = 8.40%.

If interest rates go down from 8% to 7%, then the realized rate of return over the three-year

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

investment horizon is 8.40%, higher than the original yield to maturity of 8%.
Solution to 2:
With YTM at sale = 8%, the future value of the reinvested coupons after three years is:
N = 3; PV = 0; PMT = 10; I/Y = 8; CPT FV, FV = -32.46.
The sale price of the bond is calculated as:
N = 2, I/Y = 8, PMT = 10, FV = 100; CPT PV
The sale price of the bond after three years is 103.57.
The total return after three years is 136.03 (= 32.46 + 103.57).
The realized return calculated using the keystrokes: N = 3; PMT = 0; PV = -107.99; FV =
136.03; CPT I/Y.
r = 8%.
136.03
107.99 = , r = 8.00%
(1 + r)3
If interest rates remain 8% for reinvested coupons and for the required yield on the bond,
the realized rate of return over the three-year investment horizon is equal to the yield to
maturity of 8%.
Solution to 3:
With YTM at sale = 9%: the future value of the reinvested coupons after three years is:
N = 3; PV = 0; PMT = 10; I/Y = 9; CPT FV, FV = -32.78.
The sale price of the bond is calculated as:
N = 2; I/Y = 9; PMT = 10; FV = 100; CPT PV
The sale price of the bond after three years is 101.76.
The total return after three years is 134.54 (= 32.78 + 101.76).
The realized return calculated using the keystrokes: N = 3; PV = -107.99; FV = 134.54; CPT
I/Y
134.54
107.99 = (1+r)3
, r = 7.60%;

If interest rates go up from 8% to 9%, the realized rate of return over the three-year
investment horizon is 7.60%; lower than the yield to maturity of 8%.
3. Macaulay and Modified Duration
In this section, we look at two measures of interest rate risk: duration and convexity.
3.1 Macaulay, Modified, and Approximate Duration
The duration of a bond measures the sensitivity of the bond’s full price (including accrued
interest) to changes in interest rates. In other words, duration indicates the percentage

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

change in the price of a bond for a 1% change in interest rates. The higher the duration, the
more sensitive the bond is to change in interest rates. Duration is expressed in years.
There are two categories of duration: yield duration and curve duration.
 Yield duration is the sensitivity of the bond price with respect to the bond’s own yield
to maturity.
 Curve duration is the sensitivity of the bond price with respect to a benchmark yield
curve such as a government yield curve on coupon bonds, the spot curve, or the
forward curve.

As indicated in the diagram above, there are several types of yield duration.
Macaulay duration is a weighted average of the time to receipt of the bond’s promised
payments, where the weights are the shares of the full price that correspond to each of the
bond’s promised future payments. Let us consider a 10-year, 8% annual payment bond. To
determine the Macaulay duration, we calculate the present value of each cash flow, multiply
by weight and add, as shown in the below exhibit
Exhibit 2: Macaulay Duration of a 10 – Year, 8% Annual Payment Bond
Period Cash flow Present Value Weight Period x Weight
1 8 7.246377 0.08475 0.0847
2 8 6.563747 0.07677 0.1535
3 8 5.945423 0.06953 0.2086
4 8 5.385347 0.06298 0.2519
5 8 4.878032 0.05705 0.2853
6 8 4.418507 0.05168 0.3101
7 8 4.002271 0.04681 0.3277
8 8 3.625245 0.04240 0.3392
9 8 3.283737 0.03840 0.3456
10 108 40.154389 0.46963 4.6963
85.503075 1.00000 7.0029

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

We can also use the following formula to calculate Macaulay Duration:

1 + r 1 + r + [N ∗ (c − r)] t
MacDur = ( − )−
r c ∗ [ (1 + r) − 1] + r
N T
where:
r = yield to maturity
t = number of days from the last coupon payment date to the settlement date
T = number of days in the coupon period
c = coupon rate per period
N = number of periods to maturity
Instructor’s Note:
Understanding how the Macaulay duration works is more important than memorizing the
formula.
Modified duration provides an estimate of the percentage price change for a bond given a
change in its yield to maturity. It represents a simple adjustment to Macaulay duration as
shown in the equation below:
Macaulay duration
Modified duration =
1 + r
where: r is the yield per period.
Therefore, percentage price change for a bond given a change in its YTM can be calculated
as:
%ΔPV FULL ≈ −AnnModDur x ΔYield
The AnnModDur term is the annual modified duration, and the ΔYield term is the change
in the annual yield to maturity. The ≈ sign indicates that this calculation is estimation.
The minus sign indicates that bond prices and yields to maturity move inversely.
Example 8: Calculating the modified duration of a bond
A 2-year, annual payment, $100 bond has a Macaulay duration of 1.87 years. The YTM is 5%.
Calculate the modified duration of the bond.
Solution:
Modified duration = 1.87/(1 + 0.05) = 1.78 years
The percentage change in the price of the bond for a 1% increase in YTM will be:
-1.78 * 0.01 * 100 = -1.78%.
4. Approximate Modified and Macaulay Duration
Modified duration is calculated if the Macaulay duration is known. But there is another way
of calculating an approximate value of modified duration: estimate the slope of the line

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

tangent to the price-yield curve. This can be done by using the equation below:
(PV− ) − (PV+ )
Approximate Modified Duration =
2 ∗ ∆yield ∗ PV0
where:
PV_ = price of the bond when yield is decreased;
PV0 = initial price of the bond
PV+ = price of the bond when yield is increased

Source: CFA Program Curriculum, Understanding Fixed-Income Risk and Return

Interpretation of the diagram:
 PV0 denotes the original price of the bond.
 PV+ denotes the price of the bond when YTM is increased and PV_ denotes the bond
price when YTM is decreased.
 Change in yield (up and down) is denoted by Δ yield.
 For slope calculation: vertical distance = PV− − PV+ and horizontal distance = 2 x Δ
yield.
How to calculate approximate modified duration (or estimate the slope of the price-
yield curve):
 The yield to maturity is changed (increased/decreased) by the same amount.
 Calculate the bond price for a decrease in yield (PV-).
 Calculate the bond price for an increase in yield (PV+).
 Use these values to calculate the approximate modified duration.
Once the approximate modified duration is known, the approximate Macaulay duration can
be calculated using the formula below:
Approximate Macaulay Duration = Approximate Modified Duration x (1 + r)

