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Module 4 Graphs Explained Financial Risk Management

This document explains the relationship between bond prices and interest rates, highlighting that as interest rates rise, bond prices fall and vice versa. It also categorizes bonds into premium, par, and discount based on their coupon rates relative to market yields, and discusses the effects of time to maturity and coupon rates on price volatility. Key exam points include the inverse relationship between interest rates and bond prices, and the sensitivity of long-term and low-coupon bonds to interest rate changes.

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3 views2 pages

Module 4 Graphs Explained Financial Risk Management

This document explains the relationship between bond prices and interest rates, highlighting that as interest rates rise, bond prices fall and vice versa. It also categorizes bonds into premium, par, and discount based on their coupon rates relative to market yields, and discusses the effects of time to maturity and coupon rates on price volatility. Key exam points include the inverse relationship between interest rates and bond prices, and the sensitivity of long-term and low-coupon bonds to interest rate changes.

Uploaded by

ivan sebatindira
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd

Module 4 Financial Risk Management

Graphs Explained
This document explains the bond and interest-rate graphs in a simple, exam-focused
way.

1. Bond Price vs Yield to Maturity (Interest Rate)


This graph shows the inverse relationship between bond prices and market interest rates
(Yield to Maturity).

• Vertical axis (Y-axis): Bond Price.


• Horizontal axis (X-axis): Yield to Maturity (Market Interest Rate).

As interest rates increase, bond prices decrease. As interest rates decrease, bond prices
increase.

Reason: Existing bonds have fixed coupon payments. When market rates rise, new bonds
offer higher coupons, making existing bonds less attractive. Their prices must fall to attract
buyers.

Example:
- Old bond: Face value $1,000, coupon 5% ($50/year).
- New market rate: 8%.
- New bonds pay $80/year.
- Investors prefer the new bonds, so the old bond price falls below $1,000.

Memory Trick: Interest Rates ↑ = Bond Prices ↓; Interest Rates ↓ = Bond Prices ↑.

2. Premium, Par and Discount Bonds


Compare the bond's coupon rate with the market yield:

Coupon vs Yield Bond Price Bond Type

Coupon > Yield Above Face Value Premium

Coupon = Yield Face Value Par

Coupon < Yield Below Face Value Discount

Example: Coupon 8%, Yield 3% → Premium bond because it pays more than new bonds.

3. Effect of Time to Maturity


Long-term bonds experience greater price volatility than short-term bonds.
Reason: Most of their cash flows are received further in the future, and future cash flows are
more sensitive to changes in interest rates.

Therefore, if interest rates rise by the same amount, a 20-year bond falls in price much more
than a 2-year bond.

4. Effect of Coupon Rate


Low-coupon bonds are more sensitive to interest-rate changes than high-coupon bonds.

Reason: Low-coupon bonds receive most of their value from the face value at maturity,
which is far into the future and therefore more affected by discounting.

High-coupon bonds recover more of their value earlier through coupon payments, making
them less volatile.

Exam Summary
1. Interest Rates ↑ → Bond Prices ↓.
2. Interest Rates ↓ → Bond Prices ↑.
3. Coupon > Yield → Premium Bond.
4. Coupon = Yield → Par Bond.
5. Coupon < Yield → Discount Bond.
6. Longer maturity = Higher interest-rate risk.
7. Lower coupon = Higher price volatility.

Model Exam Statement:


"Long-term, low-coupon bonds are the most sensitive to changes in market interest rates,
while short-term, high-coupon bonds are the least sensitive."

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