RISK MANAGEMENT 07 02697

Hull, J. Options, Futures and other Derivatives Pearson, 8th Ed, 2012.

Answers to Exercises on Lecture 5

1. What does duration tell you about the sensitivity of a bond portfolio to interest rates?
What are the limitations of the duration measure?
Duration provides information about the effect of a small parallel shift in the yield curve on
the value of a bond portfolio. The percentage decrease in the value of the portfolio equals the
duration of the portfolio multiplied by the amount by which interest rates are increased in the
small parallel shift. The duration measure has the following limitation. It applies only to
parallel shifts in the yield curve that are small.

2. Prices of long-term bonds are more volatile than prices of short-term bonds. However,
yields to maturity of short-term bonds fluctuate more than yields of long-term bonds.
How do you reconcile these two empirical observations?
While it is true that short-term rates are more volatile than long-term rates, the longer
duration of the longer-term bonds makes their prices and their rates of return more
volatile. The higher duration magnifies the sensitivity to interest-rate changes.

3. How can a perpetuity, which has an infinite maturity, have a duration as short as 10 or
20 years?
Duration can be thought of as a weighted average of the maturities of the cash flows
paid to holders of the perpetuity, where the weight for each cash flow is equal to the
present value of that cash flow divided by the total present value of all cash flows. For
cash flows in the distant future, present value approaches zero (i.e., the weight becomes
very small) so that these distant cash flows have little impact, and eventually, virtually
no impact on the weighted average.

4. Find the duration of a 9% coupon bond making annual coupon payments if it has 3
years until maturity and has a yield to maturity of 9%. What is the duration if the yield
to maturity is 11.4%?
YTM = 9%

(1)
Time until
Payment
(Years)

(2)

Cash Flow

1
2

1,090.00

90.00
90.00

Column sums

(3)

(4)

(5)

Weight

Column (1)
Column (4)

82.57
75.75

0.0826
0.0758

0.0826
0.1516

841.68

0.8417

2.5251

$1,000.00

1.0000

2.7593

PV of CF
(Discount
Rate = 9%)
$

Duration = 2.759 years

b.

YTM = 11.4%
(1)
Time until
Payment
(Years)

(2)

Cash Flow

(3)
PV of CF
(Discount
Rate = 11.4%)

(4)

(5)

Weight

Column (1)
Column (4)

1
2

90.00
90.00

$ 80.79
72.52

0.0858
0.0770

0.0858
0.1540

1,090.00

788.44

0.8372

2.5116

Column sums

$941.75

1.0000

2.7514

Duration = 2.7514 years, which is less than the duration at the YTM of 9%.

5. A 30-year maturity bond making annual coupon payments with a coupon rate of
10.5% has duration of 14.23 years and convexity of 282.47. The bond currently sells
at a yield to maturity of 5%. Find the price of the bond if its yield to maturity falls to
4% or rises to 6%. What prices for the bond at these new yields would be predicted by
the duration rule and the duration-with-convexity rule? What is the percentage error
for each rule? What do you conclude about the accuracy of the two rules?

We find that the actual price of the bond as a function of yield to maturity is
Yield to Maturity

Price

4%

$2,123.98

1,845.48

1,619.42

Using the duration rule, assuming yield to maturity falls to 4%

D
Predicted price change
y P0
1 y
14.23

(0.01) $1,845.48 $250.11
1.05

Therefore: predicted new price = $1,845.48 + $250.11 = $2,095.59

The actual price at a 4% yield to maturity is $2,123.98. Therefore
% error

$2, 095.59 $2,123.98

0.0134 1.34%
$2,123.98

Using the duration rule, assuming yield to maturity increases to 6%

D
Predicted price change
y P0
1 y
14.23

0.01 $1,845.48 $250.11
1.050

Therefore: predicted new price = $1,845.48 $250.11= $1,595.38

The actual price at a 6% yield to maturity is $1,619.42. Therefore
% error

$1,595.38 $1, 619.42

0.0148 1.48%
$1, 619.42

Using duration-with-convexity rule, assuming yield to maturity falls to 4%

D

2
Predicted price change
y 0.5 Convexity (y) P0
1 y

14.23

2

(0.01) 0.5 282.47 (0.01) $1,845.48 $276.17

1.050

Therefore the predicted new price = $1,845.48 + $276.17 = $2,121.66.

