Duration and Convexity: Measuring Interest Rate Risk

Thien T. Nguyen

Fisher College of Business

The Ohio State University

Nguyen (Ohio State) Duration & Convexity 1 / 34

 Introduction

Introduction

• Today, we will focus on the sensitivity of Treasury bond prices to

changes in interest rates.
• Let’s consider a specific example:
• 10-year coupon bond
• 8% coupons, paid semi-annually
• 6% yield-to-maturity, semi-annually compounded

Nguyen (Ohio State) Duration & Convexity 2 / 34

 Prices and Yields

Pricing Bonds

40 40 40 1000
Bond price = + 2
+ ... + 20
+
1.03 1.03  1.03
 1.0320
1 1 1000
= 40 × 1− +
0.03 1.0320 1.0320
= 1148.77

We can calculate the bond price for a number of different yields...

Nguyen (Ohio State) Duration & Convexity 3 / 34

 Prices and Yields

Bond Price for Other Yields

yield price yield price

0% 1800 8% 1000
1% 1664.56 9% 934.96
2% 1541.37 10% 875.38
3% 1429.22 11% 820.74
4% 1327.03 12% 770.60
5% 1233.84 13% 724.54
6% 1148.77 14% 682.18
7% 1071.06 15% 643.19

Nguyen (Ohio State) Duration & Convexity 4 / 34

 Prices and Yields

Price-Yield Relation

Nguyen (Ohio State) Duration & Convexity 5 / 34

 Duration

Duration

There are two duration concepts that different books discuss:

• The average time-to-payment for a fixed income security (often called
a Macaulay Duration)
• The (negative of the) percent sensitivity of the price of a fixed income
security to a level change in interest rates (often called a Modified
Duration).
• This is the definition that Veronesi and other Fixed Income books focus
on.

Nguyen (Ohio State) Duration & Convexity 6 / 34

 Duration

Duration as the Weighted-Average Time-to-Payment

nT
D= ∑ wτ × τ/n
τ =1
CFτ /(1 + yn /n )τ
where wτ =
Bond Price
Comments:
• CFτ /(1 + yn /n)τ is the present value of the cash flow at time τ.
• ∑nT
τ =1 CFτ / (1 + yn /n ) is the value of the bond.
τ

• ∑nT
τ =1 wt = 1
• yn is the per year n-times compounded yield.

Nguyen (Ohio State) Duration & Convexity 7 / 34

 Duration

Macaulay Duration Example

Consider the 10-year coupon bond from before:

time period payment PV of payment w w × period /2
0.5 1 40 38.83 0.0338 0.0169
1 2 40 37.70 0.0328 0.0328
1.5 3 40 36.61 0.0319 0.0478
2 4 40 35.54 0.0309 0.0619
...
8.5 17 40 24.20 0.0211 0.1791
9 18 40 23.50 0.0205 0.1841
9.5 19 40 22.81 0.0199 0.1886
10 20 1040 575.82 0.5012 5.0125
1148.77 7.2863

The Macaulay Duration is 7.29 years.

Note: We could also define Macaulay Duration in terms of period.

Nguyen (Ohio State) Duration & Convexity 8 / 34

 Duration

Modified Duration: Duration as a Sensitivity

dB 1 % change in bond price

MD = − ≈−
dy B change in interest rates
|{z}
Derivative of B wrt y

Put in words:
If interest rates increase by 1 percentage point, then the bond price
decreases by approximately MD%.

dB 1
MD = −
B dy
dB
⇒ = −MD × dy
B
|{z} |{z}
=1%
Percent change

Nguyen (Ohio State) Duration & Convexity 9 / 34

 Duration

How to Calculate Modified Duration?

– Use Approximation for a Small Change in Yield

% change in bond price

MD ≈ −
change in interest rates
B (y + ∆y ) − B (y − ∆y ) 1
≈− ×
2 × ∆y B (y )
where ∆y is small

• In this class, we always use ∆y = .1%.

