Interest Rates and Security Valuation

Thota Nagaraju
Dept of Econ & Fin
BITS-Pilani Hyd Campus
Fundamentals of Finance & Accounting
Topic: Interest Rates and Security Valuation
Source: Chapter-03: 8th edition…

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Various Interest Rate Measures
➢Coupon rate
• periodic cash flow a bond issuer contractually promises to pay a bond holder
➢Required rate of return (rrr)
• rates used by individual market participants to calculate fair present values (PV)
➢Expected rate of return (Err)
• rates participants would earn by buying securities at current market prices (P)
➢Realized rate of return (rr)
• rates actually earned on investments

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Required Rate of Return
The fair present value (PV) of a security is determined using the
required rate of return (rrr) as the discount rate
~ ~ ~ ~
CF1 CF2 CF3 CFn
PV = + + + ... +
(1 + rrr ) (1 + rrr ) (1 + rrr )
1 2 3
(1 + rrr ) n

CF1 = cash flow in period t (t = 1, …, n)

~ = indicates the projected cash flow is uncertain
n = number of periods in the investment horizon

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Expected Rate of Return
The current market price (P) of a security is determined using the
expected rate of return (Err) as the discount rate
~ ~ ~ ~
CF1 CF2 CF3 CFn
P= + + + ... +
(1 + Err ) (1 + Err ) (1 + Err )
1 2 3
(1 + Err ) n

CF1 = cash flow in period t (t = 1, …, n)

~ = indicates the projected cash flow is uncertain
n = number of periods in the investment horizon

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The Relation between Required Rate of Return and Expected Rate of Return
.

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Realized Rate of Return
The realized rate of return (rr) is the discount rate that just equates the
actual purchase price ( P ) to the present value of the realized cash flows
(RCFt) t (t = 1, …, n)
RCF1 RCF2 RCF3 RCFn
P= + + + ... +
(1 + rr) (1 + rr) (1 + rr)
1 2 3
(1 + rr) n

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Bond Valuation (Semi-Annul Compounding Method)
The present value of a bond (Vb) can be written as:

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Bond Valuation (Semi-Annul Compounding Method (S.A) Vs Continuous Compounding Method (CC))
The present value of a bond (Vb) can be written as:

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Bond Valuation (Text Book Numerical Example, Semi-Annual Compounding Method)
You are considering the purchase of a $1,000 face value bond that pays 10 percent coupon interest per year, with
the coupon paid semiannually (i.e., $50 (= 1,000(.1)/2) over the first half of the year and $50 over the second half
of the year). The bond matures in 12 years (i.e., the bond pays interest (12 × 2 =) 24 times before it matures). If
the required rate of return (𝑟𝑏 ) on this bond is 8 percent (i.e., the periodic discount rate is (8%/2 = 4 percent), the
market value of the bond is calculated as follows:

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Bond Valuation (Text Book Numerical Example S.A versus CC)

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Bond Valuation (Premium, Discount and Par)
➢A premium bond has a coupon rate (INT) greater then the required rate of return
(rrr) and the fair present value of the bond (Vb) is greater than the face value (M)
➢Discount bond: if INT < rrr, then Vb < M
➢Par bond: if INT = rrr, then Vb = M

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Bond Valuation Formula Used to Calculate Yield to Maturity
.

The yield to maturity calculation

implicitly assumes that all coupon
payments periodically received by
the bond holder can be reinvested
at the same rate—that is,
reinvested at the calculated yield
to maturity.

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Equity Valuation
➢The valuation process for an equity instrument (such as preferred or common stock)
involves finding the present value of an infinite series of cash flows on the equity
discounted at an appropriate interest rate.
➢Even if an equity holder decides not to hold the stock forever, he or she can sell it to
someone else who in a fair and efficient market is willing to pay the present value of the
remaining (expected) dividends to the seller at the time of sale.
➢Dividends on equity are that portion of a firm’s earnings paid out to the stockholders.
Those earnings retained are normally reinvested to produce future income and future
dividends for the firm and its stockholders.
➢Thus, conceptually, the fair price paid for investing in stocks is the present value of its
current and future dividends.
➢Growth in dividends occurs primarily because of growth in the firm’s earnings, which is, in
turn, a function of the profitability of the firm’s investments and the percentage of these
profits paid out as dividends rather than being reinvested in the firm.

