# week5 - Bank Management Week 5: Interest Rate Risk (III)...

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Bank Management Week 5: Interest Rate Risk (III) Market Risk (I) 2/29/12 1 NUS Business School,

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Duration Model 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 2/29/12 3 NUS Business School,

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Pricing Factors of Bonds Interest rate Time Remaining to Maturity Coupon Rate
Price Sensitivity and Maturity Example: Suppose the zero coupon yield curve is flat at 12%. Bond A pays \$1762.34 in five years. Bond B pays \$3105.85 in ten years, and both are currently priced at \$1000. Bond A: P = \$1000 = \$1762.34/(1.12)5 Bond B: P = \$1000 = \$3105.84/(1.12)10 Now suppose the interest rate increases by 1%. Bond A: P = \$1762.34/(1.13)5 = \$956.53 2/29/12 5 NUS Business School,

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Price Sensitivity of 6% Coupon Bond r 8% 6% 4% Range n 40 \$802 \$1,000 \$1,273 \$471 20 \$864 \$1,000 \$1,163 \$299 10 \$919 \$1,000 \$1,089 \$170 2 \$981 \$1,000 \$1,019 \$37
Price Sensitivity of 8% Coupon Bond r 10% 8% 6% Range n 40 \$828 \$1,000 \$1,231 \$403 20 \$875 \$1,000 \$1,149 \$274 10 \$923 \$1,000 \$1,085 \$162 2 \$981 \$1,000 \$1,019 \$38

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Coupon Effect Bonds with identical maturities will respond differently to interest rate changes when the coupons differ. With higher coupons, more of the value is generated by cash flows which take place sooner in time. Consequently, less sensitive to changes in R. 2/29/12 8 NUS Business School,
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 essentially 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. 2/29/12 9 NUS Business School,

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In general, longer maturity bonds experience greater price changes in response to any change in the discount rate. The range of prices is greater when the coupon is lower for fixed maturity. The 6% bond shows greater changes in price in response to a 2% change than the 8% bond. The first bond has greater interest rate risk. 2/29/12
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## This note was uploaded on 02/29/2012 for the course FINANCE FIN 3117 taught by Professor Lina during the Spring '12 term at National University of Singapore.

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week5 - Bank Management Week 5: Interest Rate Risk (III)...

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