Duration and Convexity, With Illustrations and Formulas Price Value of A Basis Point Yield or Interest Rate Volatility

3/4/2014 Duration and Convexity, with Illustrations and Formulas; Price Value of a Basis Point; Yield or Interest Rate
Volatility
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Duration and Convexity
Bond prices change inversely with interest rates, and, hence, there is interest rate risk with bonds. One
method of measuring interest rate risk due to changes in market interest rates is by the full valuation
approach, which simply calculates what bond prices will be if the interest rate changed by specific amounts.
The full valuation approach is based on the fact that the price of a bond is equal to the sum of the present
value of each coupon payment plus the present value of the principal payment.
Bond Value = Present Value of Coupon Payments + Present Value of Par Value
Duration
Another method, which is less computationally intensive, is by calculating the duration of a bond, which
is the weighted average of the present value of the bonds payments, and can be viewed as the average, or
effective, maturity of a bond. Graphically, the duration of a bond can be envisioned as a seesaw where the
fulcrum is placed so as to balance the weights of the present values of the payments and the principal
payment. The longer the duration, the longer is the average maturity, and, therefore, the greater the
sensitivity to interest rate changes.
Although the effective duration is measured in years, it is more useful to interpret duration as a means of
comparing the interest rate risks of different securities. Securities with the same duration have the same
interest rate risk exposure. For instance, since zero-coupon bonds only pay the face value at maturity, the
duration of a zero is equal to its maturity. It also follows that any bond of a certain duration will have an
interest rate sensitivity equal to a zero-coupon bond with a maturity equal to the bonds duration.
Duration is also often interpreted as the percentage change in a bonds price for a 1% change in its yield to
maturity (YTM). So, for instance, the price of a bond with a 10-year duration would change by 10% for a
1% change in the interest rate.
Macaulay Duration
It was Frederick Macaulay who developed the concept of duration, equating it to the average time to
maturity or the time required to receive half of the present value, discounted by the bonds yield to maturity,
of the bonds cash flow. The Macaulay duration is calculated by 1
s t
calculating the weighted
average of the present value (PV) of each cash flow at time t by the following formula:
w
t
=
CF
t
/ (1 + y)
t
Bond Price
=
Present Value of Cash Flow
Bond Price
w
t
= weighted average of cash flow at time t.
CF
t
= Cash flow at time t.
y = yield to maturity
For an interest rate that is continuously compounded, the weighted average is equal to the following:
w
t
= CF
t
/e
yt
Then these weighted averages are summed:
Macaulay Duration Formula
T = number of cash flow periods.
3/4/2014 Duration and Convexity, with Illustrations and Formulas; Price Value of a Basis Point; Yield or Interest Rate Volatility
Example 1: Calculating Duration
A three-year bond has a par value of $100 with a coupon rate of 5% and a current continuously
compounded yield of 6%. The duration can be calculated as follows:
Interest Rate
(continuously compounded)
6%
Coupon Rate 5%
Par Value $100
Current Bond Price $97.05
Time (Years) Cash Flow PV Weight Time Weight
0.5 $2.50 $2.43 0.025 0.012
1.0 $2.50 $2.35 0.024 0.024
1.5 $2.50 $2.28 0.024 0.035
2.0 $2.50 $2.22 0.023 0.046
2.5 $2.50 $2.15 0.022 0.055
3.0 $102.50 $85.62 0.882 2.647
Totals: $115 $97.05 1.000 2.820 = Duration
Because the bond price is equal to the total present value of all bond payments, the bond price will change
inversely to changes in yield, which can be calculated approximately by the following equation:
B
B
= -y
T
t=1
CF
t
t
e
y t
=-y D
B = -y B
T
t=1
CF
t
t
e
y t
=-y B D
So if interest rates increased by 0.1%, then the change in the bond price in Example 1 can be calculated
thus:
New Bond Price = Old Bond Price 0.1% $97.05 2.820 = $96.50
Compare this calculation with the bond price as given by the sum of the present value of its payments:
Interest Rate 6.1%
Coupon Rate 5.0%
Par Value $100
New Bond Price $96.78
Time (Years) PV Weight Time Weight
0.5 $2.42 0.025 0.013
1.0 $2.35 0.024 0.024
1.5 $2.28 0.024 0.035
2.0 $2.21 0.023 0.046
2.5 $2.15 0.022 0.055
3.0 $85.36 0.882 2.646
Totals: $96.78 1.000 2.819
Note that it is a close approximation for small changes in interest rates. Note also that the duration changes
as well, which is measured by the bond's convexity (discussed later). Because duration also changes, larger
changes in interest rates will yield larger discrepancies between the actual bond price and the price
calculated using duration.
