FM for Actuaries

258 CHAPTER 8
Figure 8.3:
Macaulay duration versus time to maturity
18
16
14
Macaulay duration (years)
12
10
8
6
4
Coupon rate = 2%
2
Coupon rate = 8%
Coupon rate = 10%
0
0 10 20 30 40 50
Time to maturity (years)
For premium and par bonds, the relationship is monotonic so that D always increases
with n. For deep-discount bonds, however, D may increase with n for
bonds with short maturity and then decreases with further increases in maturity.
Figure 8.3 illustrates this phenomenon. We assume the yield curve is flat at 8% per
annum, and consider three annual coupon bonds with coupon rates of 2%, 8% and
10% per annum. Thus, the bond with 2% coupon rate is in deep discount, the 8%
coupon bond is at par and the 10% coupon bond is at a premium. Figure 8.3 plots
the Macaulay duration against the time to maturity of the bond. For the 2% coupon
bond, the Macaulay duration increases with the time to maturity until the maturity
reaches 34 years, from which onwards the Macaulay duration decreases when the
time to maturity increases further. In contrast, however, for the par and premium
bonds the Macaulay duration increases monotonically with the time to maturity.
Suppose a portfolio of bonds is constructed from M bonds, with durations
Let the bond values be P 1 , ··· ,P M , so that their total value is
as the weight of Bond j in the portfolio, then
D 1 , ··· ,D M .
P = ∑ M
j=1 P j. Define w j = P j
P