Valuing Cash Flows

Non-Contingent Payments

Non-Contingent Payouts

Given an asset with fixed payments (i.e.

independent of the state of the world), the
assets price should equal the present
value of the cash flows.

Treasury Notes
US Treasuries notes have maturities
between 2 and ten years.
Treasury notes make biannual interest
payments and then a repayment of the
face value upon maturity
US Treasury notes can be purchased in
increments of $1,000 of face value.

Consider a 3 year Treasury note with a 6%

annual coupon and a $1,000 face value.

Now
F(0,1)

$30

$30

6mos

1yrs
F(1,1)

$30

$30

1.5 yrs
F(2,1)

2yrs
F(3,1)

F(0,1) = 2.25%

You have a statistical

model that generates the
following set of
(annualized) forward
rates

F(1,1) = 2.75%

F(2,1) = 2.8%
F(3,1) = 3%
F(4,1) = 3.1%
F(5,1) = 4.1%

F(4,1)

$30

$1,030

2.5yrs

3yrs

F(5,1)

Now
2.25%

$30

$30

6mos

1yrs
2.75%

$30

$30

1.5 yrs
2.8%

$30

2yrs
3%

$1,030

2.5yrs
3.1%

3yrs

4.1%

Given an expected path for (annualized) forward

rates, we can calculate the present value of future
payments.

P=

$30
$30
$30
+
+
(1.01125) (1.01125)(1.01375) (1.01125)(1.01375)(1.014)

$1,030
= $1,084.90
(1.01125).(1.0205)

Forward Rate Pricing

Cash Flow at time t

Current Asset Price

CFt

P0 t

t 1 1 Fi 1
i 1

Interest rate between

periods t-1 and t

Alternatively, we can use current spot rates from the

yield curve

Now

$30

$30

$30

6mos

1yrs

1.5 yrs

4
3

2.5

2.7

1 yr

2 yr

$30
2yrs

3.5

$30

$1,030

2.5yrs

3yrs

2
1
0
3yr

4yr

5yr

The yield curve produces the same bond

price..why?

Now

$30

$30

6mos

1yrs

$30

$30

1.5 yrs

2yrs

$30

$1,030

2.5yrs

3yrs

$30
$30
$30
$30
$30
$1,030
+
+
+
+
+
(1.0125) (1.0125) 2 (1.0135) 3 (1.0135) 4 (1.015) 5 (1.015) 6
S(1)

S(2)

S(3)

$1,084.90

Spot Rate Pricing

Current Asset Price

Cash flow at period t

CFt
P0
t
t 1 1 S (t )
Current spot rate for a
maturity of t periods

Alternatively, given the current price, what is

the implied (constant) interest rate.

Now

$30

$30

6mos

1yrs

$30
(1+i)

$1,084.90

$30
+
2
(1+i)

$30
1.5 yrs

$30
+
3
(1+i)

$30
2yrs

$30
+
4
(1+i)

$30

$1,030

2.5yrs

3yrs

$30
$1,030
+
(1+i)5
(1+i) 6

(1+i) = 1.015 (1.5%)

Given the current ,market price of

$1,084.90, this Treasury Note has an
annualized Yield to Maturity of 3%

Yield to Maturity
Cash flow at time t

CFt
P0
t
t 1 1 Y
N

Yield to Maturity
Current Market Price

Yield to maturity measures the total performance

of a bond from purchase to expiration.
Consider $1,000, 2 year STRIP
selling for $942

.5
$942 = $1,0002
(1+Y)

$1,000
(1+Y) = $942

For a discount (one payment) bond, the

YTM is equal to the expected spot rate

For coupon bonds, YTM is cash flow specific

= 1.03 (3%)

Consider a 5 year
Treasury Note with a 5%
annual coupon rate (paid
annually) and a face value
of $1,000

The one year interest rate is

currently 5% and is expected
to stay constant. Further,
there is no liquidity premium

Yield

5%

Term

$50
$50
$50
$50
$50
+
+
+
+
P =
= $1,000
(1.05)
(1.05) 2
(1.05) 3
(1.05) 4
(1.05) 5
This bond sells for Par Value and YTM = Coupon Rate

Consider a 5 year
Treasury Note with a 5%
annual coupon rate (paid
annually) and a face value
of $1,000

Now, suppose that the

current 1 year rate rises to 6%
and is expected to remain
there

Yield

6%
5%

Term

$50
$50
$50
$50
$50
+
+
+
+
P =
= $958
(1.06)
(1.06) 2
(1.06) 3
(1.06) 4
(1.06) 5
This bond sells at a discount and YTM > Coupon Rate

Price

$1,000
$958

A 1% rise in yield is associated with

a $42 (4.2%) drop in price

$42

Yield
5% 6%

Consider a 5 year
Treasury Note with a 5%
annual coupon rate (paid
annually) and a face value
of $1,000

