1
Interest Rate Risk
and Inflation
This section uses annual coupon
bonds to simplify exposition
Consider zero coupon bonds X and Y
Bond X pays $4,000 in ten years (T
X
= 10)
Bond Y pays $2,000 in five years (T
y
= 5)
The interest rate is 14.87%:
Example – Interest Rate Sensitivity
2
P
0
X
= $4,000/1.1487
10
= $1,000.0
P
0
Y
= $2,000/1.1487
5
= $1,000.0
Interest rate drops to 10%
What happens to the prices of bonds?
Which bond is more sensitive to a change in the
interest rate?
Why?
New interest rate is 10%:
P
0
X
= $4,000/1.10
10
= $1,542.2
P
0
Y
= $2,000/1.10
5
= $1,241.8
Example – Interest Rate Sensitivity
3
Now suppose interest rate increases to
20%
P
0
X
= $4,000/1.20
10
= $646.0
P
0
Y
= $2,000/1.20
5
= $803.8

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