YIELD CONVEXITY - Bond Math - Academic library - free online college e textbooks

(6.16)

Granted, there are a lot of terms in the equation, but just three variables: c, the
coupon rate per period; y, the yield to maturity per period; and N, the number of
periods to maturity. One simplification emerges for a zero- coupon bond for which c =
0. Then much of equation 6.16 drops out and the convexity reduces to N * (N+ 1)/(1 +
y)2.

Let's work on a 4%, semiannual payment, 25-year bond priced at a discount to yield
4.40% (s.a.). First, use equation 6.13 or 6.15 to get its Macaulay duration (t/T = 0),
using y = 0.0220, c = 0.02, and N = 50.

That's the Macaulay duration that corresponds to a change in the yield per period;
annualized it is 15.7156 (= 31.4312/2). The annual modified duration is 15.3773 (=
15.7156/1.0220). Note that we divide by one plus the yield per period, not by the
annualized yield.

Okay, now enter the same inputs for y, c, and N into equation 6.16.

If you tried and got that result congratulations! That's the convexity statistic that
links the change in the yield per period to the change in market value. As in equation
6.11, it is annualized by dividing by the periodicity squared. So, this bond has an
annualized yield convexity of 320.2689 (= 1,281.0757/4). Unfortunately, Excel does not
have a financial function for convexity even though it uses the same inputs as duration.

Suppose three months go by and the bond is still priced to yield 4.40% (s.a.). Let t/T
= 0.50 because we are halfway through the semiannual period. The Macaulay duration
is easily calculated: 31.4312 0.50 = 30.9312. Annualized, it is 15.4656 (= 30.9312/2)
and the modified duration is 15.1327 (= 15.4656/1.0220).

The convexity statistic between coupon payment dates is shown in equation 6.17.

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YIELD CONVEXITY - Bond Math - Academic library - free online college e textbooks

(6.17)

The first term is the convexity that would prevail at the beginning of the period
(hence t/T = 0) if the current yield per period y is used in the calculation in equation
6.16. Then we need to subtract the term in brackets, which

contains, as a bit of a surprise, the Macaulay duration (MacDur) in equation 6.15

calculated for t/T = 0 using the yield per period y.

As time passes, yields inevitably do change, and equations 6.15 and 6.16 have to be
calculated using the new yield to maturity. For convenience, I assume that the yield
remains the same at 4.40% (s.a.), so we can use the already obtained results. The
convexity after the three months is 1,250.7438, using Convexity (t/T =0) = 1,281.0757,
t/T = 0.50, y = 0.0220, and MacDur (t/T = 0) = 31.4312.

The annual convexity statistic is 312.6859 (= 1,250.7438/4).

In working through this convexity calculation, I have kept more precision (four
decimals) than really is needed. That's because I want to illustrate how the modified
duration and convexity statistics can be approximated quite accurately using
numerical methods. The idea is to estimate the values for the first and second partial
derivatives in equations 6.4 and 6.6. In calculus, dy is an infinitesimal change in the
yield per period. I use a discrete change in this approximation, here chosen to be 20
basis points up and down.

The approximation formulas for (annual) modified yield duration and yield convexity
are defined in equations 6.18 and 6.19.

(6.18)

(6.19)

MV(down) and MY(up) are the market values calculated using a pricing model (or
equation) assuming the same decrease and increase in the yield.

The initial market value for the bond, MV(initial), is 94.999558 (percent of par
value), using equation 3.11 from Chapter 3 and PMT = 2, y = 0.0220, N = 50, FV =
100, and t/T = 0.50.

This is the combined flat price and accrued interest. You also can get this result on
Excel using the financial function PRICE for the flat price and then ACCRINT to get the
accrued interest. The sum of the flat price obtained with PRICE and the accrued
interest from ACCRINT is the full price, 94.999558. Assume arbitrarily that the 4%, 25-
year bond is issued on July 15,2014, matures on July 15, 2039, and now on October

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YIELD CONVEXITY - Bond Math - Academic library - free online college e textbooks

15, 2014 (three months into the semiannual period using a 30/360 day count), the yield
is 4.40% (s.a.).

If the yield goes up by 20 basis points to 4.60% (s.a.), the market value is
92.182875, found by repeating the calculation for y = 0.0230.

If the yield goes down to 4.20% (s.a.), the market value is 97.935084, using y =
0.0210.