Now, suppose that the

current 1 year rate falls to 4%
and is expected to remain
there

Yield

5%
4%
Term

$50
$50
$50
$50
$50
+
+
+
+
P =
= $1045
(1.04)
(1.04) 2
(1.04) 3
(1.04) 4
(1.04) 5
This bond sells at a premium and YTM < Coupon Rate

Price

A 1% drop in yield is associated

with a $45 (4.5%) rise in price

$1,045
$45
$1,000
$958

$42

Yield
4% 5% 6%

A bonds pricing function

shows all the combinations of
yield/price

Price

1) The bond pricing is non-linear

2) The pricing function is unique

to a particular stream of cash
flows

$1,045
$45
$1,000
$958

$42
Pricing
Function

Yield
4% 5% 6%

Duration

Recall that in general the price of a fixed

income asset is given by the following
formula
n

CFi
P(Y)
i
i 1 1 Y

Note that we are denoting price as a

function of yield: P(Y).

For the 5 year, 5% Treasury, we had the

following:

Yield

5%

Term

P(Y=5%) =

$50
$50
$50
$50
$50
+
+
+
+
= $1,000
2
3
4
5
(1.05)
(1.05)
(1.05)
(1.05)
(1.05)

This bond sells for Par Value and YTM = Coupon Rate

Price

$1,000
Pricing
Function

Yield
5%

Suppose we take the derivative of

the pricing function with respect to
yield

i * CFi
dP

i 1
dY i 1 1 Y
n

For the 5 year, 5% Treasury, we have

dP
- $50
2$50
3$50
4$50 5$1,050

2
3
4
5
dY (1 Y)
(1 Y)
(1 Y)
(1 Y)
(1 Y) 6

Now, evaluate that derivative at a particular

point (say, Y = 5%, P = $1,000)

dP
- $50
2$50 3$50 4$50 5$1,050

$4,329
2
3
4
5
6
dY (1.05)
(1 .05)
(1 .05)
(1 .05)
(1 .05)

For every 100 basis point change in the

interest rate, the value of this bond changes
by $43.29 This is the dollar duration

DV01 is the change in a bonds price per

basis point shift in yield. This bonds
DV01 is $.43

Price
Duration predicted a
$43 price change for
every 1% change in
yield. This is different
from the actual price
Error = $2
$1,045
$1,000

Error = - $1

$958

Pricing
Function

Yield
4% 5% 6%

Dollar
Duration

Dollar duration depends on the face value of the

bond (a $1000 bond has a DD of $43 while a
$10,000 bond has a DD of $430) modified duration
represents the percentage change in a bonds
price due to a 1% change in yield

dP 1
Modified Duration
*
dY P
For the 5 year, 5% Treasury, we have

dP 1
$4,329
MD
*
4.3
dY P
$1,000
Every 100 basis point shift in yield alters this bonds price by
4.3%

Macaulay's Duration
Macaulay duration measures the percentage change in a
bonds price for every 1% change in (1+Y)
(1.05)(1.01) = 1.0605

dp (1 Y )
Macaulay's Duration
*
dY
P
For the 5 year, 5% Treasury, we have

dP (1 Y )
$4,329 (1.05 )
Mac D
*

4.55
dY
P
$1,000

For bonds with one payment,

Macaulay duration is equal to the term
Example: 5 year STRIP

Dollar Duration

$100
P(Y)
(1 Y) 5

dP
(5)($100)

dY
(1 Y) 6
Modified Duration

Macaulay Duration

dP 1 Y

5
dY P

(5)($100)

dP 1
5
(1 Y) 6

$100
dY P
(1 Y )
(1 Y )5

Think of a coupon bond as a portfolio of STRIPS. Each

payment has a Macaulay duration equal to its date. The
bonds Macaulay duration is a weighted average of the
individual durations
Back to the 5 year Treasury
P(Y=5%) =

$50
$50
$50
$50
$50
+
+
+
+
= $1,000
2
3
4
5
(1.05)
(1.05)
(1.05)
(1.05)
(1.05)
$47.62

$47.62
$1,000

1+

$45.35
$1,000

$45.35

2+

Macaulay Duration = 4.55

$43.19

$43.19
$1,000

3+

$41.14

$822.70

$41.14
$822.70
4 +
5
$1,000
$1,000

Macaulay Duration = 4.55

Macaulay Duration
Modified Duration =

(1+Y)

4.55
= 4.3
Modified Duration =
1.05

Dollar Duration = Modified Duration (Price)

Dollar Duration = 4.3($1,000) = $4,300

Duration measures interest rate risk (the

risk involved with a parallel shift in the yield
curve) This almost never happens.

