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# Interest rate risk-types_of_bonds

## by sanka on Aug 02, 2010

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## Interest rate risk-types_of_bondsPresentation Transcript

• IMPACT ON FIXED INCOME SECURITIES INTEREST RATE RISK
• Bonds, bond prices and interest rates
• Bond prices and yields
• Bond market equilibrium
• Bond risks
• Bonds: 3 types
• Zero coupon bonds
• e.g. Tbills
• Fixed payment loans
• e.g. mortgages, car loans
• Coupon bonds
• e.g. Tnotes, Tbonds
• Zero coupon bonds
• Discount bonds
• purchased price less than face value
• -- F > P
• face value at maturity
• no interest payments
• Example
• 91 day Tbill,
• P = Rs.9850, F = Rs.10,000
• YTM solves
•
• yield on a discount basis (127)
• how Tbill yields are actually quoted
• approximates the YTM
i db = F - P F x 360 d
• example
• 91 day Tbill,
• P = Rs.9850, F = Rs.10,000
• discount yield =
• i db < YTM
• why?
• F in denominator
• 360 day year
• Fixed-payment loan
• loan is repaid with equal (monthly) payments
• each payment is combination of principal and interest
• example 2: fixed pmt. loan
• Rs.20,000 car loan, 5 years
• monthly pmt. = Rs.500
• so Rs.15,000 is price today
• cash flow is 60 pmts. of Rs.500
• what is i?
• i is annual rate
• (effective annual interest rate)
• but payments are monthly, & compound monthly
• (1+i m ) 12 = i
• i m = i 1/12 -1
• i m is the periodic rate
• note: APR = i m x 12
• i m =1.44% i=(1+. 0144) 12 – 1 =18.71%
• how to solve for i?
• trial-and-error
• table
• financial calculator
• Coupon Bond
• Bond Yields
• Yield to maturity (YTM)
• chapter 4
• Current yield
• Holding period return
• Yield to Maturity (YTM)
• a measure of interest rate
• interest rate where
P = PV of cash flows
• Current yield
• approximation of YTM for coupon bonds
i c = annual coupon payment bond price
• better approximation when
• maturity is longer
• P is close to F
• example
• 2 year Tnotes, F = Rs.10,000
• P = Rs.9750, coupon rate = 6%
• current yield
i c = 600 9750 = 6.15%
• Current yield = 6.15%
• True YTM = 7.37%
• Lousy approximation
• only 2 years to maturity
• selling 2.5% below F
• Holding period return
• sell bond before maturity
• return depends on
• holding period
• interest payments
• resale price
• example
• 2 year Tnotes, F = Rs.10,000
• P = Rs.9750, coupon rate = 6%
• sell right after 1 year for Rs.9900
• Rs.300 at 6 mos.
• Rs.300 at 1 yr.
• Rs.9900 at 1 yr.
• i/2 = 3.83% i = 7.66%
• why i/2?
• interest compounds annually not semiannually
• The Bond Market
• Bond supply
• Bond demand
• Bond market equilibrium
• Bond supply
• bond issuers/ borrowers
• look at Qs as a function of price, yield
• lower bond prices
• higher bond yields
• more expensive to borrow
• lower Qs of bonds
• so bond supply slopes up with price
• Bond price Q of bonds S
• Changes in bond price/yield
• Move along the bond supply curve
• What shifts bond supply?
• Shifts in bond supply
• Change in government borrowing
• Increase in gov’t borrowing
• Increase in bond supply
• Bond supply shifts right
• P Qs S S’
• a change in business conditions
• affects incentives to expand production
exp. profits supply of bonds (shift rt.)
• exp. economic expansion shifts bond supply rt.
• a change in expected inflation
• rising inflation decreases real cost of borrowing
exp. inflation supply of bonds (shift rt.)
• Bond Demand
• look at Qd as a function of bond price/yield
• so bond demand slopes down with respect to price
Bond yield Qd of bonds price of bond Qd of bonds
• Bond price Quantity of bonds D
• Changes in bond price/yield
• Move along the bond demand curve
• What shifts bond demand?
• Wealth
• Higher wealth increases asset demand
• Bond demand increases
• Bond demand shifts right
• P Qd D D
• a change in expected inflation
• rising inflation decreases real return
inflation expected to demand for bonds (shift left)
• a change in exp. interest rates
• rising interest rates decrease value of existing bonds
int. rates expected to demand for bonds (shift left)
• a change in the risk of bonds relative to other assets
relative risk of bonds demand for bonds (shift left)
• a change in liquidity of bonds relative to other assets
relative liquidity of bonds demand for bonds (shift rt.)
• Bond market equilibrium
• changes when bond demand shifts,
• and/or bond supply shifts
• shifts cause bond prices AND interest rates to change
• Example 1: the Fisher effect
• expected inflation 3%
• exp. inflation rises to 4%
• bond demand
• -- real return declines
• -- Bd decreases
• bond supply
• -- real cost of borrowing declines
• -- Bs increases
• bond price falls
• interest rate rises
• Fisher effect
• expected inflation rises,
• nominal interest rates rise
• Example 2: economic slowdown
• bond demand
• decline in income, wealth
• Bd decreases
• P falls, i rises
• bond supply
• decline in exp. profits
• Bs decreases
• P rises, i falls
• shift Bs > shift in Bd
• interest rate falls
• Why shift Bs > shift Bd?
• changes in wealth are small
• response to change in exp. profits is large
• large cyclical swings in investment
• interest rate is pro-cyclical
• Why are bonds risky?
• 3 sources of risk
• Default
• Inflation
• Interest rate
• Default risk
• Risk that the issuer fails to make promised payments on time
• Zero for U.S. gov’t debt
• Other issuers: corporate, municipal, foreign have some default risk
• Greater default risk means a greater yield
• Inflation risk
• Most bonds promise fixed dollar payments
• Inflation erodes the real value of these payments
• Future inflation is unknown
• Larger for longer term bonds
• Interest rate risk
• Changing interest rates change the value (price) of a bond in the opposite direction.
• All bonds have interest rate risk
• But it is larger for the long term bonds