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78106_05_Web_Ch05C_p01-05

# 78106_05_Web_Ch05C_p01-05 - WEB EXTENSION 5C A Closer Look...

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WEB EXTENSION 5C A Closer Look at Bond Risk: Duration T his extension explains how to manage the risk of a bond portfolio using the con- cept of duration. 5.1 B OND R ISK In our discussion of bond valuation in Chapter 5, we discussed interest rate and rein- vestment rate risk. Interest rate (price) risk is the risk that the price of a debt secu- rity will fall as a result of increases in interest rates, and reinvestment rate risk is the risk of earning a less than expected return when debt principal or interest payments are reinvested at rates that are lower than the original yield to maturity. To illustrate how to reduce interest rate and reinvestment rate risks, we will consider a firm that is obligated to pay a worker a lump-sum retirement benefit of \$10,000 at the end of 10 years. Assume that the yield curve is horizontal, the current interest rate on all Treasury securities is 9%, and the type of security used to fund the retirement benefit is Treasury bonds. The present value of \$10,000, discounted back 10 years at 9%, is \$10,000(0.4224) = \$4,224. Therefore, the firm could invest \$4,224 in Treasury bonds and expect to be able to meet its obligation 10 years hence. 1 Suppose, however, that interest rates change from the current 9% rate immedi- ately after the firm has bought the Treasury bonds. How will this affect the situation? The answer is, It all depends. If rates fall, then the value of the bonds in the port- folio will rise, but this benefit will be offset to a greater or lesser degree by a decline in the rate at which the coupon payment of 0.09(\$4,224) = \$380.16 can be reinvested. The reverse would hold if interest rates rose above 9%. Here are some examples (for simplicity, we assume annual coupons). 1. The firm buys \$4,224 of 9%, 10-year maturity bonds; rates fall to 7% immediately after the purchase and remain at that level: Portfolio value at the end of 10 years ¼ Future value of 10 interest payments of \$380 : 16 each compounded at 7% þ Maturity value ¼ \$5 ; 252 þ \$4 ; 224 ¼ \$9 ; 476 Therefore, the firm cannot meet its \$10,000 obligation, and it must contribute additional funds. 1 For the sake of simplicity, we assume that the firm can buy a fraction of a bond. 1

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2. The firm buys \$4,224 of 9%, 40-year bonds; rates fall to 7% immediately after the purchase and remain at that level: Portfolio value at the end of 10 years ¼ \$5 ; 252 þ Value of 30-year 9% bonds when r d ¼ 7% ¼ \$5 ; 252 þ \$5 ; 272 ¼ \$10 ; 524 In this situation, the firm has excess capital at the end of the 10-year period. 3. The firm buys \$4,224 of 9%, 10-year bonds; rates rise to 12% immediately after the purchase and remain at that level: Portfolio value at the end of 10 years ¼ Future value of 10 interest payments of \$380 : 16 each compounded at 12% þ Maturity value ¼ \$6 ; 671 þ \$4 ; 224 ¼ \$10 ; 895 This situation also produces a funding surplus.
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78106_05_Web_Ch05C_p01-05 - WEB EXTENSION 5C A Closer Look...

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