Chapter 7 - Chapter 7 Introduction to the Measurement of...

Info iconThis preview shows pages 1–8. Sign up to view the full content.

View Full Document Right Arrow Icon
1 Chapter 7 Introduction to the Measurement of Interest Rate Risk
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
2 Introduction In Chapter 2 , we first discuss the interest rate risk in bond investment. We know that: Bond price and interest rate move in opposite directions In particular, a rise in the interest rates will lead to a decline in the bond value. This is known as the interest rate risk to bond investors The key in measuring the interest rate risk is the accuracy in estimating the value of the bond portfolio after an adverse interest rate move We can do so using either the full valuation approach or the duration/convexity approach
Background image of page 2
3 Full valuation approach This approach revalues a bond or bond portfolio for a given interest rate change scenario . It is also known as scenario analysis (as in ADMS3530 ) On the following two slides, we illustrate this approach using a portfolio of two bonds, bond A and bond B We consider two scenarios: In Scenario 1 , there is a parallel increase in the yields on both bonds by 50 basis points In Scenario 2 , there is a parallel decrease in the yields on both bonds by 100 basis points We can also do a similar analysis for a nonparallel shift in yields (see Exhibit 3 on p.159 )
Background image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
4 Full valuation approach Both bonds A and B are option free Bond A is 8% coupon payable semiannually, 5 years, $100 par, yields at 6%, and sells at $108.53 (N = 10; PMT = 4; FV = 100; I/Y = 3; CPT PV = -$108.53) Bond B is 5% coupon payable semiannually, 15 years, $100 par, yields at 7%, and sells at $81.61 (N = 30; PMT = 2.5; FV = 100; I/Y = 3.5; CPT PV = -$81.61) The value of the bonds and the value of the portfolio consisting of bonds A and B in each scenario are summarized in the table on the next slide …
Background image of page 4
5 Full valuation approach Scenario Yield change Bond A Bond B Porfolio Portfolio value change Current None $108.53 $81.61 $190.14 None 1 50 basis points ( ) $106.32 $77.71 $184.03 3.21% ( ) 2 100 basis points ( ) $113.13 $90.20 $203.33 6.94% ( ) In Scenario 1 (i.e., interest rates rise ), bond A declines by 2.04% [= ($106.32 - $108.53) / $108.53] in price, and bond B drops by 4.78% in price In Scenario 2 (i.e., interest rates drops ), bond A increases by 4.24% in price, and bond B rises by 10.53% in price
Background image of page 5

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
6 Full valuation approach Bond B is a longer maturity bond and has a lower coupon rate : both of which mean higher interest rate risk The changes in bond B price are 4.78% and 10.53%, both higher than the corresponding changes in bond A price (2.04% and 4.24%, respectively) Recall from Chapter 2 : Higher (lower) coupon rate means lower (higher) interest rate risk Longer (shorter) maturity means higher (lower) interest rate risk Higher (lower) yield means lower (higher) interest rate risk
Background image of page 6
7 In-class exercise 1 A portfolio manager wants to take advantage of the expected decline in yields over the next several months. Which of the following combinations of maturity and
Background image of page 7

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Image of page 8
This is the end of the preview. Sign up to access the rest of the document.

Page1 / 60

Chapter 7 - Chapter 7 Introduction to the Measurement of...

This preview shows document pages 1 - 8. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online