TOPIC: INTEREST RATE RISK
• Interest rate risk is the probability of a
decline in the value of an asset resulting
from unexpected fluctuations in interest
rates. Interest rate risk is mostly associated
with fixed-income assets (e.g., bonds)
rather than with equity investments. The
interest rate is one of the primary drivers
of a bond’s price.
Interest Rate Risk Cont..
Bond Valuation Recall:
• Calculate the Market Value of a 5 year,
$1,000 par value bond with annual coupon
rate of 8% p.a when the YTM is:
• (a) 7%
• (b) 12%
• (c) 8%
Price and Yield Relationship
Bond Value/YTM Curve
Bond Valuation Recap 2
• A bond has a $ 1,000 face value and
provides an 8% semi-annual coupon
for 15 years. The appropriate discount
rate is 10% (annual rate). What is the
market value of the bond?
Interest Rate Risk Mitigation
The most common tools for interest rate mitigation include ;
Diversification and Hedging
❖Diversification
If a bondholder is afraid of interest rate risk that can
negatively affect the value of his portfolio, he can diversify
his existing portfolio by adding securities whose value is less
prone to the interest rate fluctuations (e.g., equity). If the
investor has a “bonds only” portfolio, he can diversify the
portfolio by including a mix of short-term and long-term
bonds.
Interest Rate Risk
Mitigation Cont….
❖The interest rate risk can also be mitigated
through various hedging strategies. These
strategies generally include the purchase
of different types of derivatives. The most
common examples include interest rate
swaps, options, futures, and forward rate
agreements (FRAs).
Measuring Interest Rates
Risk in Bonds
❖Bond Duration- Macaulay’s Duration
❖Bond Convexity
Macaulay’s Duration
• Duration: an estimate of economic life of a
bond measured by the weighted average
time to receipt of cash flows
• The shorter the duration, the less sensitive
is a bond’s price to fluctuations.
Macaulay’s Duration Cont …
Macaulay’s Duration
Example 1
Calculate the Macaulay duration of a 5
year $1,000 par value bond with an
annual coupon Rate of 4% and current
interest rate of return of 4.5%
Macaulay’s Duration
Example 2
Calculate the Macaulay duration of a 5
year $1,000 par value bond with an
annual coupon Rate of 10% and current
interest rate of return of 8%
Modified Duration
❖Expresses the change in the value of a
security due to a change in interest rates.
In other words, it illustrates the effect of a
100-basis point (1%) change in interest
rates on the price of a bond.
❖Modified duration illustrates the concept
that bond prices and interest rates move
in opposite directions – higher interest
rates lower bond prices, and lower interest
rates raise bond prices.
Modified Duration
Modified Duration Example
1
Calculate the Modified duration of a 5 year
$1,000 par value bond with an annual
coupon Rate of 4% and current interest rate
of return of 4.5%
Modified Duration Example
2
Calculate the Macaulay duration of a 5 year
$1,000 par value bond with an annual
coupon Rate of 10% and current interest rate
of return of 8%
Properties of Bond price
Volatility cont.…
Effective Duration
Effective Duration Cont. …
Effective Duration Example
1
Suppose there is a 5-year, semi-annul pay,
option free non-callable bond with an
annual coupon of 7.25% trading at $98. If
interest rates rise by 50 basis points(0.50%),
the estimated price of the bond is $[Link]
interest rates fall by 0.50%, the estimated
bond price is $[Link]: Calculate
the effective duration
Effective Duration Ex.1
Solution
Challenge Problem
Solution
Challenge Problem
Solution
Convexity
Convexity
Convexity
Properties of Convexity
Convexity Formula
Convexity Example 1
• Consider a bond with a par value of $100.
Time to Maturity is 15 years and coupon
rate of 8% p.a. The Current YTM is 7.4%
Calculate the following if the Yield changes
by 1 basis point:
• (A) Effective Duration
• (B) Approximate Convexity
Approximate Convexity
Example 2
The investment manager for a defined benefit pension
scheme is considering two bonds about to be issued by a
large insurance company. Bond “A” is a 30 year, 4% semi
annual coupon payment bond. The second bond (Bond B) is
a 100 year, 4% semiannual coupon payment bond. Both
bonds are expected to trade at par value at issuance. The
bonds YTM can increase or decrease by 5 basis points. Each
bond has a par value of $100. Required:
(i) Approximate Convexity
(ii) Effective Duration
** Retain your values to 6 decimal places***