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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 57
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