Macaulay and Modified Durations I

For a given cash flow {(ak , tk ) : k ∈ N}, its present value

X ak
p(i) =
(1 + i)tk
k

is a function of the effective interest rate i.

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Macaulay and Modified Durations II

Definition
For a given cash flow {(ak , tk ) : k ∈ N}, the Macaulay duration is
defined by P ak P ak
k tk (1+i)tk k tk (1+i)tk
dmac = P ak =
k (1+i)tk p(i)
and the modified duration is defined by
P ak
−p ′ (i) k tk (1+i)tk +1
dmod = = .
p(i) p(i)

Clearly
dmac
dmod = .
1+i

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Macaulay and Modified Durations III

From the definition we can see that if there are two cash flows
A = {(tk , ak )} and B = {(tk , bk )}, then the Macaulay duration of
the cash flow A + B satisfies
P ak +bk
k tk (1+i)tk
dmac,A+B =
pA (i) + pB (i)
P ak P bk
k tk (1+i)tk k tk (1+i)tk
pA (i) pA (i) + pB (i) pB (i)
=
pA (i) + pB (i)
pA (i)dmac,A + pB (i)dmac,B
=
pA (i) + pB (i)

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Macaulay and Modified Durations IV

So we have

pA (i)dmac,A + pB (i)dmac,B
dmac,A+B = .
pA (i) + pB (i)

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Macaulay and Modified Durations V

Definition
For a given cash flow {(ak , tk ) : k ∈ N}, the Macaulay convexity
is defined by P 2 ak
k tk (1+i)tk
cmac (i) = .
p(i)
and the modified convexity is defined by
P ak
p ′′ (i) k tk (tk + 1) (1+i)tk +2
cmod (i) = = .
p(i) p(i)

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Macaulay and Modified Durations VI

Example (Exam FM Sample Question 122)

Cash flows are 40,000 at time 2 (in years), 25,000 at time 3, and
100,000 at time 4. The annual effective yield rate is 7.0%.
Calculate the Macaulay duration.

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Macaulay and Modified Durations VII

Example (Exam FM Sample Question 121)

Annuity A pays 1 at the beginning of each year for three years.
Annuity B pays 1 at the beginning of each year for four years.
The Macaulay duration of Annuity A at the time of purchase is
0.93. Both annuities offer the same yield rate.
Calculate the Macaulay duration of Annuity B at the time of
purchase.

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Macaulay and Modified Durations VIII

Example (Exam FM Sample Question 124)

Rhonda purchases a perpetuity providing a payment of 1 at the
beginning of each year. The perpetuity’s Macaulay duration is 30
years.
Calculate the modified duration of this perpetuity.

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First Order Macaulay and Modified Approximations I

By the Taylor’s formula,

p(i) ≈ p(i0 ) + p ′ (i0 )(i − i0 )

= p(i0 ) − p(i0 )dmod (i0 )(i − i0 )
= p(i0 )(1 − dmod (i0 )(i − i0 )).

So the first order modified approximation of p(i) around i0 is given

by

p(i) ≈ p(i0 )(1 − dmod (i0 )(i − i0 )).

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First Order Macaulay and Modified Approximations II

To find the first order Macaulay approximation, consider the

current value c(i, t) of cash flow at t,
X
c(i, t) = (1 + i)t p(i) = ak (1 + i)t−tk ,
k

and assume ak > 0 for all k.

Since
∂c X
(i, 0) = ak (−tk )(1 + i)−tk −1 < 0
∂i
k

and
∂c X
lim (i, t) = lim ak (t − tk )(1 + i)t−tk −1 > 0,
t→∞ ∂i t→∞
k

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First Order Macaulay and Modified Approximations III
∂c
there exists a T > 0 such that ∂i (i, T ) = 0. Let

∂c
(i, T ) = T (1 + i)T −1 p(i) + (1 + i)T p ′ (i) = 0.
∂i
Then
p ′ (i)
T (i) = −(1 + i) = (1 + i)dmod (i) = dmac (i).
p(i)

Now, by the Taylor’s formula

∂c
c(i, dmac (i0 )) ≈ c(i0 ) + (i0 , dmac (i0 ))(t − t0 ) = c(i0 ),
∂i
i.e.,
(1 + i)dmac p(i) ≈ (1 + i0 )t p(i0 ).
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First Order Macaulay and Modified Approximations IV

So we have the first order Macaulay approximation:

 dmac
1 + i0
p(i) ≈ p(t0 ) .
1+i

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First Order Macaulay and Modified Approximations V

Example (Exam FM Sample Question 178)

A 20-year bond priced to have an annual effective yield of 10% has
a Macaulay duration of 11. Immediately after the bond is priced,
the market yield rate increases by 0.25%. Calculate the bond’s
approximate percentage price change using a first-order Macaulay
approximation.