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

Example 9: Calculating the approximate modified duration and approximate Macaulay

duration
Assume that the 6% U.S. Treasury bond matures on 15 August 2017 is priced to yield 10%
for settlement on 15 November 2014. Coupons are paid semiannually on 15 February and 15
August. The yield to maturity is stated on a street-convention semiannual bond basis. This
settlement date is 92 days into a 184-day coupon period, using the actual/actual day-count
convention. Compute the approximate modified duration and the approximate Macaulay
duration for this Treasury bond assuming a 50bps change in the yield to maturity.
Solution:
The yield to maturity per semiannual period is 5% (=10/2). The coupon payment per period
is 3% (= 6/2). When the bond is purchased, there are 3 years (6 semiannual periods) to
maturity. The fraction of the period that has passed is 0.5 (=92/184).
The full price (including accrued interest) at an YTM of 5% is 92.07 per 100 of par value.
3 3 3 3 3 103 92
( )
PV0 = [ + + + + + ] ∗ (1.05) 184
(1.05)1 (1.05)2 (1.05)3 (1.05)4 (1.05)5 (1.05)6
0.5
⇒ 89.85 × (1.05) = 92.07
Increase the yield to maturity from 10% to 10.5% - therefore, from 5% to 5.25% per
semiannual period, and the price becomes 90.97 per 100 of par value.
3 3 3 3 3 103
PV+ = [ + + + + + ]
(1.0525) 1 (1.0525) 2 (1.0525) 3 (1.0525) 4 (1.0525) 5 (1.0525)6
92
∗ (1.0525)(184)
⇒ 88.67 × (1.0525)0.5 = 90.97
Decrease the yield to maturity from 10% to 9.5% - therefore, from 5% to 4.75% per
semiannual period, and the price becomes 93.19 per 100 of par value.
3 3 3 3 3 103
PV_ = [ + + + + + ]
(1.0475)1 (1.0475) 2 (1.0475) 3 (1.0475) 4 (1.0475) 5 (1.0475)6
92
∗ (1.0475)(184)
⇒ 91.05 × (1.0475)0.5 = 93.19
The approximate annualized modified duration for the Treasury bond is 2.41
93.19 − 90.97
ApproxModDur = = 2.41
2 ∗ 0.005 ∗ 92.07
The approximate annualized Macaulay Duration is 2.53
ApproxMacDur = 2.41 ∗ 1.05 = 2.53
Therefore, from these statistics, the investor knows that the weighted average time to
receipt of interest and principal payments is 2.53 years (the Macaulay Duration) and that the
estimated loss in the bond’s market value is 2.41% (the Modified Duration) if the market
discount rate were to suddenly go up by 1.0%.

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

5. Effective and Key Rate Duration

Bonds with embedded options and mortgage-backed securities do not have a well-defined
YTM. These securities may be prepaid well before the maturity date. Hence, yield duration
statistics are not suitable for these instruments. For such instruments, the best measure of
interest rate sensitivity is the effective duration, which measures the sensitivity of the bond’s
price to a change in a benchmark yield curve (instead of its own YTM).
(PV− ) − (PV+ )
Effective Duration =
2 ∗ ∆ curve ∗ PV0

Difference between approx. modified duration and effective duration:

The denominator for approx. modified duration has the bond’s own yield to maturity. It
measures the bond’s price change to changes in its own YTM. But, the denominator for
effective duration has the change in the benchmark yield curve. It measures the interest rate
risk in terms of change in the benchmark yield curve.
Example 10: Calculating the effective duration
A Pakistani defined-benefit pension scheme seeks to measure the sensitivity of its
retirement obligations to market interest rate changes. The pension scheme manager hires
an actuarial consultant to model the present value of its liabilities under three interest rate
scenarios
1. a base rate of 10%
1. a 50 bps drop in rates, down to 9.5%
2. a 50 bps increase in rates to 10.5%.
The following chart shows the results of the analysis:
Interest Rate Assumption Present Value of Liabilities
9.5% PKR 10.5 million
10% PKR 10 million
10.5% PKR 9 million
Compute the effective duration of pension liabilities. PV0 = 10, PV+ = 9, PV- = 10.5, and Δ
curve = 0.005. The effective duration of the pension liabilities is 15.
10.5 − 9
= 15
2 ∗ 0.005 ∗ 10
This effective duration statistic for the pension scheme’s liabilities might be used in asset
allocation decisions to decide the mix of equity, fixed income, and alternative assets.
5.1 Key Rate Duration
Key rate duration is a measure of a bond’s sensitivity to a change in the benchmark yield
curve at a specific maturity. This topic is covered in detail at Level II.
The duration measures we have seen so for assume a parallel shift in the yield curve. But
what if the shift in the yield curve is not parallel? Here it is appropriate to use ‘Key rate

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

duration’.
Key rate durations are used to identify “shaping risk” of a bond, which is a bond’s sensitivity
to changes in the shape of the benchmark yield curve. For instance, analysts can analyze the
interest rate sensitivity if the yield curve flattens or if the yield curve steepens.
6. Properties of Bond Duration
The input variables for determining Macaulay and modified yield duration of fixed-rate
bonds are:
 Coupon rate or payment per period
 Yield to maturity per period
 Number of periods to maturity
 Fraction of the period that has gone by
By changing one of the above variables while holding others constant, we can analyze the
properties of bond duration, which, in turn, helps us assess the interest rate risk. We will use
the formula for Macaulay duration to understand the relationship between each variable and
duration:
1+r 1 + r + [N ∗ (c − r)]
MacDur = { r
− c ∗ [ (1 + r)N − 1] + r} – (t⁄T)

The fraction of the coupon period that has gone by (t/T)

