Interest Rate Risk

Interest Rate Risk - premium ). If a firm is downgraded...

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Interest Rate Risk 1 Even ‘risk-free’ bonds (Treasuries) have risk. Bondholders are subject to interest rate risk since the value of their investment changes as interest rates change. All things being equal, the interest rate risk is higher when: The time to maturity is longer. The coupon rate is lower. r = RR + IP + DP + MP + LP + EP + TP
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Interest Rate Risk Is Higher When… 2 …the time to maturity is longer… …because securities with longer maturities are more vulnerable to price changes caused by changes in interest rates over time. ...the coupon rate is lower… …because the value of the bond’s cash flows are more dependent on the principal payment than the coupons. r = RR + IP + DP + MP + LP + EP + TP
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Other Bond Risk Factors Credit (or Default) Risk – The possibility that the firm will default on the bond. Investors require a premium ( default risk
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Unformatted text preview: premium ). If a firm is downgraded (upgraded), the required rate of return goes up (down). Taxability Investors require a premium if the cash flows are taxable. 3 r = RR + IP + DP + MP + LP + EP + TP Credit Risk Credit (or Default) Risk The possibility that the firm will default on the bond. Investors require a premium ( default risk premium ) 4 r = RR + IP + DP + MP + LP + EP + TP Taxable Equivalent Yields All things being equal, yields on taxable bonds are higher than tax-exempt ones. To demonstrate the impact of the exemption from income taxes, consider the following investor in the 30% tax bracket: Bond 1 Taxable, 5.6% Yield Bond 2 Tax-Exempt, 4.0% Yield 4.0/(1-Tax Rate) = 4.0/(1-.30) = 5.71% 5 r = RR + IP + DP + MP + LP + EP + TP Taxable Equivalent Yields 6...
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Interest Rate Risk - premium ). If a firm is downgraded...

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