Chapter 16 - Managing Bond Portfolios

CHAPTER16:MANAGINGBONDPORTFOLIOS
PROBLEMSETS
1.

Whileitistruethatshorttermratesaremorevolatilethanlongtermrates,thelonger
durationofthelongertermbondsmakestheirpricesandtheirratesofreturnmore
volatile.Thehigherdurationmagnifiesthesensitivitytointerestratechanges.

2.

Durationcanbethoughtofasaweightedaverageofthematuritiesofthecashflows
paidtoholdersoftheperpetuity,wheretheweightforeachcashflowisequaltothe
presentvalueofthatcashflowdividedbythetotalpresentvalueofallcashflows.For
cashflowsinthedistantfuture,presentvalueapproacheszero(i.e.,theweightbecomes
verysmall)sothatthesedistantcashflowshavelittleimpact,andeventually,virtually
noimpactontheweightedaverage.

3.

Thepercentagechangeinthebondspriceis:

4.

a.

Duration
7.194
y
0.005 0.0327 3.27% ora3.27%decline
1 y
1.10

YTM=6%
(1)
Timeuntil
Payment
(years)
1
2
3

(2)

(3)
PVofCF
CashFlow
(Discount
rate=6%)
$60.00
$56.60
$60.00
$53.40
$1,060.00
$890.00
ColumnSums $1,000.00

Duration=2.833years

16-1

(4)

(5)

Weight

Column(1)
Column(4)

0.0566
0.0534
0.8900
1.0000

0.0566
0.1068
2.6700
2.8334

Chapter 16 - Managing Bond Portfolios

b.

YTM=10%
(1)
Timeuntil
Payment
(years)
1
2
3

(2)

(3)
PVofCF
CashFlow
(Discount
rate=10%)
$60.00
$54.55
$60.00
$49.59
$1,060.00
$796.39
ColumnSums
$900.53

(4)

(5)

Weight

Column(1)
Column(4)

0.0606
0.0551
0.8844
1.0000

0.0606
0.1102
2.6532
2.8240

Duration=2.824years,whichislessthanthedurationattheYTMof6%.
5.

Forasemiannual6%couponbondsellingatpar,weusethefollowingparameters:coupon=
3%perhalfyearperiod,y=3%,T=6semiannualperiods.
(1)
Timeuntil
Payment
(years)
1
2
3
4
5
6

(2)

(3)
PVofCF
CashFlow
(Discount
rate=3%)
$3.00
$2.913
$3.00
$2.828
$3.00
$2.745
$3.00
$2.665
$3.00
$2.588
$103.00
$86.261

ColumnSums $100.000

(4)

(5)

Weight

Column(1)
Column(4)

0.02913
0.02828
0.02745
0.02665
0.02588
0.86261
1.00000

0.02913
0.05656
0.08236
0.10662
0.12939
5.17565
5.57971

D=5.5797halfyearperiods=2.7899years
Ifthebondsyieldis10%,useasemiannualyieldof5%,andsemiannualcouponof3%:
(1)
Timeuntil
Payment
(years)
1
2
3
4
5
6

(2)

(3)
PVofCF
CashFlow
(Discount
rate=5%)
$3.00
$2.857
$3.00
$2.721
$3.00
$2.592
$3.00
$2.468
$3.00
$2.351
$103.00
$76.860

ColumnSums
$89.849

D=5.5522halfyearperiods=2.7761years

16-2

(4)

(5)

Weight

Column(1)
Column(4)

0.03180
0.03029
0.02884
0.02747
0.02616
0.85544
1.00000

0.03180
0.06057
0.08653
0.10988
0.13081
5.13265
5.55223

Chapter 16 - Managing Bond Portfolios

6.

7.

a.

BondBhasahigheryieldtomaturitythanbondAsinceitscouponpaymentsand
maturityareequaltothoseofA,whileitspriceislower.(Perhapstheyieldis
higherbecauseofdifferencesincreditrisk.)Therefore,thedurationofBondB
mustbeshorter.

b.

BondAhasaloweryieldandalowercoupon,bothofwhichcauseBondAto
havealongerdurationthanBondB.Moreover,Acannotbecalled,sothatits
maturityisatleastaslongasthatofB,whichgenerallyincreasesduration.

a.

(1)
Timeuntil
Payment
(years)
1
5

(2)

(3)
PVofCF
CashFlow
(Discountrate=
10%)
$10million
$9.09million
$4million
$2.48million
ColumnSums $11.57million

(4)

(5)

Weight

Column(1)
Column(4)

0.7857
0.2143
1.0000

0.7857
1.0715
1.8572

D=1.8572years=requiredmaturityofzerocouponbond.
b.

Themarketvalueofthezeromustbe$11.57million,thesameasthemarketvalue
oftheobligations.Therefore,thefacevaluemustbe:
$11.57million(1.10)1.8572=$13.81million

8.

Ineachcase,choosethelongerdurationbondinordertobenefitfromarate
decrease.
a.

TheAaaratedbondhastheloweryieldtomaturityandthereforethelonger
duration.

b.

