Portfolio Management

TUTORIAL SESSION #3
BY FLORENT ROUXELIN

2015-2016 Florent Rouxelin ALL RIGHTS RESERVED. Please do not circulate.

Tutorial Session 3 - Florent Rouxelin 11/08/2017
 Macaulay duration VS Modified duration
2

=
(1+)
Macaulay duration and modified duration are mainly
used to calculate the durations of bonds.

The Macaulay duration calculates the weighted

average time before a bondholder would receive the
bond's cash flows.

Modified duration measures the price sensitivity of a

bond when there is a change in the yield to maturity

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Formula Sheet
3

Calculate Macaulay duration:

Derivation of the duration:

For small changes in yield (approximation):

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Duration
4

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Immunization
5

Immunization is a strategy that matches

the durations of assets and liabilities thereby
minimizing the impact of interest rates on the net
worth.

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 What is duration?
6

http://www.investopedia.com/video/play/basics-bond-duration/
Tutorial Session 3 - Florent Rouxelin 11/08/2017
 Exercise 1
7

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Exercise 1 a)
8

Price change if the term structure of interest rate shifts to 7%:

P D*(y)P
y 7% 6% 1%
P 20 20 20 120 $148.51
(1 6%) (1 6%)2 (1 6%)3 (1 6%)4
T CFt /(1 y)t 1 20
D t ( 20 2 20 3 120 4) 3.26
t 1 P P (1 6%) (1 6%)2 (1 6%)3 (1 6%)4

D* D 3.26 3.08
(1 y) (1 6%)
P 3.081%148.51 $ 4.58
Pnew 148.51 4.58 $143.93
t0 t1 t2 t3 t4->Maturity

Duration= 3.26 years: weighted average of the times until fixed cash flows are received
Tutorial Session 3 - Florent Rouxelin 11/08/2017
 Exercise 1 b)
9

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Exercise 1 b)
10

Actual price:
20 1 100
= 0.07 1 1.074 + 1.074=$144.03

= 144.03 143.93=$0.10

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Exercise 1 c)
11

c. Could you please explain the approximation error of

using duration rule by the price-yield curve and thus
the relationship between yield and duration?

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Exercise 1 c)
12

The price-yield curve of a bond is convex

Bonds duration @ specific yield level is the slope of the curve at that interest rate
When interest rate increases, the curve becomes flatter, and hence the duration becomes
smaller.
So when you use the duration rule to calculate price changes: DP/P ~= -DDy/(1+y), the
duration is that at the original interest rate (6%) which is bigger than the actual durations
(which keeps changing, become smaller and smaller) over the course of interest rate
increase. And thus the estimated (negative) price change is too big in magnitude.

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Exercise 1 d)
13

Now lets assume that the convexity of this bond is

13.47. Please estimate the price change by using both
duration and convexity.

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Exercise 1 d)
14

P (y ) 1
D Convexity (y ) 2
P (1 y ) 2
P
13.47 1% 3.00%
1% 1
3.26
2

P (1 6%) 2
PApprox _ New 148.51* (1 0.03) 144.06
The new approximation including convexity is much closer to the true price:
$144.03, hence $0.03 difference only.

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Exercise 1 e)
15

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Exercise 1 c)
16

The dollar error would have been smaller due to the

convex nature of the price-yield relationship. All
other things being equal, the higher the level of
interest rate, the flatter the curve is.

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Exercise 2
17

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Exercise 2
18

Portfolio of 1 bond A and 1 bond B:

Let :
CF Cash _ Flow
Pa
wa
Pa Pa
P
wa b
Pa P
b
(CF CF )
T at bt
1
Dp ( ) t
Pp t 1
(1 yt )t


CF
T CFa b
Dp ( 1 t t t
Pa P t
) t
b 1 (1 yt ) (1 yt )
t t

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Exercise 2 (continued)
19

CF
CFa b

1 T (1 yt )t (1 yt )t
Dp tP
Pa Pa t Pa t
1 Pa b Pb



CF
CF
a b

1 P T (1 yt )
t T (1 y )t
Dp t P t t
Pa P a t
1


Pa
b t 1 Pb
b

Dp 1 P D P D w D w D
Pa P a a b b a a b b
b
Tutorial Session 3 - Florent Rouxelin 11/08/2017
 Exercise 3
20

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Exercise 3
21
Zero coupon bond: Maturity == Duration

Buy Wa of bond A and Wb of bond B such that:

- Their weighted duration matches liability Xs duration
- Wa+Wb=1

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Exercise 3 a) (continued)
22
Solve :
w D w D 4 D
A A B B x
w D (1 w ) D 4 D
A A A B x

Hence :
D D
w x B
A D D
A B

Given :
D 3 years
A
D 6 years
B
D 4 years
X

Finally :
w 2/3
A
w 1 w 1/ 3
B A
Tutorial Session 3 - Florent Rouxelin 11/08/2017
 Exercise 3 a) (continued)
23

