CFA Level I Fixed Income

Understanding Fixed-Income Risk and Return

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 Contents and Introduction
1. Introduction

2. Sources of Return

3. Interest Rate Risk on Fixed-Rate Bonds

4. Interest Rate Risk and the Investment Horizon

5. Credit and Liquidity Risk

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 2. Sources of Return

Receipt of the promised coupon and principal payments on the

scheduled dates

Reinvestment of coupon payments

Potential capital gains or losses on the sale of the bond prior to

maturity

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Example 1

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Example 2

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10-year, 8% annual payment bond purchased at a price of 85.503075 per 100 of par value.

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Example 3

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Example 4

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Example 5

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Example 6

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Example 7

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 3. Interest Rate Risk on Fixed-Rate Bonds

1. Macaulay, Modified and Approximate Duration

2. Effective Duration

3. Properties of Bond Duration

4. Duration of a Bond Portfolio

5. Money Duration of a Bond and the Price Value of a Basis Point

6. Bond Convexity

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3.1 Macaulay, Modified, and Approximate Duration
The duration of a bond measures the sensitivity of the bonds full price (including
accrued interest) to changes in interest rates.

Yield Duration
Macaulay duration
Modified duration
Money duration
PVBP

Curve Duration
Effective duration

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 Macaulay Duration
Macaulay duration is a weighted average of the time to receipt of the bonds promised
payments, where the weights are the shares of the full price that correspond to each
of the bonds promised future payments.

The Macaulay duration of the 10-year, 8%

annual payment bond is calculated by
plugging r = 0.1040, c = 0.0800, N = 10, and
t/T = 0 into the above equation.

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 Modified Duration

Modified duration provides an estimate of the

percentage price change for a bond given a change in its
yield-to-maturity.

%PVFull AnnModDur yield

Modified duration provides a linear estimate of the

percentage price change.

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Approximate Modified Duration

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Example 8

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 3.2 Effective Duration
Bonds with embedded options and mortgage back securities do not have a well
defined YTM. Hence yield duration statistics do not apply.

The effective duration of a bond is the sensitivity of the bonds price to a change in
a benchmark yield curve.

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Example 9

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 3.3 Properties of a Bond Duration
The Macaulay and modified yield duration statistics for a traditional fixed-rate bond are functions of
the input variables: the coupon rate or payment per period, the yield- to-maturity per period, the
number of periods to maturity (as of the beginning of the period), and the fraction of the period that
has gone by.

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Exhibit 7 Properties of Macaulay Yield Duration

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Example 10

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Exhibit 8 Interest Rate Characteristic of a Callable Bond

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Exhibit 8 Interest Rate Characteristic of a Putable Bond

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 3.4 Duration of a Bond Portfolio
2 ways to calculate the duration of a bond portfolio
1. Weighted average of time to receipt of the aggregate cash flows
2. Weighted average of the individual bond durations that comprise the portfolio.

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 3.4 Duration of a Bond Portfolio
Weighted average of time to receipt of Weighted average of the individual bond
the aggregate cash flows durations that comprise the portfolio
Theoretically correct but difficult to use in Commonly used in practice
practice Easy to use a measure of interest rate risk
Cash flow yield not commonly used More accurate as differences in YTMs of
Amount and timing of cash flows might not be bonds in portfolio become smaller
known Assumes parallel shifts in the yield curve
Interest rate risk is usually expressed as a
change in benchmark interest rates, not as a
change in the cash flow yield
Change in the cash flow yield is not
necessarily the same amount as the change in
the yields-to-maturity on the individual bonds

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Example 11

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3.5 Money Duration of a Bond and the Price Value of a Basis Point

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3.6 Bond Convexity

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4. Interest Rate Risk and the Investment Horizon

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4.1 Yield Volatility

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4.2 Investment Horizon, Macaulay Duration, and Interest Rate Risk

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5. Credit and Liquidity Risk

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Summary

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 Conclusion
Read the summary

Review learning objectives

Examples

Practice problems

Practice questions from other sources

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