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**More on Duration & Convexity**

Class 7, Chap 9 - Appendix B

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Lecture Outline Purpose: Gain a deeper understanding of duration and its properties and weaknesses Properties of duration Hedging with duration Weaknesses of duration Convexity

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**Properties of Duration**

Duration increases with maturity but at a decreasing rate Duration decreases as the yield to maturity increases Duration decreases as the coupon payments or interest rate increases

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**1. Duration increases with maturity at a decreasing rate**

Calculate the duration for bonds of several maturities with an 8% coupon paid semiannually, $1,000 face value and yield to maturity of 12%. Adding a year means: The big payment occurs 1 year later Adds 1 year to the weighted average Because there is not a lot of discounting, the weight on the additional year is large So when you go from one year to two years the largest PV and thus the largest weight is still on the last payment. So when it comes to duration, you are adding another year and you are giving that year the largest weight. 925.60 37.74 35.60 33.58 823.78 When we add a year to a long maturity bond it changes the duration much less than when we add a year to a short maturity bond

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**1. Duration increases with maturity at a decreasing rate**

Calculate the duration for bonds of several maturities with an 8% coupon paid semiannually, $1,000 face value and yield to maturity of 12%. Adding a year means: The big payment occurs 1 year later Adds 1 year to the weighted average There is a lot of discounting so the weight on the additional year is small compared to other years On the longer end of the curve, you can see that the present value of the later payments are relatively small. This means that most of the duration weight is given to earlier years (payment periods) and that the duration is already well established. Therefore, increasing the maturity by one year will not change the duration much. Remember duration tell us, on average, when do we receive the full value of the bond. At these larger maturities, the later payments are highly discounted. Therefore, their values are relatively small. The interpretation is that we have already received most of the bond value early on. So, playing with these later payments does not affect the bond duration very much because they represent only a small fraction of the bond value. 37.74 35.60 1.53 33.42 1.44 37.74 35.60 1.36 31.53 1.29 When we add a year to a long maturity bond it changes the duration much less than when we add a year to a short maturity bond

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**1. Duration increases with maturity at a decreasing rate**

Lets just look at what happens to the present value of cash flows as the maturity increases 1,040 40 Time to Maturity = 5 years Duration = 4.14

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**1. Duration increases with maturity at a decreasing rate**

Lets just look at what happens to the present value of cash flows as the maturity increases 1,040 40 Time to Maturity = 10 years Duration = 6.61

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**1. Duration increases with maturity at a decreasing rate**

Lets just look at what happens to the present value of cash flows as the maturity increases 1,040 40 Time to Maturity = 15 years Duration = 7.91

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**1. Duration increases with maturity at a decreasing rate**

Lets just look at what happens to the present value of cash flows as the maturity increases 1,040 40 Time to Maturity = 20 years Duration = 8.53

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**1. Duration increases with maturity at a decreasing rate**

Lets just look at what happens to the present value of cash flows as the maturity increases Duration = 8.53 1,040 40 Time to Maturity = 20 years A large percent of the bond value has been received early-on !!! 86% of my value has already been received by year 19.5 and that is not going to change. So, 86% of my duration is also fixed and will not change. So, if I extend it out a little more (one more year) the best I can do is try to play with the remaining 14% Total weight (sum) = 86% Total weight (sum) = 75% Total weight (sum) = 48%

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**1. Duration increases with maturity at a decreasing rate**

Conclusion: Duration increases with maturity but at a decreasing rate because of two effects: Increasing the maturity adds more years to the bond, which increases duration As we increase the time to maturity (TTM), a smaller and smaller fraction of bond value is being received at a later date. This is because later payments are highly discounted. As a result, a large fraction of bond value is received early on, which stabilizes the duration.

