ACST2001

Financial Modelling

Week 07
DISCOVERING DURATION
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About learning …
“Schools teach you to imitate. If you
don’t imitate what the teacher wants
you get a bad grade. Here, in college, it
was more sophisticated, of course;
you were supposed to imitate the
teacher in such a way as to convince
the teacher you were not imitating.”
Robert M Pirsig, “Zen and the Art of Motorcycle
Maintenance” (1974)
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Revision - Weighted average
Twenty students sat a test which was
marked out of 10.
Their results are as follows:
Score out of 10: 9 7 6 5
Number of students: 8 7 4 1
NOTE: with NO WEIGHTING the
average of the scores is :
9+7+6+5 = 6.75
4
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Taking into account the weights
where the weights are the number
of students achieving these
scores:

Weighted average of the scores:

(9×8)+(7×7)+(6×4)+(5×1) = 7.5
(8+7+4+1)
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Bonds: two types of risk
 (1) Reinvestment risk: risk that
interest rates fall, so coupons
must be reinvested at lower rates
 (2) Interest rate risk: risk that
interest rates rise, causing the
value (market price) of the
investment to fall

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 BOND HOLDING PERIOD
Purchase Sale
date date

P2+c
c c …... c c c

0 1 2 …..... n-3 n-2 n-1 n

n half-years
P1

• Outgo (purchase price P1)

• Income (coupons, interest on
reinvested coupons, sale price P2)

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BALANCING INTEREST RATE
RISK & REINVESTMENT RISK

Suppose you have just

purchased a 10-year 8% T-
bond, and the current yield
is 9% pa (coupon rate &
yield are both semi-annual)
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 • What is the bond’s purchase
price?
 Now suppose interest rates
rise immediately, and then
remain unchanged indefinitely,
so that the reinvestment rate,
and the sale yield if you want
to sell the bond, are j2 = 10%

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•What will be your HPY (in
j2 form) if you plan to sell
the bond after:
 (a) 1 year?

 (b) 5 years?

 (c) 9 years?

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10-year Treasury bond Coupons: 8.00%

Purchase price: 93.496 Yield (j2): 9.00%

Reinvestment rate (j2): 10.00% Sale yield: 10.00%

Holding Accum Sale Total acc HPY

period (yrs) coupons price value (j2)

1 8.200 88.310 96.510 3.20%

2 17.241 89.162 106.403 6.57%
3 27.208 90.101 117.309 7.71%
4 38.196 91.137 129.333 8.28%
5 50.312 92.278 142.590 8.62%
6 63.669 93.537 157.205 8.85%
7 78.395 94.924 173.319 9.01%
8 94.630 96.454 191.084 9.14%
9 112.530 98.141 210.670 9.23%
10 132.264 100.000 232.264 9.31%
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 Returns of Short term
investor
 What can you say about the
returns achieved?
 What is the reason for these
returns?
 (a) by the short term investor
who sells after one year

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 Observation: Short term
investor
Increase in interest rates has
resulted in a HPY lower (3.2%)
than the purchase yield (9.0%)
 BECAUSE the fall in capital
value is more important than
the rise in the reinvestment
rate
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Returns Long term investor

 What can you say about the

returns achieved?
 What is the reason for these
returns?
 (b) by the long term investor
who sells after nine years

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 Observation: Long term
investor
 Increase in interest rates has
resulted in a HPY higher (9.2%)
than purchase yield (9.0%)
 BECAUSE the rise in the
reinvestment rate is more
important than the fall in capital
value
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Further observation:
 For some holding period
(between 1 and 9 years), the
two effects offset each other;
 that is, the fall in price is
exactly offset by the increase
in return from the reinvested
coupons
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Now, suppose interest rates
fall immediately after you buy
the bond, and then remain
unchanged indefinitely, so
that the reinvestment rate,
and the sale yield if you want
to sell the bond, are j2 = 8%

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• What now will be your
HPY (in j2 form) if you plan
to sell the bond after:
 (a) 1 year?

 (b) 5 years?

 (c) 9 years?

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10-year Treasury bond Coupons: 8.00%

Purchase price: 93.496 Yield (j2): 9.00%

Reinvestment rate (j2): 8.00% Sale yield: 8.00%

Holding Accum Sale Total acc HPY

period (yrs) coupons price value (j2)

1 8.160 100.000 108.160 15.11%

2 16.986 100.000 116.986 11.53%
3 26.532 100.000 126.532 10.34%
4 36.857 100.000 136.857 9.76%
5 48.024 100.000 148.024 9.40%
6 60.103 100.000 160.103 9.17%
7 73.168 100.000 173.168 9.00%
8 87.298 100.000 187.298 8.88%
9 102.582 100.000 202.582 8.78%
10 119.112 100.000 219.112 8.70%
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 Returns of Short term
investor
How do you think the HPY will
compare to the purchase yield
of 9%,
 (a) for the short term investor
who sells after one year