In Excel, repeat the PRICE calculations using 0.0460 and 0.0420 for the fourth
entries. The accrued interest is the same and is just 1.00 (= 90/180 * 2). Note that the
general bond math formula directly uses the periodic variables the payment per
period, yield per period, and number of periods to maturity whereas Excel (like other
software programs) allows you to enter the annual variables and the periodicity that
adjusts them in the formulas embedded in the programming.

Substitute these results for the MVs into equations 6.18 and 6.19 and use 0.0020 for
the change in yield.

These are really good approximations; the more accurate numbers calculated above
using the mathematically derived formulas are 15.1327 and 312.6859. In fact, the
approximations become even better for a smaller change in yield. In practice, the
differences between the approximations and the exact results are not likely to be
material. For most purposes the information content for the modified duration and
convexity of this bond is 15.14 and 312.7 precision beyond that likely is just data.

Now let's look at how you probably observe bond duration and convexity statistics in
practice.

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YIELD DURATION - Bond Math - Academic library - free online college e textbooks

(6.13)

Here the coupon rate per period is denoted c, where c = PMT/FV.

Let's go back to the 4%, annual payment, 4-year corporate bond priced at 99.342 to
yield 4.182% that we first saw in Chapter 3. Suppose that one month has transpired
since then, and the bond remarkably is still yielding 4.182%. Its Macaulay duration is
3.691, found using y = 0.04182, N = 4, c = 0.04, and t/T = 30/360 assuming the 30/360
day-count convention.

That last assumption about the day-count is important duration is the link between
the change in market value and the change in yield, so how the yield is quoted matters
(i.e., its periodicity and day-count convention). Change one of those assumptions and
you get a slightly different duration statistic.

Now suppose that the yield on the bond increased to 4.650% during the month that
has gone by instead of remaining the same. The Macaulay duration would be 3.689.

Note that 97.676 in the denominator is the price of the bond at the beginning of
the period if its yield had been 4.650%.

The modified duration for this bond is 3.525 (= 3.689/1.04650). In general, the
modified duration is the Macaulay duration divided by one plus the yield per period,
but in this case 4.650% is quoted for annual compounding. The numerical difference
between the Macaulay and modified duration statistics depends on the level of interest
rates and the periodicity. As rates are lower and/ or as the periodicity increases, the
difference diminishes. In fact, if the yield is quoted for continuous compounding, the
Macaulay and modified durations are the same. In any case, once one is known, the
other is easily obtained.

These duration calculations can be confirmed on Excel. The DURATION and

MDURATION financial functions deliver the annualized Macaulay and modified
duration statistics. Assume arbitrarily that the 4% annual payment bond matures on
December 15, 2017, and the current settlement date is January 15, 2014, one month
since the last coupon date (December 15, 2013) on a 30/360 basis.
YIELD DURATION - Bond Math - Academic library - free online college e textbooks

The entry items are the settlement date, maturity date, annual coupon rate, annual
yield to maturity, periodicity, and the code for the day-count convention (0 for 30/360, 1
for actual/actual).

The Macaulay duration of a zero-coupon bond is found by setting c = 0 in 6.12 or

PMT = 0 in 6.14. In either case, it reduces to just N (t/T), the time to maturity
measured in periods. The high duration on a long-term, zero-coupon bond sheds
further light on the Chapter 2 story about TIGRS, CATS, and TIONS. Investment banks
in the 1980s profitably transformed coupon-bearing Treasury bonds into synthetic
Treasury zeros because some investors were interested in buying duration, not yield.

Consider a 12%, semiannual payment, 28-year Treasury bond priced back then at
94 to yield 12.792% (s.a.). Its duration is 16.20 (in terms of semiannual periods), found
by entering y = 0.12792/2 = 0.06396, c = 0.12/2 = 0.06, N = 28 * 2 = 56, and t/T = 0
into 6.13.

The annualized Macaulay duration on this long-term 28-year coupon bond is just
8.10, which is the 16.20 semiannual periods divided by two periods in a year.

Note that I intentionally avoided saying that the duration of the bond is 8.10 years.
There are some circumstances when it is convenient to interpret duration in terms of
time, but in general it's better to think of it as the interest rate sensitivity factor. We can
say that this bond will be about twice as sensitive to a shift in yield as one having

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