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Transcript of Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties...
![Page 1: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/1.jpg)
Class 7, Chap 9 - Appendix B
![Page 2: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/2.jpg)
Purpose: Gain a deeper understanding of duration and its properties and weaknesses
Properties of duration
Hedging with duration
Weaknesses of duration Convexity
![Page 3: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/3.jpg)
1. Duration increases with maturity but at a decreasing rate
2. Duration decreases as the yield to maturity increases
3. Duration decreases as the coupon payments or interest rate increases
![Page 4: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/4.jpg)
Calculate the duration for bonds of several maturities with an 8% coupon paid semiannually, $1,000 face value and yield to maturity of 12%.
When we add a year to a long maturity bond it changes the duration much less than when we add a year to a short maturity bond
Adding a year means:• The big payment occurs 1 year later• Adds 1 year to the weighted average •Because there is not a lot of discounting, the weight on the additional year is large
925.6037.74
0 0.5 1
37.74
0 0.5 1 1.5 2
35.60 33.58
823.78
![Page 5: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/5.jpg)
Calculate the duration for bonds of several maturities with an 8% coupon paid semiannually, $1,000 face value and yield to maturity of 12%.
When we add a year to a long maturity bond it changes the duration much less than when we add a year to a short maturity bond
Adding a year means:• The big payment occurs 1 year later• Adds 1 year to the weighted average • There is a lot of discounting so the weight on the additional year is small compared to other years
37.74
0 0.5 1 28 28.5 29
35.60 1.53
33.42
1.44 37.74
0 0.5 1 29 29.5 30
35.60 1.36
31.53
1.29
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6
Lets just look at what happens to the present value of cash flows as the maturity increases
1,040
0 1 2 3 4 5
40
Time to Maturity = 5 years
Duration = 4.14
![Page 7: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/7.jpg)
7
Lets just look at what happens to the present value of cash flows as the maturity increases
1,040
0 1 2 3 4 5 6 7 8 9 10
40
Time to Maturity = 10 years
Duration = 6.61
![Page 8: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/8.jpg)
8
Lets just look at what happens to the present value of cash flows as the maturity increases
1,040
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
40
Time to Maturity = 15 years
Duration = 7.91
![Page 9: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/9.jpg)
9
Lets just look at what happens to the present value of cash flows as the maturity increases
1,040
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
40
Time to Maturity = 20 years
Duration = 8.53
![Page 10: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/10.jpg)
10
Lets just look at what happens to the present value of cash flows as the maturity increases
1,040
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
40
Time to Maturity = 20 years
Duration = 8.53
Total weight (sum) = 48%
A large percent of the bond value has been received early-on !!!
Total weight (sum) = 75% Total weight (sum) = 86%
![Page 11: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/11.jpg)
Conclusion: Duration increases with maturity but at a decreasing rate
because of two effects:
1. Increasing the maturity adds more years to the bond, which increases duration
2. As we increase the time to maturity (TTM), a smaller and smaller fraction of bond value is being received at a later date. This is because later payments are highly discounted. As a result, a large fraction of bond value is received early on, which stabilizes the duration.
![Page 12: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/12.jpg)
1,000
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Lets just look at what happens to the present value of cash flows as the YTM increases
40 40 40 40 40 40 40 40 40 40
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1,000
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Lets just look at what happens to the present value of cash flows as the YTM increases
40 40 40 40 40 40 40 40 40 40
YTM = 10%
Duration = 4.18
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1,000
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Lets just look at what happens to the present value of cash flows as the YTM increases
40 40 40 40 40 40 40 40 40 40
YTM = 30%
Duration = 3.74
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1,000
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Lets just look at what happens to the present value of cash flows as the YTM increases
40 40 40 40 40 40 40 40 40 40
YTM = 50%
Duration = 3.23
![Page 16: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/16.jpg)
1,000
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Lets just look at what happens to the present value of cash flows as the YTM increases
40 40 40 40 40 40 40 40 40 40
YTM = 70%
Duration = 2.71
![Page 17: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/17.jpg)
1,000
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Lets just look at what happens to the present value of cash flows as the YTM increases
40 40 40 40 40 40 40 40 40 40
YTM = 90%
Duration = 2.26
![Page 18: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/18.jpg)
1,000
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Lets just look at what happens to the present value of cash flows as the YTM increases
40 40 40 40 40 40 40 40 40 40
As we increase the yield to maturity, the present value (and as a result the duration weights) of the earlier payments increase relative to the PV (duration weights) of the later payments
That is, the percentage of value [PV(future cash flows)] received early in the bond’s life increases – so the later payments (more interest rate sensitive) are not as important
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1,000
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Again, this has to do with how the present value of cash flows is distributed over time and how that changes when we change the coupon rate.