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**2. Duration decreases as YTM ↑**

Lets just look at what happens to the present value of cash flows as the YTM increases 1,000

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**2. Duration decreases as YTM ↑**

Lets just look at what happens to the present value of cash flows as the YTM increases 1,000 YTM = 10% Duration = 4.18

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**2. Duration decreases as YTM ↑**

Lets just look at what happens to the present value of cash flows as the YTM increases 1,000 YTM = 30% Duration = 3.74

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**2. Duration decreases as YTM ↑**

Lets just look at what happens to the present value of cash flows as the YTM increases 1,000 YTM = 50% Duration = 3.23

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**2. Duration decreases as YTM ↑**

Lets just look at what happens to the present value of cash flows as the YTM increases 1,000 YTM = 70% Duration = 2.71

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**2. Duration decreases as YTM ↑**

Lets just look at what happens to the present value of cash flows as the YTM increases 1,000 YTM = 90% Duration = 2.26

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**2. Duration decreases as YTM ↑**

Lets just look at what happens to the present value of cash flows as the YTM increases 1,000 As we increase the yield to maturity, the present value (and as a result the duration weights) of the earlier payments increase relative to the PV (duration weights) of the later payments That is, the percentage of value [PV(future cash flows)] received early in the bond’s life increases – so the later payments (more interest rate sensitive) are not as important

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**3. Duration Decreases as the coupon ↑**

Again, this has to do with how the present value of cash flows is distributed over time and how that changes when we change the coupon rate. 1,000 Coupon = 10% Duration = 4.04

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**3. Duration Decreases as the coupon ↑**

Again, this has to do with how the present value of cash flows is distributed over time and how that changes when we change the coupon rate. 1,000 Coupon = 40% Duration = 3.29

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**3. Duration Decreases as the coupon ↑**

Again, this has to do with how the present value of cash flows is distributed over time and how that changes when we change the coupon rate. 1,000 Coupon = 70% Duration = 3.07

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**3. Duration Decreases as the coupon ↑**

Again, this has to do with how the present value of cash flows is distributed over time and how that changes when we change the coupon rate. 1,000 Coupon = 100% Duration = 2.97

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**3. Duration Decreases as the coupon ↑**

Again, this has to do with how the present value of cash flows is distributed over time and how that changes when we change the coupon rate. As we increase the coupon rate the present value of early cash flows (duration weights) increases relative to later payments That is, the percentage of value [PV(future cash flows)] received early in the bonds life increases – so the later payments (more interest rate sensitive) are not as important

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What do you need to know Duration increases with maturity but at a decreasing rate Duration decreases as the yield to maturity increases Duration decreases as the coupon payments increase You need to have a basic understanding of why duration behaves this way

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Hedge With Duration

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**Duration and interest rate risk**

We have seen that duration measures the sensitivity of assets to changes in interest rates Now lets see how we can use that to manage interest rate risk Basic idea: by taking an offsetting position in an asset/liability with a matched duration an investor can hedge interest rate risk

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**Hedging a single asset Suppose a company has 5 years left on a loan:**

The company wants to pay back the loan today but there are stiff prepayment penalties. So, the company decides to offset the loan with another asset. The loan is a balloon payment loan - it is paid back in one lump sum payment in five years – no interim interest payments Current value of the loan is $1,000 at 8% = $ due in 5 years The company wants to hedge against changes in interest rates and can choose from the following instruments: A 3 year 3% coupon bond with $1,000 face value A five year zero coupon bond with an 8% YTM and face value = 1000 A six year bond with an 8% coupon paid annually and face value = 1,000 and YTM = 8%

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How to choose? The company can manage its interest rate risk by matching durations The duration of the 3 year bond will definitely be too short The five year zero coupon bond has a duration of 5 years The six year coupon can not be ruled out so we need to calculate the duration

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**Duration of the 6 year bond**

Step#1 Find the coupon Coupon = (1,000)*.08 = $80 Draw the cash flows Step#2 Find present values Step#4 Find duration weights Step#5 Find duration 1,000 The 6 year bond is also a viable option for the hedge

