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Lecture 9: Interest Rate RiskFNCE90056:Investment ManagementDr. Minsoo KimDepartment of FinanceFaculty of Business and EconomicsUniversity of MelbourneUniversity of MelbourneDr. Minsoo Kim1 / 43
Lecture 9: Interest Rate RiskIntroductionIntroductionUniversity of MelbourneDr. Minsoo Kim2 / 43
Lecture 9: Interest Rate RiskIntroductionOverview of bond portfolio risksInterest rate riskInflation riskCredit (default) riskExchange rate riskLiquidity riskUniversity of MelbourneDr. Minsoo Kim3 / 43
Lecture 9: Interest Rate RiskIntroduction05101520251960198020002020dateTerm Structure of Interest RatesInterest rate riskIn the figure to the left, thebluedata represent the U.S. federalfunds (overnight) rate. Thegreendata represent the 5-year risk-freerateimplied by U.S. Treasuries.Thered data represent the30-year risk-free rateimplied byU.S. Treasuries.University of MelbourneDr. Minsoo Kim4 / 43
Lecture 9: Interest Rate RiskInterest rates and bond pricesInterest rates and bond pricesUniversity of MelbourneDr. Minsoo Kim5 / 43
Lecture 9: Interest Rate RiskInterest rates and bond pricesInterest rates and bond pricesToday, we’ll discuss interest rate risk in greater detail.If interest rates decrease, bond prices rise, butIf interest rates increase, bond prices fallcapital loss.Recall: Not a concern for an investor who invests in a defaultrisk-free, zero-coupon bond and holds the bond until maturity.University of MelbourneDr. Minsoo Kim6 / 43
Lecture 9: Interest Rate RiskInterest rates and bond pricesInterest rates and bond pricesInterest rate risk arises because interest rate changes affect the bondprice.We first need to understand the detail of how interest rates and bondprices are related.1.The bond price is inversely related to the required yield.2.This relationship is convex.3.All other things equal, the shorter the term to maturity, the smallerthe bond price sensitivity.4.All other things equal, the higher the coupon rate, the smaller thebond price sensitivity.5.All other things equal, the greater the yield, the smaller the bondprice volatility.University of MelbourneDr. Minsoo Kim7 / 43
Lecture 9: Interest Rate RiskInterest rates and bond pricesInterest rate riskSensitivity to interest rates depends on:Time to maturityCoupon RateInitial yieldHow can we quantify the interest rate risk?Commonly employed measures for interest rate risk:DurationDollar durationPrice value of a basis point (PVBP)ConvexityHow can we manage the interest rate risk?ImmunizationUniversity of MelbourneDr. Minsoo Kim8 / 43
Lecture 9: Interest Rate RiskDurationDurationUniversity of MelbourneDr. Minsoo Kim9 / 43
Lecture 9: Interest Rate RiskDurationDefinitionThedurationof a security measures the sensitivity of the security’sprice to small changes in its yield.Recalling the definition of the yield, this is equivalent to measuringthe security’s price to small parallel shiftsin the term structure.

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Bond duration, Zero coupon bond, Dr Minsoo Kim

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