Thelowercouponbondhasthelongerdurationandgreaterdefactocall
protection.

c.

Thelowercouponbondhasthelongerduration.

16-3

Chapter 16 - Managing Bond Portfolios

9.

Thetablebelowshowstheholdingperiodreturnsforeachofthethreebonds:
Maturity
1year
2years
3years
YTMatbeginningofyear
7.00%
8.00%
9.00%
Beginningofyearprices
$1,009.35 $1,000.00 $974.69
Pricesatyearend(at9%YTM) $1,000.00
$990.83 $982.41
Capitalgain
$9.35
$9.17
$7.72
Coupon
$80.00
$80.00
$80.00
1yeartotal$return
$70.65
$70.83
$87.72
1yeartotalrateofreturn
7.00%
7.08%
9.00%
Youshouldbuythe3yearbondbecauseitprovidesa9%holdingperiodreturnoverthe
nextyear,whichisgreaterthanthereturnoneitheroftheotherbonds.

10.

a.

PVoftheobligation=$10,000Annuityfactor(8%,2)=$17,832.65
(1)
(2)
(3)
(4)
(5)
Timeuntil
PVofCF
Column(1)
Payment
CashFlow
(Discount
Weight
Column(4)
(years)
rate=8%)
1
$10,000.00
$9,259.259
0.51923
0.51923
2
$10,000.00
$8,573.388
0.48077
0.96154
ColumnSums $17,832.647
1.00000
1.48077
Duration=1.4808years

b.

Azerocouponbondmaturingin1.4808yearswouldimmunizetheobligation.
Sincethepresentvalueofthezerocouponbondmustbe$17,832.65,theface
value(i.e.,thefutureredemptionvalue)mustbe:
$17,832.651.081.4808=$19,985.26

c.

Iftheinterestrateincreasesto9%,thezerocouponbondwoulddecreaseinvalue
to:
$19,985.26
$17,590.92
1.091.4808

Thepresentvalueofthetuitionobligationwoulddecreaseto:$17,591.11
Thenetpositiondecreasesinvalueby:$0.19
Iftheinterestratedecreasesto7%,thezerocouponbondwouldincreaseinvalue
to:
$19,985.26
$18,079.99
1.07 1.4808

Thepresentvalueofthetuitionobligationwouldincreaseto:$18,080.18
Thenetpositiondecreasesinvalueby:$0.19
Thereasonthenetpositionchangesatallisthat,astheinterestratechanges,so
doesthedurationofthestreamoftuitionpayments.
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Chapter 16 - Managing Bond Portfolios

11.

a.

PVofobligation=$2million/0.16=$12.5million
Durationofobligation=1.16/0.16=7.25years
Callwtheweightonthe5yearmaturitybond(whichhasdurationof4years).Then:
(w4)+[(1w)11]=7.25w=0.5357
Therefore:

0.5357$12.5=$6.7millioninthe5yearbondand
0.4643$12.5=$5.8millioninthe20yearbond.

b.

Thepriceofthe20yearbondis:
[$60Annuityfactor(16%,20)]+[$1,000PVfactor(16%,20)]=$407.12
Therefore,thebondsellsfor0.4071timesitsparvalue,and:
Marketvalue=Parvalue0.4071
$5.8million=Parvalue0.4071Parvalue=$14.25million
Anotherwaytoseethisistonotethateachbondwithparvalue$1,000sells
for$407.12.Iftotalmarketvalueis$5.8million,thenyouneedtobuy
approximately14,250bonds,resultingintotalparvalueof$14.25million.

12.

a.

Thedurationoftheperpetuityis:1.05/0.05=21years
Callwtheweightofthezerocouponbond.Then:
(w5)+[(1w)21]=10w=11/16=0.6875
Therefore,theportfolioweightswouldbeasfollows:11/16investedinthezero
and5/16intheperpetuity.

b.

Nextyear,thezerocouponbondwillhaveadurationof4yearsandtheperpetuity
willstillhavea21yearduration.Toobtainthetargetdurationofnineyears,
whichisnowthedurationoftheobligation,weagainsolveforw:
(w4)+[(1w)21]=9w=12/17=0.7059
So,theproportionoftheportfolioinvestedinthezeroincreasesto12/17andthe
proportioninvestedintheperpetuityfallsto5/17.

16-5

Chapter 16 - Managing Bond Portfolios

13.

a.

Thedurationoftheannuityifitweretostartin1yearwouldbe:
(1)
Timeuntil
Payment
(years)
1
2
3
4
5
6
7
8
9
10

(2)

(3)
PVofCF
CashFlow
(Discount
rate=10%)
$10,000
$9,090.909
$10,000
$8,264.463
$10,000
$7,513.148
$10,000
$6,830.135
$10,000
$6,209.213
$10,000
$5,644.739
$10,000
$5,131.581
$10,000
$4,665.074
$10,000
$4,240.976
$10,000
$3,855.433
ColumnSums $61,445.671

(4)

(5)

Weight

Column(1)
Column(4)

0.14795
0.13450
0.12227
0.11116
0.10105
0.09187
0.08351
0.07592
0.06902
0.06275
1.00000

0.14795
0.26900
0.36682
0.44463
0.50526
0.55119
0.58460
0.60738
0.62118
0.62745
4.72546

D=4.7255years
Becausethepaymentstreamstartsinfiveyears,insteadofoneyear,weaddfour
yearstotheduration,sothedurationis8.7255years.
b.