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**Hedge with the zero coupon bond**

The company will owe in 5 years So the company wants to receive $ (for sure) in 5 years to be completely hedged Each bond pays 1000 in 5 years so they need to buy /1000 = zero coupon bonds Cost: The price of the zero coupon = 1000/(1.08)5 = The company needs of them so the total cost is ( )(680.58) = $1,000 The full amount of their loan

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**Hedge with the zero coupon bond**

The company is perfectly hedged!!!! After purchasing the zero coupon bonds, the company has locked-in a positive cash flow in five years no matter what interest rates do!!! 1,469.33 - 1,469.33 Bond Loan

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**Hedging with the 6 year bond**

We saw that the 6 year bond had a duration of 5 years so lets try using it to hedge. To hedge the company can buy one 5 year duration bond for a cost of $1,000 Consider three cases : The YTM stays at 8% The YTM instantaneously increases to 9% The YTM instantaneously decreases to 7% Why 1 bond? – if we find the value of all cash flows at time 5 years (1000)(1.085) =$1, If this was not the case, we would need to buy more or less than one bond But if this was not the case the bond would not have a 5 year duration

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**Hedging with the 6 year bond**

Base case: Show that the company is hedged if the YTM = 8% The company will hold the bond for 5 years The coupon will be reinvested at the YTM Reinvest for 4 years Reinvest for 3 years Reinvest for 2 years Reinvest for 1 years Collect coupon & sell bond 1,000

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**Hedging with the 6 year bond**

Case YTM increases to 9% The company will hold the bond for 5 years The coupon will be reinvested at the YTM Reinvest for 4 years Reinvest for 3 years Reinvest for 2 years Reinvest for 1 years Collect coupon & sell bond 1,000

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**Hedging with the 6 year bond**

Case YTM decreases to 7% The company will hold the bond for 5 years The coupon will be reinvested at the YTM Reinvest for 4 years Reinvest for 3 years Reinvest for 2 years Reinvest for 1 years Collect coupon & sell bond 1,000

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**What kind of risk would the coupons be subject to?**

What does that all mean? If the company offsets its assets or liabilities with an instrument of the same duration the position will be immune to changes in interest rates Do you think this really works? It could, but we run into two problems The duration of the bond (used to hedge) will change The YTM of the bond used to hedge could change What kind of risk would the coupons be subject to?

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**Difficulties with duration (preview)**

1. Duration Change Lets calculate the duration of the bond right after the second coupon is paid – there are four years (coupons) left. Assume they YTM = 8% Weights: Duration Loan: the loan still has 3 years to maturity so the durations no longer match – this is ok as long as the coupons have and can continue to be reinvested at 8%

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**Difficulties with duration (preview)**

2. Reinvestment risk Suppose that after the first two payments the interest rate increases to 9% So what’s the point? This seems really ineffective – why am I not teaching you how to fully resolve this problem? 1,000 The company no longer has enough money to repay its loan of $ IT IS HARD!!!

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**Difficulties with Duration**

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**Difficulties with Duration**

Reallocating large quantities of assets or liabilities to attain the needed durations for assets and liabilities can be very costly Immunization is a dynamic problem Every time the interest rate changes the hedging portfolio must be rebalanced One decision managers have to make is how often to rebalance and weigh the cost of doing so Convexity- Duration only works for small changes in the interest rate For large changes in rates duration will not accurately predict the percent change in the price of a security

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**Price a 20 year bond with coupon of 30% and semiannual payments**

Convexity Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch Price a 20 year bond with coupon of 30% and semiannual payments

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**Price a 20 year bond with coupon of 30% and semiannual payments**

Convexity Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch Price a 20 year bond with coupon of 30% and semiannual payments

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**Price a 20 year bond with coupon of 30% and semiannual payments**

Convexity Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch Price a 20 year bond with coupon of 30% and semiannual payments

