Managing

Bond
Portfolios
Week 3
Investments FNCE30001

Dr Bryan Lim
Finance
 Warning

This material has been reproduced and communicated to you by

or on behalf of the University of Melbourne pursuant to Part VB
of the Copyright Act 1968 (the Act).

The material in this communication may be subject to copyright

under the Act.

Any further copying or communication of this material by you

may be the subject of copyright protection under the Act.

Do not remove this notice

How can we manage
bond price risks?

3
 Lecture Overview
Duration
Convexity
Bond Portfolio Management (“Immunisation”)

4
 Reading
16.1 Interest Rate Risk
16.2 Convexity (up to “Duration and Convexity of Callable Bonds”)
16.3 Passive Bond Management: “Immunization”

5
 Last week
“Bonds: 4 Main Risks”
1. Interest rate risk
2. Inflation risk
3. Credit (or, “default” ) risk
4. Exchange rate risk

Our focus today: interest rate risk

6
Duration

7
 Digression: Be careful!
Most of the texts, websites and others discussing the relation between prices
and interest rates make it sound like:

Yields ⟹ Prices
When it really is: Economic

Cash Flows & Discount rates ⟹ Prices ⟹ Yields

Definition/Mechanical

In the next part of lecture, I am going to follow the book and convention and
discuss relations between YTM and P.
• Note that because this relation is mathematical it applies just as well to P and
" $̃ as it does to P and YTM. 8
 Example: Change in interest rates
and bond prices
• 10-year default-free bond
• par value = $1000
• coupon rate = 8%, paid annually
• rf = 0.08, 0.06, 0.10

rf =0.08 Þ P=$1000
Notice: rf down 2% and price up $147.20
rf =0.06 Þ P=$1147.20
BUT rf up 2% and price down only $122.89
rf =0.10 Þ P=$877.11

9
 Properties of Bond Prices
1. The bond price is inversely related to the yield
2. An increase in the bond’s yield to maturity results in a smaller price change
than a decrease in yield of equal magnitude.
3. The longer the maturity, the more sensitive a bond’s price is to interest rate
changes.
4. Interest rate risk is less than proportional to bond maturity.
5. The lower the coupon rate, the more sensitive a bond’s price is to interest
rate changes.
6. The sensitivity of a bond’s price to a change in its yield is inversely related to
the yield to maturity at which the bond is currently selling.

10
Bond Price Versus
Change in Yield

11
 ∆y à ∆P
Key question: How does P respond to a change in ytm (“y”)?

If y changes to y + ∆y, then P changes to P + ∆P

1. How is ∆P related to ∆y?

2. What is ∆P/P, the percentage capital gain or loss on the bond?

12
 ∆y à ∆P/P
To a first-order approximation*, the percentage capital gain or loss on a bond
when the yield changes is:

Δ& −Δ)
= ×-
& 1+)

where D is the duration of the bond

(*From a Taylor series expansion)

13
 Duration
. . . + 12
×1 ×2 ×3
1+) 1+) " 1+) #
-= + + ⋯+
&! &! &!

.1$
∑#$%& $ ×6
1+)
=
&!

• D = Weighted average term to maturity

14
 Calculate Duration of a Bond
• Term = 5 years
– Assume that today is a coupon payment date (coupon has been paid)
• Coupon rate = 8.5% pa
– Coupons paid annually
• Par value = $100
• Yield = 10% pa

15
 . . . + 12
×1 ×2 ×3
1+) 1+) " 1+) #
-= + + ⋯+
&! &! &!

PV of cash PV of cash PV of cash flow/Price

Time (t) Cash flow
flow flow/Price x Time

1 $8.50 $7.73 0.081931 0.081931

2 $8.50 $7.02 0.074483 0.148966
3 $8.50 $6.39 0.067712 0.203136
4 $8.50 $5.81 0.061556 0.246225
5 $108.50 $67.37 0.714317 3.571585
$94.31 4.251844
price

16
 A Duration Cheat
The duration of a coupon bond equals:

1+% 1+% +' (−%

!= −
% ( 1+% ! −1 +%
y = yield to maturity per coupon payment interval
c = coupon rate (not $ amount) per coupon payment interval
D = duration measured as number of coupon payment intervals
T = number of remaining coupons à Must be a WHOLE NUMBER, not decimal

