Duration, convexity and other bond risk measures offers the most comprehensive coverage of bond risk measures available. Bond prices change inversely with interest rates, and, hence, there is interest rate risk with bonds. Bond duration calculator macaulay duration and modified macaulay duration. This paper aims to show the two methods of measuring the interest rate risk duration and convexity. Bond duration and convexity spreadsheet the bond duration worksheet allows you to calculate the duration of a bond quickly and easily. The equation for bond price at time zero is the discounted value of expected future cash ow. Coupon payment frequency pf this field indicates whether the coupon is paid annually or semiannually. Duration and convexity are two tools used to manage the risk exposure of fixedincome investments. They also enter into measures for interest rate risk, as shown in this paper. What this means is that for a given change in the interest rate in either direction, the extent of change in the bond price will also be similar. As a general rule, the price of a bond moves inversely to changes in interest rates. These measures are normally used to gauge how sensitive a bonds price is to a change in interestrate levels. The concept of duration is a good indicator of changes in the price of bonds but only for small changes in the interest rates.

Bond duration is an investment concept that few average investors truly understand, yet it can have a meaningful impact on how your bond mutual fund or fixed income portfolio performs relative to the bond market as a whole. The greater the duration, the more is the sensitivity to interest rate changes, which in turn means. Convexity of a bond can be defined as a measurement of the curvature in relation to changes in interest rates which shall affect the changes in the price of a bond and further it does so by measuring the duration changes, as the market interest rates fluctuate. Convexity is a measure of the curvature, or the degree of the curve, in the relationship between bond prices and bond yields. Interest rate risk, reinvestment risk, liquidation risk, macaulay duration, modified duration, convexity, targetdate immunization, networth immunization, duration gap. Duration, modified duration, and convexity reflect the bond.

To improve the estimate of the bond price based on duration, we can add a term based on the convexity measure. Duration assumes linear relationship between bond price and interest rate changes. On top of that, if we assume two bonds will provide the same duration and yield then the bond with the greater convexity will be less affected. These are the effective duration and convexity statistics obtained by shifting the benchmark treasury yield curve. However, if we recalculate the bond price at the new rate 6. As expected, the maxima calculations do indeed confirm the quantlib duration and convexity calculations, which is a good thing. Longterm bonds have greater interest rate risk than short term bonds.

Although technically a bond is a fixedincome security with a maturity of ten years or more, in this tutorial we use the term bond and fixedincome security interchangeably. If interest rates applicable for discounting fall rise, both va and vl will increase decrease. First, we introduce a model based representation of what the portfolio convexity should be using a simple vasicek setting followed by a general multifactor a ne set up. Pdf hedging bond positions under the assumption of a parallel shift of the interest rate curve is wellknown and used for a long date in finance. The coupon rate is typically stated in an annual percentage. On one hand, in the case of a callable bond, a change in interest rates may trigger the calling of the bond, thus stopping the flow of future coupons. Bond prices and yields move in opposite directions. Some evidence suggests that the yield curve is more curved when volatility is higher and convexity is worth more. An appendix proves the differential approach is equivalent to the traditional approach equation. Bond duration and convexity gary schurman, mbe, cfa october 15, 2009 bond duration and convexity are measures of the sensitivity of bond price to interest rate i. Common stock duration and convexity gary schurman, mbe, cfa october 20, 2009 common stock duration and convexity are measures of the sensitivity of stock price to changes in discount rate.

Download spreadsheet duration, convexity and price yield curve. Working with convexity and sensitivity interest rate risk. Duration measures the bonds sensitivity to interest rate changes. Convexity demonstrates how the duration of a bond changes as the.

As an example, consider a coupon bond that has a coupon rate of r, a face or par value of f, and a maturity of n. A bond is an instrument of indebtedness that obliges the bond issuer borrower to repay the lender creditor the borrowed assets plus the interest within a certain period of time fabozzi, 2000, p. Simple maturity, macaulay duration effective maturity, modified duration, and convexity. Convexity relates to the interaction between a bonds price and its yield as it experiences changes in interest rates.