Now we calculate the price of each bond:

P 100 $86.4
A (1.05)3

P 100 $74.6
B (1.05)6

Px 100 $82.3
(1.05)4

Invest (2/3 value of liability X) in bond A:

2/3*Px=2/3*82.3=$54.85
Equivalent to: Na = 54.85/86.4=0.63 bond A

Invest (1/3 value of liability X) in bond B:

1/3*Px=1/3*82.3=$27.42
Equivalent to: Nb = 27.42/74.6=0.37 bond B
Tutorial Session 3 - Florent Rouxelin 11/08/2017
 Exercise 3 b)
24

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Exercise 3 b)
25

P 100 $74.62 Invest (1.5 value of liability X) in bond B:

B (1.05)6 1.5*82.3=$123.4
Equivalent to buy: Nb = 123.4/74.62 = 1.65 bond B
P 100 $61.4
C (1.05)10 Sell/short sell (0.5 value of liability X) in bond C:
0.5*82.3=$41.1
D 6 years Equivalent to sell: Nc = 41.1/61.4 = 0.67 bond C
B
D 10 years
C
D 4 years
X
w D (1 w ) D 4 Dx
B B B C
w 1 .5
B
w 1 w 0.5
C B
Buy 1.5 bond C and short 0.5 bond C
Tutorial Session 3 - Florent Rouxelin 11/08/2017
 Exercise 3 c)
26

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Exercise 3 c)
27

100
P $74.6
B (1.05)6
100
P $61.4
C (1.05)10
100
P $82.27
X (1.05)6
100
P $64.46
Y (1.05)9
82.27
w 0.56
X 82.27 64.46 Invest (0.95 value of liability (X+Y)) in bond B:
64.46 0.95*(64.46+82.3)=$139.4
w 0.44
Y 82.27 64.46 Equivalent to buy: Nb = 139.4/74.6 = 1.87 bond B
w D w D 6 .2
X X Y Y
w D (1 w ) D 6.2 Dx Sell/short sell (0.5 value of liability (X+Y)) in bond C:
B B B C 0.05*(64.46+82.3)=$7.3
w 0.95
B Equivalent to buy: Nc = 7.3/61.4 = 0.12 bond C
w 1 w 0.05
C B
Tutorial Session 3 - Florent Rouxelin 11/08/2017
 Question 4) a)
28

Consider the following bonds:

Bond A: A 2-year zero-coupon bond with a face value of $100 and 6% YTM.
Bond B: A 2-year par-value bond with a face value of $100 and 6% coupon.
Bond C: A 2-year par-value bond with a face value of $100 and 7% coupon.
Bond D: A 3-year par-value bond with a face value of $100 and 7% coupon.
Bond E: A 4-year par-value bond with a face value of $100 and 7% coupon.
Bond F: A 4-year discount bond with a face value of $100 and 7% coupon.
If the yield curve shifts upwards by one percent,

a. Which bond among bonds A, B and C will experience the largest percentage
price change? Which will have the lowest percentage price change?

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Exercise 4) a)
29

A, B, C same maturity
A zero-coupon bond, B: 6% bond, C: 7% coupon
bond
D(A)>D(B)>D(C)
A would experience the highest price change
C would experience the lowest price change

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Exercise 4) b)
30

b. Which bond of bonds C and D will experience a

larger percentage price change?

Bond C: A 2-year par-value bond with a face value of

$100 and 7% coupon.
Bond D: A 3-year par-value bond with a face value of
$100 and 7% coupon.

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Exercise 4) b)
31

Bond D would experience a larger price change

because higher maturity

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Question 4 c)
32

c. Would you expect the difference in percentage price

change to be bigger between bonds C and D or
between bonds D and E?

Bond C: A 2-year par-value bond with a face value of

$100 and 7% coupon.
Bond D: A 3-year par-value bond with a face value of
$100 and 7% coupon.
Bond E: A 4-year par-value bond with a face value of
$100 and 7% coupon.
Tutorial Session 3 - Florent Rouxelin 11/08/2017
 Question 4 c)
33

Only difference between these 3 bonds is their

maturity
All other things being equal, duration increases with
maturity at a decreasing rate.
D(E) > D(D) > D(C), but
[D(E) D(D)] < [D(D) D(C)]
Highest difference in price change between D and C

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Question 4 d)
34

d. Which bond of bonds E and F will experience a

larger percentage price change?

Bond E: A 4-year par-value bond with a face value of

$100 and 7% coupon.
Bond F: A 4-year discount bond with a face value of
$100 and 7% coupon.

Tutorial Session 3 - Florent Rouxelin 11/08/2017

 Question 4 d)
35

The only difference between bonds E and F is the

YTM
Bond F is a discount bond so its YTM>Coupon
rate=7%, where YTM of bond E = 7% (par-value
bond)
Bond E has higher duration, hence experience a
larger price change

Tutorial Session 3 - Florent Rouxelin 11/08/2017