• Notation: ∆y v.s. dy

Nguyen (Ohio State) Duration & Convexity 10 / 34

 Duration

Duration as a Sensitivity

Let’s consider our 10-year bond.

• 8% coupon rate (4% every half-year)
• 6% yield (3% every half-year)

B(y = 3% per half year) = 1148.77

B(y = 3.1% per half year) = 1132.6677
B(y = 2.9% per half year) = 1165.1756
−1165.1756
MD ≈ − 1132.6677
2×0.001
1
× 1148.77 = 14.15
(using half-year interest rates)
• If the half-year interest rate goes up by 1 percentage point, the bond
price drops by approximately 14.15%.
Convexity

Nguyen (Ohio State) Duration & Convexity 11 / 34

 Duration

Duration as a Sensitivity

When calculating the modified duration, you can use any unit of interest
rate that you want.
For example, we can re-do our calculation using annual yields:
• 8% coupon rate (4% every half-year)
• 6% yield

B(y = 6% per year) = 1148.77

B(y = 6.1% per year) = 1140.6849
B(y = 5.9% per year) = 1156.9381
−1156.9381
MD ≈ − 1140.6849
2×0.001
1
× 1148.77 = 7.07 (using full year interest rates)
• If the annual interest rate goes up by 1 percentage point, the bond
price drops by approximately 7.07%.

Nguyen (Ohio State) Duration & Convexity 12 / 34

 Duration

Properties Duration

Source: Veronesi’s Table 3.2

• Higher coupon rate → lower duration

• Lower average time of cash flow
• Lower sensitivity to interest rates
• Higher interest rate → lower duration
• Why?

Nguyen (Ohio State) Duration & Convexity 13 / 34

 Duration

The Link Between Macaulay Duration and Modified

Duration
• For a fixed-coupon bond without option-like features

Macaulay Duration
MD =
1 + yn /n

• For a zero-coupon, option-free bond, the Macaulay duration is equal to the

maturity of the bond. Thus,
T
MD =
1 + yn /n

• Note 1: T is in years, n is the frequency of compounding, and yn is annual,

n-times compounded yield.
• Note 2: Macaulay Duration is in terms of year, so the MD given by the
formula is MD with respect to annual yield change.

Nguyen (Ohio State) Duration & Convexity 14 / 34

 Duration

Using Modified Duration to Approximate Price Changes

B(y = 3% per half-year) = 1148.77

MD ≈ 14.15 (using half-year interest rates)

Recall:
dB
≈ −MD × dy
B
Equivalently:
% change in bond price ≈ −MD × change in yield

If dy = 0.5%, then
% change in bond price ≈ −14.15 × 0.5% = −7.075%

Nguyen (Ohio State) Duration & Convexity 15 / 34

 Duration

Using Modified Duration to Approximate Price Changes

• If dy = 0.5%, that means that the semi-annual rate increases to

3.5%.
• B(y = 3.5% per half-year) = 1071.06
Exact calculation:
dB 1071.06 − 1148.77
= = −6.76%
B 1148.77

Convexity Approximation

Nguyen (Ohio State) Duration & Convexity 16 / 34

 Duration

Using Modified Duration to Approximate Price Changes

We can also do the comparison in dollars:

• At an annual yield of 6%, the price of the bond is 1148.77.
• At an annual yield of 7%, the price of the bond is 1071.06.
• The modified duration approximation says that if the half-year yield
increases by 0.5 percentage points, the % price change is
−14.15 × 0.5% = −7.075%.
• The approximate new price is 1148.77 × (1 − 0.07075) = 1067.50.

The modified duration approximation is off by about $3.50.

Nguyen (Ohio State) Duration & Convexity 17 / 34

 Duration

How Well Does Modified Duration Do?