Yield curve risk involves changes in an assets price

due to a change in the shape of the yield curve

Key Duration

In order to get a better idea of a Bonds (or

portfolios) exposure to yield curve risk, a
key rate duration is calculated. This
measures the sensitivity of a bond/portfolio
to a particular spot rate along the yield
curve holding all other spot rates constant.

Returning to the 5 Year Treasury

$50
$50
$50
$50
$1,050
P(S1 ,..., S5 )

2
3
4
(1 S1 ) (1 S2 )
(1 S3 ) (1 S4 )
(1 S5 )5
A Key duration for the three year spot rate is
the partial derivative with respect to S(3)

dP(S1 ,..., S5 ) 3($ 50 )

4
dS3
(1 S3 )
dP(S1 ,..., S5 ) 3($50 )

$123 .41
4
dS3
(1.05 )

Evaluated at S(3) = 5%

Key Durations
156.71

160
140
123.41
120
100

86.38

80
60

45.35

39.18

40
20
0
1Yr

2Yr

3Yr

4Yr

5Yr

Note that the individual key durations sum to $4329

the bonds overall duration

X 100

Yield Curve Shifts

7
6
5

+1%

0%
- 2%

- 4%

+1%
2
1
0
1 yr

2yr

3yr
Old

4yr
New

5yr

7
6
5

+1%

0%

- 2%

4
3

- 4%

+1%

2
1
0
1 yr

2yr

3yr

4yr

5yr

$.4535 1 + $.8638 1 + $.12341 0 + $.15671 (-2) + $39.81 (-4) = $161

This yield curve shift would raise a five year Treasury price by
$161

Suppose that we simply calculate

the slope between the two points
on the pricing function

Price

Slope =

$1,045 - $958
4% - 6%

= $43.50

or

$1,045

$1,045 - $958
$1,000
Slope =

$958

*100
= 4.35

4% - 6%

Yield
4%

6%

Effective duration measures interest rate

sensitivity using the actual pricing function
rather that the derivative. This is particularly
important for pricing bonds with embedded
options!!

Price

$1,045
Effective
Duration

$958

Pricing
Function

Yield
4%

6%
Dollar
Duration

Value At Risk
Suppose you are a portfolio manager.
The current value of your portfolio is a
known quantity.
Tomorrows portfolio value us an
unknown, but has a probability
distribution with a known mean and
variance
Profit/Loss = Tomorrows Portfolio Value Todays portfolio value

Known Distribution

Known Constant

Probability Distributions

1 Std Dev = 65%

2 Std Dev = 95%
3 Std Dev = 99%

One Standard Deviation Around

the mean encompasses 65% of
the distribution

Remember, the
5 year Treasury
has a MD 0f 4.3

Interest Rate
Mean = 6%
Std. Dev. = 2%

Profit/Loss
Mean = $0
Std. Dev. = $86

$1,000, 5 Year Treasury (6% coupon)

Mean = $1,000
Std. Dev. = $86

The VAR(65) for a $1,000, 5 Year Treasury

(assuming the distribution of interest rates) would
be $86. The VAR(95) would be $172
In other words, there is
only a 5% chance of
losing more that $172

1 Std Dev = 65%

One Standard Deviation Around
the mean encompasses 65% of
the distribution

2 Std Dev = 95%

3 Std Dev = 99%

A 30 year
Treasury has a
MD of 14

Interest Rate
Mean = 6%
Std. Dev. = 2%

Profit/Loss
Mean = $0
Std. Dev. = $280

$1000, 30 Year Treasury (6% coupon)

Mean = $1,000
Std. Dev. = $280

The VAR(65) for a $1,000, 30 Year Treasury

(assuming the distribution of interest rates) would
be $280. The VAR(95) would be $560
In other words, there is
only a 5% chance of
losing more that $560

One Standard Deviation Around

the mean encompasses 65% of
the distribution

Example: Orange County

In December 1994, Orange County, CA
stunned the markets by declaring
bankruptcy after suffering a $1.6B loss.
The loss was a result of the investment
activities of Bob Citron the county
Treasurer who was entrusted with the
management of a $7.5B portfolio

Example: Orange County

Actually, up until 1994, Bobs portfolio was doing very

well.

Example: Orange County

Given a steep yield curve, the portfolio was betting on

interest rates falling. A large share was invested in 5
year FNMA notes.

Example: Orange County

Ordinarily, the duration on a portfolio of 5 year notes

would be around 4-5. However, this portfolio was
heavily leveraged ($7.5B as collateral for a $20.5B loan).
This dramatically raises the VAR

Example: Orange County

In February 1994, the Fed began a series of six

consecutive interest rate increases. The beginning of
the end!

