Bond Price Sensitivity
5.1 CHAPTER OVERVIEW
This chapter explores the sensitivity of bond prices to changes in market interest rates or yields. Key terms are defined such as Macaulay’s duration, modified or adjusted duration, and the price value of a basis point (PVBP). The chapter looks at how to calculate these measures and at their interrelationships. Duration measures are approximations, and for large changes in market yields they can become increasingly inaccurate. This is because the relationship between bond price and yield is not entirely linear. In the case of a straight bond with no call features the graph of the price/yield relationship is convex. Various methods of estimating this convexity effect are illustrated, as well as how duration and convexity combined can be used to produce a more accurate estimation of the change in the price of a bond for a significant yield change. Finally, the chapter explores practical applications of duration in portfolio management. It looks at how duration can be used to create a portfolio of bonds matching future payment obligations, and how to construct a duration-based hedge against the effects of changes in interest rates on a bond portfolio.
5.2 BOND MARKET LAWS
The bond pricing model introduced in Chapter 4 shows that the price of a fixed coupon bond changes inversely with its yield. This arises from the fact that the bond’s cash flows are discounted more or less heavily depending on current market interest rates. It ...