Thepresentvalueofthedeferredannuityis:

10,000 Annuity factor (10%,10)

$41,968
1.10 4
Callwtheweightoftheportfolioinvestedinthe5yearzero.Then:
(w5)+[(1w)20]=8.7255w=0.7516
Theinvestmentinthe5yearzeroisequalto:
0.7516$41,968=$31,543
Theinvestmentinthe20yearzerosisequalto:
0.2484$41,968=$10,425
Thesearethepresentormarketvaluesofeachinvestment.Thefacevaluesare
equaltotherespectivefuturevaluesoftheinvestments.Thefacevalueofthe5
yearzerosis:
$31,543(1.10)5=$50,800
Therefore,between50and51zerocouponbonds,eachofparvalue$1,000,wouldbe
purchased.Similarly,thefacevalueofthe20yearzerosis:
$10,425(1.10)20=$70,134

16-6

Chapter 16 - Managing Bond Portfolios

14.

Usingafinancialcalculator,wefindthattheactualpriceofthebondasafunctionof
yieldtomaturityis:
Yieldtomaturity
7%
8%
9%

Price
$1,620.45
$1,450.31
$1,308.21

UsingtheDurationRule,assumingyieldtomaturityfallsto7%:

Predictedpricechange

Duration
y P0
1 y

11.54

( 0.01) $1,450.31 $154.97
1.08

Therefore:predictednewprice=$1,450.31+$154.97=$1,605.28
Theactualpriceata7%yieldtomaturityis$1,620.45.Therefore:
%error

$1,605.28 $1,620.45
0.0094 0.94% (approximationistoolow)
$1,620.45

UsingtheDurationRule,assumingyieldtomaturityincreasesto9%:

Predictedpricechange

Duration
y P0
1 y

11.54

0.01 $1,450.31 $154.97
1.08

Therefore:predictednewprice=$1,450.31$154.97=$1,295.34
Theactualpriceata9%yieldtomaturityis$1,308.21.Therefore:
%error

$1,295.34 $1,308.21
0.0098 0.98% (approximationistoolow)
$1,308.21

UsingDurationwithConvexityRule,assumingyieldtomaturityfallsto7%

Predictedpricechange

Duration
y 0.5 Convexity (y) 2
1 y

P0

11.54

2

(0.01) 0.5 192.4 (0.01) $1,450.31 $168.92
1.08

Therefore:predictednewprice=$1,450.31+$168.92=$1,619.23
Theactualpriceata7%yieldtomaturityis$1,620.45.Therefore:
%error

$1,619.23 $1,620.45
0.00075 0.075% (approximationistoolow)
$1,620.45

16-7

Chapter 16 - Managing Bond Portfolios

UsingDurationwithConvexityRule,assumingyieldtomaturityrisesto9%:

Predictedpricechange

Duration
y 0.5 Convexity (y) 2
1 y

P0

11.54

2

0.01 0.5 192.4 (0.01) $1,450.31 $141.02
1.08

Therefore:predictednewprice=$1,450.31$141.02=$1,309.29
Theactualpriceata9%yieldtomaturityis$1,308.21.Therefore:
%error

$1,309.29 $1,308.21
0.00083 0.083% (approximationistoohigh)
$1,308.21

Conclusion:Thedurationwithconvexityruleprovidesmoreaccurateapproximationsto
thetruechangeinprice.Inthisexample,thepercentageerrorusingconvexitywith
durationislessthanonetenththeerrorusingonlydurationtoestimatethepricechange.
15.

Theminimumterminalvaluethatthemanageriswillingtoacceptisdeterminedbythe
requirementfora3%annualreturnontheinitialinvestment.Therefore,theflooris:
$1million(1.03)5=$1.16million
Threeyearsaftertheinitialinvestment,onlytwoyearsremainuntilthehorizondate,
andtheinterestratehasrisento8%.Therefore,atthistime,inordertobeassuredthat
thetargetvaluecanbeattained,themanagerneedsaportfolioworth:
$1.16million/(1.08)2=$0.9945million
Thisisthetriggerpoint.

16.

Thematurityofthe30yearbondwillfallto25years,anditsyieldisforecasttobe8%.
Therefore,thepriceforecastforthebondis:$893.25
[Usingafinancialcalculator,enterthefollowing:n=25;i=8;FV=1000;PMT=70]
Ata6%interestrate,thefivecouponpaymentswillaccumulateto$394.60afterfive
years.Therefore,totalproceedswillbe:$394.60+$893.25=$1,287.85
Therefore,the5yearreturnis:($1,287.85/$867.42)1=0.4847
Thisisa48.47%5yearreturn,or8.23%annually.