Not only can the Macaulay duration measure the effective maturity of a bond, it can also be used to
calculate the average maturity of a portfolio of fixed-income securities.
Modified Duration
Modified duration is a modification of the Macaulay duration where the interest rate is compounded
according to the number payments per year rather than using a continuous compounding yield, represented
by the following formula:
Modified Duration Formula
D
m
= Modified Duration
D
Mac
= Macaulay Duration
k = number of payments per year
The modified duration formula is valid only when the change in yield will not alter the cash flow of the bond,
such as may occur, for instance, if the price change for a callable bond increases the likelihood that it will be
called.
It is also only valid for small changes in yield, because duration itself changes as the yield changes. It is a
1
s t
derivative of the price-yield curve, which is a line tangent to the curve at the current price-yield point.
Duration and Modified Duration Formulas for Bonds using Microsoft Excel
Duration = DURATION(settlement,maturity,coupon,yield,frequency,basis)
Modified Duration = MDURATION(settlement,maturity,coupon,yield,frequency,basis)
Settlement = Date in quotes of settlement.
Maturity = Date in quotes when bond matures.
Coupon = Nominal annual coupon interest rate.
Yield = Annual yield to maturity.
Frequency = Number of coupon payments per year.
1 = Annual
2 = Semiannual
4 = Quarterly
Basis = Day count basis.
0 = 30/360 (U.S. NASD basis). This is the default if the basis is omitted.
1 = actual/actual (actual number of days in month/year).
2 = actual/360
3 = actual/365
4 = European 30/360
1. ExampleCalculating Modified Duration using Microsoft Excel
Calculate the duration and modified duration of a 10-year bond paying a coupon rate of 6%, a yield to
maturity of 8%, and with a settlement date of 1/1/2008 and maturity date of 12/31/2017.
Duration = DURATION("1/1/2008","12/31/2017",0.06,0.08,2) = 7.45
Modified duration = MDURATION("1/1/2008","12/31/2017",0.06,0.08,2) = 7.16
Note that modified duration is always slightly less than duration, since the modified duration is the duration
divided by 1 plus the yield per payment period.
Convexity adds a term to the modified duration, making it more precise, by accounting for the change in
duration as the yield changeshence, convexity is the 2
nd
derivative of the price-yield curve at the current
price-yield point.
Although duration itself can never be negative, convexity can make it negative, since there are some
securities, such as some mortgage-backed securities that exhibit negative convexity, meaning that
the bond changes in price in the same direction as the yield changes.
Effective Duration for Option-Embedded Bonds
Because duration depends on the weighted averages of the present value of the bonds cash flows, a simple
calculation for duration is not valid if the change in yield could result in a change of cash flow. Valuation
models must be used in calculating new prices for changes in yield when the cash flow is modified by
options. The effective duration (aka option-adjusted duration) is the change in bond prices
per change in yield when the change in yield can cause different cash flows. For instance, for a callable
bond, the bond will not rise above the call price when interest rates decline because the issuer can call the
bond back for the call price, and will probably do so if rates drop.
Because cash flows can change, the effective duration of an option-embedded bond is defined as the
change in bond price per change in the market interest rate:
Effective Duration Formula
i = interest rate differential
P = Bond price at i + i bond price at i - i.
Note that i is the change in the term structure of interest rates and not the yield to maturity for the bond,
because YTM is not valid for an option-embedded bond when the future cash flows are uncertain.