First, let us consider the relationship between fraction of time that has gone by (t/T) and
duration. There is no change to the expression in braces {} as time passes by. Fraction of
time (t/T) increases as time passes by. Assume T is 180. If 50 days have passed, then t/T =
0.277. If 90 days have passed, then t/T = 0.5. If 150 days have passed, then t/T = 0.83. As t/T
increases from t = 0 to t = T with passing time, MacDuration decreases in value. Once the
coupon is paid, t/T becomes zero and MacDuration jumps in value. When time to maturity is
plotted against MacDuration, it creates a saw tooth pattern as shown graphically below:

Source: CFA Program Curriculum, Understanding Fixed-Income Risk and Return

Interpretation of the Macaulay duration between coupon payments with a constant yield to

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

maturity:
 Note: Read the diagram from right to left. As time passes between coupon periods,
duration decreases in value.
 Once the coupon is paid, it jumps back up creating a saw tooth pattern.
Now, we look at the relationship between Macaulay duration and change in the coupon rate,
yield to maturity, and the time to maturity. This is depicted in the exhibit below:
Properties of the Macaulay Yield Duration

Source: CFA Program Curriculum, Understanding Fixed-Income Risk and Return

Time to maturity
The relationship between Macaulay Duration and time to maturity for four types of bonds
(zero-coupon, discount, premium, and perpetuity) at t/T = 0 are shown.
 Zero-coupon bond: Pays no coupon so c = 0. Plugging in c = 0 and t/T = 0 in MacDur
formula, we get Macaulay Duration = N. For a zero-coupon bond, duration is its time
to maturity.
 Perpetuity: A perpetual bond is one that does not mature. There is no principal to
redeem. It makes a fixed coupon payment forever. If N is a large number in the above
equation, then the second part of the expression in the braces becomes zero.
1
Denominator: N is an exponent. (1 + r)N is a very large number. So (1 N must be
+ r)
zero and the value in the numerator will not matter here. Macaulay duration of a
1+r
perpetual bond is as N approaches infinity.
r
 Premium bond: Bonds are trading at a premium above par or at par. The coupon rate
is greater than or equal to yield to maturity (r). The numerator of the second
expression in braces is always positive because c-r is positive. The denominator of the
second expression in braces is always positive. Second expression as a whole is
1+r
always positive. MacDuration = less than because the second expression in
r
1+r
braces is positive. As time passes, it approaches r
.

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

 Discount bond: For a discount bond, the coupon rate is below yield to maturity. The
Macaulay Duration increases for a longer time to maturity. The numerator of the
second expression in braces is negative because c-r is negative. Put together, the
1+r 1+r
duration at some point exceeds , reaches a maximum, and approaches (the
r r
threshold) from above. This happens when N is large and coupon rate (c) is below the
yield to maturity (r). As a result, for a long-term discount bond, interest rate risk can
be lesser than a shorter-term bond.
The above points are summarized below:
Relationship between bond duration and other input parameters
Bond parameter Effect on Duration
Higher coupon rate Lower
Higher yield to maturity Lower
Longer time to maturity Higher for a premium bond. Usually, holds true for a discount
bond, but there can be exceptions. Exception: low coupon
(relative to YTM) bond with long maturity.
Example 11: Calculating the approximate modified duration
A mutual fund specializes in investments in sovereign debt. The mutual fund plans to take a
position on one of these available bonds.
Time to Yield to
Bond Coupon Rate Price
maturity maturity
(A) 5 years 10% 70.093879 20%
(B) 10 years 10% 58.075279 20%
(C) 15 years 10% 53.245274 20%
The coupon payments are annual. The yields to maturity are effective annual rates. The
prices are per 100 of par value.
1. Compute the approximate modified duration of each of the three bonds using a 5 bps
change in the yield to maturity and keeping precision to six decimals (because
approximate duration statistics are very sensitive to rounding).
2. Which of the three bonds is expected to have the highest percentage price increase if the
yield to maturity on each decreases by the same amount – for instance, by 10 bps from
20% to 19.90%?
Solution to 1:
Calculate PV+ and PV_; then calculate modified duration.
Bond A:
PV0 = 70.093879;

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

10 10 10 10 110
PV+ = + + + + = 69.977386
(1.2005)1 (1.2005) 2 (1.2005) 3 (1.2005) 4 (1.2005)5
PV+ = 69.977386
10 10 10 10 110
PV_ = + + + + = 70.210641
(1.1995)1 (1.1995) 2 (1.1995) 3 (1.1995) 4 (1.1995)5
PV_ = 70.210641
70.210641 − 69.977386
ApproxModDur = 2 ∗ 0.0005 ∗ 70.093879
= 3.33.
The approximate modified duration of Bond A is 3.33.
Bond B:
PV0 = 58.075279
10 10 10 10 110
PV+ = + + + … . + = 57.937075
(1.2005)1 (1.2005)2 (1.2005)3 (1.2005)4 (1.2005)10
PV+ = 57.937075
10 10 10 10 110
PV_ = + + + … . + = 58.213993
(1.1995)1 (1.1995)2 (1.1995)3 (1.1995)4 (1.1995)10
PV_ = 58.213993
58.213993 − 57.937075
ApproxModDur = 2 ∗ 0.0005 ∗ 58.075279
= 4.77
The approximate modified duration of Bond B is 4.77.
Bond C:
PV0 = 53.245274
10 10 10 10 110
PV+ = + + + ..+ = 53.108412
(1.2005)1 (1.2005) 2 (1.2005) 3 (1.2005) 4 (1.2005)15
PV+ = 53.108412
10 10 10 10 110
+ + + ..+ = 53.382753
(1.1995) 1 (1.1995) 2 (1.1995) 3 (1.1995) 4 (1.1995)15
PV- = 53.382753
53.382753 − 53.108412
ApproxModDur = = 5.15.
2 ∗ 0.0005 ∗ 53.245274
The approximate modified duration of Bond C is 5.15.
Solution to 2:
Bond C with 15 years-to-maturity has the highest modified duration. If the yield to maturity
on each is decreased by the same amount – for instance, by 10bps, from 20% to 19.90% -
Bond C would be expected to have the highest percentage price increase because it has the
highest modified duration.

