DURATION,
CONVEXITY &
IMMUNIZATION
CONVEXITY &
IMMUNIZATION
CONVEXITY
The price-yield relationship for a plain
vanilla bond is convex in nature.
Duration is a measure of the first derivative, and
varies along with yield.
To factor in the convex nature, or the curvature,
of the bond we need to compute the second
derivative.
Convexity is the rate of change of the
modified duration with respect to yield
CONVEXITY (CONT…)
Modified duration is the slope of the price-
yield curve at a point
Convexity measures the gap between the
modified duration tangent line and the price-
yield curve
Thus convexity may be defined as the
difference between the actual bond price
and the price predicted by the tangent line
It enhances a bond’s performance in both
bull and bear markets but not uniformly
CONVEXITY (CONT…)
For plain vanilla bonds the convexity is
always positive
Thus the price-yield curve will always lie
above the modified duration tangent line
The convexity effect becomes greater with
larger changes in yield
Modified duration is a good estimate for
small yield changes
But
loses its predictive power for large yield
changes
CONVEXITY (CONT…)
If a bond’s duration were to be constant for
all values of yield then convexity would not
exist
The change in duration with yield
movements creates the convexity effect
Duration increases in a bull market as yields
fall
This enhances the price gain
Duration decreases in a bear market as yield
rise
This mitigates the price decline
CONVEXITY (CONT…)
We will illustrate the price-yield relationship
for a plain vanilla bond.
Thebond is assumed to have 10 years to
maturity, a face value of $ 1,000, and a coupon
of 7% per annum payable semi-annually.
CONVEXITY (CONT…)
CONVEXITY
CONVEXITY (CONT…)
CONVEXITY (CONT…)
y is the semi-annual YTM
c is the semi-annual coupon
N is the number of remaining coupons
The convexity of a bond is defined as:
CONVEXITY (CONT…)
CALCULATING CONVEXITY
Take the 5-year T-note
Price is 978.9440
Coupon is 6% per annum
YTM is 6.50% per annum
CALCULATING CONVEXITY
CALCULATING CONVEXITY
(CONT…)
CALCULATING CONVEXITY
(CONT…)
The convexity in semi-annual terms is
86.4458
The convexity in annual terms is 21.6115
APPROXIMATING THE PRICE
CHANGE
APPROXIMATING (CONT…)
ILLUSTRATION
Consider a 50b.p increase in the YTM of a 5-year
T-note
The new price will be 958.4170
The exact price change is:
958.4170 – 978.9440 = -20.5270
The price change due to duration is:
-4.3853/(1.0325) x [978.9440 x0.005] = -20.7892
The price change due to convexity is:
0.5X21.6115X978.9440X(0.005)2 = 0.2645
The approximate change due to both factors is:
-21.4648 + 0.2645 = -20.5247
PROPERTIES OF CONVEXITY
The primary factors which influence a bond’s
convexity are the following
Duration
Cash flow distribution
Market yield volatility
Direction of yield change
PROPERTIES (CONT…)
Convexity is positively related to the
duration of a bond
Long
duration bonds have higher convexity than
bonds with a shorter duration
RATIONALE
Long-term cash flows carry progressively
higher amounts of convexity
Thus they provide higher convexities per year
of modified duration
A bond’s convexity reflects the convexities of
component cash flows
The wider the dispersion the greater is the
convexity effect
And it is the long-term cash flows which are
responsible
IMPACT OF YIELD VOLATILITY
Convexity is positively related to market
yield volatility
Higher volatility in interest rates creates
larger convexity effects
The curvature of the price-yield curve is
more pronounced for larger shifts in the YTM
And greater yield volatility increases the
probability of major yield changes
IMPACT OF YIELD CHANGE
DIRECTION
Convexity is more positively influenced by a
downward yield change of a given magnitude
Than by an upward movement of the same
magnitude
BOND DISPERSION
The dispersion of a bond is defined as
Thus the dispersion of a ZCB is Zero
DISPERSION (CONT…)
DISPERSION (CONT…)
Thus for a given level of duration, the lower
the dispersion the lower the convexity
Thus for a given duration zero coupon bonds
have the lowest convexity
DISPERSION (CONT…)
A bonds dispersion is the variance of the
time to receipt of all cash flows from it
While its duration is the mean of the time to
receipt of all the cash flows
Dispersion measures how spread out in time
the payments are relative to duration
The more spread out the cash flows relative
to the mean (duration) the greater the
dispersion
DISPERSION (CONT…)
For a given duration the higher the
dispersion the greater is the convexity
For plain vanilla bonds both duration and
dispersion are non-negative
Thus the convexity is positive
IMMUNIZATION
A pension fund has promised a return of 8.40% per
annum compounded annually after 8 years on an
investment of 5MM
If it were to invest the corpus in a bond, it is exposed
to two types of risks.
The first is re-investment risk
The risk that the cash flows received at
intermediate stages may have to be invested at
lower rates of interest.
The second is price or market risk
The risk that interest rates could increase, causing
the price of the bond to fall at the end of the
investment horizon.
IMMUNIZATION (CONT…)
The two risks obviously work in
opposite directions.
The issue is, is there a bond which will
ensure that the terminal cash flow is
adequate to satisfy the liability -
irrespective of whether rates rise or
fall.
The process of protecting a bond
portfolio against a change in the interest
rate is termed as Immunization.
IMMUNIZATION (CONT…)
We are considering a simple immunization
strategy where we have to immunize a
portfolio required to satisfy a single
liability.
There are two conditions that we need to
satisfy in such cases.
Firstly the present value of the liability
should be equal to the amount invested in
the bond at the outset.
Second the duration of the bond should be
equal to the investment horizon.
IMMUNIZATION (CONT…)
Consider a bond with a face value of $ 1,000
and 12 years to maturity.
Assume that the coupon rate is equal to the
YTM is equal to 8.40% per annum.
It can be shown that the duration is eight years.
Since the liability is 5 MM and the price of
the bond is 1,000, we need 5,000 bonds
Now consider a one-time change in interest
rates right at the outset.
Consider increments and decrements in multiples
of 20 bp from the prevailing rate
IMMUNIZATION (CONT…)
The following table gives the terminal cash
flow for various values of the interest rate.
The income from reinvested coupons steadily
increases with the interest rate
The sale price steadily declines with the interest
rate
When the rate does not change the terminal cash
flow is exactly adequate to satisfy the liability
In all the other cases there is a surplus
Thus the pension fund will always be able to
satisfy the liability no matter what happens
ANALYSIS (CONT…)
Thusif the pension fund were to invest in an
asset, whose duration is equal to the time to
maturity of its liability
Then the funds received will always be adequate to
meet the contractual outflow.
To meet this requirement, certain conditions
must be satisfied.
First the amount invested in the bonds must be
equal to the present value of the liability.
In this case since the bond is assumed to be
selling at par, we need to invest in 5000 bonds.
ANALYSIS (CONT…)
Second, the duration of the asset must equal the
maturity horizon of the liability.
In this case the bond has a duration of 8 years
which is the investment horizon
Third, there must be a one time change in the
interest rate, right at the very outset.
Fourth, there must be a parallel shift in the yield
curve.
That is all spot rates must change in an identical
fashion