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Equity Valuation
Using the time value of money concepts that we learnt in the previous chapter
(Determinants of Interest Rates) we can evaluate a stock from several different
perspectives.
Lets define the basic variables goes into the equation.
𝐷𝑡 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑖𝑑 𝑜𝑢𝑡 𝑡𝑜 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟 𝑡
𝑃𝑡 = 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑓𝑖𝑟𝑚’𝑠 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟 𝑡
𝑃0 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑓𝑖𝑟𝑚’𝑠 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘
𝑟𝑠 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑢𝑠𝑒𝑑 𝑡𝑜 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑜𝑛 𝑎𝑛 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛 𝑎 𝑠𝑡𝑜𝑐𝑘

1
1−
[1+𝑟𝑠 ]2 𝑃𝑡
𝑃0 = 𝐷𝑡 + ഥ 2
𝑟ഥ𝑠 (1+𝑟𝑠 )

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1. Calculation of Realized Rate of Return on a Stock Investment
Assume that we owned a stock for the last two years. You originally bought the stock two years ago for ₹25 (𝑃0 ) and
just sold it for ₹35 (𝑃2 ). The stock paid an annual dividend of ₹1(D) on the last day of each of the past two years.
Your realized rate of return on the stock investment can be calculated using the following time value of money
equation

1
1−
[1+𝑟𝑠 ]2 𝑃𝑡
𝑃0 = 𝐷𝑡 + ഥ 2 = or
𝑟ഥ𝑠 (1+𝑟𝑠 )
or by substituting the given numbers, we get that

Solving for 𝑟ഥ𝑠 , our annual realized rate of return on this investment was 22.02 percent.

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2. Calculation of Expected Rate of Return on a Stock Investment
Assume that we are considering to purchase a stock that also assume that we expect to own for the next three
years. The current market price of the stock is ₹32 (𝑃0 ) and we expect to sell it for ₹45 in three years’ time (𝑃3 ). We
also expect the stock to pays an annual dividend (D) of ₹ 1.50 on the last day of each of the next three years. our
expected return on the stock investment can be calculated using the following time value of money equation

or by substituting the given numbers, we get that

Solving for 𝐸(𝑟𝑠 ), our annual expected rate of return on this investment is 16.25 percent.

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3. Calculation of Required Rate of Return on a Stock Investment
➢ Finally, the required rate of return (𝑟𝑠 ) is the appropriate interest rate when analyzing the fair value of a stock
investment over its whole lifetime.
➢ The fair value of a stock reflects the present value of all relevant (but uncertain) cash flows to be received by an
investor discounted at the required rate of return (𝑟𝑠 )---- the interest rate or return that should be earned on the
investment given its risk.
Present value methodology applies time value of money to evaluate a stock’s cash flows over its life as follows:

The price or value of a stock is equal to the present value of its future dividends 𝐷𝑡 , whose values are uncertain.
This requires an infinite number of future dividend values to be estimated, which makes the equation above difficult
to use for stock valuation and 𝑟𝑠 calculation in practice.
Accordingly, assumptions are normally made regarding the expected pattern of the uncertain flow of
dividends over the life of the stock. Three assumptions that are commonly used are
(1) zero growth in dividends over the (infinite) life of the stock;
(2) a constant growth rate in dividends over the (infinite) life of the stock; and
(3) nonconstant growth in dividends over the (infinite) life of the stock.

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Equity Valuation - Zero Growth in Dividends
Zero growth in dividends means that dividends on a stock are expected to remain at a constant level
forever. Thus, 𝐷0 = 𝐷1 = 𝐷2 …….= 𝐷∞ =D. Accordingly, the equity valuation formula can be written as
follows:
If the fair market price is
applied to this formula, the
return we solve for is the
required rate of return.
Use the
limit
theorem If the current market price is
applied to the formula, the
= or price we solve for is the
expected return.
This formula can be generalized as follows:
Companies that issue preferred stock usually pay investors dividends that exhibit zero growth through time.
The value of a stock with zero growth in dividends is equal to the (current) dividend divided by the return on the stock.
If the required rate of return (𝑟𝑠 ) is applied to the formula, the price we solve for is the fair market price.
If the expected return E(𝑟𝑠 ) is applied to the formula, the price we solve for is the current market price.
Furthermore, the formula can be rearranged to determine a return on the stock if it were
purchased at a price, 𝑃0 :
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Zero Growth in Dividends – Numerical Example (from text book)
A preferred stock you are evaluating is expected to pay a constant dividend of ₹5 per year each year into
the future. The expected rate of return, E(𝑟𝑠 ) on the stock is 12 percent. The current market value (or
price) of this stock is calculated as follows