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

Interest Rate Risk Characteristics of a Callable Bond

A callable bond is one that might be called by the issuer before maturity. This makes the cash
flows uncertain, so the YTM cannot be determined with certainty. The exhibit below plots
the price-yield curve for a non-callable/straight bond and a callable bond. It also plots the
change in price for a change in the benchmark yield curve. Bond price is plotted on the y-axis
and the benchmark yield on the horizontal axis.

Source: CFA Program Curriculum, Understanding Fixed-Income Risk and Return

Interpretation of the diagram:
 The two bonds share the same features: credit risk, coupon rate, payment frequency,
and time to maturity, but their prices are different when interest rates are low.
 When interest rates are low (left side of the graph), the price of the non-callable bond
is always greater than the callable bond.
 The difference between the non-callable bond and callable bond is the value of the
embedded call option.
 The call option is more valuable at low interest rates because the issuer has an option
to refinance debt at lower interest rates than paying a higher interest to existing
investors. For instance, if a bond is callable at 102% of par, then its price cannot
increase beyond 102 of par even if interest rates decrease. This is the reason behind
the callable bond’s negative convexity.
 From an investor’s perspective a call option is risky. At low interest rates if the issuer
calls the bond (meaning the issuer pays back the money borrowed), then investors
must reinvest the proceeds at lower rates. Notice that at higher interest rates, there is
not much of a difference in price because the probability of calling the bond is less.
 At relatively low interest rates, the effective duration of a callable bond is lower than
that of non-callable bond, i.e., interest rate sensitivity is low.

Interest Rate Risk Characteristics of Putable Bond

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

Source: CFA Program Curriculum, Understanding Fixed-Income Risk and Return

Interpretation of the diagram:
 The diagram above shows the price-yield curve for a putable bond and a straight
bond.
 A putable bond allows the investor to sell the bond back to the issuer; usually at par.
 At low interest rates, there is not much of a difference between a straight bond and
putable bond.
 At high interest rates, the difference between the putable bond and straight bond is
the value of the put option.
 When interest rates rise, the price of the bond decreases. Investors buy putable bonds
to protect against falling prices as rates rise.
 The value of the put option increases as rates rise. This also limits the sensitivity of
the bond price to changes in benchmark rates.
7. Duration of a Bond Portfolio
In the previous section, we saw how to calculate the duration for an individual bond. What if
a portfolio consists of a number of bonds, how will its duration be calculated?
There are two ways to calculate the duration of a bond portfolio:
 Weighted average of time to receipt of the aggregate cash flows.
 Weighted average of the individual bond durations that comprise the portfolio.
The key points related to each method are outlined in the table below.
Weighted Average Time to Receipt of Weighted Average of Individual Bond
Aggregate Cash Flows Durations in Portfolio
Theoretically correct, but difficult to use in Commonly used in practice.
practice.

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

Cash flow yield not commonly used. Cash Easy to use as a measure of interest rate
flow yield is the IRR on a series of cash risk.
flows.
Amount and timing of cash flows might not More accurate as difference in YTMs of
be known because some of these bonds bonds in portfolio become smaller.
may be MBS, or with call options.
Interest rate risk is usually expressed as a Assumes parallel shifts in the yield curve,
change in benchmark interest rates, not as i.e., all rates change by the same amount in
a change in the cash flow yield. the same direction. That seldom happens in
reality.
Change in the cash flow yield is not
necessarily the same amount as the change
in yields to maturity on the individual
bonds.
Example 12: Calculating portfolio duration
An investment fund owns the following portfolio of three fixed-rate government bonds:
Bond A Bond B Bond C
Par value 15,000,000 20,000,000 40,000,000
Market value 14,769,542 25,650,379 43,796,854
Modified duration 4.328 5.643 7.210
The total market value of the portfolio is 84,216,775. Each bond is on a coupon date so that
there is no accrued interest. The market values are the full prices given the par value.
1. Calculate the average modified duration for the portfolio using the shares of market value
as the weights.
2. Estimate the percentage loss in the portfolio's market value if the yield to maturity on each
bond goes up by 10 bps.
Solution to 1:
The average modified duration of the portfolio is 6.23.
(14,769,542/84,216,775) × 4.328 + (25,650,379/84,216,775) × 5.643 +
(43,796,854/84,216,775) × 7.210 = 6.23.
Solution to 2:
The estimated decline in market value if each yield rises by 10 bps is 0.623%. -6.23 × 0.001 =
-0.00623.
8. Money Duration and the Price Value of a Basis Point
The money duration of a bond is a measure of the price change in units of the currency in
which the bond is denominated, given a change in annual yield to maturity.
Money Duration = AnnModDur x PVFULL

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

ΔPVFULL ≈ -MoneyDur x Δyield

Consider a bond with a par value of $100 million. The current yield to maturity (YTM) is 5%
and the full price is $102 per $100 par value. The annual modified duration of this bond is 3.
The money duration can be calculated as the annual modified duration (3) multiplied by the
full price ($102 million): 3 x $102 million = $306 million. If the YTM rises by 1% (100 bps)
from 5% to 6%, the decrease in value will be approximately $306 million x 1% = $3.06
million. If the YTM rises by 0.1% (10 bps), the decrease in value will be $306 million x 0.1%
= $0.306 million.
An important measure which is related to money duration is the price value of a basis
point (PVBP). The PVBP is an estimate of the change in the full price given a 1 bp change in
the yield to maturity. The formal equation is given below.
PV− − PV+
PVBP = 2
where PV_ and PV+ are full prices calculated by decreasing and increasing the YTM by 1
basis point.
A quick way of calculating the price value of a basis point is to take the money duration and
multiply by 0.0001. For example, if the money duration of a portfolio is $200,000 the price
value of a basis point is $200,000 x 0.0001 = $20. (1 bp = 0.01% = 0.0001)
Example 13: Calculating money duration of a bond
A life insurance company holds a USD 1 million (par value) position in a bond that has a
modified duration of 6.38. The full price of the bond is 102.32 per 100 of face value.
1. Calculate the money duration for the bond.
2. Using the money duration, estimate the loss for each 10 bps increase in the yield to
maturity.
Solution:
1. First calculate the full price of the bond: $1,000,000 x 102.32% = $1,023,200. The money
duration for the bond is: 6.38 × $1,023,200 = $6,528,000.
2. 10 bps corresponds to 0.10% = 0.0010. For each 10 bps increase in the yield to maturity,
the loss is estimated to be: $6,528,000 × 0.0010 = $6,528.02.

