FIN-2Lecture 9-The Term Structure of Interest Rates and Yield Derivation

In other words interest rate risk is less than

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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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This note was uploaded on 05/03/2013 for the course FIN 101 taught by Professor Mugabi during the Spring '13 term at De Haagse Hogeschool.

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