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Interest Rates and Market Dynamics Explained

The document discusses various concepts related to interest rates and bonds. It explains how interest rate changes impact call and put options as well as bond prices and yields. Key terms discussed include duration, modified duration, convexity, and yield curves. Duration measures a bond's price sensitivity to interest rate changes while convexity addresses the non-linear impact. Downward yield curves typically occur during recessions when interest rates fall, while upward curves happen during booms as rates rise.

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nidhi pahuja
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9 views3 pages

Interest Rates and Market Dynamics Explained

The document discusses various concepts related to interest rates and bonds. It explains how interest rate changes impact call and put options as well as bond prices and yields. Key terms discussed include duration, modified duration, convexity, and yield curves. Duration measures a bond's price sensitivity to interest rate changes while convexity addresses the non-linear impact. Downward yield curves typically occur during recessions when interest rates fall, while upward curves happen during booms as rates rise.

Uploaded by

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

News

1. Gas prices have been peaking up


2. Increase in prices
3. Europe recession
4. Prices of Dollar

Interest Rates are Market Risks

Impact of Interest rate on Options

1. Interest rate increase, Call option increases


2. Interest rate increases, Put option Decreases

Change in interest rate causes:

 Interest Costs
 Interest Revenue

Associated Risks

NIM (Net Interest Margin)

(Interest Income-Interest expense)/Average interest earning assets

The Market for Lemons(Book)


Duration/Modified Duration-

To understand fluctuations in interest rate, impact the prices of bonds

What happens to yield in increasing interest rate regimes?

Interest Rate increase, Price of bond decrease, yields would increase for existing bonds

Interest Rate decrease, Price of bond increase, yields would decrease for existing bonds

(Interest rate has direct relation with yields and inverse relation with bond prices)

Duration of Zero coupon Bonds= Maturity of bond price

Lower Yield bond Prices are more it will take More time Hence Higher Duration
to pay
Higher yield Bond Prices are Less it will take less time to Hence Lower Duration
pay

Long term bonds it will take More time Hence Higher Duration
to pay
Short Term bonds it will take less time to Hence Lower Duration
pay

Convexity

When interest rates go up the proportionate rise is not equal to the change in price. The price increase is
more that the rise in interest rates.

First derivative- Modified duration

Second derivative- Convexity

Yield Curve

Impact of downward yield cure

 Assuming that economy is moving towards recession


 The purchasing power falls
 Hence investing and borrowing decreases
 The interest rate decreases in the long run
Impact of Upward yield curve

 Assuming that economy is moving towards boom


 The purchasing power increases
 Hence investing and borrowing increases
 The interest rates increase in the long run
 Growth stagnates
 Prices are at all time high
 Inflation shoots ups
 When no growth is there (because growth stagnates)
 Interest rates increases (Done by RBI to decrease the purchasing power and stabilize the
economy/inflation)

Zero Curve/ Zero Coupon Bonds Curve

A curve of zero-coupon bonds and its maturity.

Uses of Zero rate

6 month Z-rate (discounting rate), can be calculated- (6 month t bill)

12 months,can be calculated using 1 yr t bill

Caluclating 2 yr bond which pays semi annual coupons-

P=C1/(1+z1)+c2/(1+z2)+c3/(1+z3)+(c+fv)/(1+z4) , to be calculated, using goal seek

Theoretical price of the bond= C1/(1+z1)+c2/(1+z2)+c3/(1+z3)+(c4+P)/(1+z4)

Forward/Future Rate= (S2T2-S1T1)/(T2-T1)

Why for hedging we use duration than convexity even when convexity is better measure than
duration?

Because yield changes in a smaller value, and the change in prices are also less, we can consider
duration for hedging for simpler process than using convexity.

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