Example 14: Calculating PVBP for a bond

Consider a $100, five-year bond that pays coupons at a rate of 10% semi-annually. The YTM
is 10% and it is priced at par. The modified duration of the bond is 3.81. Calculate the PVBP
for the bond.
Solution:
Money duration = $100 x 3.81 = $381.00

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

PVBP = $381 x 0.0001 = $0.0381

9. Bond Convexity
The graph below shows the relationship between bond price and YTM. It shows the
convexity for a traditional fixed-rate bond.

Source: CFA Program Curriculum, Understanding Fixed-Income Risk and Return

Interpretation of the diagram:
 Duration assumes there is a linear relationship between the change in a bond’s price
and change in YTM. For instance, assume the YTM of a bond is 10% and it is priced at
par (100). According to the duration measure, if the YTM increases to 11% the price
moves down to a point on the straight line.
 Similarly, the price moves up to a point on the straight line if the YTM decreases.
 The curved line in the above exhibit plots the actual bond prices against YTM. So in
reality, the bond prices do not move along a straight line but exhibit a convex
relationship.
 For small changes in YTM, the linear approximation is a good representation for
change in bond price. That is, the difference between the straight and curved line is
not significant.
 In other words, modified duration is a good measure of the price volatility.
 However, for large changes in YTM or when the rate volatility is high, a linear
approximation is not accurate and a convexity adjustment is needed.
Here we need to factor in the convexity. The percentage change in the bond’s full price with
convexity-adjustment is given by the following equation:
Change in the price of a full bond:
1
% ΔPVFULL = (−AnnModDur ∗ Δyield) + [2 ∗ AnnConvexity ∗ (Δyield)2 ]
Expression in first braces: duration adjustment
Expression in second braces: convexity adjustment
Approximate convexity can be calculated using this formula:

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

PV− + PV+ − 2 ∗ PV0

Approx. Convexity = (Δyield)2 ∗ PV0

where:
PV_ and PV+ = new full price when YTM is decreased and increased by the same amount
PV0 = original full price
The change in the full price of the bond in units of currency, given a change in YTM, can be
calculated using this formula:
1
ΔPVFULL ≈ − (MoneyDur x Δyield) + [ x MoneyCon x (Δyield)2 ]
2
Convexity is good
The following exhibit shows the price-yield curves for two bonds with the same YTM, price,
and modified duration, and why greater convexity is good for an investor.

Interpretation of the diagram:

 Both the bonds have the same tangential line to their price-yield curves.
 When YTM decreases by the same amount, the more convex bond appreciates more
in price.
 When YTM increases by the same amount, the more convex bond depreciates less in
price than the less convex bond.
 The bond with greater convexity outperforms when interest rates go up/down.
The relationship between various bond parameters with convexity is the same as with
duration.
For a fixed-rate bond,
 The lower the coupon rate, the greater the convexity.
 The lower the yield to maturity, the greater the convexity.
 The longer the time to maturity, the greater the convexity.
 The greater the dispersion of cash flow or cash payments spread over time, the
greater the convexity.

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

Effective Convexity
For bonds whose cash flows were unpredictable, we used effective duration as a measure of
interest rate risk. Similarly, we use effective convexity to measure the change in price for a
change in benchmark yield curve for securities with uncertain cash flows. The effective
convexity of a bond is a curve convexity statistic that measures the secondary effect of a
change in a benchmark yield curve. It is used for bonds with embedded options.
PV− + PV+ − 2 ∗ PV0
Effective Convexity = (Δcurve)2 ∗ PV0

Here is a summary of some important points related to bonds with embedded options:
 Option-free bonds always have positive convexity.
 Callable bonds have positive convexity at high yields but they can have negative
convexity at low yields. This is because at low yields, the call option becomes valuable
and puts a limit on how much the bond price can appreciate.
 Putable bonds always have positive convexity.
Example 15: Calculating the full price and convexity-adjusted percentage price change
of a bond
A German bank holds a large position in a 6.50% annual coupon payment corporate bond
that matures on 4 April 2029. The bond's yield to maturity is 6.74% for settlement on 27
June 2014, stated as an effective annual rate. That settlement date is 83 days into the 360-
day year using the 30/360 method of counting days.
1. Calculate the full price of the bond per 100 of par value.
2. Calculate the approximate modified duration and approximate convexity using a 1 bp
increase and decrease in the yield to maturity.
3. Calculate the estimated convexity-adjusted percentage price change resulting from a 100
bp increase in the yield to maturity.
4. Compare the estimated percentage price change with the actual change, assuming the
yield to maturity jumps to 7.74% on that settlement date.
Solution:
There are 15 years from the beginning of the current period on 4 April 2014 to maturity on 4
April 2029.
1. The full price of the bond is 99.2592 per 100 of par value.
FV = 100, I/Y = 6.74, PMT = 6.50, N = 15, CPT PV; PV = -97.777.
83
Full Price = 97.777 × 1.0674360 = 99.2592.
2. PV+ = 99.1689 .
FV = 100, PMT = 6.5, I/Y = 6.75, N = 15, CPT PV; PV = -97.687.
83
PV+ = 97.687 × 1.0675360 = 99.1689.

