The lower market expected rate means a higher selling

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Unformatted text preview: a given holding period, a bond portfolio must be rebalanced every time a change in interest rates occurs to equate the ever changing duration to the remaining holding period. 10 Cheryl Mew FINS2624 – Portfolio Management Semester 1, 2011 D URATION AND BOND PRICE SENSITIVITY F ACTORS AFFECTING DURATION Coupon Rate - The higher the coupon rate, the sooner the investor is going to recover the, costs of purchasing the bond and the shorter the bond duration. Time to Maturity - The shorter the maturity, the sooner the investor is going to recover the costs of purchasing the bond and the shorter the bond duration. Yield to Maturity - From the graph that shows the inverse relationship between price and YTM, it is clear that the slope of the curve, which reflects the price sensitivity of bond price to yield changes, declines progressively as the YTM increases. Since price sensitivity and duration is directly related, duration should also declines progressively as the YTM increases P RICE SENSITIVITY Bonds with larger duration are riskier or more price sensitive to interest rate changes than bonds with smaller duration. This relation is proven by deriving the price of a bond with respect to the yield. dP D dy D*dy 1 y P This means that for a given drop in discount rate (keeping y constant), the bond with the larger duration will experience a larger percentage increase in price than another bond with smaller duration. The negative sign can be explained intuitively. The duration of a bond must be positive from the viewpoint of bondholders, as a negative duration would imply that bondholders have already recovered their costs even before they purchased the bond. Positive duration is ensured by the negative sign as price and yield are inversely related. Time , Duration , Coupon Rate , Yield , Price , Price Sensitivity Time , Duration , Coupon Rate , Yield , Price , Price Sensitivity 11 Cheryl Mew FINS2624 – Portfolio Management Semester 1, 2011 D URATION AND CHOICE OF BONDS Investors may wish to maximize the potential values of their portfolios if interest rates fall and minimize the potential capital losses upon rises in interest rates. Too meet this objective, they may shift funds from bonds with small duration towards bonds with large duration if interest rates are predicted to fall. If interest rates do fall as expected, bond prices...
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This document was uploaded on 03/21/2014.

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