17
 Prior Example
y = 10%
c = 8.5%
T=5
1.1 1.1 + 5 ⋅ 0.085 − 0.1
-= −
.1 .085 ∗ 1.1' − 1 + .1

1.025
= 11 −
0.152

≈ 4.25

18
 Why Duration?
1. Tells us the bond price sensitivity to changes in yields
2. Recognises that term to maturity is an inadequate measure of the time
period of an investment

Consider the following (unrealistic) bond:

• Pays $100 after 1 year and $1 after 50 years
• Term to maturity: 50 years
• But it’s not really a 50-year investment

• Duration: slightly more than 1 year

19
 How Duration Behaves
All else equal, duration is higher if:
• The coupon rate is lower (why?)
• The yield is lower (why?)
• (Usually) the term to maturity is longer (why?)

1. Duration of a zero-coupon bond = the bond’s term to maturity

2. Duration of a coupon bond < the bond’s term to maturity
&()
3. Duration of a perpetuity =
)

20
 Duration Over Time
Between coupon dates: the duration of a bond decreases in line with the
change in maturity
• Duration decreases by one day, every day

On a coupon payment date: duration of a bond “jumps” up

We’ll do a specific example, but this holds in all cases

21
 Duration Over Time Example
Earlier: duration of 5-year 8.5% coupon bond (annual coupons) priced to yield
10% pa, with a par value of $100 = 4.25 years

After 3 months (0.25 years), what is the duration of the bond?

22
 #/ 1 + ' !.#$ #/ 1 + ' %.#$ (# + (/0)/ 1 + ' &.#$
!= 0.75 + 1.75 + ⋯ + 4.75
( ( (

PV of cash PV of cash
Time (t) Cash flow PV of cash flow/Price x Time
flow flow/Price

0.75 $8.50 $7.913606 0.081931 0.061449 years

1.75 $8.50 $7.194187 0.074483 0.130346 years
2.75 $8.50 $6.540170 0.067712 0.186208 years
3.75 $8.50 $5.945609 0.061556 0.230836 years
4.75 $108.50 $68.994500 0.714318 3.393006 years
Total $96.588070 1.000000 4.001845 years

23
 Suppose the next coupon will be
paid in 1 day
! ! !
!% &%
#/ 1 + ' "#$ 1 #/ 1 + ' "#$ 1 #/ 1 + ' "#$ 1
!= + 1+ + 2+ +⋯
( 365 ( 365 ( 365

After 1 day (and the first coupon is paid):

• first term in the duration equation drops out (but it was close to 0 anyway)
• the remaining cash flows lose only 1/365th in compounding
• But P will drop instantly by the amount of the newly-paid coupon

Almost the same numerator but a smaller denominator

→ duration instantly increases when the coupon is paid

24
25
Convexity

26
Convexity(Bond A) >
Convexity(Bond B)

27
 What is Convexity?
Duration: tells us something about the slope of curve relating a change in yield
to a change in price

Convexity: tells us something about the curvature of that relationship (i.e., the
second derivative)

All else equal, investors value convexity (larger upside, smaller downside)

28
 Convexity Formula
A more precise version of our earlier ∆y à ∆p/P formula (Slide 9):

Δ& Δy 1 "
≈− ×- + @ Δ)
& 1+y 2

where X (convexity) is calculated as

1 2. 6. 3 3 + 1 . + &B$
@= "
+ "
+ ⋯+
& 1+) 1+) 1+) 1+) #

29
 Calculating Convexity: Example
1 2( 6( + + + 1 ( + $,-
!= !
+ !
+ ⋯+
$ 1+& 1+& 1+& 1+& "

PV (Cash flow) ×
Cash flow Cash flow multiplier Cash flow × Cash
Time (t) Cash flow
($) t × (t + 1) flow multiplier
multiplier
1 $8.50 1×2=2 $17 15.45
2 $8.50 2×3=6 $51 42.15
3 $8.50 3 × 4 = 12 $102 76.63
4 $8.50 4 × 5 = 20 $170 116.11
5 $108.50 5 × 6 = 30 $3,255 2,021.10
Total 2,271.44

30
 Using Duration and Convexity
Recall the 5-year 8.5% coupon bond (annual coupons) priced to yield 10% pa,
with a par value of $100
• Its price is $94.3138

We found that
• D = 4.251847 years
• The [bracket] portion of X = 2271.44

If the yield were to change to 10.5% pa, what is the estimated percentage
capital loss?

