13-01-2023

Discounting, Present & Future Value

Consider a simplest bond - ZCB

• Discounting cash flows • Future Value

Bond Fundamentals • Present Value:

CT
FV  PV (1  y ) t
PV 
(1  y ) T
• 6% Int. rate, FV of $100 & • 6% Int. rate, PV of $100 &
10 years to mature 10 years to mature
$100
PV   $55.84 FV  $100  (1  0.06)10  $179.08
(1  0.06)10

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Transforming between compounding intervals

Compounding…
Annual rate can be transformed into
ZCB: • semi-annual using:
If the interest rate is compounding semi-annually: (1+ys/2)2 = (1+y)
CT • continuously compounding:
PV  2T
 ys  exp (yc) = 1+y (or) yc = ln(1+y)
1  
 2  • Increasing frequency of compounding decreases resulting
rates.
If it is Continuous compounding i.e., y > ys > yq > yc
Money works harder with more frequent compounding, a lower
PV  CT e  yT rate will achieve the same payoff.
“The most powerful force in the universe is compound interest.”-

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Price-Yield Relationship Perpetual Bonds / Consols

where ‘Ct’ is the cashflow at time • Bonds that have fixed coupon payments for infinite period
T
Ct period ‘t’, ‘T’ is the number of of time.
P
cF cF cF  1 1  cF
PV    ...  1    ... 
(1  y ) (1  y ) 2 (1  y )  (1  y ) (1  y ) 2
t 1 (1  y )
t  y
periods to maturity, and ‘y’ is the
discount factor.
• A bond that pays c.F for T periods and F at Period T can be
considered as a portfolio of Consols and a ZCB:
For a bond that pays coupons (at the rate c) each period [Long Consol + Short Consol starting at T + Long ZCB maturing at T]
and the face value (F) at T:
cF 1 cF F cF  1  F
 T c.F  F PV     1  
P      y 1  y T y 1  y T y  (1  y )T  1  y T
 t 1 (1  y )  (1  y )
t T

‘y’ can be interpreted as Internal Rate of Return (how?) • If c=y, and both are having same frequency in compounding,
then the bond is at “Par Value” 1
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Price-yield Relationship Change in P for small changes in y

• How does Price of a Bond change for small changes in ‘y’?
P • Re-price using Price-Yield relationship.
Price (P) = f(y)
(or)
• Use shortcut: Taylor expansion
• Initial value y0, new value y1, change y:
Price of a bond as a function of yield y1  y 0  y

1
P  f ( y1 )  f ( y0 )  f ' ( y0 ) y  f " ( y0 )  y 2  
2

dP d 2P
y where f '  y   , f ''  y   2 ,...
dy dy

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Taylor Expansion Contd. Taylor Expansion Contd.

• For bonds,
f ' (y0) & f ''(y0) are related to Duration & Convexity.
• These first two terms provide good approximation. (used by
practitioners) 1
For Portfolio with xi units of bond ‘i’ & a total of N bonds,
P  f ( y1 )  f ( y0 )  f ' ( y0 )y 
2
f " ( y0 )y
2
• If increment in y0 (y) is very small, then even the first Portfolio derivatives N
f '  y    xi f i '  y 
difference alone would do. i 1
• For derivatives, 1
P  f ' (s )s  f " ( s)s 2
2
dP d 2P
where f ' s   , f '' s   2
ds ds

f ' (s) is Delta & f ''(s) is Gamma.

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Bond Price Derivatives Duration & Convexity

• For fixed income instruments,
P
negative of first derivative is “Dollar Duration” [DD]
dP
f ' ( y0 )    D *  P0 Actual Price
dy Approximation with Duration
where DD = D*P & D* is “Modified Duration” Approximation with Convexity & Duration
• Dollar convexity = the second derivative,
d 2P
f " ( y0 )   C  P0
dy 2
where C is “Convexity”

•Taylor expansion for a bond, P  D *  P (y )  C  P (y 2 )  ...

1 y
2 2
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Duration & Convexity for a ZCB Greater Convexity - Beneficial

• Only Cash flow (CT at T) is the Face Value F.
Higher Convexity
P
F dP F T Lower Convexity
P &  T  P
1  y T dy 1  y T 1 1  y  Greater Convexity is beneficial for both
falling and rising yields.
• Modified Duration D* = T/(1+y)
• Duration is expressed in periods. For annual compounding, duration in yrs…
for semi-annual compounding, duration is in semesters… Price drops less Vs a bond with Lower Convexity.
• If duration is in semesters, divide it by 2 to get it for yrs. Price rises more Vs a bond with lower Convexity.
• Conventional Duration (Macaulay Duration) D = T
• Using Continuous Compounding formula gives Macaulay Duration T… How?
• In practice the difference between Modified & Macaulay Duration is small
• Second derivative: 2
d P
=T (T+ 1 )
F
=
T ( T+1 )
P
dy 2 (1 +y )T+ 2 (1 +y )2

T ( T+1 ) y
• Convexity = semester squared (for semi-annual compounding)
( 1+y )2
• If convexity is in semesters, divide by 4 to convert to years squared.

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Interpreting Duration & Convexity Interpreting Duration & Convexity Contd.

• For a coupon paying bond, • For a 6% coupon on 10 yr bond, duration is 7.8 yrs.
T
Ct This is equivalent to a ZCB maturing exactly in 7.8 yrs.
P
t 1 (1  y )
t

dP T  tC t  T  tCt   P D • For bonds with fixed coupon payments, duration is less than
     P   P
dy t 1 (1  y ) t 1  t 1 (1  y )t   1  y  1  y  maturity.
T
tCt
where, D   P
t 1 (1  y )
t • Higher coupons place more weight on prior payments &
• Average time to wait for each payment, weighted by the PV therefore, reduce duration.
of associated cash flow.
Ct
t
T
(1  y ) t T where, wt is the ratio of PV of
i.e., D   T   t  wt cash flow relative to the total
C
t 1
 t

t 1 (1  y )
t
t 1
cash flow & sum of wt is 1.

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Interpreting Duration & Convexity Contd. Interpreting Duration & Convexity Contd.
• Duration of a Consol: • For a coupon paying bond,
d 2 P T t t  1Ct T
t t  1Ct P
PV 
cF dP cF P
 2  
DC   
y
&
dy y y 1  y 
P dy 2 t 1 1  y t  2 t 1 1  y t  2 P

T
t t  1Ct
where C   P
1 y 1  y t 2
• Macaulay Duration for Consol is
t 1
Dc 
y

• Observations: • Convexity can also be written as:

• Duration of a Consol is finite even if maturity is infinite. T
t t  1 C 1  y  Tt
t t  1
C 
1  y 2 T C 1  y t 
• Duration of a Consol does not depend on coupon.  t   wt
t 1 1  y 
2

• Rule of thumb: For a long-term coupon paying bond,

t 1
 t
t 1

duration must be LOWER than 1  y [Upper Bound]. 3

y
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Portfolio Duration and Convexity

N
Portfolio Dollar Duration: D *p Pp   Di* x i Pi
i 1
where xi – No. of units of bond i

xi Pi
Portfolio weights: wi 
Pp

N
Portfolio Duration: D *p   wi Di*
i 1

N
Portfolio Convexity: C *p   wi Ci*
i 1

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