Debt Market Session 9

Convexity
Session 8
Convexity & Factors affecting Interest

Rate
Analysis of Bond Price

Volatility
Bond Price Volatility
Price Yield Relationship for Six

Hypothetical Bonds
9% coupon bond with 5 years to maturity
Req 9%/5
yield yr
9%/
25 yr
6%
112.79
7%
6%/ 25 0%/5
yr
yr
0%/
25 yr
138.59 100
100
74.4
22.8
108.3
123.45 95.84
88.27
70.89
17.90
8%
104.05
110.7
91.88
78.51
67.55
14.07
9%
100
100
88.13
70.35
64.39
11.07
9.01
%
10%
99.96
99.90
88.09
70.28
64.36
96.139
90.87
84.55
63.48
61.39
11.04
4
8.7
11%
92.46
83.06
81.15
57.6
58.54
6.8
12%Bond88.95
76.35
Price Volatility
77.91
52.71
55.83
5.52
6%/5
yr
Percentage Price Change

Req Change 9%/5
yield in Basis yr
9%/
25 yr
6%/5
yr
6%/
25 yr
0%/5
yr
0%/
25 yr
6%
-300
12.80
38.59
13.47
42.13
15.56
106.0
4
7%
-200
8.32
23.46
8.75
25.46
10.09
61.73
8%
-100
4.06
10.74
4.26
11.60
4.91
27.10
9.01
%
-0.04
-0.10
-0.04
-0.11
-0.05
-0.24
10%
100
-3.86
-9.13
-4.06
-9.76
-4.66
-21.23
11%
200
-7.54
-16.93
-7.91
-18.03
-9.08
-37.89
12%
300
-11.04 -23.64
-11.59
-25.08
-13.28 -50.96
Point
Price Volatility Characteristics of

Option- Free Bonds (Properties)
Although the prices of all the option free
bonds move in the opposite direction from

the change in yield required, the
percentage price change is not the same
for all bonds.
For very small changes in the yield
required, the percentage price change for a
given bonf is roughly the same, whether
the yield required increases or decreases
For large changes in the required yield, the
percentage price change is not the same

for an increase in the required yield as it is
for a decrease in the required yield
For a given change in basis point, the
percentage price increase is greater than
the percentage price decrease. (Long
position: Potential capital gain is more than
the capital loss, Short position: )
Characteristics of a Bond that Affect

its Price Volatility
There are two characteristics of an option
free bonds that determine its price

volatility: Coupon and Term to Maturity
For a given term to maturity and initial
yield, the price volatility of a bond is
greater, than the lower the coupon rate
For a given coupon rate and initial yield,
the longer the term to maturity, the greater
the price volatility
Long maturities in portfolio:

Investors who wants to increase a portfolios price
volatility because they expect interest rate to fall, all

other factors being constant, should hold for long
maturity
Short maturities in portfolio:
Duration Question?
Calculate the Bond duration and Modified
bond for the bond with the face value of Rs

1000 for 5 years coupon rate is 10% semi
annually. YTM is 9%
10

Rate
Period
0
Cash Flow
PV Cash Flow
($1,039.56)
Duration Calc
50.00
47.85
47.85
50.00
45.79
91.57
50.00
43.81
131.44
50.00
41.93
167.71
50.00
40.12
200.61
50.00
38.39
230.37
50.00
36.74
257.19
50.00
35.16
281.27
50.00
33.65
302.81
10
1,050.00
676.12
6,761.24
11

Rate
Total
8,472.07
Bond price = 1039.56

Duration = 8472.07 / 1039.56 / 2
= 4.07
Modified Duration = 4.07 / 1.045
= 3.90
12

Rate
Duration Adjustment
Modified duration x Yield change x Bond
price
13

Rate
Convexity
14

Rate
The Importance of Convexity

Convexity is the difference between the
actual price change in a bond and that

predicted by the duration statistic
Convexity helps to approximate the change
in price that is not explained by duration

because of the convex nature of the yield
curve.
In practice, the effects of convexity are minor
15

Rate
Convexity
Measures
how
much
a
bonds
price-yield
curve
deviates from a
straight line
Convexity refers to
the shape of the

price/yield function,
and is a measure
used in conjunction
with duration to
estimate
bond
price sensitivity to
changes in interest
rates
16

Rate
Convexity
Convexity is useful
for
comparing
bonds with same
duration and yield.
Convexity
is
a
measure
of
the
curvature of the
price-yield
relationship.
17