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

PV_ = 99.3497.
FV = 100, I/Y = 6.73, PMT = 6.5, N = 15, CPT PV; PV = -97.869.
83
PV_ = 97.869 × 1.0673360 = 99.3497.
99.3497 – 99.1689
ApproxModDur = ( ) = 9.1075.
2 ∗ 99.2592 ∗ .0001

The approximate modified duration is 9.1075.

99.1689 + 99.3497 – (2 × 99.2592)
ApproxCon = .00012 ∗ 99.2592
= 201.493

The approximate convexity is 201.493.

3. The convexity-adjusted percentage price drop resulting from a 100 bp increase in the
yield to maturity is estimated to be -8.1% (-9.1075 + 1.00746).
Modified duration alone estimates the percentage drop to be 9.1075%. The convexity
adjustment adds 100.746 bps (0.5 × 201.493 × .012 = 1.00746%).
4. The new full price if the yield to maturity goes from 6.74% to 7.74% on that settlement
date is 90.7623. The actual percentage change in the bond price is -8.5603%. The convexity-
adjusted estimate is -8.1%.

Example 16: Calculating the approximate modified duration and approximate

convexity
The investment manager for a US defined-benefit pension scheme is considering two bonds
about to be issued by a large life insurance company. The first is a 25-year, 5% semiannual
coupon payment bond. The second is a 75-year, 5% semiannual coupon payment bond. Both
bonds are expected to trade at par value at issuance.
Calculate the approximate modified duration and approximate convexity for each bond using
a 5 bp increase and decrease in the annual yield to maturity.
Solution:
In the calculations, the yield per semiannual period goes up by 2.5 bps to 2.525% and down
by 2.5 bps to 2.475%.
The 25-year bond has an approximate modified duration of 14.18.
PV+ : FV = 100, I/Y = 2.525, PMT = 2.5, N = 50, CPT PV, PV = -99.2945.
PV__: FV = 100, I/Y = 2.475, PMT = 2.5, N = 50, CPT PV, PV = -100.7126.
100.7126 – 99.2945
ApproxModDur = = 14.18 and an approximate convexity of 284.
2 ∗ 100∗ 0.0005

100.7126 + 99.2945 – (2 ∗ 100)

ApproxCon = ( 100 ∗ 0.00052
) = 284. Similarly, the 75-year bond has an

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

approximate modified duration of 19.51 and an approximate convexity of 708.

10. Investment Horizon, Macaulay Duration and Interest Rate Risk
In this section, we look at how yield volatility affects the investment horizon. We also study
the interaction between the investment horizon, market price risk, and coupon reinvestment
risk.
10.1 Yield Volatility
If there is a change in a bond’s YTM, there will be a corresponding change in the price of a
bond. The change in the price can be explained as the product of two factors:
1. Price value of a basis point (PVBP): Impact on bond price of a one basis point change in
YTM. This factor is based on the duration and convexity of the bond.
2. Number of basis points: This is the change in yield measured in basis points.
The percentage change in the price of a bond for a given change in yield can also be
determined using this equation:
1
%ΔPVFULL = (−AnnModDur ∗ Δyield) + [2 ∗ AnnConvexity ∗ (Δyield)2 ]

Example 17: Ranking bonds in terms of interest rate risk

A fixed-income analyst is asked to rank three bonds in terms of interest rate risk. The
increases in the yields to maturity represent the "worst case" for the scenario being
considered.
Bond Modified Duration Convexity ∆Yield
A 3.65 14.8 50 bps
B 5.75 38.7 25 bps
C 12.28 146 15 bps
The modified duration and convexity statistics are annualized. ∆Yield is the increase in the
annual yield to maturity. Rank the bonds in terms of interest rate risk.
Solution:
Calculate the estimated price change for each bond:
Bond A:
The duration effect is -3.65 × 0.005 = -1.825%.
The convexity effect is 0.5 × 14.8 × 0.0052 = 0.0185%.
The expected change in bond price is -1.825% + 0.0185% = -1.8065%.
Bond B:
The duration effect is -5.75 × 0.0025 = -1.4375%.
The convexity effect is 0.5 × 38.7 × 0.00252 = 0.0121%.

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

The expected change in bond price is -1.4375% + 0.0121% = -1.4254%.

Bond C:
The duration effect is -12.28 × 0.0015 = -1.842%.
The convexity effect is 0.5 × 146 × 0.00152 = 0.0164%.
The expected change in bond price is -1.842% + 0.0164% = -1.8256%.
Bond C has the highest degree of interest rate risk (a potential loss of 1.8256%), followed by
Bond A (a potential loss of 1.8065%) and Bond B (a potential loss of 1.4254%).
10.2 Investment Horizon, Macaulay Duration, and Interest Rate Risk
The impact of a sudden change in yield on the price of a bond is of particular concern to
short-term investors (price risk). Long-term investors will also be concerned about the
impact of a change in yield on the reinvestment income (reinvestment risk). An investor who
plans to hold the bond to maturity will only be concerned about reinvestment risk.
Consider another 10-year, 8% annual coupon bond priced at 85.5 and YTM of 10.4%. If the
investment horizon is 10 years, the only concern is reinvestment risk. Consider a scenario
where interest rates go down. In this case, reinvestment income goes down. When the price
of the bond goes up, it does not matter to the investor because at maturity he will simply
receive par value.
When interest rates go up, the reinvestment income goes up. If the investment horizon is 4
years, then the major concern is price risk. In this case, the price effect dominates relative to
the gain/loss from reinvestment of coupons. If the investment horizon is 7 years, the
reinvestment risk and price risk offset each other. For this particular bond the Macaulay
duration is 7 years.
Macaulay duration indicates the investment horizon for which coupon reinvestment risk
and market price risk offset each other. The assumption is a one-time parallel shift in the
yield curve.
Note: Investment horizon is different from the bond’s maturity. In this case, the maturity is 10
years while the horizon is 7 years.
The duration gap of a bond a bond is defined as the Macaulay duration – investment
horizon.
Duration gap = Macaulay duration – Investment horizon
 If Macaulay duration < investment horizon, the duration gap is negative: coupon
reinvestment risk dominates.
 If investment horizon = Macaulay duration, the duration gap is zero: coupon
reinvestment risk offsets market price risk.
 If Macaulay duration > investment horizon, the duration gap is positive: market price

