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MSF274(11C) - Market Risk Metrics#3 Duration Convexity and...

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Duration, Convexity and Beta Duration, Convexity and Beta Market Risk Metrics (#3) Market Risk Metrics (#3)
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2 THAILAND 10 11 12 13 14 3 mo 1 yr 2 yr 5 yr International Yield Curves UNITED STATES 4 5 6 7 8 90 day 2 yr 30 yr INDONESIA 10 11 12 13 14 3 mo 6 mo 1 yr HONG KONG 5 6 7 8 9 3 mo 1 yr 2 yr 6 yr Thailand United States Hong Kong Indonesia
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3 Term Structure Theory Expectations Long-term interest rates equal the serial sequence of short-term rates. The forward yield reflects the expected rate. Liquidity Preference Long-term interest rates equal the serial sequence of short-term interest rates plus a liquidity premium to reflect incremental price risk. The forward rate is biased high due to the premium. Market Segmentation The yield curve reflects supply/demand by institutions with term preferences. The yield curve conveys no information regarding interest rate trends in the future.
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4 Risk, Leverage and Liquidity Too Much Short term Debt! High-grade Firms Less Debt Financing Stable and High Cash Flow Borrow Short-term Debt to Avoid Liquidity Premium in Yield Curve Low-grade Firms More Debt Financing Unstable Cash Flow Borrow Long-term to Avoid Liquidity Crisis Consequence of Panic of 2008? 4 4.5 5 5.5 6 6.5 0 2 4 5 7 9 11 Yield 0 2 4 6 8 10 12 MATURITY YIELD US Treasury Yield Curve
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5 Market Risk: I Consequence of a Change in Yield on the Price or Value of Security and Portfolio Measure: Effective Duration Average Absolute Percentage Change in Price Given: +/- 1% Change in Yield Risk: Higher Effective Duration (More Exposure to Market Risk)
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6 Computing Effective Duration Two step Process Prior to estimating absolute average percentage change in price derived from +/- 1% change in yield (not rate or coupon), one must determine the direction of price change. Positive effective duration prices move inversely to yield; this is encountered about 99% of time in the market. Instruments with negative effective duration possess prices that move directly with yields; mortgage servicing rights and interest-only MBS are common examples.
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7 + 1 Percent: 108.98 Enter 104.38 % - 4.22 % (- 4.60 ÷ 108.98) - 1 Percent: 108.98 Enter 113.83 % + 4.45 % (+4.85 ÷ 108.98) ED = 4.34 Computing Effective Duration Market + 1% Yield -1% Yield FV 100.00 PMT 3.00 n 10.00 i 2.00 2.50 1.50 PV 108.98 104.38 113.83 Market Valuation Example $100 5-year, 6% Rate (semiannual payment) U.S. Treasury Note Priced @ 4% Yield
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Republic of Brasil Bond USD 4 Year 7.88 % Rate Priced @ 120.00 Effective Duration? Yield Price % Change fCLX 3.58 ÷ 2i 100 FV PV 115.87 - 3.44 3.94 PMT 1.58 ÷ 2i 8 n PV 124.31 + 3.59 120CHSPV i 1.29 2 × 2.58
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9 Effective Duration Estimate the effective duration of each of the three assets based on the percentage change in price and the relationship of the change to higher or lower yields -1% Base +1% Federal Funds 0.0 0.0 T-note 3.4 -3.2 IO MBS - 2.4 3.6 Percentage Change in Value
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10 Effective Duration Problem
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