Duration and Portfolio Immunization.PPT

Duration and Portfolio Immunization Let P denote the price of a bond with m coupon payments per year; also, lety : yield per each coupon payment period,n : number of coupon payment periodsF: par value paid at maturity * * Macaulay duration The duration of a fixed income instrument is a weighted average of the times that payments (cash flows) are made. The weighting coefficients are the present values of the individual cash flows. where PV(t) denotes the present value of the cash flow that occurs at time t. If the present value calculations are based on the bond’s yield, then it is called the Macaulay duration. : coupon amount in each coupon payment Now, then Note that l = my. modified duration = Macaulay duration = ? The negativity of indicates that bond price drops as yield increases. ? Prices of bonds with longer maturities drop more steeply with increase of yield. This is because bonds of longer maturity have longer Macaulay duration: Example Consider a 7% bond with 3 years to maturity. Assume that the bond is selling at 8% yield. ? ? Here, l = 0.08, m = 2, y = 0.04, n = 6, C = 3.5, F = 100. ~ Quatitative properties of duration Duration of bonds with 5% yield as a function of maturity and coupon rate. Coupon rate Suppose the yield changes to 8.2%, what is the corresponding change in bond price? Here, y = 0.04, ?? = 0.2%, P = 97.379, D = 2.753, m = 2. The change in bond price is approximated by i.e. Properties of duration 1. Duration of a coupon paying bond is always less than its maturity. Duration decreases with the increase of coupon rate. Duration equals bond maturity for non-coupon paying bond. 2. As the time to maturity increases to infinity, the duration do not increase to infinity but tend to a finite limit independent of the coupon rate. Actually, where l is the yield per annum, and m is the number of coupon payments per year. Durations are not qu