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

risk dominates.
Example 18: Calculating duration gap and assessing interest rate risk
An investor plans to retire in 8 years. As part of the retirement portfolio, the investor buys a
newly issued, 10-year, 6% annual coupon payment bond. The bond is purchased at par
value, so its yield to maturity is 6.00% stated as an effective annual rate.
1. Calculate the approximate Macaulay duration for the bond, using a 1 bp increase and
decrease in the yield to maturity, and calculating the new prices per 100 of par value.
2. Calculate the duration gap at the time of purchase.
3. Does this bond at purchase entail the risk of higher or lower interest rates? Interest rate
risk here means an immediate, one-time, parallel yield curve shift.
Solution to 1:
100.0736 – 99.9264
The approximate modified duration of the bond is 7.36 = ( 2 × 100 × 0.0001
).

PV0 = 100, PV+ = 99.9264

FV = 100, PMT = 6, I/Y = 6.01, N = 10, CPT PV, PV = -99.9264
PV_ = 100.0736; FV = 100, PMT = 6, I/Y = 5.99, N = 10, CPT PV, PV = -100.0736.
The approximate Macaulay duration = 7.36 × 1.06 = 7.8016.
Solution to 2:
Given an investment horizon of 8 years, the duration gap for this bond at purchase is
negative: 7.8016 - 8 = -0.1984
Solution to 3:
A negative duration gap entails the risk of lower interest rates. To be precise, the risk is an
immediate, one-time, parallel, downward yield curve shift because the coupon reinvestment
risk dominates market price risk. The loss from reinvesting coupons at a rate lower than 6%
is larger than the gain from selling the bond at a price above the constant-yield price
trajectory.
11. Credit and Liquidity Risk
So far in this reading, we focused on how to use duration and convexity to measure the price
change given a change in YTM. Now, we will look at what causes the YTM to change.
 The YTM on a corporate bond consists of two parts: government benchmark yield and
a spread over the benchmark. Change in YTM can be due to either of these or both.
 The change in the spread can result from a change in credit risk or liquidity risk.
 Credit risk involves the probability of default and degree of recovery if default occurs.
 Liquidity risk refers to the transaction costs associated with selling a bond.

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

 For a traditional (option-free) fixed rate bond, the same duration and convexity
statistics apply if a change occurs in the benchmark yield or a change occurs in the
spread.
 A change in benchmark yield could be because of a change in the expected rate of
inflation or expected real rate of interest.
 In practice, there is often the interaction between changes in benchmark yields and in
the spread over the benchmark, and between credit and liquidity risk. It is rare for
any individual component of the YTM to change.
Example 19: Calculating modified duration
Consider a 4-year, 9% coupon paying semi-annual bond with an YTM of 9%. The duration of
the bond is 6.89 periods. Calculate the modified duration.
Solution:
MacDuration 6.89
Modified duration = 1 +r
= .09 = 6.593 periods or 3.297 years.
1+
2

For a one percent change in the annual YTM, the percentage change in the bond price is
3.297%.

Example 20: Calculating the change in the credit spread on a corporate bond
The (flat) price on a fixed-rate corporate bond falls one day from 96.55 to 95.40 per 100 of
par value because of poor earnings and an unexpected ratings downgrade of the issuer. The
(annual) modified duration for the bond is 5.32. What is the estimated change in the credit
spread on the corporate bond, assuming benchmark yields are unchanged?
Solution:
Given that the price falls from 96.55 to 95.40, the percentage price decrease is 1.191%.
-1.191% ≈ -5.32 × ∆Yield,
∆Yield = 0.2239%
Given an annual modified duration of 5.32, the change in the yield to maturity is 22.39 bps.
12. Empirical Duration
The approach used in this reading to estimate duration and convexity with mathematical
formulas is called analytical duration. This approach implicitly assumes that benchmark
yields and credit spreads are uncorrelated with one another.
However, in practice, changes in benchmark yields and credit spreads are often correlated.
So, many fixed income analysts use an alternate approach – Empirical duration. This
approach uses statistical methods and historical bond prices to derive the price-yield
relationship for specific bonds or bond portfolios.
For a government bond with little or no credit risk, the analytical and empirical duration

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

would be similar because bond prices are largely driven by changes in the benchmark yield.
However, for a high-yield bonds with significant credit risk, the analytical and empirical
duration will be different. In a market stress scenario, many investors switch to high quality
government bonds due to which their yields (i.e., benchmark yields) fall. But at the same
time the credit spreads on high-yield bonds will widen (i.e., credit spreads and benchmark
yields are negatively correlated). The wider credit spreads will fully or partially offset the
decline in government benchmark yields. Thus, the empirical duration for high yield bonds
will be lower than their analytical duration.

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

Summary
LO: Calculate and interpret the sources of return from investing in a fixed-rate bond.
A bond investor has three sources of return:
 Receiving the full coupon and principal payments on the scheduled dates.
 Reinvesting the interest payments. This is also known as interest-on-interest.
 Potential capital gain or loss on sale of the bond, if the bond is sold before maturity
date.
Interest rate risk affects the realized rate of return for any bond investor in two ways:
coupon reinvestment risk and market price risk.
 Reinvestment income is directly proportional to interest rate movements. The value
of reinvested coupons increases when the interest rate goes up.
 Bond price is inversely proportional to interest rate movements. Bond price
decreases when the interest rate goes up.
 Coupon reinvestment risk matters when an investor has a long time horizon. If the
investor buys a bond and sells it before the first coupon payment, then this risk is
irrelevant.
 Market price risk matters when an investor has a short time horizon.
LO: Define, calculate, and interpret Macaulay, modified, and effective durations.
Macaulay duration is the weighted average of the time to receipt of coupon interest and
principal payments.
Modified duration is a linear estimate of the percentage price change in a bond for a 100
basis points change in its yield to maturity.
Macaulay Duration
Modified duration =
(1 + r)
FULL
% ∆ PV ≈ −AnnModDur ∗ ΔYield
(PV − ) − (PV + )
Approximate Modified Duration =
2 ∗ ∆ yield ∗ PV0
Effective duration is a linear estimate of the percentage change in a bond’s price that would
result from a 100 basis points change in the benchmark yield curve.
(PV− ) − (PV+ )
Effective Duration =
2 ∗ ∆curve ∗ PV0
LO: Explain why effective duration is the most appropriate measure of interest rate
risk for bonds with embedded options.
The difference between modified duration and effective duration is that modified duration
measures interest rate risk in terms of a change in the bond’s own yield to maturity, whereas
effective duration measures interest rate risk in terms of changes in the benchmark yield

