BOND PRICE VOLATILITY

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INTRODUCTION
Bond Price Volatility refers to the fluctuations in the price of a bond due to changes in various underlying factors such as interest rate. Bond is a fixed income bearing security , still it is being traded in the secondary market similar to any other security. This brings volatility in the bond prices. Traders use bond volatility to make profit and also to balance their portfolio risk.

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REASON FOR VOLATILTIY

Price Yield Relationship:- The main cause of changes in the price of a bond is current interest rates. When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. So, every time the interest rate changes the bond price fluctuates.

Credit Rating Change:Credit Rating companies give rating to the bond on the basis of default risk involved. If the credit rating of the bond improves ,it leads to an increase in bond price and vice versa, causing fluctuation in bond prices. 4/13/12

REASON FOR VOLATILTIY

Inflation:-Inflation can have similar effects on bond price as interest rates do. During an inflationary period, bond prices may drop as investors may not be getting compensated high enough to keep pace with inflation.

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FACTORS DETERMINING VOLATILITY

The volatility of bond price depends primarily on interest rate. But the fluctuation in the bond price varies for similar interest rate changes .The actual volatility depends mainly on 3 factors: maturity yield credit rating of the issuer.

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VOLATILITY RELATIONSHIP WITH MATURITY

The greater the length of the bonds remaining term,

the more sensitive it will be to changes in interest rates. related

Bond price volatility and time to maturity are directly

EXAMPLE:A 1-year bond will change less than a 30-year bond. Since it has shorter length to maturity. But it will have the same sensitivity to interest rates as a 30-year bond with 1 year to go until maturity.
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REASON WHY MATURITY AFFECTS BOND PRICE.

Time Value of money:- The greater the bonds term, the lesser the present value of the bonds payments. Because the present value of any future payment is inversely proportional to length of time and to interest rates.

Therefore, rising interest rates will cause the prices of bonds with long remaining terms to drop more than those with shorter remaining terms. DEFAULT RISK:- Higher the term ,more is the chance of defaulting, leads to higher volatility.

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VOLATILITY RELATIONSHIP WITH YIELD

Bonds with higher yields will be less volatile than bonds with low yields. EXAMPLE

A bond with 15% coupon will have less price change than a bond with 10% coupon if both bond yield falls by 1%. When a bonds yield is already high, then changes in interest rates will have less effect on its price than a bond with a lower yield.

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REASON WHY YIELD AFFECTS BOND PRICE.

Proportion effect:-When a bonds yield is already high, then changes in interest rates will have less effect on its price than a bond with a lower yield. if interest rates increase by 1%, then the price of a bond with a yield of 10% will drop less than a bond with a yield of 4%, because 1% is only 1/10thof 10%, but of 4%. Liquidity :- Bonds having high coupon rate are generally low credit bonds. So they have less movement due to illiquidity.
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VOLATILITY RELATIONSHIP WITH CREDIT RATING

The better the credit rating of the bonds issuer, the less sensitive the bonds price will be to interest rates and vice versa. REASON

A lower credit rating increases a bonds volatility because higher interest rates will hurt a company in poor financial shape more than one in good financial health. Thus, bonds with a lower credit rating will drop in price faster when interest rates rise.

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MEASURING- BOND PRICE VOLATILITY

Duration is used for measuring the bond price volatility. It is a measure to guide the sensitivity of a bond to interest rate changes. It the weighted average of the present value of the bonds payments, and can be viewed as the average, or effective, maturity of a bond. It is the average time to receive all cash flows from a bond. Thus can be regarded as the time in which interest rate risk becomes zero.