The actual price at a 4% yield to maturity is $2,123.98. Therefore
% error

$2,121.66 $2,123.98
0.0011, or 0.11%
$2,123.98

Using duration-with-convexity rule, assuming yield to maturity rises to 6%

D

2
Predicted price change
y 0.5 Convexity (y) P0

1 y

14.23

2

0.01 0.5 282.47 (0.01) $1,845.48 $224.04

1.05

Therefore the predicted new price = $1,845.48 $224.04 = $1,621.44.

The actual price at a 6% yield to maturity is $1,619.42. Therefore
3

% error

$1, 621.44 $1, 619.42

0.0013, or 0.13% (approximation is too high).
$1, 619.42

Conclusion: The duration-with-convexity rule provides more accurate approximations

to the true change in price. In this example, the percentage error using convexity with
duration is less than one-tenth the error using only duration to estimate the price change.

6. A 11.25-year maturity zero-coupon bond selling at a yield to maturity of 6%

(effective annual yield) has convexity of 152.7 and modified duration of 10.31 years.
A 30-year maturity 8% coupon bond making annual coupon payments also selling at a
yield to maturity of 6% has nearly identical duration10.29 yearsbut considerably
higher convexity of 238.
a. Suppose the yield to maturity on both bonds increases to 7%. What will be the
actual percentage capital loss on each bond? What percentage capital loss
would be predicted by the duration-with-convexity rule?
b. Repeat part (a), but this time assume the yield to maturity decreases to 5%.
c. Compare the performance of the two bonds in the two scenarios, one
involving an increase in rates, the other a decrease. Based on the comparative
investment performance, explain the attraction of convexity.
d. In view of your answer to (c), do you think it would be possible for two bonds
with equal duration but different convexity to be priced initially at the same
yield to maturity if the yields on both bonds always increased or decreased by
equal amounts, as in this example? Would anyone be willing to buy the bond
with lower convexity under these circumstances?
a.

The price of the zero-coupon bond ($1,000 face value) selling at a yield to maturity of
6% is $519.17 and the price of the coupon bond is $1,275.30.
At a YTM of 7%, the actual price of the zero-coupon bond is $467.12 and the
actual price of the coupon bond is $1,124.09.
Zero-coupon bond:
Actual % loss

$467.12 $519.17
0.1002 10.02% loss
$519.17

The percentage loss predicted by the duration-with-convexity rule is:

Predicted % loss (10.31) 0.01 0.5 152.7 0.012 0.0955 9.55% loss
Coupon bond:
Actual % loss

$1,124.09 $1, 275.30

0.1186 11.86% loss
$1, 275.30

The percentage loss predicted by the duration-with-convexity rule is:

Predicted % loss (10.29) 0.01 0.5 238 0.012 0.0910, or 9.10% loss

b.

Now assume yield to maturity falls to 5%. The price of the zero increases to
$577.59, and the price of the coupon bond increases to $1,461.17.
Zero-coupon bond:
Actual % gain

$577.59 $519.17
0.1125, or11.25% gain
$519.17

The percentage gain predicted by the duration-with-convexity rule is:

Predicted % gain (10.31) (0.01) 0.5 152.7 0.012 0.1107, or11.07% gain
Coupon bond:
Actual % gain

$1, 461.17 $1, 275.30

0.1458, or14.58% gain
$1, 275.30

The percentage gain predicted by the duration-with-convexity rule is:

Predicted % gain (10.29) (0.01) 0.5 238 0.012 0.1148, or 11.48% gain

c.

The 8% coupon bond, which has higher convexity, outperforms the zero
regardless of whether rates rise or fall. This can be seen to be a general property
using the duration-with-convexity formula: the duration effects on the two bonds
due to any change in rates are equal (since the respective durations are virtually
equal), but the convexity effect, which is always positive, always favors the higher
convexity bond. Thus, if the yields on the bonds change by equal amounts, as we
assumed in this example, the higher convexity bond outperforms a lower
convexity bond with the same duration and initial yield to maturity.

d.