16-8

Chapter 16 - Managing Bond Portfolios

Thematurityofthe20yearbondwillfallto15years,anditsyieldisforecasttobe7.5%.
Therefore,thepriceforecastforthebondis:$911.73
[Usingafinancialcalculator,enterthefollowing:n=15;i=7.5;FV=1000;PMT=65]
Ata6%interestrate,thefivecouponpaymentswillaccumulateto$366.41afterfiveyears.
Therefore,totalproceedswillbe:$366.41+$911.73=$1,278.14
Therefore,the5yearreturnis:($1,278.14/$879.50)1=0.4533
Thisisa45.33%5yearreturn,or7.76%annually.The30yearbondoffersthehigher
expectedreturn.
17.
a.

A. 8% coupon bond

Time
until
Cash
Period
Payment Flow
(Years)
1
0.5
$40
2
1.0
40
3
1.5
40
4
2.0
1,040

Sum:
B. Zero-coupon

1
2
3
4

0.5
1.0
1.5
2.0

$0
0
0
1,000

Sum:

PV of CF
Discount rate =
6% per period

Weight

Years
Weight

$37.736
35.600
33.585
823.777
$930.698

0.0405
0.0383
0.0361
0.8851
1.0000

0.0203
0.0383
0.0541
1.7702
1.8829

$0.000
0.000
0.000
792.094
$792.094

0.0000
0.0000
0.0000
1.0000
1.0000

0.0000
0.0000
0.0000
2.0000
2.0000

For the coupon bond, the weight on the last payment in the table above is less than it is in
Spreadsheet 16.1 because the discount rate is higher; the weights for the first three payments
are larger than those in Spreadsheet 16.1. Consequently, the duration of the bond falls. The
zero coupon bond, by contrast, has a fixed weight of 1.0 for the single payment at maturity.
b.

A. 8% coupon bond

Time
until
Cash
Period
Payment Flow
(Years)
1
0.5
$60
2
1.0
60
3
1.5
60
4
2.0
1,060

Sum:

PV of CF
Discount rate =
5% per period
$57.143
54.422
51.830
872.065
$1,035.460

Weight

Years
Weight

0.0552
0.0526
0.0501
0.8422
1.0000

0.0276
0.0526
0.0751
1.6844
1.8396

Since the coupon payments are larger in the above table, the weights on the earlier payments are
higher than in Spreadsheet 16.1, so duration decreases.

16-9

Chapter 16 - Managing Bond Portfolios

18.
Time
(t)

Cash
Flow

PV(CF)

t + t2

Coupon = $80

$80

$72.727

145.455

YTM =

80

66.116

396.694

Maturity = 5

80

60.105

12

721.262

Price =

80

54.641

20

1,092.822

1,080

670.595

30

20,117.851

a.

0.10

$924.184

(t + t2) PV(CF)

Price: $924.184
Sum: 22,474.083
Convexity = Sum/[Price (1+y)2] = 20.097
Time
(t)

Cash
Flow

PV(CF)

t2 + t

(t2 + t) PV(CF)

Coupon = $0

$0

$0.000

0.000

YTM =

0.000

0.000

Maturity = 5

0.000

12

0.000

Price =

0.000

20

0.000

1,000

620.921

30

18,627.640

b.

0.10

$924.184

Price: $620.921
Sum: 18,627.640
Convexity = Sum/[Price (1+y)2] = 24.793

19.

a.

Thepriceofthezerocouponbond($1,000facevalue)sellingatayieldtomaturity
of8%is$374.84andthepriceofthecouponbondis$774.84
AtaYTMof9%theactualpriceofthezerocouponbondis$333.28andthe
actualpriceofthecouponbondis$691.79
Zerocouponbond:
Actual%loss

$333.28 $374.84
0.1109 11.09% loss
$374.84

Thepercentagelosspredictedbythedurationwithconvexityruleis:

16-10

Chapter 16 - Managing Bond Portfolios

Predicted%loss ( 11.81) 0.01 0.5 150.3 0.012 0.1106 11.06% loss

Couponbond:
Actual%loss

$691.79 $774.84
0.1072 10.72% loss
$774.84

Thepercentagelosspredictedbythedurationwithconvexityruleis:

Predicted%loss (11.79) 0.01 0.5 231.2 0.012 0.1063 10.63% loss

16-11

Chapter 16 - Managing Bond Portfolios

b.

Nowassumeyieldtomaturityfallsto7%.Thepriceofthezeroincreasesto
$422.04,andthepriceofthecouponbondincreasesto$875.91
Zerocouponbond:
Actual%gain

$422.04 $374.84
0.1259 12.59% gain
$374.84

Thepercentagegainpredictedbythedurationwithconvexityruleis:

Predicted%gain (11.81) (0.01) 0.5 150.3 0.012 0.1256 12.56% gain

Couponbond
Actual%gain

$875.91 $774.84
0.1304 13.04% gain
$774.84

Thepercentagegainpredictedbythedurationwithconvexityruleis:

Predicted%gain ( 11.79) ( 0.01) 0.5 231.2 0.012 0.1295 12.95% gain

c.

