Seeing is believing!

Before you order, simply sign up for a free user account and in seconds you'll be experiencing the best in CFA exam preparation.

Subject 2. Bond Portfolio Duration and Convexity PDF Download

There are two ways to calculate the duration of a bond portfolio:

  • The weighted average of the time to receipt of aggregate cash flows. This method is based on the cash flow yield, which is the internal rate of return on the aggregate cash flows.

    Limitations: This method cannot be used for bonds with embedded options or for floating-rate notes due to uncertain future cash flows. The cash flow yield is not commonly calculated. The change in cash flow yield is not necessarily the same as the change in the yields-to-maturity on the individual bonds. Interest rate risk is not usually expressed as a change in the cash flow yield.

  • The weighted average of the durations of individual bonds that compose the portfolio. The weight is the proportion of the portfolio that a bond comprises.

    Portfolio Duration = w1D1 + w2D2 + w3D3 + ... + wkDk

    wi = the market value of bond i / market value of the portfolio
    Di = the duration of bond i
    k = the number of bonds in the portfolio

    This method is simpler to use and quite accurate when the yield curve is flat. Its main limitation is that it assumes a parallel shift in the yield curve.

To illustrate this calculation, consider the following three-bond portfolio in which all three bonds are option-free:

  • 10% 5-year 100.0000 10 $4 million $4,000,000 3.861
  • 8% 15-year 84.6275 10 $5 million $4,231,375 8.047
  • 14% 30-year 137.8586 10 $1 million $1,378,586 9.168

In this illustration, it is assumed that the next coupon payment for each bond is exactly six months from now (i.e., there is no accrued interest). The market value for the portfolio is $9,609,961. Since each bond is option-free, modified duration can be used.

  • w1 = $4,000,000/$9,609,961 = 0.416, D1 = 3.861
  • w2 = $4,231,375/$9,609,961 = 0.440, D2 = 8.047
  • w3 = $1,378,586/$9,609,961 = 0.144, D3 = 9.168

The portfolio's duration is: 0.416 (3.861) + 0.440 (8.047) + 0.144 (9.168) = 6.47.

A portfolio duration of 6.47 means that for a 100 basis point change in the yield for each of the three bonds, the market value of the portfolio will change by approximately 6.47%. Keep in mind that the yield for each of the three bonds must change by 100 basis points for the duration measure to be useful. This is a critical assumption and its importance cannot be overemphasized.

Portfolio convexity can be calculated similarly.

For example, with method two, you'll need the convexity of each individual security within the portfolio, as well as the weights of each security in the portfolio. The formula for portfolio convexity is as follows:

Portfolio Convexity = Sum [(Weight of Securityi) × (Convexity of Securityi)]

User Contributed Comments 9

User Comment
WaheedAbbasKhan can anyone help? what does this mean?
"10% 5-year 100.0000 10 $4 million $4,000,000 3.861"
10% copuon - 5Year Maturity - FV100 - next?
zackychoo 10 is 10%, the interest rate.
$4 mill is the total par val of the bonds
$4,000,000 is the total market value of the bonds, which is equal to par value because coupon rate is equal to interest rate.
3.861 is the duration.
papajeff This is hands down the shittiest part of the whole course.
johntan1979 Nah... this is an easy piece of shit.

Econ is the worst, whether micro or macro.
gill15 This is easy crap. Problem is i think nobody reads the notes as we're nearing the end of lessons....

Accounting ---- by far the worst and most boring --- Taxes still scare me..
ldfrench This sections sucks. Accounting sucks too.
farhan92 eco is fun -except the global eco! Fixed income is just shitty
sandra1010 Can someone help?
How did you get the market value of 4,231,375?
bemccall95 sandra1010 you do the par value of 5,000,000 times the discount value of 0.846275 to get the market value
You need to log in first to add your comment.
I am happy to say that I passed! Your study notes certainly helped prepare me for what was the most difficult exam I had ever taken.
Andrea Schildbach

Andrea Schildbach

My Own Flashcard

No flashcard found. Add a private flashcard for the subject.

Add

Actions