This situation cannot persist. No one would be willing to buy the lower convexity
bond if it always underperforms the other bond. The price of the lower convexity
bond will fall and its yield to maturity will rise. Thus, the lower convexity bond
will sell at a higher initial yield to maturity. That higher yield is compensation for
lower convexity. If rates change only slightly, the higher yieldlower convexity
bond will perform better; if rates change by a substantial amount, the lower yield
higher convexity bond will perform better.

7. A newly issued bond has a maturity of 10 years and pays a 5.5% coupon rate (with
coupon payments coming once annually). The bond sells at par value.
a. What are the convexity and the duration of the bond?
b. Find the actual price of the bond assuming that its yield to maturity
immediately increases from 5.5% to 6.5% (with maturity still 10 years).
c. What price would be predicted by the duration rule? What is the percentage
error of that rule?
d. What price would be predicted by the duration-with-convexity rule? What is
the percentage error of that rule?
5

a. The following spreadsheet shows that the convexity of the bond is 72.310. The
present value of each cash flow is obtained by discounting at 5.5%. (Since the
bond has a 5.5% coupon and sells at par, its YTM is 5.5%.)
Convexity equals: the sum of the last column (8,048.267) divided by:
[P (1 + y)2] = 100 (1.055)2 = 111.30
Time

t2 + t

(t2 + t) PV(CF)

2
6

10.427
29.649

(t)
1

Cash
Flow
5.5
(CF)

5.5

5.213
4.941

5.5

4.684

12

56.207

5.5

4.440

20

88.800

5.5

4.208

30

126.247

5.5

3.989

42

167.532

5.5

3.781

56

211.731

5.5

3.584

72

258.033

5.5

3.397

90

305.726

10

105.5

61.763

110

6,793.922

Sum:

PV(CF)

100.000

8,048.267
Convexity:

72.31

The duration of the bond is:

(1)
Time until
Payment
(Years)

(2)

Cash Flow

(3)
PV of CF
(Discount
Rate = 5.5%)

(4)

(5)

Weight

Column (1)
Column (4)

1
2

$5.5
5.5

$ 5.213
4.941

0.05213
0.04941

0.05213
0.09883

5.5

4.684

0.04684

0.14052

5.5

4.440

0.04440

0.17759

$5.5

0.04208

0.21041

5.5

4.208
3.989

0.03989

0.23933

5.5

3.781

0.03781

0.26466

5.5

3.584

0.03584

0.28670

5.5

3.397

0.03397

0.30573

10

105.5
Column sums

61.763

0.61763

6.17629

$100.000

1.00000

7.95220

D = 7.925 years

b.

If the yield to maturity increases to 6.5%, the bond price will fall to 92.81% of par
value, a percentage decrease of 7.19%.

c.

The duration rule predicts a percentage price change of

D

7.95220

0.01
0.01 0.075, or 7.54%
1.055
1.055

This overstates the actual percentage decrease in price by 0.38%.

The price predicted by the duration rule is 7.54% less than face value, or 92.46%
of face value.

d.

The duration-with-convexity rule predicts a percentage price change of

7.95220

2
1.055 0.01 0.5 72.310 0.01 0.0718, or 7.18%

The percentage error is 0.18%, which is substantially less than the error using the
duration rule.
The price predicted by the duration with convexity rule is 7.18% less than face
value, or 92.82% of face value.
8. Explain the impact on the offering yield of adding a call feature to a proposed bond
issue.
The call feature provides a valuable option to the issuer, since it can buy back the
bond at a specified call price even if the present value of the scheduled remaining
payments is greater than the call price. The investor will demand, and the issuer will
be willing to pay, a higher yield on the issue as compensation for this feature.

9. Explain the impact on both effective bond duration and convexity of adding a call
feature to a proposed bond issue.
The call feature reduces both the duration (interest rate sensitivity) and the convexity
of the bond. If interest rates fall, the increase in the price of the callable bond will not
be as large as it would be if the bond were noncallable. Moreover, the usual curvature
that characterizes price changes for a straight bond is reduced by a call feature. The
price-yield curve flattens out as the interest rate falls and the option to call the bond
becomes more attractive. In fact, at very low interest rates, the bond exhibits negative
convexity.