Rate
The relationship between the convexity,
coupon, maturity and yield of bond:

The coupon of a bond and convexity (when
coupon and maturity are constant) are inversely

related ie lower coupon, higher convexity.
The maturity of a bond and convexity (when
coupon and yields are constant) are directly
related ie Longer maturity, higher convexity.
The yield of a bond and convexity (when coupon
and maturity are constant) are inversely related.
The price yield curve is more convex at its lower
yield
18

Rate
Convexity Calculation
19

Rate
Question
Calculate convexity measure for 5 year
semi annually bond face value Rs 100

coupon rate is 9% semi annually, YTM 9%.
Cash flow = 4.5 for the period of 10
20

Rate
21
Period
Cashflow(Rs)
1
(1.045)t+2
t(t+1)CF
t(t+1)CF*
1/(1.045)t+2
4.5
0.876296
7.886
4.5
0.838561
27
22.641
4.5
0.802451
54
43.332
4.5
0.767895
90
69.110
4.5
0.734828
135
99.201
4.5
0.703185
189
132.901
4.5
0.672904
252
169.571
4.5
0.643927
324
208.632
4.5
0.616198
405
249.560
10
104.50
0.589663
11495
6778.186
Total
7781.020

Rate
Convexity measures = conv cal / bond price /

(2)^Frequency of payment in a year
= 7781.020 / 100 = 77.8102 / 4
=
19.45
22

Rate
Convexity Adjustment
=0.5*Convexity*Yield_Change^2*Bond_Price
0.5* 19.45* (0.02^2)*100
0.5* 19.45* 0.0004*100
0.389
Yield change is the difference between
the initial yield and current market yield.
23

Rate
Question 1
Calculate:
Duration
Modified Duration
Convexity
Adjustment of Bond price if yield will change
by 3% (+ & -)
For 5 year bond face value Rs 1000 coupon
rate is 8% compounding semi annually,

YTM 10%.
24

Rate
Duration calculation
Period
25
Cash Flow
PV Cash Flow
Duration Calc
($922.78)
40.00
38.10
38.10
40.00
36.28
72.56
40.00
34.55
103.66
40.00
32.91
131.63
40.00
31.34
156.71
40.00
29.85
179.09
40.00
28.43
198.99
40.00
27.07
216.59
40.00
25.78
232.06
10
1,040.00
638.47
6,384.70

Rate
7714.08
Duration = 7714.08 / 922.78 / 2
= 4.18
Modified Duration = 4.18 / 1.05
= 3.98
If 3% change in yield means bond price will
change:
Modified duration x Yield change x Bond price
3.98* 0.03* 922.78
= 110.20
26

Rate
Convexity calculation
Period
CF
PV on YTM
t(t+1)CF
3x4
40.00
0.863837599
80.00
69.11
40.00
0.822702475
240.00
197.45
40.00
0.783526166
480.00
376.09
40.00
0.746215397
800.00
596.97
40.00
0.71068133
1,200.00
852.82
40.00
0.676839362
1,680.00
1,137.09
40.00
0.644608916
2,240.00
1,443.92
40.00
0.613913254
2,880.00
1,768.07
40.00
0.584679289
3,600.00
2,104.85
10
1,040.00
0.556837418
114,400.00
63,702.20
Total
27

Rate
72,248.57
Convexity measures = conv cal / bond price
/4
= 72248.57 / 922.78 = 78.295 / 4
19.57
28

Rate
=0.5*Convexity*Yield_Change^2*Bond_Pric
e
0.5* 19.57* (0.03^2)*922.78
0.5* 19.57* 0.0009*922.78
8.13
29

Rate
if 3% change in yield means bond price will
change by
Duration adjustment is 110.20
Convexity adjustment is 8.13
Total adjustment on bond price if yield will
increase by 3% is 110.20 8.13 = 102.07
Total adjustment on bond price if yield will
reduce by 3% is 110.20 + 8.13 = 118.33
30
Yield
Duration
Convexit
y
Adjustm
ent
Bond
price
13%
110.20
8.13
102.07
820.71
7%
110.20
8.13
118.33
1041.11

Rate
Question- Duration
Calculate:
Macaulay's duration
Modified duration
Convexity
Bond price with duration and convexity adjustment
if yield will increase and decrease by 3%.
35
Bond FaceValue
Couponrate
YTM
Maturity
1000
10%
12%
5yrs
1000
10%
9%
7yrs

