CHAPTER 5
BOND PRICES AND INTEREST RATE RISK
CHAPTER OBJECTIVES
1.
This chapter explains how interest rate changes affect bond prices.
The student should come
to understand the mechanics of bond pricing and the way bond markets simultaneously set prices and
yields.
2.
The chapter compares and contrasts the concepts of coupon rate, yield to maturity, expected
yield, realized yield, and total return.
3.
The chapter surveys the nature, measurement, and management of interest rate risk, with
attention to volatility, price risk, reinvestment risk, and duration.
Beyond learning the formula, the
student should grasp the importance of duration
as a measure of a) volatility and b) the holding period
for which price risk and reinvestment risk just offset, assuring the investor the yield to maturity.
CHANGES FROM THE LAST EDITION
Anecdotal materials have been updated.
CHAPTER KEY POINTS
1.
Beyond the calculations, students should understand why money has time value.
Inflation
expectations may affect the discount rate, but the time value of money has nothing
primarily
to do with
inflation.
Deferred consumption has an opportunity cost irrespective of expected changes in purchasing
power. Use of financial calculators should be encouraged.
Students can demonstrate to themselves the
price and yield mechanisms on which fixed-income markets are based.
2.
The value or price of a bond (or any fixed-income security) is the present value of the
promised cash flows discounted at the market rate of return, i.e., the required return on this risk class in
today’s market.
3.
Certain risks affect prices and yields.
A bond yield rewards at least 3 risks:
default risk, price
risk, and reinvestment risk. Price risk and reinvestment risk offset one another to some extent as interest
rates vary.
Yields may be classified as expected or
ex ante
(yield to maturity and expected yield) or as
realized or
ex post
, (realized yield and total return).
Yield to maturity assumes coupon reinvestment at
the same yield.
4.
Price volatility is a proxy for price risk.
Duration is also used as a price risk measure--the
higher the duration, the greater the potential volatility.
Bond volatility is directly related to term to
maturity and inversely related to coupon rate.
5.
Duration is the sum of the discounted, time weighted cash flows divided by the price of the
security.
A simple two- or three-year example is an efficient
way to explain how varying contract
terms and levels of interest rates affect duration.
Durations change dynamically.
Duration is directly
related to term to maturity
and
inversely related to coupon rate and yield.
6.
Duration is a measure of interest rate risk: a) as a measure of bond volatility; b) a time point
where price and reinvestment risk are offset; and, c) later when studying financial institutions, as a means
of managing interest rate risk by matching the durations of sources and uses of funds.
Matching
maturities gives no recognition to the varied cash flows, and varied coupon reinvestment of sources and
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