You are on page 1of 7
youu ey waoiness eenunee ws auusunuERe, 244) AMWAY 1399, UIUO DUDA 92.00 aur ANALYTICS OF DURATION AND CONVEXITY FOR. BONDS WITH EMBEDDED OPTIONS: THE CASE OF CONVERTIBLES JAMSHID MEHRAN AND GHASSEM HOMAIFAR* INTRODUCTION Most recent advances in the application of duration and convexity to bond valuation focus on option free bonds or the so called ‘plain vanilla’ variet Astudy by Dunetz and Mahoney (1988) extends duration-convexity analysis to callable bonds. But, as yet no one has provided an adequate analytical formulation of duration and convexity for convertible bonds. Presented in this study is a method for estimating duration and convexity for convertible bonds. A convertible bond is a pure bond with a latent nonseparable call option. The price behavior of the convertible bonds differs from a non-convertible bond, because the convertible’s price reflects the underlying value of the issuing firm's common stock, as well as the changes in market interest rates. As noted by Yawitz (1988), a convertible bond possesses greater positive convexity than a comparable callable bond because of the inclusion of the call option. This unique feature of convertibles makes their cash flows and maturities uncertain ‘and thus, the simple duration and convexity of pure bonds is an insufficient proxy for the duration-convexity of a convertible bond. DURATION, CONVEXITY, AND VELOCITY Macaulay (1938) used the basic valuation equation for pricing debt instruments to derive the duration of an option free bond: OP/k = —1K[E(OR(K)~ + nM (K)~*), ay dividing both sides of equation (1) by P app = -1/K (Pee ® OP/P = —\/K[D] 6K (2a) PAK ~ D*-P, (2) where CF, and M, respectively, are cash flows at time ¢ and face value of the bond: ‘The authors are respectively, Associate Professor of Finance at the Indiana University South Bend; Professor of Finance at Middle Tennessee State University. (Paper received November 1989, revised and accepted November 1990) Basil Blackwell Ld, 1993, 108 Cowley Road, Oxford OX4 JF, UK tnd 298 Main Stret, Suite $01, MA 02142, USA 108 MEHRAN AND HOMAIFAR K = one plus the yield to maturity, P_ = price of pure bond, n= time to maturity, D = Macaulay duration, ie., the term in the bracket of equation (2 D* = modified Macaulay duration D/K. ‘Asa measure of price elasticity, Macaulay duration or its modified versi D/k provides a means of analyzing the changes in the price of a bond fo given percentage change in the yield to maturity. Macaulay’s duration m provides valuable information to bond portfolio managers and investors int efforts to manage interest rate risk. However, like any proximate me it is only as good as its underlying assumptions. For Macaulay’s me price yield relationship is assumed to be linear, implying zero cor Furthermore, shifts in the yield curve are assumed to be parallel. In however, both assumptions are violated. For example, the first three ter a Taylor expansion series can be used to approximate the changes inthe values: @P = aPAK-(aK) + @P/AK?-(AK)/2) + d°PAK-(AK)%/3! + where R, represents the remaining terms in the Taylor expansion series are assumed to be insignificant. Dividing both sides of equation (3) by the percentage change in price which are expressed as: ] @P/P = aP/K x 1/P - (8K) + OPK? x 1/P - (GK)12 + @PAR x UP - (@K)/3! + R,/P. 4 For small changes in discount rates, duration approximates the ch the value of underlying bonds reasonably well. However, for larger in discount rates, duration underestimates (overestimates) the change value of bonds associated with a decrease (increase) in the discount rates ‘equation (3), it can be shown that inclusion of the second term, conte and the third term, the change in convexity (velocity), substantially it the estimation of the change in the price of an option free bond, with: to changes in discount rates. Fabbozzi and Fabbozzi (1989) show that derivative of equation (3) is positive, that is @°P/@K">0. Inclusion of com improves the precision in the Taylor expansion of equation (3). Mai an option free bond the following signs are consistent with the bond. equation: aPAk<0, PAK >0, and ——d°P/AK?<0. Fabbozzi and Fabozzi express the value of the second derivative as PPAR = Seer NOR ALF HO + n(n MIL + Since 3°P/@E’>0 and (8k)? is always positive, it then follows that c« © Basil Black DURATION AND CONVEXITY FOR CONVERTIBLE BONDS 109 af convexity improves the approximation of bond price changes when dealing th large shifts in the term structure of interest rates. ‘The value of the third derivative, the velocity, is estimated from the changes convexity as follows: PPAR = E14)" CRI + A)? + (a(n y(n + MULE. 6) us analyze the third term from equation (5), 3°P/@k°<0, in Taylor's nsion series. For example, if the discount rate increases (decreases) the (@8)° will be positive (negative). It then follows that for a decrease in the int rate, the term 4°P/3k*(Ak)° will be positive. Of course, this term will E negative for an increase in the discount rate. As a measure of the shape Price/yield relationship, convexity improves the predictions of duration. urthermore, the velocity reinforces the impact of the positive convexity on when rates decrease. However, in times of rising interest rates, the lessens the impact of positive convexity on duration, thus increasing ision of the Taylor expansion series, DURATION AND CONVEXITY OF CONVERTIBLE BONDS as a measure of changes in the price of a call option induced by the in the value of the convertible bond as follows:? d= ACAP5 — for values of OSAS1 © Cis the price of the call option and Pg is the price of convertible debt. 1 slope of the curve that relates the price of derivative security to the lying security price. Similar to delta of a call option pricing model, 4 © a function of time and the price of underlying instrument (see Hull, is taken to have a value of zero when the option is worthless in the However, \ is expected to take positive values once the option on the slying stock becomes valuable. By definition the value of the convertible id is equal to the pure bond plus the value of the call option which must. hon-hegative.° So, it follows that AP, = AP + AC. @ change in the price of a convertible bond must be due to a change in either ure bond and/or the call option values. However, when ) is positive the ertible bond value exceeds the value of the pure bond. In the limit when eaches 1, the convertible bond is converted into the common stock. Figure les a convenient means of analyzing changes in the value of the call induced by the change in the value of the convertible bond. Note that call option is out of the money ) is equal to zero. However, \ becomes fe as the underlying common stocks approach the conversion value. [Bclwell Led. 1999,

You might also like