Duration Formulas for Specific Bonds and Annuities
There are several formulas for calculating the duration of specific bonds that are simpler than the above
general formula.
The formula for the duration of a coupon bond is the following:
Duration Formula for Coupon Bond
c = coupon interest rate in decimal form
T = years till maturity
If the coupon bond is selling for par value, then the above formula can be simplified:
Duration Formula for Coupon Bond Selling for Face Value
The duration of a fixed annuity for a specified number of payments T and yield per payment y can be
calculated with the following formula:
Fixed Annuity Duration Formula
A perpetuity is a bond that does not have a maturity date, but pays interest indefinitely. Although the
series of payments is infinite, the duration is finite, usually less than 15 years. The formula for the duration
of a perpetuity is especially simple, since there is no principal repayment:
Perpetuity Duration Formula
Portfolio Duration
Duration is an effective analytic tool for the portfolio management of fixed-income securities because it
provides an average maturity for the portfolio, which, in turn, provides a measure of interest rate risk to the
portfolio.
The duration for a bond portfolio is equal to the weighted average of the duration for each type of bond in
the portfolio:
Portfolio Duration = w
1
D
1
+ w
2
D
2
+ + w
K
D
K
w
i
= market value of bond i / market value of portfolio
D
i
= duration of bond i
K = number of bonds in portfolio
To better measure the interest rate exposure of a portfolio, it is better to measure the contribution of the
issue or sector duration to the portfolio duration rather than just measuring the market value of that issue or
sector to the value of the portfolio:
Portfolio Duration Contribution = Weight of Issue in Portfolio Duration of Issue
Convexity
Duration is only an approximation of the change in bond price. For small changes in yield, it is very accurate,
but for larger changes in yield, it always underestimates the resulting bond prices for non-callable, option-
free bonds. This is because duration is a tangent line to the price-yield curve at the calculated point, and the
difference between the duration tangent line and the price-yield curve increases as the yield moves farther
away in either direction from the point of tangency.
A diagram of the convexity of 2
representative bond portfolios.
Convexity is the rate that the duration changes along the price-yield curve, and, thus, is the 1
s t
derivative to the equation for the duration and the 2
nd
derivative to the equation for the price-yield function,
and is calculated by the following equation:
Convexity Formula
P = Bond price.
y = Yield to maturity in decimal form.
T = Maturity in years.
CF
t
=Cash flow at time t.
The equation for duration can be improved by adding the convexity term:
Calculating the Change in Bond Prices with Interest Rates Using Duration + Convexity Adjustment
y = yield change
P = Bond price change
Convexity can also be estimated with a simpler formula:
1. Convexity Approximation Formula
Convexity =
P
+
+ P
-
- 2P
0
2 P
0
(y)
2
P
0
= Bond price.
P
-
= Bond price when interest rate is incremented.
P
+
= Bond price when interest rate is decremented.
y = change in interest rate in decimal form.
Note, however, that this convexity approximation formula must be used with this convexity adjustment
formula, then added to the duration adjustment:
1. Convexity Adjustment Formula
Convexity Adjustment = Convexity 100 (y)
2 y = change in interest rate in decimal form.
Hence:
Bond Price Change Formula
Bond Price Change = Duration Yield Change + Convexity Adjustment
Important Note! The convexity can actually have several values depending on the convexity adjustment
formula used. Many calculators on the Internet calculate convexity according to the following formula:
2. Convexity Approximation Formula
Convexity =
P
+
+ P
-
- 2P
0
P
0
(y)
2
P
0
= Bond price.
P
-
= Bond price when interest rate is incremented.
P
+
= Bond price when interest rate is decremented.
y = change in interest rate in decimal form.
Note that this formula yields double the convexity as the Convexity Approximation Formula #1. However, if
this equation is used, then the convexity adjustment formula becomes:
2. Convexity Adjustment Formula
Convexity Adjustment = Convexity/2 100 (y)
2 y = change in interest rate in decimal form.
As you can see in the Convexity Adjustment Formula #2 that the convexity is divided by 2, so using the
Formula #2's together yields the same result as using the Formula #1's together.