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MATHEMATICAL FORMULA
D = t t w
t= 1 T

D = uai n Dr t o

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Calculate the durations of an 8% coupon and zerocoupon bond, each with two years to maturity. Assume that the yield to maturity on each bond is 10%, or 5% per half-year. The present value of each payment is discounted at 5% per period for the number of (semiannual) periods. Maturity at par $1000

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FEATURES OF DURATION

It calculates a bonds volatility independently of its maturity and yield which allows an easier comparison of different bonds. It is equal to the volatility of a zero coupon bond with a term equal to the duration. It is an essential tool in immunizing portfolios from interest rate risk. Duration is measured in years Greater the duration, the more volatile the bond.

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Bond Duration versus Bond Maturity

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MODIFIED DURATION

An adjusted measure of Macaulays duration is called modified duration. It is a natural measure of the bonds exposure to changes in interest rates. This is applied only incase of the small changes in the bonds yield. It is a 1stderivative of the price-yield curve, which is a line tangent to the curve at the current price-yield point.

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INTERPRETATION OF DURATION

It is used as a rough measure of how much a bonds price will change for a change in interest rate. For calculation always modified duration is used. Hence, The percentage change in bond price is just the product of modified duration and the change in the bonds YTM. Example

If duration is 5 and the change in interest rate is 150 basis points then it means that price on change in interest rate will change by 7.5%.
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INTERPRETATION OF DURATION

There is an Inverse relationship between coupon and duration. So if duration is high holding maturity constant, it can be interpreted that the coupon rate is low.

There is a positive relationship between term to maturity and duration. So if duration is high, it means it is for longer maturity period.

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USE OF DURATION IN PORTFOLIO

If a manager believes that bond prices will rise (interest rates fall), then he will lengthen the duration of the portfolio to increase profits. Profits increase because bonds with longer durations rise in price faster because of the longer effective maturities and vice versa.

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CONVEXITY

Duration and Modified Duration of the bond assume a linear relationship between price and yield. However, since the actual yield curve is usually convex, measurement of the bond risk using its duration may not give a perfect picture.

Convexity takes into account the shape of the Price yield relationship when making price sensitivity calculations. It is the rate of change of duration with a change in the yield.

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WHY TO USE CONVEXITY

Duration rule is a good approximation for only small changes in bond yield. For large changes in bond yields, duration can be supplemented with an additional measure to capture the curvature or convexity of a bond.

It is a measure of the curvature of the price/yield curve. Mathematically, convexity is the second derivative of price with respect to yield divided by the price. It is a measure of how much a bonds price-yield curve deviates from the linear approximation of that curve.

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MEASURING CONVEXITY

Duration attempts to estimate relationship with a straight line.

convex

If we add convexity to duration, we get a better approximation to the price of the bond due to change in required yield. Convexity can be negative ,but for non callable bonds, convexity is always positive

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MATHEMATICAL FORMULA

Correction for Convexity- price change using convexity:

P = D y + P

1Convexity [ 2

y (

)]

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Date 1/1/2008 1/6/2008

Type of security 8.24% GOVT.STOCK 2018 8.24% GOVT.STOCK 2018

PRICE 96.84

YTM 8.7288

Date

Type of security

PRICE

YTM

1/1/200 8.24% GOVT.STOCK 8 2027

97.17

8.6765

108.19 6.984 0.11720 4 0.19989

Volatility

Type of security 8.15% GOVT. STOCK 1/1/20092025 8.15% GOVT. STOCK 1/6/20092025

Date

INTERPRETATION- The above table exhibits the same property of bond which says higher the maturity higher is the volatility. Date Type of security PRICE YTM
PRICE YTM 109.85 101.33 7.1 8 1/1/2007.35% GOVT. 9STOCK 2025 1/6/2007.35% GOVT. 9STOCK 2025 108.86 100.26 7.2 8.12

1/6/200 8.24% GOVT.STOCK 8 2027 113.95 6.9 0.17268 Volatility 7 -0.20475

Volatility

0.12676 0.07756 1

Volatility

-0.079

0.127778

INTERPRETATION- The above table exhibits the same property of bond which says higher the coupon lesser is the volatility.
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