5
𝑃0 = = ₹41.67
0.12

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Equity Valuation - Constant Growth in Dividends

or If the required rate of return is

applied to the formula, the
price we solve for is the fair
market price

If the expected rate of return is

applied to the formula, the
price we solve for is the current
market price

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Equity Valuation - Constant Growth in Dividends

The equity valuation formula can also be rearranged to determine a rate of return on the
stock if it were purchased at a price
If the fair market price is applied to the
formula, the return we solve for is the
required rate
or of return.

Numerical Example
A stock you are evaluating paid a dividend at the end of last year of ₹4.80. If the current market price is applied to
Dividends have grown at a constant rate of 1.75 percent per year over the the formula, the price we solve for is the
expected return
last 15 years, and this constant growth rate is expected to continue into the
future. The stock is currently selling at a price of ₹52 per share. The expected
rate of return on this stock is calculated as follows:

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Equity Valuation - Supernormal (or Nonconstant) Growth in Dividends
Firms often experience periods of supernormal or nonconstant dividend growth, after which
dividend growth settles at some constant rate.
To find the present value of a stock experiencing supernormal or nonconstant dividend
growth, we calculate the present value of dividends during the two different growth periods.
A three-step process is used as follows:

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Equity Valuation - Supernormal (or Nonconstant) Growth in Dividends

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Equity Valuation - Supernormal (or Nonconstant) Growth in Dividends
•.

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Relation between Interest Rates and Bond Values
From chapter 2, we have learnt that the variability of financial security prices
depends on interest rates and the characteristics of the security. Specifically, the
factors that affect financial security prices include interest rate changes, the time
remaining to maturity, and the coupon rate.

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Maturity and Security Prices
Notice that for each of these bonds, the closer the bond is to maturity, the closer the fair present value of the bond
is to the $1,000 face value. This is true regardless of whether the bond is a premium, discount, or par bond. For
example, at an 8 percent interest rate, the 12-year, 14-year, and 16-year bonds have present values of $1,152.47,
$1,166.63, and $1,178.74, respectively. The intuition behind this is that nobody would pay much more than the
face value of the bond and any remaining (in this case semiannual) coupon payments just prior to maturity since
these are the only cash flows left to be paid on the bond. Thus, the time value effect is reduced as the maturity of
the bond approaches.

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Maturity and Security Price Sensitivity to Changes in Interest Rates
From the below data we see that the longer the time remaining to maturity on a bond, the more sensitive are bond
prices to a given change in interest rates.
For example, the fair present value of the 12-year bond falls 13.23 percent (i.e., ($1,000 = $1,152.47)/$1,152.47 = =-
.1323 = -13.23%) as the required rate of return increases from 8 percent to 10 percent. The same 2 percent increase
(from 8 percent to 10 percent) in the required rate of return produces a larger 14.28 percent drop in the fair present
value of the 14-year bond, and the 16-year bond’s fair present value drops 15.16 percent. This same trend is
demonstrated when the required rate of return increases from 10 percent to 12 percent—the longer the bond’s
maturity, the greater the percentage decrease in the bond’s fair present value.

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Incremental Changes in Maturity and Security Price Sensitivity to Changes in Interest Rates
For example, a 2 percent increase in the required rate of return (from 8 percent to 10 percent) on the 12-year bond
produces a 13.23 percent (i.e., ($1,000 - $1,152.47)/$1,152.47 =-.1323 =-13.23%) decrease in the bond’s fair
present value. The same 2 percent increase (from 8 percent to 10 percent) in the 14-year bond produces a 14.28
percent decrease in the fair present value. The difference, as we move from a 12-year to a 14-year maturity, is 1.05
percent (14.28% -13.23%). Increasing the time to maturity two more years (from 14 years to 16 years) produces an
increase in price sensitivity of 0.88 percent (-14.28% - (-15.16%)).

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Impact of Coupon Rates on Interest Rate Sensitivity
.

