BEHAVIOR OF
MACAULAY’S
DURATION
HAZEL JANE G. ESCLAMADA - BSAIS 2C
Macaulay’s duration of a bond behavior can be summarized by a set of rules.
Rule 1: The duration of a zero coupon bond equals its time to maturity. Since a zero coupon
bond generates only one cash flow, the payment of principal at maturity, the average time to
the receipt of cash flows equals the time to that payment.
Rule 2: Holding time to maturity and redemption yield constant, duration is inversely
related to the coupon.
Rule 3: Holding the coupon rate constant, duration generally increases with time to
maturity.
Rule 4: Holding coupon and maturity constant, duration is inversely related to redemption
yield.
Rule 5: The duration of an irredeemable bond is given by (1 + r)/r, where r is the
redemption yield. If a bond pays the same coupon each period forever without the principal
ever being repaid, the duration equals (1 + r)/r.
EXAMPLE
A fund manager holds a 100-million Euro bond
portfolio comprising three bonds: A, B, and C. Bond A
has duration of four years and accounts for 25 Euro
million of the portfolio. Bond B has a duration of seven
years and accounts for 25 Euro million. Bond C, of which
50 Euro million is held, has duration of ten years. What is
duration of the portfolio?
SOLUTION AND ANSWER
• A = (1+4)/4 =1.25
• B = (1+7)/7 = 1.42
• C = (1+10/10 = 1.1
1.25 + 1.42 + 1.1 = 3.77
IMMUNIZATIO
N
• Bonds are used in institutional investment portfolios not only as
means of accumulating wealth but also as means of funding annuity
payments.
• Duration is also important for the structuring of bond index
tracker funds. If such a fund were to be constructed using
stratified sampling based on a cell structure, one of the
characteristics of a cell would be duration. Other characteristics
might be redemption yield and credit rating.
BOND
CONVEXITY
• Duration provides just an approximation to the relationship between yield
changes and bond price movements. The analysis of the price/yield
relationship for a bond together with a straight line representing duration (i.e.
price value of a basis point, PVBP), shows that for small changes in yield it is
sufficient.
• However, the actual price change is expressed by the curved price/yield
relationship. Thus for large yield changes, the duration line provides a poor
estimate of the actual price change. Duration underestimates price rises and
overestimates falls. In both cases the new bond price is underestimated. The
inaccuracies arise because money duration fails to take account of the
convexity (curvature) of the actual price/yield relationship of a bond.
Convexity is a measure of the change in duration with
respect to changes in interest rates.
• While constructing bond portfolios a bond portfolio manager should be
concerned with not only duration, but also convexity.
• Convexity has value in that it leads to higher bond prices following interest
rate movements, when compared with an investment with zero convexity.
• High convexity bonds provide this benefit to a greater extent than low
convexity bonds.
• The benefits of convexity are greater when interest rate changes are
relatively large. This implies that the portfolio manager needs to consider
the prospective size of interest rate movement as well as the direction
EXAMPLE
A bond has just paid a six-monthly coupon of 4 Euro. There
are four more coupons to be paid by maturity. How accurate
is modified duration for the purpose of estimating the effect
y3 y1 y2 Initial interest rate First & second derivatives First
derivative Interest rate Price e Price 67 of a (a) 0.2% p.a.,
and (b) 1% p.a., decrease in the redemption yield on the
bond price, when redemption yields are initially 2% p.a.
Comment on the results of the calculations.
EXPLANATION
• A bond with high convexity will tend to have a relatively low
redemption yield. The advantage from high convexity would be
offset by a lower yield. If interest rate movements are small, the
gains from convexity would not compensate for the low yield.
• Convexity is greatest for low coupon, long maturity, and low-
redemption-yield bonds (i.e. high duration bonds).Convexity can
be calculated and combined with measures of duration when
evaluating the potential effects of interest rate changes on bond
prices.
POSITIVE &
NEGATIVE
CONVEXITY
