Week 10_Fixed Income 2

# Week 10_Fixed Income 2 - Fixed Income Interest Rate...

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1 Fixed Income Interest Rate Management

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2 Overview ± Last time we covered ² A basic review of the instruments used ² Examined the basics of bond pricing ² Described yield measures ± Today we will consider ² the yield curve ² Interest rate risk and how it effects bond portfolios
3 Bonds ± Essentially a loan – bond issuer borrows from bond purchaser ± Default risk ² Default premium = YTM of corporate bonds – YTM of T-bonds ± Interest risk ² Changes in market interest rates ± Nominal interest rate = real interest rate + inflation ± Short-term inflation is often predictable. ² Reinvestment of coupon payments

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4 Bond Pricing on Coupon Days ± Assuming future interest rates are constant r and the bond has exactly T periods to maturity: = Coupon × AF(r,T) + Par Value × PF(r,T) ± When coupon rate = r, bond price = par value T T T T T T t t r value Par r r C r C r value Par r r Coupon r value Par r Coupon ) 1 ( ) 1 ( ) 1 ( ) 1 ( 1 ) 1 ( ) 1 ( Price Bond 1 + + + = + + + × = + + + = =
5 Between Coupon Dates ± If a bond is purchased between coupon dates, then the price should reflect the time passed since the last coupon payment. ± Define the ratio w as ± Then period coupon current the in Days payment coupon next and settlement between Days w = w 1 T T 1 t w 1 t ) r 1 ( value Par ) r 1 ( Coupon price bond + = + + + + =

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6 Yield To Maturity ± Internal Rate of Return (IRR) that equates the PV of future cash flows to the current price 1028.68=30[1/(1+y)+1/(1+y) 2 +…+1/(1+y) 6 ]+ 1000/(1+y) 6 y = 2.48% ± Average rate of return if held to maturity and all coupon payments are reinvested at YTM ± Given the coupon rate and maturity, there is a one-to-one relationship between bond price and YTM ± Bonds are often quoted in YTM
7 Other Yield Measures ± Realised yield: based on the actual reinvestment rate and the total cash received at maturity ± Bond Equivalent Yield: 2% x 2 = 4% ± Effective Annual Yield: (1.02) 2 - 1 = 4.04% ± Current Yield = Annual Coupon/Market Price = \$60/\$1056.01 = 5.68% ± Holding period returns = (coupon + capital gain) / original investment = [30+(1000-1056.01)]/ 1056.01 = -2.46%. ² HPR = realized yield (if held to maturity)

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8 Bond Prices and YTM ± Bond prices are inversely related to YTM, and more sensitive to changes in YTM at low YTM than at high YTM.
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## This note was uploaded on 05/02/2010 for the course ACCT 3756 taught by Professor Leung during the Three '09 term at University of Sydney.

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Week 10_Fixed Income 2 - Fixed Income Interest Rate...

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