FE 445 – Investment Analysis and Portfolio
Management
Fall 2020
Farzad Saidi
Boston University | Questrom School of Business
Chapter 18: Bond duration and
portfolio management
Duration
price
Duration: slope of price-yield
or P(y ) function
P0 B
As the yield changes, so does
the slope
Higher-duration bonds ⇒ more
P A sensitive to interest rate
changes!
y0 y
yield
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Duration: example
Consider a 1yr and a 10yr zero-coupon bond. The spot rate is r = 10%,
the par value is Par = $1, 000, and the market prices of the 1yr and 10yr
bond are P(1yr ) = $909.09 and P(10yr ) = $385.54
How does the price change if the spot rate moves to 11%?
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Duration: example
Consider a 1yr and a 10yr zero-coupon bond. The spot rate is r = 10%,
the par value is Par = $1, 000, and the market prices of the 1yr and 10yr
bond are P(1yr ) = $909.09 and P(10yr ) = $385.54
How does the price change if the spot rate moves to 11%?
Solution:
First, we need to calculate the new bond prices:
$1, 000
P(1yr ) = = $900.90
(1 + 0.11)1
$1, 000
P(10yr ) = = $352.18
(1 + 0.11)10
The return is then:
($900.90 − $909.09)
r (1yr ) = = −0.9%
$909.09
($352.18 − $385.54)
r (10yr ) = = −8.6%
$385.54
The drop in the 10yr bond is almost 10 times larger than for the 1yr
bond. Why?
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Macaulay duration
Duration is the weighted average of the times until each payment:
T
X
D= Wt × t
t=1
CFt = Cash Flow at time t:
T
X CFt
Pt = t
t=1
(1 + y )
Wt = weight of PV of time t cash flow in price
CFt /(1 + y )t
Wt =
P
Careful: We assume that the term structure is flat!
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Duration: example
3yr bond with 8% annual coupon and y = 10%
What is the duration of this bond?
year CF NPV weight t * weight
1 80 72.727 0.0765 0.0765
2 80 66.116 0.0696 0.1392
3 1,080 811.42 0.8539 2.5617
950.263 1 2.7774
The duration is less than maturity (in this case)!
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Duration and price changes
Price change is proportional to duration:
∆P ∆y
= −D ×
P 1+y
% price change increases in duration D
P, y : original price and yield before change
Modified duration:
D ∆P
D? = thus = −D ? × ∆y
1+y P
Dollar duration:
D$ = D ? × P thus ∆P = −D$ × ∆y
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Determinants of duration
All else equal...
Maturity effect:
Shorter maturity ⇒ lower duration
Coupon effect:
Higher coupon ⇒ lower duration (because coupons come earlier)
Yield effect:
Higher bond yield ⇒ lower duration (because later payments are
discounted more)
Except for zero-coupon bonds
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More on duration
Zero-coupon bonds:
The duration is equal to the maturity
Perpetuity:
Pays the same coupon C forever
In this case, the duration is as follows:
1+y C
Dperpetuity = Pperpetuity =
y y
Finite duration since far away payments heavily discounted
Not affected by the coupon C
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Problem
Consider a 2yr bond, 20% annual coupon, r = 10%, Par = $1, 000
a) What is the duration of the bond?
b) Price change if r increases by 50bps
c) Price change if r decreases by 100bps?
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Pricing error due to convexity
Consider a 25yr bond, C = 6%, y = 6%, and D ? = 10.62
Dy Predicted Actual
+1bp -0.11% -0.11%
-1bp 0.11% 0.11%
+200bp -21.24% -18.03%
-200bp 21.24% 25.46%
Conclusions:
Duration is a great approximation for small yield changes
However, it is not appropriate for large changes
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Pricing error due to convexity
Duration is only an approximation, more precise formula:
∆P ∆y 1
= −D × + × Convexity × ∆y 2
P 1+y 2
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Duration of a portfolio
Portfolio duration: X
DP = w i Di
wi : portfolio weight of bond i
Di : duration of bond i
Formula holds if y common for all bonds, otherwise only true for
modified duration
Example:
You have a $10 million portfolio consisting of $5 million bonds with
D1 = 2 years and $5 million bonds with D2 = 10 years. What is the
portfolio duration?
Portfolio: DP = 0.5 × 2 + 0.5 × 10 = 6 years
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Defined benefit pension funds
Liabilities:
Fixed payments to pensioners far in the future, e.g., $20,000 every
year for the next 30 years
Assets:
Bonds with different maturities
Problem:
If interest rates changes might become underfunded!
Solution: immunize interest rate risk.
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Cash flow matching
Definition: Match cash flows in each year with zero-coupon bonds
Pros:
Shortfall impossible: assets = liabilities always
Automatically immunizes a portfolio from interest rate movements:
set and forget
Cons:
Very long maturity bonds hard or impossible to find
Severely limits choice of bonds
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Immunization
Idea: Investor’s equity does not change even if y changes
1. Immunize: choose portfolio s.t. DL = DA
2. Fully fund: choose $ amounts s.t. A = L
Remarks:
Requires periodic rebalancing of the portfolio
Not perfect because of convexity
If not fully funded, set duration gap = 0:
liabilities
Dgap = Dassets − × Dliabilities ≡ 0
assets
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Example
Obligation: $2 million per year perpetuity
y = 16% on all bonds:
5 year bond, C = 12% (annual), D = 4 years
20 year bond, C = 6% (annual), D = 8 years
Construct a fully funded immunized portfolio!
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Case study: Fannie
In August 2002 Fannie’s Duration Gap was –1.17 years:
D(assets) < D(liabilities)
Fannie’s target duration gap is +/- 6 months
Fannie’s Balance Sheet (in billions as of Dec 2002):
Assets Liabilities & Equity
mortgages $798 bonds (L) $871
other $89 Equity (E) $16
total $887 total $887
On November 6, y = 6% fell by 50bps
∆E ∆y −0.005
= −Dgap × = −(−1.17) × = −55bps
A 1+y 1 + 0.06
Loss: 0.55% × $887 = $4.9 billion, which is 30% of equity!
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More advanced models
We assumed:
Flat yield curve
Only parallel shifts in the yield curve ⇒ single factor drives entire
yield curve
Multifactor Models for bond prices:
All rt matter!
More than one factor might drive the yield curve
Typical factors:
1. Level
2. Slope
3. Curvature
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Summary
This class:
Bond prices sensitive to interest rate changes, measured according
to duration
In bond portfolios, you want to match duration of assets and
liabilities
Additional reading:
[Link]/en-us/resources/education/understanding-duration/
Next class:
Default risk
Credit default swaps
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