Rate
Bond A
Year
Cash flow
PV of cashflow
50
47.17
47.17
50
44.50
89.00
50
41.98
125.94
50
39.60
158.42
50
37.36
186.81
50
35.25
211.49
50
33.25
232.77
50
31.37
250.96
50
29.59
266.35
10
50
586.31
TOTAL
36

Rate
926.40
Duration cal
5,863.15
7,432.07
Mac duration = 4.01

Modified duration = 3.78
Duration adjustment @ 3% YTM changed
= 3.78 x 0.03 x 926.40

105.10
37

Rate
Period
1
2
3
4
5
6
7
8
9
10
38
Cashflow(Rs)
1
(1.06)t+2
t(t+1)CF
t(t+1)CF*
1/
(1.045)t+2
50.00
0.83961928
100
83.96
50.00
0.79209366
300
237.63
50.00
0.74725817
600
448.35
50.00
0.70496054
1000
704.96
50.00
0.66505711
1500
997.59
50.00
0.62741237
2100
1,317.57
50.00
0.59189846
2800
1,657.32
50.00
0.55839478
3600
2,010.22
50.00
0.52678753
4500
2,370.54
1,050.00
0.49696936
115500
Total
57,399.96

Rate
67,228.10
Convexity = (67228.10 / 926.40) /4
=18.14
Convexity adjustment
= 0.5 x18.14 x (0.03)2 x 926.40
=7.56
39

Rate
40
yiel
d
Bond price Duration

@ 12%
adjustme
nt
Convexity
adjustme
nt
Total
Changed
Adjustmen BP
t
9%
926.40
105.10
7.56
112.66
1039.06
15% 926.40
105.10
7.56
97.54
828.86

Rate
Bond B
Rs 1000
10% SA
9%
7 yrs
Macaulay's Duration
4.07
Modified Duration
3.90
Duration Adjustment
121.61
Convexity
19.06
8.92
Bond price @ 12%
1039.56 (121.61 -8.92) =

909.03
Bond price @ 6%
1039.56 + (121.61 +8.92) =

1170.09
41

Rate

Debt Market Session 9

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Debt Market Session 9

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Convexity

Convexity & Factors affecting Interest

Analysis of Bond Price

Bond Price Volatility

Price Yield Relationship for Six

Bond Price Volatility

Percentage Price Change

Bond Price Volatility

Price Volatility Characteristics of

bonds move in the opposite direction from

Bond Price Volatility

For large changes in the required yield, the

percentage price change is not the same

Bond Price Volatility

Characteristics of a Bond that Affect

free bonds that determine its price

Bond Price Volatility

Long maturities in portfolio:

volatility because they expect interest rate to fall, all

Short maturities in portfolio:

Bond Price Volatility

bond for the bond with the face value of Rs

Convexity & Factors affecting Interest

Convexity & Factors affecting Interest

Bond price = 1039.56

Convexity & Factors affecting Interest

Convexity & Factors affecting Interest

Convexity & Factors affecting Interest

The Importance of Convexity

actual price change in a bond and that

in price that is not explained by duration

Convexity & Factors affecting Interest

the shape of the

Convexity & Factors affecting Interest

Convexity & Factors affecting Interest

The relationship between the convexity,

coupon, maturity and yield of bond:

coupon and maturity are constant) are inversely

Convexity & Factors affecting Interest

Convexity & Factors affecting Interest

semi annually bond face value Rs 100

Convexity & Factors affecting Interest

Convexity & Factors affecting Interest

Convexity measures = conv cal / bond price /

Convexity & Factors affecting Interest

the initial yield and current market yield.

Convexity & Factors affecting Interest

rate is 8% compounding semi annually,

Convexity & Factors affecting Interest

Convexity & Factors affecting Interest

Duration = 7714.08 / 922.78 / 2

Convexity & Factors affecting Interest

Convexity & Factors affecting Interest

Convexity measures = conv cal / bond price

Convexity & Factors affecting Interest

Convexity & Factors affecting Interest

if 3% change in yield means bond price will

Convexity & Factors affecting Interest

if yield will increase and decrease by 3%.

Convexity & Factors affecting Interest

Convexity & Factors affecting Interest

Mac duration = 4.01

= 3.78 x 0.03 x 926.40