Duration

# Duration - Duration Measuring Interest Rate Sensitivity...

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Duration Measuring Interest Rate Sensitivity

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Measuring Interest Rate Risk We know: An increase in interest rates causes bond prices to fall, and a decrease in interest rates causes bond prices to rise. We also know that longer maturity debt securities tend to be more volatile in price. For a given change in interest rates, the price of a longer term bond generally changes more than the price of a shorter term bond.
Measuring Interest Rate Risk Two bonds with the same term to maturity do not have the same interest-rate risk. A 10 year zero coupon bond makes all of its payments at the end of the term. A 10 year coupon bond makes payments before the maturity date. Which bond has the highest interest-rate risk?

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Interest Rate Risk Problem Calculate the rate of capital gain or loss on a ten year zero coupon bond for which the interest rate has increased from 10% to 20%. The bond has a face value of \$1000. – Capital gain = (P t+1 - P t ) / P t – - 49.7% = (\$193.81 - \$385.54)/\$385.54
Interest Rate Risk Problem The rate of capital gain or loss on a ten year coupon bond that has a face value of \$1000 for which the interest rate has increased from 10% to 20% is -40.3%. The interest rate risk on a ten year coupon bond is less than the interest rate risk on a 10 year zero coupon bond. Why?

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Varying Coupon Rates: Coupon Effect A security promising lower annual coupon payments behaves as though it has a longer maturity even if it is due to mature on the same date as a security carrying a higher coupon rate.
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## This note was uploaded on 10/14/2009 for the course IEMS 395 taught by Professor Bob during the Winter '09 term at Northwestern.

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Duration - Duration Measuring Interest Rate Sensitivity...

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