Fixed Interests - Risks

Question 1

What is Duration used to measure? (Macaulay)

Answer 1

The sensitivity of fixed interest investments to a change in interest rates.

It shows the period of time it will take to repay initial outlay.

Question 2

What is Modified Duration?

Answer 2

Estimates the change in a bonds value if there is a change in interest rates (and thus yields)

Question 3

What is the Modified Duration formula?

Answer 3

Duration (Macaulay) / ( 1 + Gross Redemption Yield)

You are given the duration in the exam

Question 4

What would be the Modified Duration based on:

Clean price £95
Macaulay Duration 4.5
Gross Redemption Yield 3

Answer 4

Answer: 4.5 / 1.03 = 4.37

Duration / 1 + Gross Redemption Yield (decimalized)

Question 5

What would be the new clean price if interest rates rised by 1%?

Clean price £95
Macaulay Duration 4.5
Gross Redemption Yield 3
Modified Duration 4.37

Answer 5

4.37 x 0.1 x 95 = £4.15 change

£95 - £4.15 = £90.85

Modified Duration - change in interest x clean price. Then minus from current clean price.

(If interest rates go up, the new clean price will go down)