The6%couponbond,whichhashigherconvexity,outperformsthezeroregardless
ofwhetherratesriseorfall.Thiscanbeseentobeageneralpropertyusingthe
durationwithconvexityformula:thedurationeffectsonthetwobondsduetoany
changeinratesareequal(sincetherespectivedurationsarevirtuallyequal),but
theconvexityeffect,whichisalwayspositive,alwaysfavorsthehigherconvexity
bond.Thus,iftheyieldsonthebondschangebyequalamounts,asweassumedin
thisexample,thehigherconvexitybondoutperformsalowerconvexitybondwith
thesamedurationandinitialyieldtomaturity.

d.

Thissituationcannotpersist.Noonewouldbewillingtobuythelowerconvexity
bondifitalwaysunderperformstheotherbond.Thepriceofthelowerconvexity
bondwillfallanditsyieldtomaturitywillrise.Thus,thelowerconvexitybond
willsellatahigherinitialyieldtomaturity.Thathigheryieldiscompensationfor
lowerconvexity.Ifrateschangeonlyslightly,thehigheryieldlowerconvexity
bondwillperformbetter;ifrateschangebyasubstantialamount,theloweryield
higherconvexitybondwillperformbetter.

16-12

Chapter 16 - Managing Bond Portfolios

20.

a.

Thefollowingspreadsheetshowsthattheconvexityofthebondis64.933.The
presentvalueofeachcashflowisobtainedbydiscountingat7%.(Sincethebond
hasa7%couponandsellsatpar,itsYTMis7%.)
Convexityequals:thesumofthelastcolumn(7,434.175)dividedby:
[P(1+y)2]=100(1.07)2=114.49
Time
(t)
1
2
3
4
5
6
7
8
9
10

Cash flow
PV(CF)
(CF)
7
6.542
7
6.114
7
5.714
7
5.340
7
4.991
7
4.664
7
4.359
7
4.074
7
3.808
107
54.393
Sum:
100.000

t2 + t

(t2 + t) PV(CF)

2
6
12
20
30
42
56
72
90
110

13.084
36.684
68.569
106.805
149.727
195.905
244.118
293.333
342.678
5,983.271
7,434.175
Convexity:
64.933

Thedurationofthebondis:
(1)
Timeuntil
Payment
(years)
1
2
3
4
5
6
7
8
9
10

(2)
CashFlow
$7
$7
$7
$7
$7
$7
$7
$7
$7
$107
ColumnSums

(3)
PVofCF
(Discount
rate=7%)
$6.542
$6.114
$5.714
$5.340
$4.991
$4.664
$4.359
$4.074
$3.808
$54.393
$100.000

(4)

(5)

Weight

Column(1)
Column(4)

0.06542
0.06114
0.05714
0.05340
0.04991
0.04664
0.04359
0.04074
0.03808
0.54393
1.00000

0.06542
0.12228
0.17142
0.21361
0.24955
0.27986
0.30515
0.32593
0.34268
5.43934
7.51523

D=7.515years
b.

Iftheyieldtomaturityincreasesto8%,thebondpricewillfallto93.29%ofpar
value,apercentagedecreaseof6.71%.

16-13

Chapter 16 - Managing Bond Portfolios

c.

Thedurationrulepredictsapercentagepricechangeof:

D
7.515
0.01
0.01 0.0702 7.02%
1.07
1.07

Thisoverstatestheactualpercentagedecreaseinpriceby0.31%.
Thepricepredictedbythedurationruleis7.02%lessthanfacevalue,or92.98%
offacevalue.
d.

Thedurationwithconvexityrulepredictsapercentagepricechangeof:

7.515
2
1.07 0.01 0.5 64.933 0.01 0.0670 6.70%

Thepercentageerroris0.01%,whichissubstantiallylessthantheerrorusingthe
durationrule.
Thepricepredictedbythedurationruleis6.70%lessthanfacevalue,or93.30%
offacevalue.
CFAPROBLEMS
1.

a.

Thecallfeatureprovidesavaluableoptiontotheissuer,sinceitcanbuybackthe
bondataspecifiedcallpriceevenifthepresentvalueofthescheduledremaining
paymentsisgreaterthanthecallprice.Theinvestorwilldemand,andtheissuer
willbewillingtopay,ahigheryieldontheissueascompensationforthisfeature.

b.

Thecallfeaturereducesboththeduration(interestratesensitivity)andthe
convexityofthebond.Ifinterestratesfall,theincreaseinthepriceofthecallable
bondwillnotbeaslargeasitwouldbeifthebondwerenoncallable.Moreover,
theusualcurvaturethatcharacterizespricechangesforastraightbondisreduced
byacallfeature.Thepriceyieldcurve(seeFigure16.6)flattensoutastheinterest
ratefallsandtheoptiontocallthebondbecomesmoreattractive.Infact,atvery
lowinterestrates,thebondexhibitsnegativeconvexity.

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Chapter 16 - Managing Bond Portfolios

2.

a.

Bondpricedecreasesby$80.00,calculatedasfollows:
100.01800=80.00

3.

b.

