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Convexity and Duration

The bonds are exposed to reinvestment risk as their durations are shorter than the investment horizon. Bond X has duration risk as its duration exceeds the investment horizon. Selling Bond X on the 4th year mitigates reinvestment risk. To immunize, the portfolio duration should match the 6 year investment horizon through bond laddering or derivatives.

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Nikka Casyao
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135 views20 pages

Convexity and Duration

The bonds are exposed to reinvestment risk as their durations are shorter than the investment horizon. Bond X has duration risk as its duration exceeds the investment horizon. Selling Bond X on the 4th year mitigates reinvestment risk. To immunize, the portfolio duration should match the 6 year investment horizon through bond laddering or derivatives.

Uploaded by

Nikka Casyao
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Combined Effects:

Duration and Convexity


Duration and Convexity

Negative Duration
Positive and Negative Convexity

Positioning :

Callable Bond Price = Noncallable Bond Price


less Call Option Price
Effective Convexity

Calculated using cash flows

Positive Convexity vs Negative Convexity


Convex vs Concave

Effective Convexity :
P + P - 2P
+ _ 0
----------------------------------------

2
2P0 ( )
Sample Problem

Due to the change of interest


movement, from 8% to 7% in the
market rate, the bond price resulted to
99.0768 and 97.2691 from its original
value of 98.166. What would be its
computed effective convexity? What
would be its estimated price change?
Solution:

97.2691 + 99.0768 2(98.166)


------------------------------------ = .7079
2
2(98.166)(1%)
2
- .9108 (-1%)*100 + .7079 * (-1%) x 100 = .2029
Combined Effects

Given : 18 year bond, 12% coupon, 9% YTM


Price : 126.50
Modified Duration : 8.38
Convexity : 107.70
Interest change : 100 bps

Calculate the combined effects of duration


and convexity.
Solution

Change in Yield : -100BP


Duration change : -8.38 x (-100/100) =+ 8.38%
8.38% x 126.50 = $10.60
2
Convexity Change: x (126.50) x 107.70 x (.01)
6,812.03 x .0001 =$ .68

Combined Effect : 126.50 +10.60 +.68 = $137.78


Immunization

matches the durations of assets and liabilities thereby minimizing the


impact of interest rates on the net worth
ensures that a change in interest rates will not affect the value of a
security (Frank Redington)

Ways to Immunize:
-matching the duration, cash flow, volatility and convexity
trading thru derivatives (forward, futures and options)

If the immunization is incomplete, the strategies are usually hedging


while If immunization is complete, the strategies are usually arbitrage.
Passive and Active Strategies in Bonds
Benchmarking
benchmark interest rate = base interest rate - minimum
interest rate investors will accept for investing in a non-Treasury
security ; either an estimated yield curve or an estimated spot
rate curve. It is the yield that is earned on the most recent on
the run Treasury security.

Relative Value Analysis : identifies securities being


overpriced (rich) or underpriced (cheap) or fairly priced thru
benchmark interest rates

*spread measure depends on the benchmark used


Option Adjusted Spread (OAS) (spread of the forward rates in
the Interest rate tree)
Interest Rate Tree

Constructed using a process similar to bootstrapping with interest


rates that will produce a value for the on the run issues

The illustration may


explain:
9.60%

8.48%
1. Backward induction
7.50% 7.86%
2. arbitrage free
6.94%
3. Interest rate shock
6.43%

Entrepreneurship perspective
Finance perspective
Valuing Bonds with Embedded Options

Valuation models can give different values for the


same bond depending on the assumptions:
1. volatility assumption
2. benchmark interest rates
3. call rule

However,
1. the OAS is constant even when interest rates change
2. an OAS of zero means that the issue is fairly priced
Callable Bonds Conversion
Conversion ratio = Par Value / Conversion Price
Conversion value = (market price of stock) (conversion ratio)

Market Conversion Price = Market Price of Convertible Bond


Conversion ratio
Conversion Premium per Share = MCP - MPS
Conversion Premium Ratio = CP per share / MPS
Premium Over Straight Value = MPCB / Straight value 1
Income Differential :
Coupon interest from bond-(conversion ratio x dividend/share)
conversion ratio
Premium Payback Period = Market Conversion Premium/ID
Sample Problem

A convertible bond is priced at $900 with coupon


interest of $85 while the common stock is worth $25
which earns a dividend of $1 per share. If the
conversion ratio is at 30 and straight value of the bond
is estimated to be at $700, calculate the following:
1.1 conversion value
1.2 market conversion price
1.3 conversion premium per share
1.4 conversion premium ratio
1.5 premium over straight value
1.6 income differential
1.7 premium payback
Solution:

1.1 CV = $25 x 30 = $750


1.2 MCP = $900 / 30 = $30
1.3 CP/share = $30 - $25 = $5
1.4 CP Ratio = $5/$25 = 20%
1.5 P/SV = $900/$700 1 = 28.6%
1.6 ID = $85- (30 x $1) / 30 =$1.833
1.7 PB = $5/$1.833 = 2.73 years
Bond Strategies

Horizon Matching and Immunization

Investment Horizon = Duration Immunized YTM

Flat Interest Rates : wealth position is compounded


e.g $1,000,000 @ 8% semi annual coupon rate for 20yrs
20
$1,000,000 x (1.04) = $2,191,123
Bond Strategies

Risk for Not having Flat Interest Structure


Interest Rate Risk

1. Price Risk :
Duration > Investment Horizon

2. Reinvestment Risk
Duration < Investment Horizon
Illustrations: Interest Risks on Bonds

Bond A : a 10 yr bond, paying a 9% annual coupon, YTM of


10% and sell it in 3 years at 8% (prevailing market rate)
Initial Purchase = 10
90/(1+.10) + 1,000/(1+.10) = $938.55
7
Ending Purchase = 1,000/(1+.08) =$1,052.06 (P)
2 dd
=90(1+.08) +90(1.08) + 90 = $292.18 (C) = $1,344.24
3
RY = 1,344.24/938.55 1 = 12.72%
Illustrations: Interest Risks on Bonds

Bond B: 3 consecutive one-year pure discount bond,


YTM of 10%, market rate declined to 8% for 2nd & 3rd yr. with
initial purchase of 1,000 (roll over strategy)

Year 1 : (1,000)(1+.10) = $1,100.00


Year 2 : (1,100)(1.08) = 1,188.00
Year 3 : (1,188) (1.08) = $1,283.04

3
RY = 1,283.04 / 1,000 - 1 = 8.66%
Illustrations: Interest Risks on Bonds

Bond C : three-year pure discount bond, YTM of


10%, 8% market rate after 3 years (straight)

Initial Purchase : 3
1,000 / (1+.10) = $751.31
3
RY = 1,000/751.31 1 = 10.00%
Sample Problem

Assume that you have these bonds with YTM as 12%,


but the market rate flanked to 9% after 3 years and
projected to be steady by this rate for the next 3 more
years. Under this scenario, would you recommend to
sell on the 4th year? What interest rate risks are these
bonds exposed of? How will you immunize?
Bond X = 5 years; annual coupon of 6%
Bond Y = 4 year consecutive one year pure discount
bond
Bond Z = 4 year pure discount bond

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