Ch11outline - Chapter 11 I Interest Rate Risk A There is an inverse relationship between bond prices and yields and that interest rates can

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Chapter 11 I. Interest Rate Risk A. There is an inverse relationship between bond prices and yields and that interest rates can fluctuate substantially B. As interest rates rise and fall, bondholders experience capital losses and gains C. It is these gains and losses that make fixed-income investments risk, even if the coupon and principal payments are guaranteed, as in the case of Treasury obligations D. In a competitive market, all securities must offer investors fair expected rates of return E. Investors eager for that return will respond by bidding the bond price above its par value until the total rate of return falls to the market rate F. Interest Rate Sensitivity 1. The sensitivity of bond prices to changes in market interest rates is obviously of great concern to investors 2. Bond prices and yields are inversely related: As yields increase, bond prices fall; as yields fall, bond prices rise 3. An increase in a bond’s yields to maturity results in a smaller price change than a decrease in yield of equal magnitude 4. Prices of long-term bonds tend to be more sensitive to interest rate changes than prices of short-term bonds 5. If rates increase, for example, the bond is less valuable as its cash flows are discounted at a now-higher rate 6. The impact of the higher discount rate will be greater as that rate is applied to more-distant cash flows 7. Although interest rate sensitivity seems to increase with maturity, it does so less than proportionally as bond maturity increases 8. The sensitivity of bond prices to changes in yields increases at a decreasing rate as maturity increases. In other words, interest rate risk is less than proportional to bond maturity 9. Interest rate risk is inversely related to the bond’s coupon rate. Prices of lower-coupon bonds are more sensitive to changes in interest rates than prices of high-coupon bonds a. The lower-coupon bond exhibits greater sensitivity to changes in interest rates 10. The sensitivity of a bond’s price to a change in its yield is inversely related to the yield to maturity at which the bond currently is selling 11. The first five are sometimes known as Malkiel’s bond-pricing relationships 12. The last property was demonstrated by Homer and Liebowitz 13. These six propositions confirm that maturity is a major determinant of interest rate risk 14. However, they also show that maturity alone is not sufficient to measure interest rate sensitivity 15. For maturities beyond one year, the price of the zero-coupon bond falls by a greater proportional amount than the price of the 8% coupon bond
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16. The observation that long-term bonds are more sensitive to interest rate movements than short-term bonds suggests that in some sense a zero-coupon bond represents a longer term investment than an equal-time-to-maturity coupon bond 17. The 8% bond makes many coupon payments, most of which come years before the bond’s maturity date 18. Each payment may be considered to have its own “maturity date”
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This note was uploaded on 09/10/2010 for the course FIN 367 taught by Professor Han during the Fall '08 term at University of Texas at Austin.

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Ch11outline - Chapter 11 I Interest Rate Risk A There is an inverse relationship between bond prices and yields and that interest rates can

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