∆ =-0.68
∆ =-0.66

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Duration
➢The estimation of the effect of maturity and coupon rates on the sensitivity of bond prices to
changes in interest rates (we have discussed so far), is complex and using these relationships as
the basis for decision making is difficult in dealing with multiple bonds.
➢Duration, on the other hand, provides a simple measure that allows for a straightforward
calculation of a bond’s interest rate sensitivity.
➢In this section, we show that the price sensitivity of a bond, or the percent change in the
bond’s fair present value, for a given change in interest rates (as discussed above) can be more
directly measured by a concept called duration (or Macauley’s duration).
➢We also show that duration produces an accurate measure of the price sensitivity of a bond to
interest rate changes for relatively small changes in interest rates.
➢The duration measure is a less accurate measure of price sensitivity the larger the change in
interest rates.

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Duration
➢Duration is the weighted - average time to maturity on a financial security using the
relative present values of the cash flows as weights.
➢On a time value of money basis, duration measures the weighted average of when cash
flows are received on a security.
or
➢Duration is the weighted-average time to maturity (measured in years) on a financial security.

➢In addition to being a measure of the average life of an asset or liability, duration also
has economic meaning as the sensitivity, or elasticity , of that asset or liability’s
value to small interest rate changes (either required rate of return or yield to maturity).
➢Duration describes the percentage price, or present value, change of a financial security
for a given (small) change in interest rates. That is, rather than calculating present value
changes resulting from interest rate changes, as we did in the previous sections, the
duration of a financial security can be used to directly calculate the price change.
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A Simple Illustration of Duration
➢consider a bond with one year remaining to maturity, a $1,000 face value, an 8 percent coupon rate
(paid semiannually), and an interest rate (either required rate of return or yield to maturity) of 10
percent. The promised cash flows from this bond are illustrated in the below figure. The bond holder
receives the promised cash flows ( CF ) from the bond issuer at the end of one-half year and at the end
of one year.
➢CF is the $40 promised payment of (semiannual) coupon interest ($1000 X 8% X 1/2) received after six
months. CF1/2 is the promised cash flow at the end of year 1; it is equal to the second $40 promised
(semiannual) coupon payment plus the $1,000 promised payment of face value. To compare the relative
sizes of these two cash flow payments—since duration measures the weighted-average time to
maturity of a bond—we should put them in the same dimensions, because $1 of principal or interest
received at the end of one year is worth less to an investor in terms of time value of money than is $1 of
principal or interest received at the end of six months.

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Duration is the weighted-average time to maturity (measured in years) on a financial security
➢The bond holder receives some cash flows at one-half year and some at one year. Intuitively,
duration is the weighted-average maturity on the portfolio of zero coupon bonds, one that has
payments at one-half year and at the end of the year (year 1) in this example.

➢Specifically, duration analysis weights the time at which cash flows are received by the relative
importance in present value terms of the cash flows arriving at each point in time. In present
value terms, the relative importance of the cash flows arriving at time t= ½ year and time t = 1
year are as follows:

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Duration is the weighted-average time to maturity (measured in years) on a financial security cont…

➢In present value terms, the bond holder receives 3.88 percent of the cash flows on the bond
with the first coupon payment at the end of six months (t½) and 96.12 percent with the second
payment of coupon plus face value at the end of the year (t1). By definition, the sum of the
(present value) cash flow weights must equal 1:

➢We can now calculate the duration (D), or the weighted-average time to maturity of the bond,
using the present value of its cash flows as weights:

➢Thus, although the maturity of the bond is one year, its duration or average life in a cash flow
sense is only .9806 years.
➢Duration is less than maturity because in present value terms, 3.88 percent of the cash flows
are received during the year.
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A General Formula for Duration
Formula slightly differs when the time period changes

We can calculate the duration for any We can calculate the duration for any fixed-
fixed-income security that pays interest income security that pays interest Semi-annually
annually using the following formula: using the following formula:

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The Duration of a Zero-Coupon Bond
➢Zero-coupon bonds sell at a discount from face value on issue and pay their face value (e.g.,
$1,000) on maturity. These bonds have no intervening cash flows, such as coupon payments,
between issue and maturity. The current price that an investor is willing to pay for such a bond,
assuming semiannual compounding of interest, is equal to the present value of the single, fixed
(face value) payment on the bond that is received on maturity (here, $1,000):

➢Because the only cash flow received on these securities is the final payment at maturity (time
Tzc), the following must be true:

➢That is, the duration of a zero-coupon bond equals its maturity. Note that it is only for zero
coupon bonds that duration and maturity are equal. Indeed, for any bond that pays some cash
flows prior to maturity, its duration will always be less than its maturity.
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The Duration of a Zero-Coupon Bond – Text Book Example
➢Suppose that we have a zero-coupon bond with a face value of $1,000, a
maturity of four years, and a current rate of return of 8 percent compounded
semiannually. Since the bond pays no interest, the duration equation consists of
only one term—cash flows at the end of year 4:

➢or duration equals the maturity of the zero-coupon bond.