The use of convexity matching, in addition to duration matching, is an attempt to explain the price sensitivity in a better fashion. Duration of a bond is a measure often used to assess the risk involved with the bond instrument. However, as concepts, both duration and convexity have wider application. In finance, bond convexity is a measure of the nonlinear relationship of bond prices to changes in interest rates, the second derivative of the price of the bond with respect to interest rates duration is the first derivative.

Combining the basics, the underlying math, a practical perspective on the relative size of duration error, and. However, also implicit in the convexity measure is the assumption of parallel shifts in yields and, therefore, the duration convexity. Understanding duration and convexity of fixed income. The effective convexity is the difference in dollar durations for a movement in both directions and is positive if the duration increases as. Sensitivity analysis duration and convexity finance train. Determine how much money you would accumulate by investing a given amount of money at a fixed annual rate of return at recurring intervals. Common misunderstandings concerning duration and convexity.

Nawalkha in our experience, most finance students are unnecessarily confused by the roles that duration and convexity play in the traditional textbook plot of bond price versus bond yield. The priceyield relationship investors who own fixed income securities should be aware of the relationship between interest rates and a bonds price. As the yield on a bond changes so too does its duration, a bonds convexity measures the sensitivity of a bonds duration to changes in yield. Duration and convexity of zerocoupon convertible bonds. Duration of a bond university of california, davis. There are four measures of bond price sensitivity that are commonly used. In calculating the duration of a bond, we convert the maturity of a given bond to the maturity of an equivalent zero coupon bond. Estimate the percentage price change of a bond for a specified change in yield, given the bonds approximate duration and convexity. In general, the higher the duration, the more sensitive the bond price is to the change in interest rates. What is the difference between duration and convexity of a. May 30, 2015 duration assumes linear relationship between bond price and interest rate changes. For a bond of face value usd1,000 with a semiannual coupon of 8.

Effective duration and convexity are duration and convexity measures that capture the effects of price movements in both the up and down scenarios. Bond price is a function of time t and discount rate k. Price change of a bond duration convexity cfa level. Investors tend to shy away from discussions of bond duration because the underlying math is relatively difficult. Application of the concepts of duration and convexity to portfolio will be clari. For investors who hold bonds, the issue of how sensitive a bonds price is to changes in the required rate of return is important. Understanding duration and convexity of fixed income securities vinod kothari notation y. Bond duration calculator macaulay duration and modified. Common misunderstandings concerning duration and convexity timothy falcon crack and sanjay k. Those risk statistics are considerably higher than the modified yield duration of 27. Duration measures the bond s sensitivity to interest rate changes. Convexity builds on the concept of duration by measuring the sensitivity of the duration of a bond as yields change.

One of the most common computations of duration is mccauley duration d. Hence, we multiply the convexity by 2 to obtain the convexity adjustment. Note that the second term in the taylor expansion contains the coef. Convexity is a better measure of interest rate risk, concerning bond duration. For most investors, the primary importance of bond duration is that it predicts how sharply the market price of a bond will change as a result of changes in interest rates. As the yield on a bond changes so too does its duration, a bond s convexity measures the sensitivity of a bond s duration to changes in yield. Bond duration and convexity introduction continued economics of capital markets version 1. Bond duration and convexity applied business economics.

Duration and convexity, with illustrations and formulas. This, perhaps, has to do with the history of fixed income investments, when investors used to approximate the sensitivity by looking at the weighted average time for which money is invested. Approximate modified duration is 9 years and approximate convexity is 105. In addition to computing the change in a bond s price due to a given change in yield, modified duration and convexity can be combined to give the approximate. A subordinated debenture is an unsecured bond that is junior to senior unsecured bonds, and hence there is more uncertainty pertaining to these securities. Duration, convexity and managing bond portfolios key takeaways. An investment bank holds a considerable position in a 7% annual coupon payment bond.

Lecture 11 duration, convexity and immunisation reading. The overall effect is to shorten duration, while the effect on convexity is ambiguous. Scribd is the worlds largest social reading and publishing site. Pdf enhancement of the bond durationconvexity approximation.

