Duration Convexity 02

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
(CONT…)
(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…)
 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
 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
 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.
 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.
 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
 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

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DURATION,

Thus the dispersion of a ZCB is Zero

The risk that the cash flows received at

The risk that interest rates could increase, causing

portfolio against a change in the interest

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