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Ch 4 ans - Questions and Problems on Duration and Interest...

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Questions and Problems on Duration and Interest rate risk. Questions: 1. What is the reinvestment risk? (Reinvestment risk is the risk that as investors receive interest and principal payments on their bonds they may have to reinvest these cash flows at a rate lower than they currently receive on the existing bond.) 2. How does duration differ from maturity? (Duration differs from maturity as a measure of interest rate sensitivity because duration takes into account the time of arrival and the rate of reinvestment of all cash flows during the assets life). 3. Duration is time to recover initial investment, a measure of interest rate sensitivity, weighted average time to maturity taking PV of cash flows as weights. Problems: 1. Calculate the duration of a \$1,000 6% coupon bond with three years to maturity. Assume that all market interest rates are 7%. Solution: Year 1 2 3 Sum Payments 60.00 60.00 1060.00 PV of Payments 56.07 52.41 865.28 973.76 Time Weighted PV of Payments 56.07 104.81 2595.83 2,756.71 Time Weighted PV of Payments Divided by Price 2.83 This bond has a duration of 2.83 years. Note that the current price of the bond is \$973.76, which is

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