Department of Statistics, The Chinese University of Hong Kong

RMSC 2001 Introduction to Risk Management (Term 2, 2024-25)

Tutorial 7: Yield and Duration

Fong Si Cheng (Ryan)

7.1 Yields
Recall that zero rate is the annualized rate of return of zero coupon bond, the Yield-to-Maturity (YTM) (of a coupon
bond) is the single internal rate of return (IRR) that sets the present value of the cash flows equal to the bond price.

Definition 7.1 (Yield). We say y is the Yield to Maturity (YTM) if we can represent

mT
X CFi
P = P (y) = .
ay (i/m)
i=1

where
• (Annual Compounding) ay (t) = (1 + y)t ;
• (k-times-per-year compounding) ay (t) = (1 + y/k)kt ;
• (Continuous) ay (t) = eyt .

Remark 7.1 (More about yield).

higher above
   
• If a bond has price than it’s face value, we say it is selling par.
lower below
• Since the yield y determines the price P and vice-versa, we may denote P = P (y) to regard the coupon bond
price as a function of yield y. Note that P (y) is decreasing with y. (Why?)
• We say a bond is at par if it’s price equals it’s principal. The yield (y) is equal to its coupon rate (c) if and only
if the bond is selling at par, i.e.,
mT  
X i
y=c ⇔ F =P = CFi · B 0, .
m
i=1

Exercise 7.1 (Yield). Suppose you invest in a 10-year U.S. Treasury Note sold at par (with face value $1000), with
an annual coupon rate of 8% and semi-annual coupon payment.
1. What is the yield of this Treasury Note?
2. Assume the coupon payments are reinvested at YTM and you plan to hold the bond for 3 years. What is the
future value of coupon payments at the end of the third year? [Hint: use the formula for the future value of
an annuity.]
3. At the end of the third year, if you sell the Treasury Note, what is your capital gain? Assume a flat yield curve.
[Hints: capital gain = sales price - purchase price, and a flat yield curve means the yields are the same for all
maturities.]
4. Immediately after the bond is issued, the market yield falls to 6%. Suppose you still want to hold the bond for
3 years, what are the future value of coupon payments and capital gain? Compare the results with the answers
in 2 and 3.

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7.1 Yields Rmsc 2001 | Tutorial 7

Solution:

1. By directly calculation, we can find the yield as follows:

19
X $40 $1040
$1000 = t
+ ⇒ y = 8% .
(1 + y/2) (1 + y/2)40
t=1

We can also get this result without calculation: because the bond is sold at par, the coupon rate must be equal
to its yield, i.e., y = c = 8%.

2.
1.046 − 1
 
5
F V (C) = $40 + $40(1 + y/2) + · · · + $40(1 + y/2) = $40 = $265.32 .
0.04

3. At the end of the third year, the Treasury Note can be regarded as a coupon bond with the same coupon rate
as its yield, so it is still a par bond. Hence, the new price is still $1000 and the capital gain is 0.

4.
1.036 − 1
 
′ 5
F V (C) = $40 + $40(1 + 0.06/2) + · · · + $40(1 + 0.06/2) = $40 = $258.74 ,
0.03
13
X $40 $1030
P′ = t
+ = $1112.96 .
(1 + 0.06/2) (1 + y/2)14
t=1

As the market yield decreases, the accrued coupon interest will decrease, but you will get a positive capital gain
of $112.96.

Takeaway: There are three components affect the return on bond investment:
1. Coupon payments,
2. Income from reinvestment of coupons,
3. capital gains/losses when the bond matures or is sold.
The second one reflects the reinvestment risk, and the third reflects interest rate risk. In this Exercise, the drop
in yield leads to a smaller reinvestment income, but the capital gain dominates the overall return. To see this, we can
calculate the realized yield by
F V (C)′ + P ′
P = ⇒ y ′ = 10.82% .
(1 + y ′ /2)6
Note that the realized yield (10.82%) is higher than the original YTM (8%). What is the realized yield if your
holding period is 7 years? Have a try!

What happened to Silicon Valley Bank (SVB) recently

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7.1 Yields Rmsc 2001 | Tutorial 7

Source: Investopedia

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7.2 Duration Rmsc 2001 | Tutorial 7

Remark 7.2 (Use Excel to calculate or verify the Yield/PV/FV). Consider a 3-year bond with a 8% semiannual
coupon, selling at $97.42 (per $100 face) to yield 9%.

1. The bond price P is unknown:

Function: PV(rate,nper,pmt,[fv],[type]).
Input: =-PV(0.09/2,6,4,100).
Output: $97.42.

2. The yield y is unknown:

Function: RATE(nper,pmt,pv,[fv],[type],[guess]).
Input: =2*RATE(6,4,-97.42,100).
Output: 9%
(You can also use “Goal Seek” introduced in class).

3. Total value of coupons at maturity:

Function: FV(rate,nper,pmt,[pv],[type]).
Input: =-FV(0.09/2,6,4).
Output: $26.87.

4. The coupon payment is unknown:

Function: PMT(rate,nper,pv,[fv],[type]).
Input: =PMT(0.09/2,6,-97.42,100).
Output: $4.00.
(So the coupon rate is 2 × 4/100 = 8%).

