Advanced Financial Concepts

and Models
Main References:
• Zvi Bodie, Alex Kane and Alan Marcus. Investments.
10/11/12th Edition. McGraw Hill
• John C. Hull. Options, Futures, and Other Derivatives.
7/8th Edition. Pearson

1
 Contents
• Part I: Managing Bond Portfolios and Term Structure of Interest Rates
• Interest Rate Risk, Duration, and Convexity
• The Term Structure of Interest Rates and Related Theories
• Part II: Standard Portfolio Theory and Practice
• Risk Aversion and Capital Allocation across Risky Portfolio and Risk-free Assets
• Optimal Risky Portfolios and Markowitz’s Model Portfolio Theory
• Risk Pooling, Risk Sharing, and the Risk of Long-Term Investments
• Part III: Fundamentals of Financial Derivatives
• Futures and Forward Contracts
• Swaps
• Standard Option Theory
• Other Derivatives

2
 Review: Bond Characteristics

• We shall first briefly review the main

characteristics of bonds, as they are crucial for
the subsequent topics
• Bonds are debt that obligate issuers
(borrowers) to bondholders (creditors)
• Face value: Face or par value is the principal repaid
at maturity
• Coupon rate: The coupon rate determines the
interest payment (“coupon payments”) paid
semiannually

3
 Bond Pricing

PB = 
T
C + Par Value
t T
t=1 (1+r) (1+r)
• PB = Price of the bond
• C = Interest or coupon payments
• T = Number of periods to maturity
• r = Semi-annual discount rate or the semi-annual
yield to maturity

4
 Bond Prices and Yields

• Prices and yields have an inverse relationship

• The bond price curve is convex
• The longer the maturity → the more sensitive
the bond’s price to changes in market interest
rates

5
The Inverse Relationship Between Bond
Prices and Yields

• Bond prices fall as market

interest rates rise

• The bond price curve is

convex. It becomes flatter
at higher interest rates

6
 Bond Prices at
Different Interest Rates

Main observation: The longer the maturity of the bond, the greater the sensitivity of price to
fluctuations in the interest rate

7
 Bond Yields: Yield to Maturity

• Yield To Maturity (YTM): Interest rate that

makes the present value of the bond’s
payments equal to its current price

• → Solve the bond formula for YTM = r in the

following equation:
PB = 
T
C +
Par Value
t T
t=1 (1+r) (1+r)

8
Advanced Concepts and Models in
Finance
Part I: Managing Bond Portfolios and
Term Structure of Interest Rates

9
Interest Rate Risk, Duration, and
Convexity

10
 Overview

• Interest rate risk

• Interest rate sensitivity of bond prices: the
sensitivity of bond prices to interest rate
fluctuations
• Duration and its determinants
• Convexity

11
 Characteristics of Interest
Rate Sensitivity (1 of 2)
From the price formula and characteristics of
bonds, we know that:

1. Bond prices and yields are inversely related

2. An increase in a bond’s yield to maturity → smaller

price change than a decrease of equal magnitude (the
price curve is convex)

3. Long-term bonds tend to be more price sensitive than

short-term bonds

12
 Characteristics of Interest
Rate Sensitivity (2 of 2)
4. As maturity increases, price sensitivity increases
at a decreasing rate

5. Interest rate risk is inversely related to the

bond’s coupon rate

6. Price sensitivity is inversely related to the yield

to maturity at which the bond is selling

13
Change in Bond Price as a Function
of Change in Yield to Maturity

Question: Check and compare A, B, C, D, and see how the aforementioned 14

six properties can be illustrated in this Figure!

 Prices of 8% Coupon Bond
(Coupons Paid Semiannually)

For Coupon Bond:

Example on how a change in YTM influences the bond price at

different times to maturity T

15
 Prices of Zero-Coupon Bond
(Semiannual Compounding)

For Zero-Coupon Bond:

Example on how a change in YTM influences the price (of zero-

coupon bond) at different times to maturity T

16
 Duration
• → Summary: Maturity is a major determinant of interest
rate risk. However, maturity alone is not sufficient to
measure interest rate sensitivity → New measure is needed:
Duration

• Duration: A measure of the effective maturity of a bond. It is

the weighted average of the times until each payment is
received
• The weight for each payment is proportional to the
present value of the payment
• Duration = Maturity for zero coupon bonds
• Duration < Maturity for coupon bonds

17
 Duration Calculation

• (Macaulay’s) Duration calculation:

T
D=  t w t

t =1
CFt (1+ y )
t
the weighted average
wt = of the times t
P
CFt = Cash Flow Received at Time t
P = Price of Bond
y = Yield to Maturity

18
 Interest Rate Risk

• Duration-Price Relationship
• Price change is proportional to duration

 P = − D    ( 1+ y ) 
P  1 + y 
• → Define D* = Modified duration such that:

P = − D * y
P

19
 Remarks
• Modified duration (often used by practitioners) is defined as:

D * = D / ( 1 + y)