10.
a. A 6% coupon bond paying interest annually has a modified duration of 10 years,
sells for $800, and is priced at a yield to maturity of 8%. If the YTM increases to
9%, what is the predicted change in price using the duration concept?
b. A 6% coupon bond with semiannual coupons has a convexity (in years) of 120,
sells for 80% of par, and is priced at a yield to maturity of 8%. If the YTM
increases to 9.5%, what is the predicted contribution to the percentage change in
price due to convexity?
c. A bond with annual coupon payments has a coupon rate of 8%, yield to maturity
of 10%, and Macaulay duration of 9 years. What is the bond's modified duration?
a.

Bond price decreases by $80.00, calculated as follows:

10 0.01 800 = 80.00

b.

120 (0.015)2 = 0.0135 = 1.35%

c.

9/1.10 = 8.18

11. A newly issued bond has the following characteristics:

a. Calculate modified duration using the information above.

b. Explain why modified duration is a better measure than maturity when calculating the
bond's sensitivity to changes in interest rates.
c. Identify the direction of change in modified duration if:
I.
II.

The coupon of the bond were 4%, not 8%.

The maturity of the bond were 7 years, not 15 years.

d. Define convexity and explain how modified duration and convexity are used to
approximate the bond's percentage change in price, given a change in interest rates.

a.

Modified duration

b.

Macaulay duration
10

9.26 years
1 YTM
1.08

For option-free coupon bonds, modified duration is a better measure of the bonds
sensitivity to changes in interest rates. Maturity considers only the final cash flow,
while modified duration includes other factors, such as the size and timing of
8

coupon payments, and the level of interest rates (yield to maturity). Modified
duration indicates the approximate percentage change in the bond price for a given
change in yield to maturity.

c.

i. Modified duration increases as the coupon decreases.

ii. Modified duration decreases as maturity decreases.

Convexity measures the curvature of the bonds price-yield curve. Such curvature
means that the duration rule for bond price change (which is based only on the
slope of the curve at the original yield) is only an approximation. Adding a term to
account for the convexity of the bond increases the accuracy of the
approximation. That convexity adjustment is the last term in the following
equation:

d.

P
1

( D* y ) Convexity (y) 2
P
2

12. Sandra Kapple presents Maria VanHusen with a description, given in the following
table, of the bond portfolio held by the Star Hospital Pension Plan. All securities in
the bond portfolio are noncallable U.S. Treasury securities.

a. Calculate the effective duration of each of the following:

I.
II.

The 4.75% Treasury security due 2036.

The total bond portfolio.

b. VanHusen remarks to Kapple, If you changed the maturity structure of the bond
portfolio to result in a portfolio duration of 5.25 years, the price sensitivity of the
portfolio would be identical to that of a single, noncallable Treasury security that also
has a duration of 5.25 years. In what circumstance would VanHusen's remark be
correct?

a. (i) The effective duration of the 4.75% Treasury security is:

P / P (116.887 86.372) /100

15.2575
r
0.02

(ii) The duration of the portfolio is the weighted average of the durations of the
individual bonds in the portfolio:
Portfolio duration = w1D1 + w2D2 + w3D3 + + wkDk
where
wi = Market value of bond i/Market value of the portfolio
Di = Duration of bond i
k = Number of bonds in the portfolio
The effective duration of the bond portfolio is calculated as follows:
[($48,667,680/$98,667,680) 2.15] + [($50,000,000/$98,667,680) 15.26] = 8.79

b.

VanHusens remarks would be correct if there were a small, parallel shift in

yields. Duration is a first (linear) approximation only for small changes in yield.
For larger changes in yield, the convexity measure is needed in order to
approximate the change in price that is not explained by duration. Additionally,
portfolio duration assumes that all yields change by the same number of basis
points (parallel shift), so any nonparallel shift in yields would result in a
difference in the price sensitivity of the portfolio compared to the price sensitivity
of a single security having the same duration.

