Discounting, Present & Future Value

Consider a simplest bond - ZCB

• Discounting cash flows • Future Value

Bond Fundamentals • Present Value:

CT
FV = PV (1 + y ) t
PV =
(1 + y ) T
• 6% Int. rate, FV of $100 & • 6% Int. rate, PV of $100 &
10 years to mature 10 years to mature
$100
PV = = $55.84 FV = $100 × (1 + 0.06)10 = $179.08
(1 + 0.06)10

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Transforming between compounding intervals

Compounding…
Annual rate can be transformed into
ZCB: • semi-annual using:
If the interest rate is compounding semi-annually:
(1+ys/2)2 = (1+y)
CT • continuously compounding:
PV = 2T
 ys  exp (yc) = 1+y (or) yc = ln(1+y)
1 + 
 2  • Increasing frequency of compounding decreases resulting
rates.
If it is Continuous compounding i.e., y > ys > yq > yc
Money works harder with more frequent compounding, a lower
PV = CT e − yT rate will achieve the same payoff.
“The most powerful force in the universe is compound interest.”-

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Price-Yield Relationship Perpetual Bonds / Consols

where ‘Ct’ is the cashflow at time • Bonds that have fixed coupon payments for infinite period
T
Ct of time.
P=∑
cF cF cF  1 1  cF
period ‘t’, ‘T’ is the number of PV = + + ... = 1 + + + ...  =
(1 + y ) (1 + y ) 2 (1 + y )  (1 + y ) (1 + y) 2
t =1 (1 + y )
t  y
periods to maturity, and ‘y’ is the
discount factor. • A bond that pays c.F for T periods and F at Period T can be
considered as a portfolio of Consols and a ZCB:
For a bond that pays coupons (at the rate c) each period [Long Consol + Short Consol starting at T + Long ZCB maturing at T]
and the face value (F) at T:
cF 1 cF F cF  1  F
 T c.F  PV = − + = 1 −  +
P =  ∑  +
F y (1 + y )T y (1 + y )T y  (1 + y )T  (1 + y )
T

 t =1 (1 + y )  (1 + y )
t T

• If c=y, and both are having same frequency in compounding,

‘y’ can be interpreted as Internal Rate of Return (how?) then the bond is at “Par Value”

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 Price-yield Relationship Change in P for small changes in y
• How does Price of a Bond change for small changes in ‘y’?
P • Re-price using Price-Yield relationship.
Price (P) = f(y)
(or)
• Use shortcut: Taylor expansion
• Initial value y0, new value y1, change ∆y:
Price of a bond as a function of yield y1 = y 0 + ∆y

1
P = f ( y1 ) = f ( y0 ) + f ' ( y0 )∆y + f " ( y0 ) ∆y 2 + K
2

d 2P
where f ' ( y ) = , f '' ( y ) = 2 ,...
dP
y
dy dy

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Taylor Expansion Contd. Taylor Expansion Contd.

• For bonds,
f ' (y0) & f ''(y0) are related to Duration & Convexity.
• These first two terms provide good approximation. (used by
practitioners) For Portfolio with xi units of bond ‘i’ & a total of N
1
∆P = f ( y1 ) − f ( y0 ) = f ' ( y0 ) ∆y + f " ( y0 ) ∆y 2 bonds,
2
• If increment in y0 (∆y) is very small, then even the first N
Portfolio derivatives f ' ( y ) = ∑ xi f i ' ( y )
difference alone would do. i =1
• For derivatives, 1
∆P = f ' ( s ) ∆s + f " ( s )∆s 2
2
d 2P
where f ' (s ) = , f '' (s ) = 2
dP
ds ds

f ' (s) is Delta & f ''(s) is Gamma.

