Understanding FI Risk and Return Flashcards
For a hold to maturity bond investor and rates go up after the purchase but before the first coupon payment, calculate the investor’s realized rate of return. Orginal I= 12%, increased to 15%
n=5, 10% coupon, PV= 92.79, interest rate goes up to 15%
*the bondholder will reinvest the coupon payments at 15% for the 5 yr period
n=5, PV=0, I/Y=15, PMT=10
FV= 67.42 (the amount in excess of the coupons, $17.42 (67.42 - 50), is the “interest-on-interest” gain from
compounding)
the total return at maturity is then 167.42 (67.42+100)
thus, the realized rate of return is 12.53%
n=5, FV=167.42, PV= -92.79, pmt=0
CPT I/Y = 12.53
If an investor buys a 5-yr, 10% coupon bond at 92.79, where interest rates move from 12%-15%, and he sells after 3-yrs, what is the effect?
- the 3-yr coupons = 34.73 (n=3, I/Y=15, pv=0, pmt=10, FV= 34.73)
-
**to calculate the sale price after 3 yrs, THERE ARE ONLY 2 YRS REMAINING ON THE BOND and FV =100
- n=2, fv=100, I/Y=15, pmt= 10, - solve for PV= 91.87 (the sale price!)
- total return = 126.60 (91.87 + 34.73)
- so, the 3-yr “horizon yield” is: n=3, pv= 92.79 (the orginal PV amt), FV= 126.60 (the total return)
- cpt I/y = 10.91%
Compared to holding this bond to maturity, selling the bond after 3 years results in a lower return (10.91% v 12%)
Although the coupons were invested at a higher rate, the capital loss was greater than the gain from reinvesting coupons.
Interest rate risk affects bondholders in two different ways:
- coupon reinvestment risk
- market price risk
*these are offsetting risks; different time horizons will experience different exposures
When does coupon reinvestment risk matter?
- when an investor has a long-term horizon
- a buy-and-hold investor has only coupon reinvestment risk
When does market price risk matter?
- when the investor has a short-term horizon relative to the time to maturity of the bond
Duration
the duration of a bond measures the sensitivity of the bond’s full price (including AI) to changes in interest rates
- indicates the % change in the price of a bond for a 1% change in interest rates.
the higher the duration, the more sensitive the bond is to change in interest rates
duration is expressed in years
- the time it will take a bond to repay its value
The two categories of duration are:
- yield duration
2. curve duration
Yield duration is …
- yield duration is the sensitivity of the bond price with respect to the bond’s own yield to maturity
Curve duration is…
curve duration is the sensitivity of the bond price with respect to a benchmark yield curve
- such as a govt yield curve, the spot curve, or the forward curve
Types of duration under yield duration:
YIELD DURATION
- macaulay
- modified
- money
- PVBP
Types of duration under curve duration:
CURVE DURATION
- effective
Macaulay duration definition
indicates the investment horizon for which coupon reinvestment risk and market price risk offset each other
- is a weighted average of the time to receipt of the bond’s promised payments
- the weights are the time period’s share of the full price that corresponds to each of the bond’s promised future coupon payments
- ie; calculate the present value of each CF, multiply by its weight and sum the total
ex. a 10-yr, 8% annual bond
Per CF PV Weight (PV/price) Period * Weight 1 8 find 2 8 3 8 4 8 5 8 6 8 7 8 8 8 9 8 10 108 Total: price 1 7.0029 (example (sum pv) (sum)
Modified duration
THE MODIFIED DURATION IS CALCULATED IF THE MACAULAY DURATION IS KNOWN.
- an estimate of the % price change for a bond given a change in its YTM.
- its just a simple adjustment to the Macaulay duration
modified duration = macaulay duration / (1 + r)
r = yield per period; ie YTM
A % price change for a bond given a change in its YTM =
%PVfull = -AnnualModifiedDuration * deltaYTM
A 2-yr annual $100 bond has a Macaulay duration of 1.87 years. The YTM is 5%. Calculate the modified duration.
modified duration = macaulay duration / (1 + YTM)
= 1.87 / 1.05 = 1.78 years
Approximate Modified Duration
- if the yield is A and increases by 1% (A+1%), then the price of the bond will decrease by B% (the output of the equation )
- used to estimate the value of modified duration; if Macaulay D isn’t known
- this method estimates the slope of the line tangent to the price-yield curve
- y-axis: price
- x-axis: YTM
Appx Modified Duration = (PV-) - (PV+) / ( 2 * ▲Yield * PVo)
ie: = (price of bond when yield is decreased) - (price of bond when yield is increased) / ( 2 * delta yield * initial bond price)
- once the appx modified duration is solved, the appx Macaulay duration can be calculated
Approximate Macaulay Duration
- can be solved for once the appx modified duration is known
- it is the weighted avg time to receipt to receipt of interest and principal payments
appx Macaulay Duration = Appx modified duration * ( 1 + r )
r = periord YTM
A 12% annual bond with 10-yr to maturity currently trading at par. Assume a 10bps change in ytm; what is the bond’s approximate modified duration?
What is the formula?
What steps are needed to calculate?
Appx Modified Duration = (PV-) - (PV+) / ( 2 * ▲Yield * PVo)
need to know current bond price and current ytm to start
n=10, pmt=12, fv=100, pv=100; cpt I/Y = 12 (and BC its trading at par)
Find the price if ytm increased by 10bps
Find the price if ytm decreased by 10 bps
10bps = .1% = .001
solve
100.57 - 99.44 / (2 * .001 * 100)
= 5.65 years
The modified duration of a bond is 6.54. The approximate percentage change in price using duration only for a yield decrease of 120bps is ….
which formula?
what does 120bps convert to?
what to watch for
%PVfull = -modified duration * delta ytm 120bps = 1.2%
%PVfull = -6.54 * -1.20
make sure to remember the (-) before modified duration and if YTM decreases, its a (-) as well.
The effective duration is the _____ appropriate measure of interest risk of a bond with an embedded call option
the MOST
- bonds with embedded options and mortgage-backed securities do not have a well-defined YTM
Effective Duration
- falls under the curve duration category
- it is a measure of the sensitivity of the bond’s price to a change in a benchmark yield curve (instead of its own YTM)
- the best measure of interest rate sensitivity for bonds with embedded options and mortgage-backed securities, or securities without well-defined YTM (pension fund liabilities)
- because these securities may be prepaid before the maturity date
Effective duration = = (PV-) - (PV+) / ( 2 * ▲CURVE * PVo)
*note its a similar formula to appx modified duration, but its the delta curve (not delta yield)
As the coupon rate increases, the Macaulay duration ____
- decreases
- a higher coupon rate has a lower duration
As the time to maturity increases, Macaulay duration ___
- increases
- a longer time to maturity has higher duration
A higher YTM results in a ____ duration
- lower duration