In: Finance
Suppose that a bond has the following terms:
•10-years-to-maturity
•$1000 face value
•Semi-annual coupons, with an annual coupon rate of 5%
Suppose that all discount rates are 7%.
1. Calculate the price of the bond.
2. Calculate the bond’s modified duration.
3. Calculate the bond’s convexity.
4. If discount rates increase to 10%, what is the new price of the bond. Do (i) the actual calculation and (ii) approximate the new bond price using the duration and convexity. How well does the duration and convexity approximation work?
1
K = Nx2 |
Bond Price =∑ [( Coupon)/(1 + YTM/2)^k] + Par value/(1 + YTM/2)^Nx2 |
k=1 |
K =10x2 |
Bond Price =∑ [(5*1000/200)/(1 + 7/200)^k] + 1000/(1 + 7/200)^10x2 |
k=1 |
Bond Price = 857.88 |
2
Period | Cash Flow | Discounting factor | PV Cash Flow | Duration Calc |
0 | ($857.88) | =(1+YTM/number of coupon payments in the year)^period | =cashflow/discounting factor | =PV cashflow*period |
1 | 25.00 | 1.04 | 24.15 | 24.15 |
2 | 25.00 | 1.07 | 23.34 | 46.68 |
3 | 25.00 | 1.11 | 22.55 | 67.65 |
4 | 25.00 | 1.15 | 21.79 | 87.14 |
5 | 25.00 | 1.19 | 21.05 | 105.25 |
6 | 25.00 | 1.23 | 20.34 | 122.03 |
7 | 25.00 | 1.27 | 19.65 | 137.55 |
8 | 25.00 | 1.32 | 18.99 | 151.88 |
9 | 25.00 | 1.36 | 18.34 | 165.09 |
10 | 25.00 | 1.41 | 17.72 | 177.23 |
11 | 25.00 | 1.46 | 17.12 | 188.36 |
12 | 25.00 | 1.51 | 16.54 | 198.53 |
13 | 25.00 | 1.56 | 15.99 | 207.81 |
14 | 25.00 | 1.62 | 15.44 | 216.22 |
15 | 25.00 | 1.68 | 14.92 | 223.83 |
16 | 25.00 | 1.73 | 14.42 | 230.68 |
17 | 25.00 | 1.79 | 13.93 | 236.81 |
18 | 25.00 | 1.86 | 13.46 | 242.26 |
19 | 25.00 | 1.92 | 13.00 | 247.07 |
20 | 1,025.00 | 1.99 | 515.13 | 10,302.60 |
Total | 13,378.83 |
Macaulay duration =(∑ Duration calc)/(bond price*number of coupon per year) |
=13378.83/(857.88*2) |
=7.797613 |
Modified duration = Macaulay duration/(1+YTM) |
=7.8/(1+0.07) |
=7.533925 |
3
Period | Cash Flow | Discounting factor | PV Cash Flow | Duration Calc | Convexity Calc |
0 | ($857.88) | =(1+YTM/number of coupon payments in the year)^period | =cashflow/discounting factor | =PV cashflow*period | =duration calc*(1+period)/(1+YTM/N)^2 |
1 | 25.00 | 1.04 | 24.15 | 24.15 | 45.10 |
2 | 25.00 | 1.07 | 23.34 | 46.68 | 130.72 |
3 | 25.00 | 1.11 | 22.55 | 67.65 | 252.59 |
4 | 25.00 | 1.15 | 21.79 | 87.14 | 406.75 |
5 | 25.00 | 1.19 | 21.05 | 105.25 | 589.49 |
6 | 25.00 | 1.23 | 20.34 | 122.03 | 797.38 |
7 | 25.00 | 1.27 | 19.65 | 137.55 | 1,027.22 |
8 | 25.00 | 1.32 | 18.99 | 151.88 | 1,276.05 |
9 | 25.00 | 1.36 | 18.34 | 165.09 | 1,541.13 |
10 | 25.00 | 1.41 | 17.72 | 177.23 | 1,819.90 |
11 | 25.00 | 1.46 | 17.12 | 188.36 | 2,110.03 |
12 | 25.00 | 1.51 | 16.54 | 198.53 | 2,409.35 |
13 | 25.00 | 1.56 | 15.99 | 207.81 | 2,715.85 |
14 | 25.00 | 1.62 | 15.44 | 216.22 | 3,027.71 |
15 | 25.00 | 1.68 | 14.92 | 223.83 | 3,343.22 |
16 | 25.00 | 1.73 | 14.42 | 230.68 | 3,660.86 |
17 | 25.00 | 1.79 | 13.93 | 236.81 | 3,979.19 |
18 | 25.00 | 1.86 | 13.46 | 242.26 | 4,296.94 |
19 | 25.00 | 1.92 | 13.00 | 247.07 | 4,612.92 |
20 | 1,025.00 | 1.99 | 515.13 | 10,302.60 | 201,969.35 |
Total | 13,378.83 | 240,011.76 |
Convexity =(∑ convexity calc)/(bond price*number of coupon per year^2) |
=240011.76/(857.88*2^2) |
=69.94 |
4
i
Actual bond price change |
K = Nx2 |
Bond Price =∑ [( Coupon)/(1 + YTM/2)^k] + Par value/(1 + YTM/2)^Nx2 |
k=1 |
K =10x2 |
Bond Price =∑ [(5*1000/200)/(1 + 10/200)^k] + 1000/(1 + 10/200)^10x2 |
k=1 |
Bond Price = 688.44 |
ii
Using only modified duration |
Mod.duration prediction = -Mod. Duration*Yield_Change*Bond_Price |
=-7.53*0.03*857.88 |
=-193.9 |
Using convexity adjustment to modified duration |
Convexity adjustment = 0.5*convexity*Yield_Change^2*Bond_Price |
0.5*69.94*0.03^2*857.88 |
=27 |
We can check how well it works by calculating %age between actual and predicted values
Difference in price predicted and actual |
=predicted price-actual price |
=690.99-688.44 |
=2.545 |
%age difference = difference/actual-1 |
=2.55/688.44 |
=0.3697% |
New bond price = bond price+Mod.duration pred.+convex. Adj. |
=857.88-193.9+27 |
=690.99 |