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Characteristics of Bonds
Volatility, Duration and Convexity
Bond Management
Characteristics of bonds:
When we look at the redemption yield formula for a bond it becomes clear that prices
and yields are inversely related ie a rise in yields lowers the price of a bond and vice
versa.
Bond price
P = Σ Ct/ (1+y)t
ytm `y’
P= Market price of Bond
Ct= cash Flow in time `t,’
(For this lecture, the last payment, R, redemption value, is counted within Ct.)
For a given yield change, the rise in price is more than the fall; ie for a 1% fall in
yield the % increase in price of the bond is higher than the % fall in the price of a
bond for a 1% increase in yield. Hence the price-yield graph is convex to the origin.
(ii) As the life of a bond reduces, the size of the discount/premium gets smaller.
Bond Price
premium
par value
discount
Maturity `t’
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Duration, Convexity and Dispersion
the average time after which the cash flows on the bond will be received.
Σ C t t / ( 1 +y ) t Σ t . (PV) C t
D = -------------------------------- = ----------------------------
Σ Ct / (1+y)t Σ (PV) C t (= P)
100
Present
Value 10 10 10
0 1 2 3
Present value:
= 2.74
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Note the following about Duration:
coupon
decreases
term to maturity
`t’
Maturity
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Convexity and Dispersion
As the Price (Present Value) - Yield profile of a bond is convex to the origin, we
stated earlier that a fall in yield will result in a relatively higher increase in the price
of a bond than a corresponding rise on yield will lower the price of the bond
By mathematical definition P
2
or ∆P / P = -- D. dy / ( 1+ y) +. C. (dy)
Convexity allows for a correction in the bond price due to the curved profile of the P-
Y graph.
M 2 ≈ 2C - D(D+1)
Dispersion is higher when the cashflows on a bond are distributed across several
years.
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Illustration
Q. For a 10% coupon bond with 3 years to redemption, and current ytm of 8% :
(ii) If yields change by 2% estimate the change in fall in the price the bond using
(a) duration only and (b) both duration and convexity.
Answer
(ii) Using duration only, estimated change in price of bond for 2% rise in yield
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Bond Management strategies
Passive Strategies:
The duration of a portfolio is the weighted average of the duration of the components;
ie Portfolio Duration Dport = Σ Wi. Di ;
Σ Wi = 1
( More rigorously, the convexity of assets also needs to be > convexity of liabilities,
though this involves computer programmes and is beyond the scope of this course. )
As time passes, with interest rate changes, immunisation is affected and it is necessary
to rebalance the portfolio.
Do nonparallel shifts in a yield curve which is not horizontal affect such a strategy of
immunisation?
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What period is immunisation achieved for?
Horizon analysis:
focuses on the yields/ bond prices at the end of a holding period. and examines
alternative scenarios at the end of the period starting from the existing yield structure.
It follows through the `time effect’ and `change in yield’ effect to evaluate the total
cash flow from the bond at the end of the holding period.
Bond swaps:
- Substitution swaps are based on substituting higher priced bonds (lower ytm) for
lower priced bonds (higher ytm). Bonds which lie significantly above the ytm curve
(are lower in price) while bonds which lie significantly below the yield curve are
higher in price.
- Intermarket spread swaps are based on exchange of bonds from different sectors
of the market on the basis of expectations of narrowing yield spreads. Eg treasury
bond for Baa of same maturity but higher yield, if business conditions stabilise.
Alternatively, if short term interest rates are expected to rise: short term bonds will
fall in price. Here the strategy is to sell shorts and shift into longs.
If a fall in all interest rates or a rise in all interest rates is expected: price changes are
larger in longer term bonds than those with shorter duration.
In an environment where the yield curve is expected to be upward sloping for some
time there are profit opportunities in buying and selling longer dated bills/bonds over
a particular holding period compared to a `simple buy and hold strategy’ of a bond
maturing at the end of the holding period. This technique is called `riding the yield
curve.’
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