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First Order Macaulay and Modified Approximations VI

Example (Exam FM Sample Question 189)

A bond has a modified duration of 8 and a price of 112,955
calculated using an annual effective interest rate of 6.4%. EMAC is
the estimated price of this bond at an interest rate of 7.0% using
the first-order Macaulay approximation. EMOD is the estimated
price of this bond at an interest rate of 7.0% using the first-order
modified approximation. Calculate EMAC − EMOD .

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First Order Macaulay and Modified Approximations VII

Example (Exam FM Sample Question 190)

SOA Life Insurance Life Insurance Company has a portfolio of two
bonds:
Bond 1 is a bond with a Macaulay duration of 7.28 and a
price of 35,000; and
Bond 2 is a bond with a Macaulay duration of 12.74 and a
price of 65,000.
The price and Macaulay duration for both bonds were calculated
using an annual effective interest rate of 4.32%. Bailey estimates
the value of this portfolio at an interest rate of i using the
first-order Macaulay approximation to be 105,000. Determine i.

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Cash-flow Matching I

The Cash-flow Matching is to structure an asset portfolio in such a

fashion that the cash inflow that will be generated will exactly
match the cash outflow from the liabilities in every period.

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Cash-flow Matching II

Example (Exam FM Sample Question 181)

A company has liabilities that require it to make payments of 1000
at the end of each of the next five years. The only investments
available to the company are as follows:
Investment Price Subsequent Cash Flows
J 1500 500 at the end of each year for 5 years
K 500 1000 at the end of year 5
L 1000 500 at the end of each year for 4 years
M 4000 1000 at the end of each year for 5 years
The company is able to purchase as many of each investment as it
wants, but only in whole units. The company’s investment
objective is to be fully immunized over the next five years.
Calculate the lowest possible cost to achieve this objective.

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Cash-flow Matching III

Example (Exam FM Sample Question 132)

A bank accepts a 20,000 deposit from a customer on which it guarantees to
pay an annual effective interest rate of 10% for two years. The customer needs
to withdraw half of the accumulated value at the end of the first year. The
customer will withdraw the remaining value at the end of the second year. The
bank has the following investment options available, which may be purchased
in any quantity:
Bond H: A one-year zero-coupon bond yielding 10% annually
Bond I: A two-year zero-coupon bond yielding 11% annually
Bond J: A two-year bond that sells at par with 12% annual coupons
Any portion of the 20,000 deposit that is not needed to be invested in bonds is
retained by the bank as profit. Determine the investment strategies produces
the highest profit for the bank, and is guaranteed to meet the customer’s
withdrawal needs.

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Redington Immunization I

Redington immunization assumes the yield curve is flat and the

changes are parallel, i.e., the interests of all zero coupon bonds are
the same and change the same amount regardless their durations.
The first assumption for the Redington immunization is that the
present values of cash inflow and outflow are equal, i.e.

p(i) = 0

To achieve the Redington immunization, p(i) = 0 is a local

minimum, i.e.,
p(i + ϵ) ≥ 0, for small |ϵ|
(the present value of the cash inflow is always greater than or
equal to present value of the cash outflow no matter which
directions of the interest rate moves).
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Redington Immunization II

From the calculus, we know that the conditions are:

p ′ (i) = 0,
p ′′ (i) > 0.

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Redington Immunization III

So the Redington immunization strategy is to arrange the assets so

that:
1) The present value of the cash inflows from the assets equals
the present value of the cash outflows from the liabilities.
2) The duration of the assets equals the duration of the liabilities
(either Macaulay or modified, and only the numerators of the
durations).
3) The convexity (either Macaulay or modified, and only the
numerators of the convexity) of the assets is greater than the
convexity of the liabilities.

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Redington Immunization IV

Redington Immunization
Let {(Lj , tj ) : j = 1, . . . , n} be the liabilities. The Redington
immunization strategy is to arrange the assets providing cash
inflows {(Ak , sk ) : k = 1, . . . , m} so that:
1) A1 v s1 + · · · + Am v sm = L1 v t1 + · · · + Ln v tn ,
2) s1 A1 v s1 + · · · + sm Am v sm = t1 L1 v t1 + · · · + tn Ln v tn , or the
durations (either Macaulay or modified) of the assets and
liabilities are equal.
2 A v sm > t 2 L v t1 + · · · + t 2 L v tn , or the
3) s12 A1 v s1 + · · · + sm m 1 1 n n
convexity of the assets is greater than the convexity of the
liabilities,
1
where v = 1+i0 is the current discount factor.