120(0.015)2=0.0135=1.35%

c.

9/1.10=8.18

d.

(i)

e.

(i)

f.

(iii)

a.

Modifiedduration

b.

Foroptionfreecouponbonds,modifieddurationisabettermeasureofthebonds
sensitivitytochangesininterestrates.Maturityconsidersonlythefinalcashflow,
whilemodifieddurationincludesotherfactors,suchasthesizeandtimingof
couponpayments,andthelevelofinterestrates(yieldtomaturity).Modified
duration,unlikematurity,indicatestheapproximatepercentagechangeinthebond
priceforagivenchangeinyieldtomaturity.

c.

i. Modifieddurationincreasesasthecoupondecreases.
ii. Modifieddurationdecreasesasmaturitydecreases.

d.

Convexitymeasuresthecurvatureofthebondspriceyieldcurve.Suchcurvature
meansthatthedurationruleforbondpricechange(whichisbasedonlyonthe
slopeofthecurveattheoriginalyield)isonlyanapproximation.Addingatermto
accountfortheconvexityofthebondincreasestheaccuracyoftheapproximation.
Thatconvexityadjustmentisthelastterminthefollowingequation:

Macaulay duration
10

9.26 years
1 YTM
1.08

P
1

( D * y) Convexity ( y) 2
P
2

4.

a.

(i)Currentyield=Coupon/Price=$70/$960=0.0729=7.29%
(ii)YTM=3.993%semiannuallyor7.986%annualbondequivalentyield.
Onafinancialcalculator,enter:n=10;PV=960;FV=1000;PMT=35
Computetheinterestrate.

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Chapter 16 - Managing Bond Portfolios

(iii)Horizonyieldorrealizedcompoundyieldis4.166%(semiannually),or
8.332%annualbondequivalentyield.Toobtainthisvalue,firstfindthefuture
value(FV)ofreinvestedcouponsandprincipal.Therewillbesixpaymentsof$35
each,reinvestedsemiannuallyat3%perperiod.Onafinancialcalculator,enter:
PV=0;PMT=$35;n=6;i=3%.Compute:FV=$226.39
Threeyearsfromnow,thebondwillbesellingattheparvalueof$1,000because
theyieldtomaturityisforecasttoequalthecouponrate.Therefore,totalproceeds
inthreeyearswillbe$1,226.39.
Thenfindtherate(yrealized)thatmakestheFVofthepurchasepriceequalto
$1,226.39:
$960(1+yrealized)6=$1,226.39yrealized=4.166%(semiannual)

5.

b.

Shortcomingsofeachmeasure:
(i)Currentyielddoesnotaccountforcapitalgainsorlossesonbondsboughtatprices
otherthanparvalue.Italsodoesnotaccountforreinvestmentincomeoncoupon
payments.
(ii)Yieldtomaturityassumesthebondishelduntilmaturityandthatallcoupon
incomecanbereinvestedatarateequaltotheyieldtomaturity.
(iii)Horizonyieldorrealizedcompoundyieldisaffectedbytheforecastof
reinvestmentrates,holdingperiod,andyieldofthebondattheendoftheinvestor's
holdingperiod.
Note:Thiscriticismofhorizonyieldisabitunfair:whileYTMcanbecalculated
withoutexplicitassumptionsregardingfutureYTMandreinvestmentrates,you
implicitlyassumethatthesevaluesequalthecurrentYTMifyouuseYTMasa
measureofexpectedreturn.

a.

(i)Theeffectivedurationofthe4.75%Treasurysecurityis:

P/P (116 .887 86.372) / 100

15.2575
r
0.02

(ii)Thedurationoftheportfolioistheweightedaverageofthedurationsofthe
individualbondsintheportfolio:
PortfolioDuration=w1D1+w2D2+w3D3++wkDk
where
wi=marketvalueofbondi/marketvalueoftheportfolio
Di=durationofbondi
k=numberofbondsintheportfolio
Theeffectivedurationofthebondportfolioiscalculatedasfollows:
[($48,667,680/$98,667,680)2.15]+[($50,000,000/$98,667,680)15.26]=8.79

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Chapter 16 - Managing Bond Portfolios

6.

b.

VanHusensremarkswouldbecorrectiftherewereasmall,parallelshiftinyields.
Durationisafirst(linear)approximationonlyforsmallchangesinyield.For
largerchangesinyield,theconvexitymeasureisneededinordertoapproximate
thechangeinpricethatisnotexplainedbyduration.Additionally,portfolio
durationassumesthatallyieldschangebythesamenumberofbasispoints
(parallelshift),soanynonparallelshiftinyieldswouldresultinadifferenceinthe
pricesensitivityoftheportfoliocomparedtothepricesensitivityofasingle
securityhavingthesameduration.

a.