50 50 50 50 50 50 50 50 50 50
Coupon = 10%
Duration = 4.04
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1,000
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Again, this has to do with how the present value of cash flows is distributed over time and how that changes when we change the coupon rate.
200 200 200 200 200 200 200 200 200 200
Coupon = 40%
Duration = 3.29
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1,000
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Again, this has to do with how the present value of cash flows is distributed over time and how that changes when we change the coupon rate.
Coupon = 70%
350 350 350 350 350 350 350 350 350 350
Duration = 3.07
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1,000
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Again, this has to do with how the present value of cash flows is distributed over time and how that changes when we change the coupon rate.
500 500 500 500 500 500 500 500 500 500
Coupon = 100%
Duration = 2.97
![Page 23: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/23.jpg)
Again, this has to do with how the present value of cash flows is distributed over time and how that changes when we change the coupon rate.
As we increase the coupon rate the present value of early cash flows (duration weights) increases relative to later payments
That is, the percentage of value [PV(future cash flows)] received early in the bonds life increases – so the later payments (more interest rate sensitive) are not as important
![Page 24: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/24.jpg)
1. Duration increases with maturity but at a decreasing rate
2. Duration decreases as the yield to maturity increases
3. Duration decreases as the coupon payments increase
4. You need to have a basic understanding of why duration behaves this way
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Hedge With Duration
25
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We have seen that duration measures the sensitivity of assets to changes in interest rates
Now lets see how we can use that to manage interest rate risk
Basic idea: by taking an offsetting position in an asset/liability with a matched duration an investor can hedge interest rate risk
26
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Suppose a company has 5 years left on a loan: The company wants to pay back the loan today but there are stiff
prepayment penalties. So, the company decides to offset the loan with another asset.
The loan is a balloon payment loan - it is paid back in one lump sum payment in five years – no interim interest payments
Current value of the loan is $1,000 at 8% = $1469.33 due in 5 years
The company wants to hedge against changes in interest rates and can choose from the following instruments: A 3 year 3% coupon bond with $1,000 face value A five year zero coupon bond with an 8% YTM and face value = 1000 A six year bond with an 8% coupon paid annually and face value =
1,000 and YTM = 8%27
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The company can manage its interest rate risk by matching durations
The duration of the 3 year bond will definitely be too short
The five year zero coupon bond has a duration of 5 years
The six year coupon can not be ruled out so we need to calculate the duration
28
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Step#1 Find the couponCoupon = (1,000)*.08 = $80
Draw the cash flows
Step#2 Find present values
Step#4 Find duration weights
Step#5 Find duration
1,000
80 80 80 80 80 80
1 2 3 4 5 6
65432 08.1
1080
08.1
80
08.1
80
08.1
80
08.1
80
08.1
80P
000,158.68045.5480.5851.6359.6804.74 P
1000
58.680
1000
45.54
1000
80.58
1000
51.63
1000
59.68
1000
04.74654321 wwwwww
9927.4)6)(68058.0()5)(05445.0()4)(05880.0()3)(06351.0()2)(06859.0()1)(07404.0( D
The 6 year bond is also a viable option for the hedge
29
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The company will owe 1469.33 in 5 years
So the company wants to receive $1469.33 (for sure) in 5 years to be completely hedged
Each bond pays 1000 in 5 years so they need to buy 1469.33/1000 = 1.46933 zero coupon bonds
Cost: The price of the zero coupon = 1000/(1.08)5 = 680.58 The company needs 1.46933 of them so the total cost is (1.46933)
(680.58) = $1,000 The full amount of their loan
30
![Page 31: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/31.jpg)
The company is perfectly hedged!!!!
After purchasing the zero coupon bonds, the company has locked-in a positive1469.33 cash flow in five years no matter what interest rates do!!!
31
0 1 2 3 4 5
1,469.33
- 1,469.33
Bond
Loan
![Page 32: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/32.jpg)
We saw that the 6 year bond had a duration of 5 years so lets try using it to hedge.