31
 Estimating ∆P/P given ∆y
Using only duration:

Δ& 0.005
≈− 4.251847 = −1.93266%
& 1.1

The convexity adjustment:

1 "
1 "
@ Δ) = ×2271.44× 0.005 = 0.02488%
2 2×94.3138×1.1"

Updated estimate of Δ&/& = −1.93266% + 0.02488% = −1.90778%

32
 Estimation vs Actual
We could have calculated the exact answer from bond price formula

When yield increases from 10.0% to 10.5%:

• Price falls from $94.313818 to $92.514284
• Exact percentage capital loss = 1.90803%
• Our approximation (−1.90778%) was very close

But if we could calculate the change directly, why bother with duration and
convexity?

33
 Bond Portfolio
Management
(“Immunisation”)

34
 Duration is used for three main
purposes
1. As a summary measure of a bond’s sensitivity to changes in yield (interest
rates)
2. As a guide to act on expectations
3. As a tool to immunise a bond portfolio.

35
 Bond Portfolio Immunisation
“Immunise”: to ensure that a bond portfolio achieves a target rate of return
even if yields change.

Suppose you need to invest today to be certain of having $1 million in five years’
time
• Simple solution: buy a five-year zero-coupon bond.
• Problem: In practice, there are very few five-year zeros to buy!
You can invest in coupon bonds
• but then face the problem of changes in yield

Strategy: invest in a bond (or, more likely, a portfolio of bonds) whose duration
is five years
36
 Why does this work?
When yields decrease:
• Good news: capital gain
• Bad news: expect a lower reinvestment rate

When yields increase:

• Good news: expect a higher reinvestment rate
• Bad news: capital loss

Duration-matching strategy exactly balances the good news and the bad news

37
 Is it as simple as that? (No.)
Unlike buying a zero, duration-matching with coupon bonds isn’t a “set and
forget” strategy
• Any time a bond’s duration changes significantly à portfolio must be
rebalanced to have the desired duration

For example,
• When a coupon is paid
– the portfolio’s duration ≠ time horizon
• When yields change
– duration changes

Technically, this immunisation strategy only works perfectly if the yield curve is
flat (so that all zero rates equal the yield) and is sure to stay flat
38
 Immunisation Example
An investor needs to invest today to have $1,275,311 in 3 years’ time
There is a bond with a term of 3.4 years, paying annual coupons of 7%
The current yield curve is flat at 10% pa

Claim: By investing in this bond, the investor will achieve the target even if
yields decrease to 8% pa or increase to 12 % pa.

39
 Immunisation Example
Use the formulae to solve for
• Current price of the bond: 95.816022 (per 100 FV)
• Duration of the bond: 287.740099 / 95.816022 = 3 years

How much to buy?

• At the current yield-to-maturity of 10%:
$&,",',-&&
= $958,160
&.&'

• (This corresponds to $1,000,000 FV)

40
 What happens if...?
…yields decrease to 8% pa immediately after the investment is made and stay at
the new level for the next 3 years?

…yields increase to 12% pa immediately after the investment is made and stay
at the new level for the next 3 years?

41
 Progress of investment if yields
fall to 8%

Date 0 0.4 1.4 2.4 3.0

Bond term left 3.4 3.0 2.0 1.0 0.4

Coupon Interest Paid $0 $70,000 $75,030 $80,377 $0

Bond Price (Par $1m) $958,161 $974,229 $982,167 $990,741 $1,037,563

No. of bonds bought 1.00000 0.07185 0.07639 0.08113 0

No. of bonds held 1.00000 1.07185 1.14824 1.22937 1.22937

Value of bonds held $958,161 $1,044,227 $1,127,764 $1,217,987 $1,275,549

42
 Progress of investment if yields
rise to 12%

Date 0 0.4 1.4 2.4 3.0

Bond term left 3.4 3.0 2.0 1.0 0.4

Coupon Interest Paid $0 $70,000 $75,568 $81,374 $0

Bond Price (Par $1m) $958,161 $879,908 $915,497 $955,357 $1,022,578

No. of bonds bought 1.00000 0.07955 0.08255 0.08515 0

No. of bonds held 1.00000 1.07955 1.16210 1.24725 1.24725

Value of bonds held $958,161 $949,905 $1,063,897 $1,191,565 $1,275,406

43
 Key Questions
What is duration?
Why might some bond holders prefer low duration over high duration (and vice
versa)?
Why do investors like convexity?
How does portfolio immunisation work?