TheAabondinitiallyhasahigherYTM(yieldspreadof40b.p.versus31b.p.),
butitisexpectedtohaveawideningspreadrelativetoTreasuries.Thiswillreduce
therateofreturn.TheAaaspreadisexpectedtobestable.Calculatecomparative
returnsasfollows:
IncrementalreturnoverTreasuries=
Incrementalyieldspread(Changeinspreadduration)
Aaabond:

31bp(03.1years)=31bp

Aabond:

40bp(10bp3.1years)=9bp

Therefore,choosetheAaabond.
b.

7.

a.

Othervariablestobeconsidered:

Potentialchangesinissuespecificcreditquality.Ifthecreditqualityofthe
bondschanges,spreadsrelativetoTreasurieswillalsochange.

Changesinrelativeyieldspreadsforagivenbondrating.Ifqualityspreads
inthegeneralbondmarketchangebecauseofchangesinrequiredrisk
premiums,theyieldspreadsofthebondswillchangeevenifthereisno
changeintheassessmentofthecreditqualityoftheseparticularbonds.

Maturityeffect.Asbondsneartheirmaturity,theeffectofcreditqualityon
spreadscanalsochange.Thiscanaffectbondsofdifferentinitialcredit
qualitydifferently.

%pricechange=(Effectiveduration)ChangeinYTM(%)
CIC:

(7.35)(0.50%)=3.675%

PTR: (5.40)(0.50%)=2.700%

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Chapter 16 - Managing Bond Portfolios

b.

Sinceweareaskedtocalculatehorizonreturnoveraperiodofonlyonecoupon
period,thereisnoreinvestmentincome.
Horizonreturn=

c.

8.

9.

CIC:

$31.25 $1,055.50 $1,017.50

0.06806 6.806%
$1,017.50

PTR:

$36.75 $1,041.50 $1,017.50

0.05971 5.971%
$1,017.50

NoticethatCICisnoncallablebutPTRiscallable.Therefore,CIChaspositive
convexity,whilePTRhasnegativeconvexity.Thus,theconvexitycorrectionto
thedurationapproximationwillbepositiveforCICandnegativeforPTR.

Theeconomicclimateisoneofimpendinginterestrateincreases.Hence,wewillseek
toshortenportfolioduration.
a.

Choosetheshortmaturity(2012)bond.

b.

TheArizonabondlikelyhaslowerduration.TheArizonacouponsarelower,butthe
Arizonayieldishigher.

c.

Choosethe123/8%couponbond.Thematuritiesareapproximatelyequal,butthe
123/8%couponismuchhigher,resultinginalowerduration.

d.

ThedurationoftheShellbondisloweriftheeffectofthehigheryieldtomaturity
andearlierstartofsinkingfundredemptiondominatesitsslightlylowercoupon
rate.

e.

Thefloatingratenotehasadurationthatapproximatestheadjustmentperiod,
whichisonly6months.

a.

Amanagerwhobelievesthatthelevelofinterestrateswillchangeshouldengage
inarateanticipationswap,lengtheningdurationifratesareexpectedtofall,and
shorteningdurationifratesareexpectedtorise.

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Chapter 16 - Managing Bond Portfolios

10.

b.

Achangeinyieldspreadsacrosssectorswouldcallforanintermarketspread
swap,inwhichthemanagerbuysbondsinthesectorforwhichyieldsareexpected
tofallrelativetootherbondsandsellsbondsinthesectorforwhichyieldsare
expectedtoriserelativetootherbonds.

c.

Abeliefthattheyieldspreadonaparticularinstrumentwillchangecallsfora
substitutionswapinwhichthatsecurityissoldifitsyieldisexpectedtorise
relativetotheyieldofothersimilarbonds,orisboughtifitsyieldisexpectedto
fallrelativetotheyieldofothersimilarbonds.

a.

Theadvantagesofabondindexingstrategyare:
Historically,themajorityofactivemanagersunderperformbenchmarkindexesin
mostperiods;indexingreducesthepossibilityofunderperformanceatagiven
levelofrisk.
Indexedportfoliosdonotdependonadvisorexpectationsandsohavelessriskof
underperformingthemarket.
Managementadvisoryfeesforindexedportfoliosaredramaticallylessthanfees
foractivelymanagedportfolios.Feeschargedbyactivemanagersgenerally
rangefrom15to50basispoints,whilefeesforindexedportfoliosrangefrom1
to20basispoints(withthehighestofthoserepresentingenhancedindexing).
Othernonadvisoryfees(i.e.,custodialfees)arealsolessforindexedportfolios.
Plansponsorshavegreatercontroloverindexedportfoliosbecauseindividual
managersdonothaveasmuchfreedomtovaryfromtheparametersofthe
benchmarkindex.Someplansponsorsevendecidetomanageindexportfolios
withinhouseinvestmentstaff.
Indexingisessentiallybuyingthemarket.Ifmarketsareefficient,anindexing
strategyshouldreduceunsystematicdiversifiablerisk,andshouldgenerate
maximumreturnforagivenlevelofrisk.

Thedisadvantagesofabondindexingstrategyare:

Indexedportfolioreturnsmaymatchthebondindex,butdonot
necessarilyreflectoptimalperformance.Insometimeperiods,manyactive
managersmayoutperformanindexingstrategyatthesamelevelofrisk.