Similarly, you can also use PMT(rate,nper,pv,[fv],[type]) to calculate the payment in each period of a mort-
gage, and use IRR(values,[guess]) to calculate the return of a series of irregular cash flows.

7.2 Duration

Definition 7.2 (Duration). Suppose the face value of coupon bond were $100. Given initial yield is y0 .
• (Dollar Duration) We say the derivative P ′ (y) = dP dy is the Dollar Duration ($Dur). We may approximate
the profit resulting from a decrease in yield of ∆y0 by

P (y0 − ∆y0 ) − P (y0 ) ≈ (−∆y0 )P ′ (y0 ).

For a bond, the dollar duration is

n
′
X t · CFt
P (y) = − .
(1 + y)t+1
t=1

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7.2 Duration Rmsc 2001 | Tutorial 7

• (DV01) We define the change in bond price for one basis point decrease in yield as

P ′ (y0 )
DV01 = − .
10000
Note that the profit generated by a decrease of δ b.p. in yield follows
position size
Approximated profit = × δ × DV01.
100
• (Modified duration) We say the proportional change −P ′ (y0 )/P (y0 ) is the Modified Duration (MD).

Remark 7.3 (More about duration).

• Duration is a commonly used measure of bond price sensitivity. Higher duration means higher price sensi-
tivity to interest rate changes (more volatile).
• Dollar duration can be interpreted as the slope of a price curve P (y).
• Dollar Duration is a negative value (in $-term).
• One basis point (1 b.p.) equals 0.01%.
• Modified duration measures the percentage increase in bond value per one basis point of decrease of yield.
And it is a positive unitless value.
• Relationship among Dollar Duration ($Dur), DV01 and MD:

−$Dur MD × P
DV 01 = = .
10000 10000

Exercise 7.2 (Approximate profit by duration). A bond that pays annual coupons has a par value of $1,000, an 8%
coupon rate, 3 years left to maturity, and is currently priced at a YTM of 6.0%.
1. Calculate the dollar duration and modified duration for the bond.
2. If the YTM changes from its current 6.0% to 8.0%, what are the approximated profit?
3. What is the approximation error?
4. If the YTM changes from 6.0% to 10.0%, what is the approximation error?

Solution:

1. We can first calculate the bond price,

$80 $80 $1080
P = + 2
+ = $1053.46 .
(1 + 6%) (1 + 6%) (1 + 6%)3
Then the dollar duration and modified duration are given by
 
1 × $80 2 × $80 3 × $1080
$Dur = − + + = −$2771.92 ,
(1 + 6%)2 (1 + 6%)3 (1 + 6%)4
M D = −$Dur/P = 2.63 .

2. We can calculate the price change by dollar duration or modified duration:

∆P = 2.0% × (−$2771.92) = −$55.44 ,
or equivalently,
∆P/P = −2.0% × 2.63 ⇒ ∆P = −$55.44 .
So the approximated loss is $55.44.

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7.2 Duration Rmsc 2001 | Tutorial 7

3. Note that the new yield is equal to the coupon rate, so the new price of the bond is its par value, $1000. So
the exact change in price is $1000 − $1053.46 = $ − 53.46, which is quite close to our approximation in 2.
The approximation error is $55.44 − $53.46 = $1.98.

4. First calculate the new price and the actual price change:

$80 $80 $1080

P′ = + 2
+ = $950.26 .
(1 + 10%) (1 + 10%) (1 + 10%)3

So the actual change in price is $950.26 − $1053.46 = −$103.20. If we approximate this change by dollar
duration:
∆P = 4% × (−$2771.92) = −$110.88 .
So the approximation difference is $110.88 − $103.20 = $7.68, which is larger than the error in the last
question.

Takeaway: Duration approach for estimating price change is only accurate for small yield changes!

Remark 7.4 (@Macaulay Duration). Macaulay Duration (D) is the weighted average of the times to each coupon
or principal payments made by the bond. The formula for a bond that pays annual coupon is
T
X P V (CFt ) CFt
D= t × w(t), w(t) = = ,
T otalP V P · (1 + y)t
t=1

where y is the yield. From the formula, notice that its relationship with dollar duration and modified duration is
D = −$Dur(1+y)
P = M D(1 + y).

Recall in Exercise 7.1, if the market yield goes up, then the reinvestment income goes up, but there is a capital loss;
on the contrary, if the yield goes down, the reinvestment income goes down, but there is a capital gain. So at what
investment horizon, does the two effects offset each other (the portfolio return will not be affected by the interest rate
change)? The answer is (Macaulay) Duration. Duration can be interpreted as a break-even point. If the investment
horizon in Exercise 7.1 is 7 years, which is the duration of the bond, then you might find the realized yield is quite
close to the original YTM, which means the impact of the yield change is very small.

Remark 7.5 (Immunization). To manage the risk of loss, portfolio managers may immunize the portfolio, by taking
long and short positions in certain bonds with certain durations so that the portfolio as a whole doesn’t change value
even when interest rates do.

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