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Redington Immunization V

Example (Exam FM Sample Question 73)

Trevor has assets at time 2 of A and at time 9 of B. He has a
liability of 95,000 at time 5. Trevor has achieved Redington
immunization in his portfolio using an annual effective interest rate
of 4%. Calculate BA .

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Redington Immunization VI

Example (Exam FM Sample Question 127)

A company owes 500 and 1000 to be paid at the end of year one
and year four, respectively. The company will set up an investment
program to match the duration and the present value of the above
obligation using an annual effective interest rate of 10%. The
investment program produces asset cash flows of X today and Y
in three years. Calculate X and determine whether the investment
program satisfies the conditions for Redington immunization.

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Redington Immunization VII

Example (Exam FM Sample Question 182)

A railroad company is required to pay 79,860, which is due three
years from now. The company invests 15,000 in a bond with
modified duration 1.80, and 45,000 in a bond with modified
duration dmod , to Redington immunize its position against small
changes in the yield rate. The annual effective yield rate for each
of the bonds is 10%. Calculate dmod .

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Full Immunization I

Redington immunization technique is designed to work for small

changes in i. Full immunization can be applied for changes of any
magnitude in i.
Consider a liability cash outflow of L at the time t. The concept of
full immunization is to hold assets providing cash inflows of A and
B at times t − a and t + b, respectively, where a, b > 0, such that
the current value function at t

p(i) = A(1 + i)a + B(1 + i)−b − L

satisfies two conditions:

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Full Immunization II

1) p(i0 ) = 0, i.e.,

A(1 + i0 )a + B(1 + i0 )−b = L

2) p ′ (i0 ) = 0, i.e.,

aA(1 + i0 )a−1 − bB(1 + i0 )−b−1 = 0,

or
aA(1 + i0 )a − bB(1 + i0 )−b = 0

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Full Immunization III

Full Immunization
Let L be a liability at the time t. The full immunization strategy is
to arrange the assets providing cash inflows A and B at the times
t − a and t + b, a, b > 0, respectively, so that:
1) Au a + Bu −b = L,
2) aAu a − bBu −b = 0, where u = 1 + i0 is the current
accumulation factor.

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Full Immunization IV
To see that the full immunization achieves the desired result, let’s
re-write p(i) as

p(i) = A(1 + i)a + B(1 + i)−b − L

= A(1 + i)a + B(1 + i)−b − (A(1 + i0 )a + B(1 + i0 )−b )

Since B(1 + i0 )−b = ba A(1 + i0 )a ,

p(i) = A(1 + i)a + B(1 + i)−b − (A(1 + i0 )a + B(1 + i0 )−b )

1 + i −b
 
a a a
= A(1 + i) + A(1 + i0 )
b 1 + i0
a
−(A(1 + i0 )a + A(1 + i0 )a )
b !
1 + i a a 1 + i −b 
   
a a
= A(1 + i0 ) + − 1+
1 + i0 b 1 + i0 b
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Full Immunization V

Consider the function

a  a
f (x) = x a + x −b − 1 + .
b b
We have
f (1) = 0
a a 
f ′ (x) = a(x a−1 − x −b−1 ) = x − x −b
x
So f ′ (x) < 0 for all x ∈ (0, 1), f ′ (x) > 0 for all x ∈ (1, ∞), and
therefore f (1) = 0 is the global minimum value for all x ∈ (0, ∞).

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Full Immunization VI

Since  
a 1+i
p(i) = A(1 + i0 ) f
1 + i0
we have
p(i0 ) = 0 and p(i) > 0 for all i ̸= i0 .

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Full Immunization VII

Example (Exam FM Sample Question 71)

Aakash has a liability of 6000 due in four years. This liability will
be met with payments of A in two years and B in six years. Aakash
is employing a full immunization strategy using an annual effective
interest rate of 5%. Calculate |A − B|.

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Full Immunization VIII

Example (Exam FM Sample Question 72)

Jia Wen has a liability of 12,000 due in eight years. This liability
will be met with payments of 5000 in five years and B in 8 + b
years. Jia Wen is employing a full immunization strategy using an
annual effective interest rate of 3%. Calculate Bb .

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