Thechosenbondindexandportfolioreturnsmaynotmeettheclient
objectivesortheliabilitystream.

Bondindexingmayrestrictthefundfromparticipatinginsectorsorother
opportunitiesthatcouldincreasereturns.

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Chapter 16 - Managing Bond Portfolios

11.

b.

Thestratifiedsampling,orcellular,methoddividestheindexintocells,witheach
cellrepresentingadifferentcharacteristicoftheindex.Commoncellsusedinthe
cellularmethodcombine(butarenotlimitedto)duration,coupon,maturity,
marketsectors,creditrating,andcallandsinkingfundfeatures.Theindex
managerthenselectsoneormorebondissuestorepresenttheentirecell.Thetotal
marketweightofissuesheldforeachcellisbasedonthetargetindexs
compositionofthatcharacteristic.

c.

Trackingerrorisdefinedasthediscrepancybetweentheperformanceofan
indexedportfolioandthebenchmarkindex.Whentheamountinvestedis
relativelysmallandthenumberofcellstobereplicatedislarge,asignificant
sourceoftrackingerrorwiththecellularmethodoccursbecauseoftheneedtobuy
oddlotsofissuesinordertoaccuratelyrepresenttherequiredcells.Oddlots
generallymustbepurchasedathigherpricesthanroundlots.Ontheotherhand,
reducingthenumberofcellstolimittherequirednumberofoddlotswould
potentiallyincreasetrackingerrorbecauseofthemismatchwiththetarget.

a.

Foranoptionfreebond,theeffectivedurationandmodifieddurationare
approximatelythesame.Usingthedataprovided,thedurationiscalculatedas
follows:

b.

P/P (100.71 99.29) / 100

7.100
r
0.002

Thetotalpercentagepricechangeforthebondisestimatedasfollows:
Percentagepricechangeusingduration=7.900.02100=15.80%
Convexityadjustment=1.66%
Totalestimatedpercentagepricechange=15.80%+1.66%=17.46%

c.

Theassistantsargumentisincorrect.Becausemodifiedconvexitydoesnotrecognize
thefactthatcashflowsforbondswithanembeddedoptioncanchangeasyields
change,modifiedconvexityremainspositiveasyieldsmovebelowthecallablebonds
statedcouponrate,justasitwouldforanoptionfreebond.Effectiveconvexity,
however,takesintoaccountthefactthatcashflowsforasecuritywithanembedded
optioncanchangeasinterestrateschange.Whenyieldsmovesignificantlybelowthe
statedcouponrate,thelikelihoodthatthebondwillbecalledbytheissuerincreases
andtheeffectiveconvexityturnsnegative.

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Chapter 16 - Managing Bond Portfolios

12.

P/P=D*y
ForStrategyI:
5yearmaturity:

P/P=4.83(0.75%)=3.6225%

25yearmaturity:

P/P=23.810.50%=11.9050%

StrategyI:

P/P=(0.53.6225%)+[0.5(11.9050%)]=4.1413%

ForStrategyII:
15yearmaturity:
13.

a.

P/P=14.350.25%=3.5875%

i.Strongeconomicrecoverywithrisinginflationexpectations.Interestratesand
bondyieldswillmostlikelyrise,andthepricesofbothbondswillfall.The
probabilitythatthecallablebondwillbecalledwoulddecrease,andthecallable
bondwillbehavemorelikethenoncallablebond.(Notethattheyhavesimilar
durationswhenpricedtomaturity).Theslightlylowerdurationofthecallablebond
willresultinsomewhatbetterperformanceinthehighinterestratescenario.
ii.Economicrecessionwithreducedinflationexpectations.Interestratesandbond
yieldswillmostlikelyfall.Thecallablebondislikelytobecalled.Therelevant
durationcalculationforthecallablebondisnowmodifieddurationtocall.Price
appreciationislimitedasindicatedbythelowerduration.Thenoncallablebond,on
theotherhand,continuestohavethesamemodifieddurationandhencehasgreater
priceappreciation.

b.

Projectedpricechange=(modifiedduration)(changeinYTM)
=(6.80)(0.75%)=5.1%
Therefore,thepricewillincreasetoapproximately$105.10fromitscurrentlevel
of$100.

c.

ForBondA,thecallablebond,bondlifeandthereforebondcashflowsareuncertain.
Ifoneignoresthecallfeatureandanalyzesthebondonatomaturitybasis,all
calculationsforyieldanddurationaredistorted.Durationsaretoolongandyieldsare
toohigh.Ontheotherhand,ifonetreatsthepremiumbondsellingabovethecallprice
onatocallbasis,thedurationisunrealisticallyshortandyieldstoolow.Themost
effectiveapproachistouseanoptionvaluationapproach.Thecallablebondcanbe
decomposedintotwoseparatesecurities:anoncallablebondandanoption:
Priceofcallablebond=Priceofnoncallablebondpriceofoption
Sincethecalloptionalwayshassomepositivevalue,thepriceofthecallablebondis
alwayslessthanthepriceofthenoncallablesecurity.

16-21