Lecture+18+Nov+16+2011

Lecture+18+Nov+16+2011 - FINA3104:...

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FINA 3104: Investment Analysis and Portfolio Management Lecture 18 – Managing Fixed Income Portfolios (continued) Darwin Choi November 16, 2011
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Recap from Last Lecture Interest Rate Sensitivity Maturity, Coupon, Yield, and Duration Duration and Bond Price Sensitivity Determinants and Properties of Duration For zero coupon bonds Duration equals Maturity Duration as Coupon rate Duration usually as Maturity Duration as Yield 2
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Outline of Today’s Lecture Duration and Convexity How to Manage Interest Rate Risk? Match Duration to Holding Period Match Asset & Liability Duration 3
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The second term is the modification for convexity For a bond with positive convexity, the second term is positive, regardless of whether the yield rises or falls. If the change in yield is small, the convexity term will be extremely small Duration & Convexity A Second order Approximation 2 ) ( 2 1 * y Convexity y D P P
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Convexity Formulation T t t t t t y CF y P Convexity 1 2 2 ) ( ) 1 ( ) 1 ( 1
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Duration & Convexity Still Only an Approximation -15% -10% -5% 0% 5% 10% 15% -4% -3% -2% -1% 1% 2% 3% 4% Duration Only Duration & Convexity Actual Price Change % Yield Change % Bond Price Change
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Outline of Today’s Lecture Duration and Convexity How to Manage Interest Rate Risk? Match Duration to Holding Period Match Asset & Liability Duration 7
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What Is Interest Rate Risk? Interest Rates Risk Takes Two Forms: 1) Re Investment (Re Financing) Risk: Arises if assets (liabilities) must be re invested (re financed) at future, unknown interest rates. (e.g., Reinvesting Coupons, Roll Over Strategy) 2) Price Risk: Gain or loss in debt instruments that have not reached maturity and interest rates have changed.
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Lecture+18+Nov+16+2011 - FINA3104:...

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