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03B Fin 301 Interest Rate Risk Ulearn

# 03B Fin 301 Interest Rate Risk Ulearn - Interest Rate Risk...

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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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