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The Duration of a Four-Year Bond –Text Book Example
➢ Suppose that we have a bond that offers a coupon rate of 10 percent paid semiannually (or 5 percent paid
every 6 months). The face value of the bond is $1,000, it matures in four years, its current rate of return (rb) is 8
percent, and its current price is $1,067.34.
➢ Below the calculation indicates, the duration, or weighted-average time to maturity, on this bond is 3.42 years.
In other words, on a time value of money basis, the initial investment of $1,067.34 is recovered after 3.42 years.
Duration of a Four-Year Bond with 10 Percent Coupon Paid Semiannually and 8 Percent Yield

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Changes in the coupon rates Vs Bond Durations

..

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Changes in the discount rates Vs Bond Durations

..

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Changes in the maturity periods Vs Bond Durations

..

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Features of Duration
➢The higher the coupon or promised interest payment on a
security, the shorter is its duration.

➢The higher the rate of return on a security, the shorter is its

duration.

➢Duration increases with maturity at a decreasing rate.

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Economic Meaning of Duration (Second Meaning of Duration)
➢In addition to being a measure of the average life of a bond, duration is also a direct
measure of its interest rate sensitivity, or elasticity.
➢In other words, the larger the numerical value of duration ( D ), the more sensitive the
price of that bond to (small) changes or shocks in interest rates.
➢The specific relationship between these factors for securities with annual compounding of
interest is represented as*:

➢ For securities with semiannual receipt (compounding) of interest, it is represented as:

*In practical life, we use the ∆ (change) notation instead of d (derivative notation) to recognize that interest rate changes tend
to be discrete rather than infinitesimally small. For example, in real world financial markets the smallest observed rate change is
usually one basis point, or 1/100 of 1 percent (Those who follow the financial newspapers or news channel, quite often they
hear that RBI is going to increase or decrease the policy rates by X number of bps or basis points. 100 basis points == 1%.

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Economic Meaning of Duration (Second Meaning of Duration)

➢.

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Economic Meaning of Duration (Second Meaning of Duration)
The definition of duration can be rearranged in another useful way for interpretation
regarding interest sensitivity:
For Annual Compounding Semi-Annual Compounding

or

This equation shows that for small changes in interest rates, bond prices move in an
inversely proportional manner according to the size of D .
Clearly, for any given change in interest rates, long duration securities suffer a larger capital
loss (or receive a higher capital gain) should interest rates rise (fall) than do short duration
securities.

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting Second Sem 2021-22 45
Modified Duration (MD)

The above duration equation can be rearranged, combining D and (1 + 𝑟𝑏 ) into a

single variable 𝐷/(1 + 𝑟𝑏 ) to produce what practitioners call modified duration
(MD). For annual compounding of interest:

For semiannual compounding of interest:

This form is more intuitive than the Macauley’s duration because we multiply MD by the simple change
in interest rates rather than the discounted change in interest rates as in the general duration equation.
Thus, the modified duration is a more direct measure of bond price elasticity.
Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting Second Sem 2021-22 46
Modified Duration (MD) – Text book numerical example-1
➢Consider a four-year bond with a 10 percent coupon paid semiannually (or 5 percent paid every 6
months) and an 8 percent rate of return (𝒓𝒃 ). According to slide number 38, 39 and 41, the bond’s
duration is D=3.42 years. Suppose that the rate of return increases by 10 basis points (1/10 of 1
percent) from 8 to 8.10 percent; then, using the semiannual compounding version of the duration
model shown above, the percentage change in the bond’s price is:
or

The bond price had been $1,067.34, which was the present value of a four-year bond with a 10 percent
coupon and an 8 percent rate of return. However, the duration model predicts that the price of this bond
will fall by 0.329 percent, or by $3.51, to $1,063.83 after the increase in the rate of return on the bond of
10 basis points. Observe that we don’t have to do all those present value calculations for the newly
quoted rrr. It is so simple and straight forwarded.