13. Patrick Wall is considering the purchase of one of the two bonds described in the
following table. Wall realizes his decision will depend primarily on effective duration,
and he believes that interest rates will decline by 50 basis points at all maturities over
the next 6 months.

10

a. Calculate the percentage price change forecasted by effective duration for both the
CIC and PTR bonds if interest rates decline by 50 basis points over the next 6
months.
b. Calculate the 6-month horizon return (in percent) for each bond, if the actual CIC
bond price equals 105.55 and the actual PTR bond price equals 104.15 at the end
of 6 months.
c. Wall is surprised by the fact that although interest rates fell by 50 basis points, the
actual price change for the CIC bond was greater than the price change forecasted
by effective duration, whereas the actual price change for the PTR bond was less
than the price change forecasted by effective duration. Explain why the actual
price change would be greater for the CIC bond and the actual price change would
be less for the PTR bond.
a.

% price change = (Effective duration) Change in YTM (%)

CIC:

(7.35) (0.50%) = 3.675%

PTR: (5.40) (0.50%) = 2.700%

b.

Since we are asked to calculate horizon return over a period of only one coupon
period, there is no reinvestment income.
Horizon return =

Coupon payment +Year-end price Initial Price

Initial price

CIC:

$26.25 $1, 055.50 $1, 017.50

0.06314, or 6.314%
$1, 017.50

PTR:

$31.75 $1, 041.50 $1, 017.50

0.05479, or 5.479%
$1, 017.50

c. Notice that CIC is noncallable but PTR is callable. Therefore, CIC has positive
convexity, while PTR has negative convexity. Thus, the convexity correction to
the duration approximation will be positive for CIC and negative for PTR.

14. A five-year bond with a yield of 11% (continuously compounded) pays an 8% coupon
at the end of each year.
a) What is the bonds price?
b) What is the bonds duration?
c) Use the duration to calculate the effect on the bonds price of a 0.2% decrease in
its yield.
d) Recalculate the bonds price on the basis of a 10.8% per annum yield and verify
that the result is in agreement with your answer to (c).

11

a) The bonds price is

8e011 8e0112 8e0113 8e0114 108e0115 8680

b) The bonds duration is

1 011
2 8e0112 3 8e0113 4 8e0114 5 108e0115
8e

8680
4256 years

c) Since, with the notation in the chapter

B BDy
the effect on the bonds price of a 0.2% decrease in its yield is

8680 4256 0002 074

The bonds price should increase from 86.80 to 87.54.
d) With a 10.8% yield the bonds price is
8e0108 8e01082 8e01083 8e01084 108e01085 8754
This is consistent with the answer in (c).

15. Portfolio A consists of a one-year zero-coupon bond with a face value of $2,000 and a
10-year zero-coupon bond with a face value of $6,000. Portfolio B consists of a 5.95year zero-coupon bond with a face value of $5,000. The current yield on all bonds is
10% per annum.
(a) Show that both portfolios have the same duration.
(b) Show that the percentage changes in the values of the two portfolios for a 0.1% per
annum increase in yields are the same.
(c) What are the percentage changes in the values of the two portfolios for a 5% per
annum increase in yields?
a) The duration of Portfolio A is
1 2000e011 10 6000e0110
595
2000e011 6000e0110
Since this is also the duration of Portfolio B, the two portfolios do have the same
duration.
b) The value of Portfolio A is
2000e01 6000e0110 401695
When yields increase by 10 basis points its value becomes
2000e0101 6000e010110 399318

12

The percentage decrease in value is

2377 100
059%
401695

The value of Portfolio B is

5000e01595 275781
When yields increase by 10 basis points its value becomes
5000e0101595 274145
The percentage decrease in value is

1636 100
059%
275781
The percentage changes in the values of the two portfolios for a 10 basis point
increase in yields are therefore the same.

c) When yields increase by 5% the value of Portfolio A becomes

2000e015 6000e01510 306020
and the value of Portfolio B becomes
5000e015595 204815
The percentage reductions in the values of the two portfolios are:

95675
100 2382
401695
70966
Portfolio B
100 2573
275781
Since the percentage decline in value of Portfolio A is less than that of Portfolio B,
Portfolio A has a greater convexity.
Portfolio A

13