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**Price a 20 year bond with coupon of 30% and semiannual payments**

Convexity Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch Price a 20 year bond with coupon of 30% and semiannual payments

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**Price a 20 year bond with coupon of 30% and semiannual payments**

Convexity Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch Price a 20 year bond with coupon of 30% and semiannual payments

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**Price a 20 year bond with coupon of 30% and semiannual payments**

Convexity Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch Price a 20 year bond with coupon of 30% and semiannual payments

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**Price a 20 year bond with coupon of 30% and semiannual payments**

Convexity Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch Price a 20 year bond with coupon of 30% and semiannual payments

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**Price a 20 year bond with coupon of 30% and semiannual payments**

Convexity Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch Price a 20 year bond with coupon of 30% and semiannual payments

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Convexity Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch

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**Convexity What does duration say about this relation?**

Duration is the derivative of the bond pricing formula with respect to the interest rate at a specific point on the graph What does the derivative look like on the graph?

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**Duration is the derivative. It is the slope of the tangent line**

Convexity Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch Duration is the derivative. It is the slope of the tangent line This is what duration says the graph (relationship) should look like When we do the duration calculation, we find a point on this line 13%

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**Convexity & accuracy of duration**

Calculate the duration of the bond if the YTM is 13% D = 7.23 years If the YTM dropped to 3% what price would the duration predict? What is the actual price?

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**Convexity & accuracy of duration**

Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch 3% 13%

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**Convexity & accuracy of duration**

Calculate the duration of the bond if the YTM is 13% D = 7.23 years If the YTM jumped to 23% what price would the duration predict? What is the actual price?

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**Convexity & accuracy of duration**

Convexity refers to the curvature in the relationship between bond prices and interest rates. What does that mean? – watch Asymmetric Pricing Errors! 23% 3% 13%

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**Convexity & accuracy of duration**

The larger the convexity the more curvature there is in the line Duration will work better for bonds with low convexity We will calculate convexity next

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Take away Duration is only accurate for small changes in interest rates Duration will predict lower than actual values The under prediction error is greater when interest rates fall then when they increase Duration will change depending on the interest rate!!!!!!!!!

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**Calculate Convexity Calculate the duration weights**

Multiply the weights by the time period squared plus and the same time period Sum values and divide by (1+ YTM)2 to get convexity

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**Convexity Calculation Example**

Consider a 6 year bond with an 8% coupon paid annually the YTM is 6%. Face value of Calculate the convexity of the bond 1000 Step #1 find the present value of payments Step #2 calculate weights

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**Convexity Calculation Example**

Consider a 6 year bond with an 8% coupon paid annually the YTM is 6%. Face value of Calculate the convexity of the bond Step #3 calculate the convexity Measures the curvature of the YTM bond price relationship – larger values = more curvature

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**Calculate the convexity of a 1**

Calculate the convexity of a 1.5 year 4% coupon bond with semiannual payments and face value of 5,000 if the risk free rate is currently 5% and the YTM is 9%

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**So what good is convexity?**

We can use it to adjust the accuracy of the duration calculation!! Example: Estimate the expected percent change in the price of the bond from the previous example (FV = 5000, coupon = 4%, TTM = 1.5yrs, semiannual compounding) if interest rates are expected to increases from 9% to 11.4% (the duration of the bond 1.47yrs).

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**Convexity Adjustment Price implied by Duration**

Price implied by Duration & Convexity

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**Lecture Summary 3 properties of duration Hedging by matching duration**

Duration increases with maturity but at a decreasing rate Duration decreases as the yield to maturity increases Duration decreases as the coupon payments or interest rate increases Hedging by matching duration The hedge is only perfect if YTM remains constant over the life of the hedge Convexity Concept Calculation

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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 3-1 Chapter Three Interest Rates and Security Valuation.

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 3-1 Chapter Three Interest Rates and Security Valuation.

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