Convexity, ultimately, dominates at the long end of the yield curve. This would explain why the term structure is often hump. Analysts should be aware that duration is only an estimate, and convexity can be used in conjunction with duration to arrive at a more accurate estimation of a bonds future price. The shorter the maturity of a bond, and the higher its yield, the shorter its duration. Convexity note that duration says the bond price will rise by 5. It can be used to account for the inaccuracies of the modified duration approximation. Macauley duration modified duration effective duration percentage change in price for a 1% increase in the yield to maturity problem 2 consider a bond that has a coupon rate of 7. Financial expert frank fabozzi walks you through every aspect of bond risk measures from the price volatility characteristics of optionfree bonds and bonds with embedded options to the proper method for calculating duration and convexity. For a 25bps change in yield, what is the approx price change for a bond with the following characteristics. The purpose of this research is examined duration and convexity to measure the bond price sensitivity towards changes in interest rate. Taking the second derivative of the duration expression and again dividing by the bond price p gives us the formula for convexity. For the calculation not on a coupon date, this is the bond s quoted price plus accrued interest i. The video uses a comprehensive example to demonstrate how macaulay duration is calculated, and it explains how macaulay duration is used to compare the interest rate risk of different bonds.

Bond duration and convexity simplified part 2 of 2. Traditional approach bond pricing is a relatively straight forward application of the discounted cash flow. Apr 06, 2020 to demonstrate how to calculate duration and convexity for specific us treasuries we select instruments from recent us treasury bill, note and bond auctions. The approximate change using both dollar duration and convexity is. Pdf duration and convexity of bonds slobodan cerovic. This form of active hedge management both dynamic delta hedging as well as outright purchase of options has had a pronounced impact on the bond markets. One method of measuring interest rate risk due to changes in market interest rates is by the full valuation approach, which simply calculates what bond prices will be if the interest rate changed by specific amounts. Here is an example of calculate approximate duration for a bond.

Bond convexity is defined formally as the degree to which the duration changes when the yield to maturity changes. Modified duration for downloadable excel spreadsheets on duration and convexity calculation examples and pdf files on asset liability management and risk management, please see the online finance course store. Bond duration and convexity introduction continued bond duration and convexity introduction continued economics of capital markets version 1. Sep 06, 2019 the modified duration alone underestimates the gain to be 9. Bond portfolio immunization example how to immunize bond. We have derived closedform expressions for duration and convexity of zerocoupon convertibles, incorporating the impact of default risk, conversion option, and subordination. In this essay, we study bond portfolio convexity and we do so from three di erent perspectives. The price movements are of course of the same magnitude. Convexity formula how to calculate convexity of a bond. Convexity is always lurking at the scene of the crime. Fourth, the differential approach pedagogic insight into the more sophisticated bond valuation duration and convexity concept is demonstrated.

Convexity describes the relationship between price and yield for a standard, noncallable bond. Bond price face value coupon rate life in years yield frequency macaulay duration modified. To give some perspective, over the past two years, the oad of the mbs index has shortened by 2. Duration and convexity 3 also referred to as debentures. Annuity factors simplify valuation of level cash flows, such as the coupon payments of bonds. Duration is an imperfect way of measuring a bonds price change, as it indicates that this change is linear in nature when in fact it exhibits a sloped or convex shape. Price change of a bond duration convexity cfa level 1. The discount rate is the riskfree interest rate plus a premium for risks applicable to holding common stock. Convexity measures bond price and bond yield relationships. Analyzing yield, duration and convexity of mortgage loans. Why is the sensitivity referred to as duration and not the beta of the bond or similar name. This video illustrates how duration can be used to approximate the change in bond price given a change in interest rates. Duration and convexity are important measures in fixedincome portfolio management.

I hope you have gained a new appreciation for how duration and convexity are employed to help assess the riskiness of a bond and reprice a bond when interest rates change. It is the effective duration in years or maturity time, in which the bond price is repaid by the internal cash flows. Convexity 7 the convexity correction is always positive suppose the 20year rate fell 100 bp 5. Duration is an imperfect way of measuring a bond s price change, as it indicates that this change is linear in nature when in fact it exhibits a sloped or convex shape.

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