44
 COMMONWEALTH OF AUSTRALIA

Copyright Regulations 1969

Warning

This material has been reproduced and communicated to you by

or on behalf of the University of Melbourne pursuant to Part VB
of the Copyright Act 1968 (the Act).

The material in this communication may be subject to copyright

under the Act. Any further copying or communication of this
material by you may be the subject of copyright protection
under the Act.

Do not remove this notice

Investments
FNCE30001
Week 3 Problem Set and Solutions

You may use a spreadsheet program like Excel or Google Sheet`s for this homework, though as
preparation for the eventual exams, I’d suggest first trying to do it manually with a calculator.

1. Consider a 3-year 12% coupon bond with a par value of $100 and which has just paid a coupon.
The yield curve is flat at 9.25% pa. Coupons are paid annually.

a. Calculate the duration. Use the duration to make a first approximation of the percentage
capital gain or loss if the yield increases by 25 basis points.
I basis 0001
point : 0 .

Duration

>
- Duration cheat

%: 9 25% .
(yield to maturity

C : 12 % (Corpon rate)

T : 3 (time to maturity

1 + 0 0925 . (1 + 0 .
0925) + 3 (0 12 - 0.0925) .

2 7
D =
0 0925
-

0 12.
[11 + 0 0925)" 1) + 0
.
=
. 0925
= .

OR

flow/price x Time
Cash flow Dr of cash flow PV of cash
Time (t)
= 0 1027
10 98/106 92
x1

925
.
.

10 98
.

I 12 =
.

12 05/106 92X2 = 0 1880

10
.
.

12 05
.

2 10
09252
= .
1 .

112 4099
85 89/106 92x3 : 2 .

85 89
. .

3 112 1 . 09253 = .

Duration : 0 1027 + o . 1880 + 2 11099 : .7

2
price : 10 98 + 10 05 +85 89 106 92
. .
= .
. .
.

OR

12
C : 0 . 12 x 100 =

7 : 9 , 25 %

T :S

Po :
0 !g25(1-1 09253) + 09253 .
1 .
= 106 93 .

12 12 112

D =
1

095X
· +
1.
09 +
1. 09253X3
106 . 93
: 2 7 .

Estimated percentage change (*(

-
Dy = = 0 . 0025

%: 9 25 % .

D: 2 7 .

&p 700025X2 00618 0 618 % O

.

-0 or
7
1
= .
.

.
b. Calculate the convexity adjustment. Use this adjustment to make a second approximation
of the percentage capital gain or loss if the yield increases by 25 basis points.

Convexity

+x(t + )
cash flow multiplier (XC)
=

p = 106 93 .

y =
9 25 %
.

C : 12

Par = 100

T = 3

3(3 + 1)(12 + 100)

X =
106 93(1 .
I
+ 0 . 092512170
2(12)
.
0935 (1 + 0 . 0925/3
= 8 7207
.

Estimated percentage change (*(

+ x8 7207X0 00252
# T00025 x 2 . 7 . .
: -0 . 0065 Or 0 6 %O
.

2
c. Calculate the exact percentage capital gain or loss if the yield increases by 25 basis points.
25 %
points
= 0
25 basis
.

Y: 9 25 % + 0 25%.
= 9 5%
.

PX : o ! g5 (1-1 .
0953) + 1893 = 106 . 27 - new price

Exact price change

-1-1 =
-0 . 00617 or 0 . 61 % of capital loss

2*. In the preceding question, you should have found that the duration of the bond is about 2.7 years.
Assuming the yield remains 9.25%, what will be the duration of the bond

(a) in three months?

3 months = 0 . 25 years
I
coupon payment subtracted
can be
2 7 0 25 = 2 45 years before ,

D= .
-
.
.

(b) immediately before the next coupon payment?

. 7-1
2 = 1 7
.
years

(c) immediately after the next coupon payment? T

>
- decrease by 1 year

PVCF xt PVCEXt/price
CF DV CF
time
0 105
984 984/104 821
=
10
984 10
.

10 . .
.

I 12 .

1 790
187 674/104
=
187 674 821
.