Yield Yield dy (1/2yr) MD approx Actual
(1/2yr)
0 0 -0.03 1636.39 1800
0.01 0.005 -0.025 1555.12 1664.56
0.02 0.01 -0.02 1473.85 1541.37
0.03 0.015 -0.015 1392.58 1429.22
0.04 0.02 -0.01 1311.31 1327.03
0.05 0.025 -0.005 1230.04 1233.84
0.055 0.0275 -0.0025 1189.41 1190.34
0.059 0.0295 -0.0005 1156.90 1156.94
0.061 0.0305 0.0005 1140.65 1140.68
0.065 0.0325 0.0025 1108.14 1109.05
0.07 0.035 0.005 1067.50 1071.06
0.08 0.04 0.01 986.24 1000
0.09 0.045 0.015 904.97 934.96
0.1 0.05 0.02 823.70 875.38
0.11 0.055 0.025 742.43 820.74
0.12 0.06 0.03 661.16 770.60

Nguyen (Ohio State) Duration & Convexity 18 / 34

 Duration

How Well Does Modified Duration Do?

Nguyen (Ohio State) Duration & Convexity 19 / 34

 Duration

Modified Duration when the Term Structure is Not Flat

Consider a zero-curve (annually compounded) of

t 1 2 3 4 5
r 2% 3% 5% 6% 8%

Price a 5-year bond with a coupon rate of 4%, paying coupons annually,
and having a face value of $1000.
40 40 1040
Bond price = 1.02 + 1.032
+ ... + 1.085
= 850.9633

Nguyen (Ohio State) Duration & Convexity 20 / 34

 Duration

Modified Duration when the Term Structure is Not Flat

• The modified duration is defined as the (negative of) percentage

change in the bond price with a small level change in interest rates.
• For example, suppose that we change the term structure to:

t 1 2 3 4 5
r 2.1% 3.1% 5.1% 6.1% 8.1%
40 40 1040
Bond price = 1.021 + 1.0312
+ ... + 1.0815
= 847.3662

Nguyen (Ohio State) Duration & Convexity 21 / 34

 Duration

Modified Duration when the Term Structure is Not Flat

Now, let’s consider a term structure of

t 1 2 3 4 5
r 1.9% 2.9% 4.9% 5.9% 7.9%
40 40 1040
Bond price = 1.019 + 1.0292
+ ... + 1.0795
= 854.5799

B (y + ∆y ) − B (y − ∆y ) 1
MD ≈ − ×
2 × ∆y B (y )
847.3662 − 854.5799 1
≈− ×
2 × 0.001 850.9633
≈ 4.2385

Nguyen (Ohio State) Duration & Convexity 22 / 34

 Duration

Modified Duration of a Portfolio

MDportfolio = w1 × MDbond 1 + w2 × MDbond 2 + ... + wN × MDbond N

where the weights are based on the proportion of the overall portfolio
value from each bond

Let’s actually use the term structure example we considered previously to

illustrate how to use this formula.

Nguyen (Ohio State) Duration & Convexity 23 / 34

 Duration

Modified Duration of a Portfolio

Recall that we were looking at a bond with the following terms:

• Face value $1000
• 4% coupon rate, coupons paid annually
• 5 years-to-maturity
The zero-curve (annually compounded) was given as:

t 1 2 3 4 5
r 2% 3% 5% 6% 8%

Let’s break our bond into five zero-coupon bonds...

Nguyen (Ohio State) Duration & Convexity 24 / 34

 Duration

Modified Duration of a Portfolio

Zero-coupon bonds from our coupon bond

Maturity discount Face value Price Modified
rate Duration
1 2% 40 39.22 0.9804
2 3% 40 37.70 1.9417
3 5% 40 34.55 2.8571
4 6% 40 31.68 3.7736
5 8% 1040 707.81 4.6296

Nguyen (Ohio State) Duration & Convexity 25 / 34

 Duration

Modified Duration of a Portfolio

Maturity discount Face Price Modified w w ×

rate value Dura- MD
tion
1 2% 40 39.22 0.9804 0.0461 0.0452
2 3% 40 37.70 1.9417 0.0443 0.0860
3 5% 40 34.55 2.8571 0.0406 0.1160
4 6% 40 31.68 3.7736 0.0372 0.1405
5 8% 1040 707.81 4.6296 0.8318 3.8508
850.9633 4.2385

