Chapter 25 - Derivatives and hedging risk

Chapter 25 - Derivatives and hedging risk - • duration =...

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Chapter 25 Derivatives and hedging risk 25.5 Duration hedging The case of zero-coupon bonds when interest rate changes, 5 -year bond has greater price swings than 1- year bond subject to more price volatility general rule → the percentage price changes in long-term pure discount bonds are greater than the percentage price changes in short-term pure discount bonds The case of 2 bonds with the same maturity but with different coupons percentage price changes on 1%-coupon bond are greater than are the percentage price changes on the 10%-coupon bond Duration calculate average maturity (1) calculate present value of each payment (2) express PV of each payment in relative terms (3) weight the maturity of each payment by its relative value
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Unformatted text preview: • duration = effective maturity • the percentage price changes of a bond with high duration are greater than the percentage price changes of a bond with low duration • 1-percent-bond has a higher duration than 10-percent-bond →since the 10% have a higher weight than a lot of money coming in, in the end Matching liabilities with assets • hedge inteerst-rate risk by matching liabilities with assets • immunize (i.e. make immune to interest-rate risk) duration of assets * market value of assets = duration of liabilities * market value of liabilities • used by pension funds, actuaries and leasing...
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