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 Observation: Short term
investor
Decrease in interest rates has
resulted in a HPY higher
(15.1%) than the purchase yield
(9.0%)
 BECAUSE the rise in capital
value is more important than
the fall in the reinvestment rate
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 Returns of Long term
investor
How do you think the HPY will
compare to the purchase yield
of 9%,
 (a) for the long term investor
who sells after nine years

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 Observation: Long term
investor
Decrease in interest rates has
resulted in a HPY lower (8.8%)
than purchase yield (9.0%)
 BECAUSE the fall in the
reinvestment rate is more
important than the rise in capital
value
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Further observation:
 For some holding period
(between 1 and 9 years), the
two effects offset each other;
 that is, the rise in price is
exactly offset by the decrease
in return from the reinvested
coupons
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 IMPORTANT:
This special holding period,
where the two effects offset
each other, is known as the
DURATION of the bond

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 HOLDING PERIOD
PROPERTY OF DURATION
 If a security is held for a holding
period equal to its duration, the
yield over the holding period
(HPY) will be unaffected by
changes in reinvestment (and
sale yield) rates ……..

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 HOLDING PERIOD
PROPERTY OF DURATION

 ……. PROVIDED THAT

 interest rate changes are
assumed to occur immediately,
and remain in effect throughout
the holding period

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 HOLDING PERIOD
PROPERTY OF DURATION
This property of duration occurs
because:
 • reinvestment gains or losses
on coupons
 are EXACTLY OFFSET by

 • capital losses or gains when

the security is sold
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What is Duration? ….. 1

 • Average time to receipt of the

cash flows from an investment
 • Weighted average, using the
present values of the cash flows
as weights
 • Duration depends on time to
maturity, coupon rate and yield
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What is Duration? ….. 2
 • Calculating duration
 • Duration can be calculated by
formula, or by table (manual or
spreadsheet or other software)
 Σ t Ct vt
 D = ————
 Σ Ct vt
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 What is Duration? ….. 3
 Calculating duration:

Σ t C t vt
D = ————
Σ Ct vt
Note: The denominator is the sum of the
weights, or the sum of the present
values of the cash flows; that is, the
price of the instrument

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What is Duration? ….. 4

 • Holding period property

 • If an investment is held for a
holding period equal to its
duration, HPY is unaffected by
changes in reinvestment (and sale
yield) rates
 • Subject to certain assumptions

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 Problem 1
 •What is the duration of a
$100 1-year zero coupon
bond at a yield of
j2 = 6.4%?
 D = {2×100×v2}/{100×v2}

 = 2 half-years (1 year)

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DURATION OF A ZERO COUPON BOND

Maturity
Current date
date
$M
…...

n periods

ZCB has just one cash flow (maturity amount),

so duration (average time to receipt of cash
flows) must always be equal to term to maturity

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 Duration of a Zero-Coupon
Bond
Acknowledgement - Investopedia:
http://www.investopedia.com/terms/i/immunization.asp

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 Duration of a Bond
(Five year bond that pays coupons
annually and matures in five years.)
 Acknowledgement - Investopedia

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 Problem 2
• What is the duration of a
$100 1-year 10% T-bond at
a yield of j2 = 6.4%?
 D = {1×5×v+2×105×v2}

 {5×v+105×v } 2

 = 1.953 half-years
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 Problem 3
Find the duration of a 2-year
5% Treasury Bond at a yield
of j2 = 5%.

 Ans: 1.928 years

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 Bond duration

 Provides a single measure of the

impact of interest rate changes on
the value of bonds.
Bonds with lower duration are less
sensitive to interest rate changes
 Bonds with higher duration are
more sensitive to interest rate
changes.
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 Bond Duration

 Duration depends on time

to maturity, coupon rate
and yield

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 What bond characteristics
make duration HIGHER?
 Duration will be HIGHER (other
things being equal) if:

 • Term to maturity is LONGER*

 • Coupon rate is LOWER

 • Yield to maturity is LOWER

 (* except for extremely long low coupon bonds)

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 What bond characteristics
make duration LOWER?
 Duration will be LOWER (other
things being equal) if:
 • Term to maturity is SHORTER*
 • Coupon rate is HIGHER
 • Yield to maturity is HIGHER
 (*except for extremely long low coupon bonds)

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 Summary - Duration
 Duration of a bond is the weighted
average time to receipt of the cash
flows
 Duration depends on time to
maturity, coupon rate and yield
 Provides a measure of sensitivity of
the bond to changes in interest rates
 Holding Period Property of Duration,
(subject to certain conditions).
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