Nguyen (Ohio State) Duration & Convexity 26 / 34

 Convexity

Improving on Modified Duration

Let’s go back to our 10-year bond from earlier.

dB
≈ −MD × dy
B
Nguyen (Ohio State) Duration & Convexity 27 / 34
 Convexity

Convexity: Improving on Modified Duration

d 2B 1
Convexity = C =
dy 2 B
|{z}
Second derivative

You can approximate convexity using:

B (y + ∆y ) + B (y − ∆y ) − 2 × B (y ) 1
C ≈ ×
(∆y ) 2 B (y )

For a zero-coupon bond

T (T + 1/n )
(1 + yn /n)2
where n is the frequency of compounding.
Nguyen (Ohio State) Duration & Convexity 28 / 34
 Convexity

Approximating Bond Price Changes

We can now approximate bond price changes more precisely by using

dB 1
≈ −MD × dy + C × (dy )2
B 2

Nguyen (Ohio State) Duration & Convexity 29 / 34

 Convexity

Calculating Convexity

Recall that our previous example:

• 8% coupon rate (4% every half-year)
• 6% yield (3% every half-year)

B(y = 3% per half year) = 1148.774749

B(y = 3.1% per half year) = 1132.667667
B(y = 2.9% per half year) = 1165.175574
1132.667667+1165.175574−2×1148.774749 1
C ≈ 0.0012
× 1148.774749 = 255.70

If the yield goes from 3% per half-year to 3.5% per half-year,

dB 1 2
B ≈ −14.15 × 0.005 + 2 × 255.70 × 0.005 = −0.06755

Bond Prices Actual Change

Nguyen (Ohio State) Duration & Convexity 30 / 34

 Convexity

How Much Does Adding Convexity Help?

Yield Yield dy MD ap- Including Actual
(1/2yr) (1/2yr) prox Convex-
ity
0 0 -0.03 1636.39 1768.58 1800
0.01 0.005 -0.025 1555.12 1646.92 1664.56
0.02 0.01 -0.02 1473.85 1532.60 1541.37
0.03 0.015 -0.015 1392.58 1425.63 1429.22
0.04 0.02 -0.01 1311.31 1326.00 1327.03
0.05 0.025 -0.005 1230.04 1233.72 1233.84
0.055 0.0275 -0.0025 1189.41 1190.33 1190.34
0.059 0.0295 -0.0005 1156.90 1156.94 1156.94
0.061 0.0305 0.0005 1140.65 1140.68 1140.68
0.065 0.0325 0.0025 1108.14 1109.06 1109.05
0.07 0.035 0.005 1067.50 1071.18 1071.06
0.08 0.04 0.01 986.24 1000.92 1000
0.09 0.045 0.015 904.97 938.01 934.96
0.1 0.05 0.02 823.70 882.44 875.38
0.11 0.055 0.025 742.43 834.22 820.74
0.12 0.06 0.03 661.16 793.34 770.60

Nguyen (Ohio State) Duration & Convexity 31 / 34

 Convexity

Applying Convexity

Nguyen (Ohio State) Duration & Convexity 32 / 34

 Convexity

Convexity of a Portfolio

Similar to Modified Duration:

Cportfolio = w1 × Cbond 1 + w2 × Cbond 2 + ... + wN × Cbond N

where the weights are based on the proportion of the overall portfolio
value from each bond

Nguyen (Ohio State) Duration & Convexity 33 / 34

 Convexity

Portfolios

dB 1
≈ −MD × dy + C × (dy )2
B 2
If a portfolio has a 0 duration and a 0 convexity, how sensitive is it to level
changes in interest rates?

Nguyen (Ohio State) Duration & Convexity 34 / 34