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**Unformatted text preview: **lds increases
at a decreasing rate as maturity increases . In other words,
interest rate risk is less than proportional to bond maturity
Interest rate risk is inversely related to the bond’s coupon
rate. Prices of high coupon bonds are less sensitive to
changes in interest rates than prices of low coupon bonds
The sensitivity of a bond’s price to a change in its yield is
inversely related to the yield to maturity at which the bond is
currently selling Investment, Risks & Required rates of Return
§
§
§ §
§ § Every Investor would like to invest in an
investment that has no risk at all! (get a Rf)
Unfortunately, such a thing does not exist in the
world!!
Even what we would call Risk-free should
compensate you for Inflation! (purchasing power
risk)
For every investment, the investor should be
compensated for risk he/she is taking
In other words for every risk an investor demands
that he gets a premium above the Rf for every risk
factor
So the Required rate of return should be: Risk, Interest Rate and Inflation
§ You have €1,000 today and you are not interested in consuming it
now. Suppose a bank offers you a one-year interest rate of 10%. § Is this return good enough?
The Answer can only be put into perspective after examining inflation
during the year. Suppose inflation is 6%!!
Imagine a restaurant charges €1 for a burger today. You are able to
buy 1,000 burgers now.
But in a year from now, you will need €1.06 to buy one burger. So, you
will have €1,000 x 1.1 = €1,100; enough to buy 1,037.74 (1,100÷1.06)
burgers
This suggests that your €1,000 will have grown in 3.77% in value in a
year
In other words inflation eats up a huge part of your 10% promised
return
Financial Economists refer to the 3.77% as the Real Interest Rate; the
10% as the Nominal 1+Nominal Interest Rate
rate or just interest rate §
§
§ §
§
§
§ Real Interest Rate = -1 (1+Nominal Interest rate)1+Inflation Rate
= (1+Real Interest rate) x (1+Inflation rate) How Financial Markets
Work
Financial markets Corporation
Investment
in real assets Reinvestment Stock markets
Fixed-income markets
Money markets
Markets for
Commodities
Foreign exchange
Derivatives Financial
Intermediaries
Mutual Funds
Pension funds
Financial Institutions
Banks
Insurance
companies Investors
worldwide Bond Risks
§ Interest Rate Risk: When interest rates rise (fall), bon...

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