To hedge the company can buy one 5 year duration bond for a cost of $1,000
Consider three cases :a. The YTM stays at 8%
b. The YTM instantaneously increases to 9%
c. The YTM instantaneously decreases to 7%
Why 1 bond? – if we find the value of all cash flows at time 5 years (1000)(1.085) =$1,469.33.•If this was not the case, we would need to buy more or less than one bond •But if this was not the case the bond would not have a 5 year duration
32
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Base case: Show that the company is hedged if the YTM = 8% The company will hold the bond for 5 years The coupon will be reinvested at the YTM
1,000
80 80 80 80 80 80
1 2 3 4 5 6
Reinvest for 4 years
4)08.1)(80( 3)08.1)(80( 2)08.1)(80( )08.1)(80(08.1
108080
Reinvest for 3 years
Reinvest for 2 years
Reinvest for 1 years
Collect coupon & sell bond
33.1469)100080(40.8631.9378.10084.1085 yrCF
33
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Case 1 YTM increases to 9% The company will hold the bond for 5 years The coupon will be reinvested at the YTM
1,000
80 80 80 80 80 80
1 2 3 4 5 6
Reinvest for 4 years
4)09.1)(80( 3)09.1)(80( 2)09.1)(80( )09.1)(80(09.1
108080
Reinvest for 3 years
Reinvest for 2 years
Reinvest for 1 years
Collect coupon & sell bond
33.1469)83.99080(20.8705.9560.10393.1125 yrCF
34
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Case 2 YTM decreases to 7% The company will hold the bond for 5 years The coupon will be reinvested at the YTM
1,000
80 80 80 80 80 80
1 2 3 4 5 6
Reinvest for 4 years
4)07.1)(80( 3)07.1)(80( 2)07.1)(80( )07.1)(80(07.1
108080
Reinvest for 3 years
Reinvest for 2 years
Reinvest for 1 years
Collect coupon & sell bond
33.1469)35.100980(60.8559.9100.9886.1045 yrCF
35
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If the company offsets its assets or liabilities with an instrument of the same duration the position will be immune to changes in interest rates
Do you think this really works?
It could, but we run into two problems1. The duration of the bond (used to hedge) will change
2. The YTM of the bond used to hedge could change
36
What kind of risk would the coupons be subject to?
![Page 37: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/37.jpg)
Lets calculate the duration of the bond right after the second coupon is paid – there are four years (coupons) left. Assume they YTM = 8%
Weights:
Duration
Loan: the loan still has 3 years to maturity so the durations no longer match – this is ok as long as the coupons have and can continue to be reinvested at 8%
100008.1
1080
08.1
80
08.1
80
08.1
80432P
000,183.79351.6359.6804.74 P
1000
83.793
1000
51.63
1000
59.68
1000
04.744321 wwww
yearsD 577.34)079383.0()3)(06351.0()2)(06859.0()1)(07404.0(
1. Duration Change
37
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Suppose that after the first two payments the interest rate increases to 9%
So what’s the point? This seems really ineffective – why am I not teaching you how to fully resolve this problem?
1,000
80 80 80 80 80 80
1 2 3 4 5 64)08.1)(80( 3)08.1)(80( 2)09.1)(80( )09.1)(80(
09.1
108080
69.1462)83.99080(20.8705.957.10084.1085 yrCF
The company no longer has enough money to
repay its loan of $1469.33
IT IS HARD!!!
2. Reinvestment risk
38
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Difficulties with Duration
39
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1. Reallocating large quantities of assets or liabilities to attain the needed durations for assets and liabilities can be very costly
2. Immunization is a dynamic problem1. Every time the interest rate changes the hedging portfolio must be rebalanced
2. One decision managers have to make is how often to rebalance and weigh the cost of doing so
3. Convexity- Duration only works for small changes in the interest rate 1. For large changes in rates duration will not accurately predict the percent
change in the price of a security
40
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Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch
41
Price a 20 year bond with coupon of 30% and semiannual
payments
![Page 42: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/42.jpg)
Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch
42
69.908,5$
)2/015.1(
1000
)2/015.1(
150
%5.1
40
40
1
t
t
YTM
Price a 20 year bond with coupon of 30% and semiannual
payments
![Page 43: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/43.jpg)
Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch
43
21.556,4$
)2/04.1(
1000
)2/04.1(
150
%4
40
40
1
t
t
YTM
Price a 20 year bond with coupon of 30% and semiannual
payments
![Page 44: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/44.jpg)
Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch
44
21.177,3$
)2/08.1(
1000
)2/08.1(
150
%8
40
40
1
t
t
YTM
Price a 20 year bond with coupon of 30% and semiannual
payments
![Page 45: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/45.jpg)
Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch
45
37.202,2$
)2/13.1(
1000
)2/13.1(
150
%13
40
40
1
t
t
YTM
Price a 20 year bond with coupon of 30% and semiannual
payments
![Page 46: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/46.jpg)
Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch
46
95.488,1$
)2/20.1(
1000
)2/20.1(
150
%20
40
40
1
t
t
YTM
Price a 20 year bond with coupon of 30% and semiannual
payments
![Page 47: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/47.jpg)
Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch
47
000,1$
)2/30.1(
1000
)2/30.1(
150
%30
40
40
1
t
t
YTM
Price a 20 year bond with coupon of 30% and semiannual
payments
![Page 48: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/48.jpg)
Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch
48
$77.666
)2/45.1(
1000
)2/45.1(
150
%45
40
40
1
t
t
YTM
Price a 20 year bond with coupon of 30% and semiannual
payments
![Page 49: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/49.jpg)
Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch
49
![Page 50: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/50.jpg)
What does duration say about this relation?