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting Second Sem 2021-22 47
Modified Duration (MD) – Text book numerical example-2
➢Consider a four-year bond with a 6 percent coupon paid semiannually (or 3 percent paid every 6
months) and an 8 percent rate of return (𝒓𝒃 ). According to slide number 39, the bond’s duration is
D=3.60 years. Suppose that the rate of return increases by 10 basis points (1/10 of 1 percent) from 8
to 8.10 percent; then, using the semiannual compounding version of the duration model shown
above, the percentage change in the bond’s price is:
or

for a 10-basis-point increase in the rate of return for each semiannual period. The bond’s price drops by
0.346 percent, or by $3.23, from $932.68 (reported in slide no 39) to $929.45.
Notice again that, all else held constant, the higher the coupon rate on the bond, the shorter the
duration of the bond and the smaller the percentage decrease in a bond’s price for a given increase in
interest rates.

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting Second Sem 2021-22 48
Large Interest Rate Changes and Duration
➢It needs to be stressed here that duration accurately measures the price sensitivity of financial
securities only for small changes in interest rates of the order of one or a few basis points (a
basis point is equal to one-hundredth of 1 percent).
➢Suppose, however, that interest rate shocks are much larger, of the order of 2 percent or 200
basis points or more. While such large changes in interest rates are not common, this might
happen in a financial crisis or if the central bank (we will see in the next class) suddenly
changes its monetary policy strategy.
➢In this case, duration becomes a less accurate predictor of how much the prices of bonds will
change, and therefore, a less accurate measure of the price sensitivity of a bond to changes in
interest rates.

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Large Interest Rate Changes and Duration

➢As above figure shows, in actuality, the capital loss effect of large rate increases tends to be smaller
than the capital gain effect of large rate decreases. This is the result of a bond’s price–interest rate
relationship exhibiting a property called convexity rather than linearity, as assumed by the simple
duration model. Intuitively, this is because the sensitivity of the bond’s price to a change in interest
rates depends on the level from which interest rates change (i.e., 6 percent, 8 percent, 10 percent, and
12 percent). In particular, the higher the level of interest rates, the smaller a bond’s price sensitivity to
interest rate changes.
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Calculation of the Change in a Security’s Price Using the Duration
versus the Time Value of Money Formula
➢ To see the importance of accounting for the effects of convexity in assessing the impact of large interest rate changes, consider
the four-year, $1,000 face value bond with a 10 percent coupon paid semiannually and an 8 percent rate of return. In slide no
38, 39 and 41, we found this bond has a duration of 3.42 years, and its current price is $1,067.34. We represent this as point A
in the below figure. If rates rise from 8 percent to 10 percent, the duration model predicts that the bond price will fall by 6.577
percent; that is:

➢ or from a price of $1,067.34 to $997.14 (see point B in the below figure).

However, calculating the exact change in the bond’s price after a rise in rates
to 10 percent, we find its true value is:

➢ This is point C in the figure. As we can see, the true or actual fall in price is less than the predicted fall by $2.86. The reason
for this is the natural convexity to the price-rate curve as interest rates rise.
➢ Reversing the experiment reveals that the duration model would predict the bond’s price to rise by 6.577 percent if yields fell
from 8 percent to 6 percent, resulting in a predicted price of $1,137.54 (see point D in right hand side figure). By comparison,
the true or actual change in price can be computed as $1,140.39 by estimating the present value of the bond’s coupons and its
face value with a 6 percent rate of return (see point E in figure). The duration model has under predicted the bond price
increase by $2.85 ($1,140.39 - $1,137.54).

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Convexity & Characteristics of Convexity
➢Convexity (CX) measures the change in slope of the price-yield curve around
interest rate level R
➢Convexity incorporates the curvature of the price-yield curve into the estimated
percentage price change of a bond given an interest rate change.

➢Convexity is desirable. The greater the convexity of a security or portfolio of

securities, the more insurance or interest rate protection an investor or FI manager
has against rate increases and the greater the potential gains after interest rate falls.

➢Convexity diminishes the error in duration as an investment criterion. The larger the
interest rate changes and the more convex a fixed-income security or portfolio, the
greater the error the investor or FI manager faces in using just duration (and
duration matching) to immunize exposure to interest rate shocks.

➢All fixed-income securities are convex. That is, as interest rates change, bond prices
change at a non-constant rate zero.
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