• And for the change, note that:

 ( 1+ y)=  y

• The percentage change in bond price is just the product of modified

duration D*and the change in the bond’s yield to maturity → D* is a
measure of the bond’s exposure to interest rate risk

20
 Example: Duration and Interest Rate
Risk (1 of 3)
• Assume two bonds have duration D = 1.8852 years
• Bond A: 2-year to maturity, 8% coupon bond with
YTM = 10% (i.e., with a per semiannual period
interest rate y = 5%)
• Bond B: Zero coupon bond maturing in 1.8852
years
• Duration of both bonds is 1.8852 × 2 = 3.7704
semiannual periods
• → Modified duration D* = D / ( 1 + y ) = 3.7704/(1 +
0.05) = 3.591 periods

21
 Example (cont.):
(2 of 3)

• Now, suppose the semiannual interest rate increases

by 0.01%. → Bond prices fall by
P = − D * y
P
= - 3.591 × 0.01%
= - 0.03591 %
• Two Bonds with equal D have the same interest rate
sensitivity (at least for a small change in interest rate)

22
 Example (cont.):
(3 of 3)

Coupon Bond Zero-Coupon Bond

• The coupon bond price • The zero-coupon bond
drops from $964.540 to price drops from
$964.1942, when its $831.9704
semiannual yield ($1,000/1.053.7704) to
increases to 5.01% $831.6717
($1,000/1.05013.7704)

• Percentage decline of • Percentage decline of

0.0359% 0.0359%

23
 Duration Rules
(1 of 2)

What Determines Duration?

• Rule 1
• The duration of a zero-coupon bond equals its time to
maturity
• Rule 2
• Holding maturity constant, a bond’s duration is higher
when the coupon rate is lower
• Rule 3
• Holding the coupon rate constant, a bond’s duration
generally increases with its time to maturity

24
 Duration Rules
(2 of 2)

• Rule 4
• Holding other factors constant, the duration of a coupon
bond is higher when the bond’s yield to maturity is lower
• Rule 5
• The duration of a level perpetuity (recalling: a perpetual
bond is a bond with infinite maturity date) is equal to:
(1+ y)
y
where y is the bond’s yield to maturity

25
 Example:
Bond Duration versus Bond Maturity

Durations of bonds with

different coupon rates c
and YTM y

26
 Example: Bond Durations
( Yield to Maturity = 8% APR; Semiannual Coupons)

→ D depends on both c and y

27
 Convexity
(1 of 2)

• The relationship between bond prices and

yields is not linear (recalling the bond
price formula)
• → Duration rule is a good approximation for
only small changes in bond yields
• Bonds with greater convexity have more
curvature in the price-yield relationship

28
 Bond Price Convexity
(30-Year Maturity, 8% Coupon; Initial YTM = 8%)

Not a good approx. for large change

29
 Convexity
(2 of 2)

Convexity = 1/P (𝜕 2 P /𝜕𝑦 2 )

1 𝑇 𝐶𝐹𝑡 2
= σ (𝑡 + 𝑡)
𝑃 1+𝑦 2 1 1+𝑦 𝑡

• →Correction for Convexity (via second order

approximation):
 P = − D*y + ½ [Convexity (y) 2 ]
P
Effect of complexity on sensitivity

30
 Convexity of Two Bonds
P / P
Bond A is more
convex than bond B.
It enjoys greater
price increases and
smaller price
decreases when
interest rates
fluctuate by larger
amounts.

y

31
 Why D o Investors L i k e Convexity?

• Higher Convexity → Bigger price increases

when yields fall than loses when yields rise

• The more volatile interest rates, the more

attractive this asymmetry

• But convexity is not for free: bonds with greater

convexity usually have higher prices and/or lower
yields, all else equal

32
 Duration and Convexity for a Callable
Bond
• Callable (Redeemable) Bonds: callable bonds give the issuer
the option to repurchase the bond from the holder at a
specified call price (usually higher than the par value).
• As rates fall, there is a ceiling on the bond’s market price,
which cannot rise above the call price
• Negative convexity over a certain region of interest rates
• The former equation for duration is no longer
appropriate
• → Use effective duration:

Effective Duration= - P P
r

33
 Price–Yield Curve for a Callable Bond
Upper bound for
bond price

When interest
rates are high, the
curve has a
positive convexity
as in a normal
straight bond
But when interest
rates fall and are low,
the curve has a
nagative convexity

34
 Final Remark: Duration and Convexity
for Bonds embedded with Options
• Callable Bonds, and more generally, bonds with
“embedded options,” have uncertainty in the future
cashflows (options can be exercised or not exercised)

• → Difficult to take a weighted average of times until

each future cash flow as in conventional approach to
compute duration (i.e., Macaulay’s duration approach)

• → Alternative approaches such as effective duration

have been proposed and used in financial industry

35
 Bond Price Examples in Python

• Example in Google Colab

36