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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2 Example (Question #3) ± Consider bonds A and B ± Coupon rate: r Coupon A = r Coupon B = 10% ± Annual coupons ± Maturity in years: T A = 20; T B = 10 4 ± Interest rate: 10% ± Both bonds sell for $1000 ± Interest rate drops to 4% ± What happens to the prices of bonds? ± Which bond is more sensitive to a change in the interest rate?
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This note was uploaded on 11/01/2011 for the course BUSINESS FIN301 taught by Professor Andrew during the Fall '10 term at University of Alberta.

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

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