Risk vs. Return

As a portfolio manager, your job is to

maximize your risk adjusted return
Risk Adjusted
Return

Nominal Return Risk Penalty

You can accomplish this by 1 of two methods:

1) Maximize the nominal return for a given level of risk
2) Minimize Risk for a given nominal return

Again, assume that the one year spot rate is currently 5% and
is expected to stay constant. There is no liquidity premium, so
the yield curve is flat.
Yield

5%

Term

$5
$5
$5
$5
+
+
+
+
P =
2
3
4
(1.05)
(1.05)
(1.05)
(1.05)

= $100

All 5% coupon bonds sell for Par Value and YTM = Coupon Rate =
Spot Rate = 5%. Further, bond prices are constant throughout their
lifetime.

Available Assets
1 Year Treasury Bill (5% coupon)
3 Year Treasury Note (5% coupon)
5 Year Treasury Note (5% coupon)
10 Year Treasury Note (5% coupon)
20 Year Treasury Bond (5% coupon)
STRIPS of all Maturities

How could you maximize your risk adjusted return on a $100,000

Treasury portfolio?

Suppose you buy a 20 Year

Treasury

$100,000

P(Y=5%) =

20
Year

$5000/yr

$105,000

$5000
$5000
$5000
+
+
+
2
3
(1.05)
(1.05)
(1.05)
$4,762

$4,762
1+
$100,000

$4,535

$4,535
2 +
$100,000

Macaulay Duration = 12.6

$4,319

$4,319
$100,000

$105,000
(1.05) 20
$39,573

3+ +

$82,270
$100,000

20

Alternatively, you could buy a

20 Year Treasury and a 5 year
STRIPS
$50,000

$50,000

20
Year

$2500/yr

5
Year
$63,814

$52,500

5
Year
$63,814

5
Year
$63,814

5
Year
$63,814

(Remember, STRIPS have a Macaulay

duration equal to their Term)

Portfolio Duration =

$50,000
12.6 +
$100,000

$50,000
$100,000

5 = 8.8

Alternatively, you could buy a

20 Year Treasury and a 5 year
Treasury
$50,000

20
Year

$50,000

5
Year

$2500/yr

$2500/yr

5
Year

$52,500

5
Year

5
Year

$52,500

(5 Year Treasuries have a Macaulay duration

equal to 4.3)

Portfolio Duration =

$50,000
12.6 +
$100,000

$50,000
$100,000

4.3 = 8.5

Even better, you could buy a 20 Year

Treasury, and a 1 Year T-Bill
$2500/yr

$50,000

20
Year

$50,000

1
Year

1
Year

1
Year

$52,500

$52,500

$52,500

$52,500

(1 Year Treasuries have a Macaulay duration

equal to 1)

Portfolio Duration =

$50,000
12.6 +
$100,000

$50,000
$100,000

1 = 6.3

Alternatively, you could buy a 20 Year Treasury, a 10

Year Treasury, 5 year Treasury, and a 3 Year Treasury

$25,000
D = 12.6

20
Year

$25,000
D = 7.7

10
Year

$25,000
D = 4.3

5
Year

$25,000
D = 2.7

3
Year

$25,000
$100,000

$1250/yr

$1250/yr
$1250/yr
$1250/yr

12.6 +

$25,000
$100,000

Portfolio Duration = 6.08

7.7 +

$25,000
$100,000

4.3 +

$25,000
$100,000

2.7

Obviously, with a flat yield curve, there is no advantage to

buying longer term bonds. The optimal strategy is to buy
1 year T-Bills

$100,000

1
Year

1
Year

1
Year

$105,000 $105,000 $105,000

Portfolio Duration = 1

However, the
yield curve
typically slopes
up, which creates
a risk/return
tradeoff

Also, with an upward sloping yield

curve, a bonds price will change
predictably over its lifetime

4.00
3.50

3.04

3.00
2.50

2.55

3.28

3.48

3.69

3.75

6 Yr

7 Yr

2.78

2.00
1.50
1.00
0.50
0.00
1 Yr

2 Yr

3 Yr

4 Yr

5 Yr

A Bonds price will always approach its face

value upon maturity, but will rise over its lifetime
as the yield drops

Pricing Date Coupon

YTM

Price ($)

Issue
2005
2006
2007
2008
2009
2010
2011

3.75%
3.69
3.48
3.28
3.04
2.78
2.55
Matures

100.00
100.96
101.77
102.20
102.35
102.11
101.29
100.00

3.75%
3.75
3.75
3.75
3.75
3.75
3.75
3.75

Also, the change is a bonds

duration is also a non-linear function

Length of
Bond

Initial
Duration

Duration
Percentage
after 5 Years Change

30 Year
20 Year
10 Year

15.5
12.6
7.8

14.2
10.5
4.4

-8%
-17%
-44%

As a bond ages, its duration drops at an increasing

rate