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Bond Price Derivatives Duration & Convexity

• For fixed income instruments,
P
negative of first derivative is “Dollar Duration” [DD]
dP
f ' ( y0 ) = = − D * × P0 Actual Price
dy Approximation with Duration
where DD = D *P & D* is “Modified Duration” Approximation with Convexity & Duration
• Dollar convexity = the second derivative,
d 2P
f " ( y0 ) = = C × P0
dy 2
where C is “Convexity”

• Taylor expansion for a bond, ∆P = −[D* × P ]( ∆y ) + 1 [C × P ]( ∆y 2 ) + ... y

2

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 Duration & Convexity for a ZCB Greater Convexity - Beneficial
• Only Cash flow (CT at T) is the Face Value F. Higher Convexity
P
F dP F T Lower Convexity
P= & = −T =− P
(1 + y )T dy (1 + y )T +1 (1 + y ) Greater Convexity is beneficial for both
falling and rising yields.
• Modified Duration D* = T/(1+y)
• Duration is expressed in periods. For annual compounding, duration in yrs…
for semi-annual compounding, duration is in semesters… Price drops less Vs a bond with Lower Convexity.
• If duration is in semesters, divide it by 2 to get it for yrs. Price rises more Vs a bond with lower Convexity.
• Conventional Duration (Macaulay Duration) D = T
• Using Continuous Compounding formula gives Macaulay Duration T… How?
• In practice the difference between Modified & Macaulay Duration is small
• Second derivative: d 2P T (T + 1)
= −T (T + 1)
F
=− P
dy 2 (1 + y )T + 2 (1 + y )2
T (T + 1) y
• Convexity =− semester squared (for semi-annual compounding)
(1 + y )2
• If duration is in semesters, divide by 4 to convert to years squared.

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Interpreting Duration & Convexity Interpreting Duration & Convexity Contd.

• For a coupon paying bond, • For a 6% coupon on 10 yr bond, duration is 7.8 yrs.
T
Ct This is equivalent to a ZCB maturing exactly in 7.8 yrs.
P=∑
t =1 (1 + y )
t

dP T − tCt  T − tCt   P D • For bonds with fixed coupon payments, duration is less than
=∑ =  ∑  P  × =− P
dy t =1 (1 + y) t +1  t =1 (1 + y) t   (1 + y ) (1 + y ) maturity.
T
tCt
where, D = ∑ P • Higher coupons place more weight on prior payments &
t =1 (1 + y )
t

• Average time to wait for each payment, weighted by the PV therefore, reduce duration.
of associated cash flow.
Ct
t
T
(1 + y )t T where, wt is the ratio of PV of
i.e., D = ∑ T = ∑ t × wt cash flow relative to the total
Ct
t =1
∑
t =1 (1 + y )
t
t =1 cash flow & sum of wt is 1.

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Interpreting Duration & Convexity Contd. Interpreting Duration & Convexity Contd.

• Macaulay Duration of a Consol: • For a coupon paying bond,

d 2 P T t (t + 1)Ct T
t (t + 1)Ct P
PV =
cF dP cF P
=− 2 =− =−
DC =∑ =∑ ×
y
&
dy y y (1 + y )
P dy 2 t =1 (1 + y )t + 2 t =1 (1 + y )t + 2 P

T
t (t + 1)Ct
where C = ∑ P
1+ y t =1 (1 + y )t +2
• Macaulay Duration for Consol is Dc =
y

• Observations: • Convexity can also be written as:

• Duration of a Consol is finite even if maturity is infinite.
t (t + 1) Ct (1 + y ) t (t + 1)
T t T

• Duration of a Consol does not depend on coupon. C=∑ × =∑ ×w

(1 + y )2 T
(1 + y )2 t
t =1
∑ C (1 + y ) t =1
t

• Rule of thumb: For a long-term coupon paying bond, t =1

t

1+ y
duration must be LOWER than [Upper Bound].
y
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 Portfolio Duration and Convexity
N
Portfolio Dollar Duration: D *p Pp = ∑ Di* xi Pi
i =1
where xi – No. of units of bond i

xP
Portfolio weights: wi = i i
Pp

N
Portfolio Duration: D *p = ∑ wi Di*
i =1

N
Portfolio Convexity: C *p = ∑ wi Ci*
i =1

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