To add further to the confusion, sometimes both convexity measure formulas are calculated by multiplying
the denominator by 100, in which case, the corresponding convexity adjustment formulas are multiplied by
10,000 instead of just 100! Just keep in mind that convexity values as calculated by various calculators on
the Internet can yield results that differ by a factor of 100. They can all be correct if the correct convexity
adjustment formula is used!
Convexity is usually a positive term regardless of whether the yield is rising or falling, hence, it is positive
convexity. However, sometimes the convexity term is negative, such as occurs when a callable bond is
nearing its call price. Below the call price, the price-yield curve follows the same positive convexity as an
option-free bond, but as the yield falls and the bond price rises to near the call price, the positive convexity
becomes negative convexity, where the bond price is limited at the top by the call price. Hence,
similar to the terms for modified and effective duration, there is also modified convexity, which is the
measured convexity when there is no expected change in future cash flows, and effective
convexity, which is the convexity measure for a bond for which future cash flows are expected to
change.
Price Value of a Basis Point
Sometimes the volatility of bond prices to interest rates is calculated as the absolute value of the change in
price when the interest rate changes by 1 basis point (0.01%), which is called, aptly enough, the price
value of a basis point (PVBP), or the dollar value of a 01 (DV01).
PVBP = |initial price price if yield changes by 1 basis point|
(Math note: the expression || denotes the absolute value of .)
Although bond prices increase more when yields decline than decrease when yields increase, a change in
yield of 1 basis point is considered so small that the difference is negligible. Since duration is the
approximate change in bond price for a 100 basis point change in yield, the price value of a basis point is 1%
of the duration percentage.
For instance, in the example of above, the duration for the bond was found to be 7.45%. Hence, the PVBP
is equal to:
PVBP = Duration 1% = 7.45% 0.01 = 0.0745 0.01 = .0745%
So a bond selling for par would change by:
Price Change = 100 0.0745% = 100 0.000745 = $0.0745
Hence, a bond with a par value of $1,000 would change in price by $0.75 (rounded) when the yield changes
by 1 basis point.
Yield Volatility (Interest Rate Volatility)
Duration gives an estimate of the interest rate risk of a particular bond by relating the change in price to the
change in yield, but neither duration nor convexity gives a complete picture of interest rate risk because
bond yields can also change because of changes in the credit default risk as evidenced by changes in the
credit ratings of the issuer or because of detrimental changes to the economy that may increase the credit
default risk of many businesses.
For instance, U.S. Treasuries generally have lower coupon rates and current yields than corporate bonds of
similar maturities because of the difference in default risk. Therefore, U.S. Treasuries should have higher
durations than corporate bonds, and, therefore, change in price more when market interest rates change.
However, changes in perception of the risk of default may also change bond prices, blunting or augmenting
what duration would predict.
For instance, during the recent subprime mortgage crisis, many bonds were perceived to be more risky than
investors realized, even those that had received top ratings from the credit rating agencies, and so many
securities, especially those based on subprime mortgages, lost value, greatly increasing their yields, while
yields on Treasuries declined as the demand for these securities, which are considered to be free of default
risk, increased in price caused, not by the decline in market interest rates, but by the flight to quality
selling risky securities to buy securities with little or no default risk. The flight to quality is augmented by
the fact that laws and regulations require that pension funds and other funds that are held for the benefit of
others in a fiduciary capacity be invested only in investment grade securities. So when investment ratings
decline for a large number of securities to below investment grade, managers of funds held in trust must sell
the riskier securities and buy securities that are likely to retain an investment grade rating or be free of
default riskin most cases, U.S. Treasuries.
Therefore, yield volatility, and therefore, interest rate risk, is greater for securities with more default risk,
even if their durations are the same.
Information is provided 'as is' and solely for education, not for trading purposes or professional advice.
Copyright 1982 - 2014 by William C. Spaulding

Duration and Convexity, With Illustrations and Formulas Price Value of A Basis Point Yield or Interest Rate Volatility

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