93 837 .
.

Z
.

2 11 .

D = 1 . 895
104 821 ,

OR

1 + 0
, 0925 (1 + 0 0925) + 2(0 . . 12 -
0 . 0925)
D =
=
1 . 895
12 (1 09252
-

0 . 0925 0 . .
-
1) + 0 . 0925

3
3. What is the “convexity” of a coupon bond? Why do investors have a positive view of convexity?

4
Question 1. Zero coupon bond : Duration Time to maturity
=

What is the duration of a $1,000, zero-coupon bond that

has a maturity of 9 years if its yield-to-maturity is 10%? T9 =

,
thus D= 9
A. 7.92
B. 8.55
C. 9
D. Duration is a meaningless number when dealing with
zero-coupon bonds
E. None of the above
Question 2. Interest rate risk
Duration is a concept that is useful in assessing a bond’s
________.
A. Interest rate risk
B. Credit risk
C. Liquidity risk
D. None of the above
Question 3. Zero coupon bond : Duration Time to maturity
=

A 3-year, zero-coupon bond offers an interest rate of 9% per

T S thus D:
annum. How does a 3-basis-point increase in the prevailing
:
,

interest rate change the value of this bond (in %)? Choose the
closest answer.
Estimated percentage change (*)
A. -0.08% 3 basis point increase : 0 . 0003 or 0 03.
%
B. -0.03%
C. 0.03% y= 9 %, y8 = 0 03
. %, D: S
D. 0.08% 0003
=
- 0
-0 08 %
.
-0 0008
E. None of the above X3 = . or .

1+ 0 . 09

Question 4. Longer maturity date :

longer duration

Consider two bonds, A and B. Both bonds presently are

selling at their par value of $1,000. Each pays interest of more sensitive to interest rate changes (higher gain/loss)
$100 annually. Bond A will mature in 6 years while bond B
will mature in 8 years. If the yields to maturity on the two Yield to maturity increase value decrease

bonds change from 9% to 10%,

TA 6
A. Both bonds will increase in value but bond A will :

increase more than bond B S

TB
B. Both bonds will increase in value but bond B will
increase more than bond A While both bonds decrease in value ,
Bond B decrease more

C. Both bonds will decrease in value but bond A will

decrease more than bond B
D. Both bonds will decrease in value but bond B will
decrease more than bond A
Question 5. 1
=
0 001 .

XD
A bond presently has a price of $1,020. The present yield 1020 1 + 0 081 .

on the bond is 8.10%. If the yield changes from 8.10% to D =, p+.

8.00%, the price of the bond will go up to $1,031. The
duration of the bond is ________. Choose the closest
answer.
A. 7.98
B. 8.27
C. 10.40
D. 11.66
Question 6.
Calculate the duration of a $1,000, level-coupon, 8% bond
that matures in three years. The bond makes annual interest 6 %, = 8 %. T
y = =
3
payments and repays its principal at the end of the third
061 + 310 08 0 . 06
year, and the yield curve is a flat 6%. Choose the closest 06 (1 + 0
-
1+ 0 . .
.

D =
= 2 79
08((1 + 0 0633 11 + 0 06
-

06
.

0 0
answer.
- .
.
. .

A. 2.25
B. 2.69
C. 2.79
D. 2.88
E. None of the above
 Solutions

(*Solutions to questions with an asterisk will be covered in lecture.)

1. See the spreadsheet for calculations.

a. Follow the duration formula:

 T=3
 C=12
 FV=100
 Y=9.25%

You should find that the price of the bond is 106.93, and the duration works out to 2.7 years.

The estimated percent change is -.0025*2.7/1.0925=-0.618%.

b. Follow the convexity formula to find X = 8.7207

The estimated percent change is -0.618%+8.7207*.00252/2= -0.6152%.

c. Use the textbook bond pricing formula with Y=9.5% to find the new price is $106.2723,
which corresponds to a -0.6153% change.

3. The bond price is negatively related to the yield (first derivative). The curve is convex to
the origin (second derivative). The more convex the curve, the greater is the gain if yields fall
and the smaller is the loss if yields rise.

If the current yield-to-maturity increases or decreases, the high-convexity bond is the better
one to have (and hence, contrary to the diagram, the bond prices today would not be equal –
the higher convexity bond would have a higher price).

5
6
Online Quiz Solution