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

curve.
Bonds with an embedded option do not have a meaningful internal rate of return (YTM)
because future cash flows are contingent on interest rates.
Therefore, effective duration is the appropriate interest rate risk measure, not modified
duration.
LO: Define key rate duration and describe the use of key rate durations in measuring
the sensitivity of bonds to changes in the shape of the benchmark yield curve.
Key rate duration is a measure of the price sensitivity of a bond to a change in the spot rate
for a specific maturity.
Key rate durations can be used to measure a bond’s sensitivity to changes in the shape of the
yield curve, i.e., for non-parallel shifts in the yield curve.
LO: Explain how a bond’s maturity, coupon, and yield level affect its interest rate risk.
The interest rate risk of a bond is measured by duration. All else equal:
 Duration increases when maturity increases.
 Duration decreases when coupon rate increases.
 Duration decreases when yield to maturity increases.
LO: Calculate the duration of a portfolio and explain the limitations of portfolio
duration.
The weighted average of the time to receipt of aggregate cash flows
• This method is better in theory.
• Its main limitation is that it cannot be used for bonds with embedded options or for
floating-rate notes.
The weighted average of the durations of individual bonds that compose the portfolio
• This method is simpler to use and quite accurate when the yield curve is relatively
flat.
• Its main limitation is that it assumes a parallel shift in the yield curve.
LO: Calculate and interpret the money duration of a bond and price value of a basis
point (PVBP).
The money duration of a bond is a measure of the price change in units of the currency in
which the bond is denominated, given a change in annual yield to maturity.
Money Duration = AnnModDur ∗ PV FULL
∆ PV FULL ≈ −MoneyDur ∗ Δyield
The PVBP is an estimate of the change in the full price, given a 1bp change in the yield to
maturity.

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

PV− − PV+
PVBP =
2
LO: Calculate and interpret approximate convexity and compare approximate and
effective convexity.
A bond’s convexity can be estimated as:
PV− + PV+ − 2 ∗ PV0
Approx. Convexity =
(Δyield)2 ∗ PV0
Effective convexity of a bond is a curve convexity statistic that measures the secondary effect
of a change in a benchmark yield curve. It is used for bonds with embedded options.
PV− + PV+ − 2 ∗ PV0
Effective Convexity =
(Δcurve)2 ∗ PV0
LO: Calculate the percentage change of a bond for specified change in yield, given the
bond’s approximate duration and convexity.
The percentage change of a bond can be calculated using the following formula if modified
duration and convexity are given:
1
% Δ PV FULL = (−AnnModDur ∗ Δyield) + [ ∗ AnnConvexity ∗ (Δyield)2 ]
2
LO: Describe how the term structure of yield volatility affects the interest rate risk of a
bond.
If there is a change in a bond’s YTM, there will be a corresponding change in the price of a
bond. The change in the price can be explained as the product of two factors:
1. Price value of a basis point (PVBP): Impact on bond price of a one basis point change in
YTM. This factor is based on the duration and convexity of the bond.
2. Number of basis points: This is the change in yield measured in basis points.
The percentage change in the price of a bond for a given change in yield can also be
determined using this equation:
1
% Δ PV FULL = (−AnnModDur ∗ Δyield) + [ ∗ AnnConvexity ∗ (Δyield)2 ]
2
LO: Describe the relationships among a bond’s holding period return, its duration, and
the investment horizon.
The Macaulay duration can be interpreted as the investment horizon for which coupon
reinvestment risk and market price risk offset each other.
Duration gap = Macaulay duration – Investment horizon
 If the investment horizon is greater than the Macaulay duration of the bond, coupon
reinvestment risk dominates price risk. The investor’s risk is that interest rates will

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LM05 Understanding Fixed-Income Risk and Return 2023 Level I Notes

fall. The duration gap is negative.

 If the investment horizon is equal to the Macaulay duration of the bond, coupon
reinvestment risk offsets price risk. The duration gap is zero.
 If the investment horizon is less than the Macaulay duration of the bond, price risk
dominates coupon reinvestment risk. The investor’s risk is that interest rates will
rise. The duration gap is positive.
LO: Explain how changes in credit spread and liquidity affect yield to maturity of a
bond and how duration and convexity can be used to estimate the price effect of the
changes.
• The YTM on a corporate bond consists of two parts: government benchmark yield
and a spread over the benchmark. Change in YTM can be due to either of these or
both.
• The change in the spread can result from a change in credit risk or liquidity risk.
• Credit risk involves the probability of default and degree of recovery if default
occurs.
• Liquidity risk refers to the transaction costs associated with selling a bond.
• For a traditional (option-free) fixed rate bond, the same duration and convexity
statistics apply if a change occurs in the benchmark yield or a change occurs in the
spread.
• A change in benchmark yield could be because of a change in the expected rate of
inflation or expected real rate of interest.
LO: Describe the difference between empirical duration and analytical duration.
 Analytical duration approach uses mathematical formulas to estimate duration and
convexity. The approach implicitly assumes that benchmark yields and credit spreads
are uncorrelated with one another.
 The empirical duration approach does not rely on this assumption. It uses statistical
methods and historical bond prices to derive the price-yield relationship for specific
bonds or bond portfolios.
 For government bonds, both approaches will give similar results.
 For high yield bonds, the empirical duration will be lower than analytical duration.

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