Chap09_Saunders7e_SLIDES

# Chap09_Saunders7e_SLIDES - 9-1 Chap-9 Interest Rate Risk...

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Chap-9 Interest Rate Risk Overview This chapter discusses a market value-based model for assessing and managing interest rate risk: Duration Computation of duration Economic interpretation Immunization using duration *Problems in applying duration 9-1

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Price Sensitivity and Maturity In general, the longer the term to maturity, the greater the sensitivity to interest rate changes Example: Suppose the zero coupon yield curve is flat at 12%. Bond A pays \$1790.85 in five years. Bond B pays \$3207.14 in ten years, and both are currently priced at \$1000. 9-2
Example continued. .. Bond A: P = \$1000 = \$1790.85/(1.06) 10 Bond B: P = \$1000 = \$3207.14/(1.06) 20 Now suppose the annual interest rate increases by 1% (0.5 % semiannually). Bond A: P = \$1762.34/(1.065) 10 = \$954.03 Bond B: P = \$3105.84/(1.065) 20 = \$910.18 The longer maturity bond has the greater drop in price because the payment is discounted a greater number of times. 9-3

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Coupon Effect Bonds with identical maturities will respond differently to interest rate changes when the coupons differ. This is easily understood by recognizing that coupon bonds consist of a bundle of “zero-coupon” bonds. With higher coupons, more of the bond’s value is generated by cash flows which take place sooner in time. Consequently, it is less sensitive to changes in R. 9-4
Remarks on Preceding Slides In general , longer maturity bonds experience greater price changes in response to any change in the discount rate range of prices is greater when the coupon is lower A 6% bond will have a larger change in price in response to a 2% change than an 8% bond The 6% bond has greater interest rate risk 9-5

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Extreme Examples With Equal Maturities Consider two ten-year maturity instruments: A ten-year zero coupon bond A two-cash flow “bond” that pays \$999.99 almost immediately and one penny ten years hence Small changes in yield will have a large effect on the value of the zero but almost no impact on the hypothetical bond Most bonds are between these extremes The higher the coupon rate, the more similar the bond is to our hypothetical bond with higher value of cash flows arriving sooner 9-6
Duration Weighted average time to maturity using the relative present values of the cash flows as weights Combines the effects of differences in coupon rates and differences in maturity

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## This note was uploaded on 11/10/2011 for the course ECON 4620 taught by Professor Victorwakeling during the Fall '11 term at Kennesaw.

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Chap09_Saunders7e_SLIDES - 9-1 Chap-9 Interest Rate Risk...

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