In: Finance
Elliot Karlin is a 35-year-old bank executive who has just
inherited a large sum of money. Having spent several years in the
bank's investments department, he's well aware of the concept of
duration and decides to apply it to his bond portfolio. In
particular, Elliot intends to use $ 1 million of his inheritance to
purchase 4 U.S. Treasury bonds:
1. An 8.69 %, 13-year bond that's priced at $ 1 comma 100.37 to
yield 7.47 %.
2. A 7.821 %, 15-year bond that's priced at $ 1024.08 to yield
7.55 %.
3. A 20-year stripped Treasury (zero coupon) that's priced at $
198.52 to yield 8.25 %.
4. A 24-year, 7.46 % bond that's priced at $ 957.11 to yield 7.86
%.
Note that these bonds are semiannual compounding bonds.
a. Find the duration and the modified duration of each bond.
b. Find the duration of the whole bond portfolio if Elliot puts $
250 comma 000 into each of the 4 U.S. Treasury bonds.
c. Find the duration of the portfolio if Elliot puts $ 380 comma
000 each into bonds 1 and 3 and $ 120 comma 000 each into bonds 2
and 4.
d. Which portfoliolong dashb or clong dashshould Elliot select if
he thinks rates are about to head up and he wants to avoid as much
price volatility as possible? Explain. From which portfolio does
he stand to make more in annual interest income? Which portfolio
would you recommend, and why?
Part (a)
I have used the excel functions Duration and Mduration. Inputs are settlement date which i have arbitrarily assumed to be 01/01/2019 for each of them. This doesn't impact any of the answers. Maturity date has been assumed to be the same date i.e. (01/01) but as many years later as is the maturity of the bond. Type is 2 which reflects semi annual coupon payment.
Bond | Settlement | Maturity | Coupon | Yield | Duration | Modified Duration |
A | B | C | D | E = DURATION (A, B, C, D, 2) | F = MDURATION (A, B, C, D, 2) | |
13 years bond | 1/1/2019 | 1/1/2032 | 8.69% | 7.47% | 8.2791 | 7.9810 |
15 year bond | 1/1/2019 | 1/1/2034 | 7.82% | 7.55% | 9.1561 | 8.8230 |
20-year Zero coupon bond | 1/1/2019 | 1/1/2039 | 0% | 8.25% | 20.0000 | 19.2077 |
24 year bond | 1/1/2019 | 1/1/2043 | 7.46% | 7.86% | 11.2516 | 10.8261 |
Part (b)
Equal weights across all four. Hence, duration = average duration = (8.2791 + 9.1561 + 20.0000 + 11.2516) / 4 = 12.1717
Part (c)
Duration = Weighted average duration = 0.38 x 8.2791 + 0.12 x 9.1561 + 0.38 x 20 + 0.12 x 11.2516 = 13.1950
Part (d)
Duration is a measure of volatility or interest rate risk. A lower duration assures a relatively lower decline in price when interest rate rises. Hence, Elliot should select the first portfolio where an amount of $ 250,000 is invested across each of the four bonds. This portfolio has lower duration and hence should have lower reduction in value when interest rate heads up.
Lower the proportion of zero coupon bond in the portfolio, higher will be the interest income. Hence, the first portfolio where an amount of $ 250,000 is invested across each of the four bonds, will give the higher interest income.
I would have advised the first portfolio where an amount of $ 250,000 is invested across each of the four bonds. This portfolio has lower duration as well as higher interest income.