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CHAPTER 16

CHAPTER 16. Managing Bond Portfolios. Inverse relationship between price and yield An increase in a bond’s yield to maturity results in a smaller price decline than the gain associated with a decrease in yield Long-term bonds tend to be more price sensitive than short-term bonds.

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CHAPTER 16

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  1. CHAPTER 16 Managing Bond Portfolios

  2. Inverse relationship between price and yield An increase in a bond’s yield to maturity results in a smaller price decline than the gain associated with a decrease in yield Long-term bonds tend to be more price sensitive than short-term bonds Bond Pricing Relationships

  3. Change in Bond Price as a Function of Change in Yield to Maturity

  4. As maturity increases, price sensitivity increases at a decreasing rate Price sensitivity is inversely related to a bond’s coupon rate Price sensitivity is inversely related to the yield to maturity at which the bond is selling Bond Pricing Relationships Continued

  5. Prices of 8% Coupon Bond (Coupons Paid Semiannually)

  6. Prices of Zero-Coupon Bond (Semiannually Compounding)

  7. A measure of the effective maturity of a bond The weighted average of the times until each payment is received, with the weights proportional to the present value of the payment Duration is shorter than maturity for all bonds except zero coupon bonds Duration is equal to maturity for zero coupon bonds Duration

  8. Duration: Calculation

  9. Calculating the Duration of Two Bonds

  10. Price change is proportional to duration and not to maturity D*= modified duration Duration/Price Relationship

  11. Rules for Duration Rule 1 The duration of a zero-coupon bond equals its time to maturity Rule 2 Holding maturity constant, a bond’s duration is higher when the coupon rate is lower Rule 3 Holding the coupon rate constant, a bond’s duration generally increases with its time to maturity Rule 4 Holding other factors constant, the duration of a coupon bond is higher when the bond’s yield to maturity is lower Rules 5 The duration of a level perpetuity is equal to: (1+y) / y

  12. Bond Duration versus Bond Maturity

  13. Bond Durations (Yield to Maturity = 8% APR; Semiannual Coupons)

  14. Convexity The relationship between bond prices and yields is not linear Duration rule is a good approximation for only small changes in bond yields

  15. Bond Price Convexity: 30-Year Maturity, 8% Coupon; Initial Yield to Maturity = 8%

  16. Correction for Convexity Correction for Convexity:

  17. Convexity of Two Bonds

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