CHAPTER 5 Martellini Lecture


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CHAPTER 5 MARTELLINI HEDGING INTEREST RATE RISK WITH DURATION Need to understand how bond prices change, given a change in interest rates. BASICS OF INTEREST RATE RISK: QUALITATIVE INSIGHTS Using the information on page 163, Table 5.1, the following observations can be made: Using the bond valuation model, one can show the changes that occur in the price of a bond (its volatility), given a change in yields, as a result of bond variables such as time to maturity and coupon, and show that these observations actually hold in all cases. THE FIVE THEOREMS OF BOND PRICING They are: 1. Bond prices move inversely to interest rates. Bond prices move inversely to market yields. When the level of required yields demanded by investors on new issues changes, the required yields on all bonds already outstanding will also change. For these yields to change, the prices of these bonds must change. 2. Holding maturity constant, a decrease in rates will raise bond prices on a percentage basis more than a corresponding increase in rates will lower bond prices. 3. All things being equal, bond price volatility is an increasing function of maturity. Long term bond prices fluctuate more than short term bond prices. Although the inverse relationship between bond prices and interest rates is the basis of all bond analysis, a complete understanding of bond price changes as a result of interest changes requires additional information. An increase in interest rates will cause bond prices to decline, but the exact amount of decline will depend on important variables unique to each bond, such as time to maturity and coupon. An important rule is that for a given change in market yields, changes in bond prices are directly related to time to maturity. Therefore, as interest rates change, the prices of longer term bonds will change even more than the prices of shorter term bonds, everything else being equal. 1
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4. The percentage price change that occurs as a result of the direct relationship between a bond’s maturity and its price volatility increases at a decreasing rate as time to maturity increases. Here, the percentage of price changes resulting from an increase in time to maturity increases, but at a decreasing rate.
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This note was uploaded on 04/07/2012 for the course ECONOMICS 101 taught by Professor Tillet during the Spring '12 term at Broward College.

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