Duration is the derivative of the bond pricing formula with respect to the interest rate at a specific point on the graph
What does the derivative look like on the graph?
50
![Page 51: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/51.jpg)
Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch
51
13%
• This is what duration says the graph (relationship) should look like
• When we do the duration calculation, we find a point on this line
Duration is the derivative. It is the slope of the tangent line
![Page 52: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/52.jpg)
Calculate the duration of the bond if the YTM is 13%
D = 7.23 years
If the YTM dropped to 3% what price would the duration predict?
What is the actual price?
52
7880.02/13.01
1.23.7
)1(
R
RD
P
P
47.1735)37.2202)(7880.0( P
84.393747.173513.22021 PPP tt
64.5038)2/03.1(
1000
)2/03.1(
15040
40
1
tt
80.1100
84.3937
64.5038
![Page 53: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/53.jpg)
Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch
53
13%3%
80.110084.3937
64.038,5
![Page 54: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/54.jpg)
Calculate the duration of the bond if the YTM is 13%
D = 7.23 years
If the YTM jumped to 23% what price would the duration predict?
What is the actual price?
54
7880.02/13.01
1.23.7
)1(
R
RD
P
P
47.735,1)37.2202)(7880.0( P
39.46647.173513.22021 PPP tt
44.1300)2/23.1(
1000
)2/23.1(
15040
40
1
tt
834.05
44.1300
39.466
![Page 55: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/55.jpg)
Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch
55
13%3%
80.1100
23%
05.834
Asymmetric Pricing Errors!
39.666
44.1300
![Page 56: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/56.jpg)
The larger the convexity the more curvature there is in the line Duration will work better for bonds with low convexity We will calculate convexity next
56
![Page 57: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/57.jpg)
1. Duration is only accurate for small changes in interest rates
2. Duration will predict lower than actual values
3. The under prediction error is greater when interest rates fall then when they increase
4. Duration will change depending on the interest rate!!!!!!!!!
57
![Page 58: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/58.jpg)
1. Calculate the duration weights
2. Multiply the weights by the time period squared plus and the same time period
3. Sum values and divide by (1+ YTM)2 to get convexity
58
nnn ttWttWttWC 22
2221
211 ...
![Page 59: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/59.jpg)
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80 80 80 80 80 80
Consider a 6 year bond with an 8% coupon paid annually the YTM is 6%. Face value of 1000. Calculate the convexity of the bond
1000
Step #1 find the present value of payments
66554433221 06.1
1080)(
06.1
80)(
06.1
80)(
06.1
80)(
06.1
80)(
06.1
80)( CFpvCFpvCFpvCFpvCFpvCFpv
36.761)( 78.59)( 37.63)( 17.67)( 20.71)( 47.75)( 654321 CFpvCFpvCFpvCFpvCFpvCFpv
Step #2 calculate weights
35.1098
36.761
35.1098
78.59
35.1098
37.63
35.1098
17.67
35.1098
20.71
35.1098
47.75654321 wwwwww
693.0 054.0 058.0 061.0 065.0 069.0 654321 wwwwww
![Page 60: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/60.jpg)
Consider a 6 year bond with an 8% coupon paid annually the YTM is 6%. Face value of 1000. Calculate the convexity of the bond
60
)66)(0.6932()55)(0.0544()44)(0.0577(
)33)(0.0612()22)(0.0648()11)(0687.0(
)06.1(
1222
222
2C
54.29C
16.3306.1
12
C
Measures the curvature of the YTM bond price relationship – larger values = more curvature
Step #3 calculate the convexity
![Page 61: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/61.jpg)
Calculate the convexity of a 1.5 year 4% coupon bond with semiannual payments and face value of 5,000 if the risk free rate is currently 5% and the YTM is 9%
61
![Page 62: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/62.jpg)
We can use it to adjust the accuracy of the duration calculation!!
Example:
Estimate the expected percent change in the price of the bond from the previous example (FV = 5000, coupon = 4%, TTM = 1.5yrs, semiannual compounding) if interest rates are expected to increases from 9% to 11.4% (the duration of the bond 1.47yrs).
62
R
RD
P
P
1
209.01
024.047.1
P
P
)(2
1 2RC
03279.0)024)(.346.3(2
1 2 03375.0
![Page 63: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/63.jpg)
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Price implied by Duration
Price implied by Duration & Convexity
![Page 64: Class 7, Chap 9 - Appendix B. Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with.](https://reader035.fdocuments.us/reader035/viewer/2022062421/56649cd85503460f949a09a5/html5/thumbnails/64.jpg)
3 properties of duration Duration increases with maturity but at a decreasing rate Duration decreases as the yield to maturity increases Duration decreases as the coupon payments or interest rate increases
Hedging by matching duration The hedge is only perfect if YTM remains constant over the life of the hedge
Convexity Concept Calculation
64