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IMPACT ON FIXED INCOME
SECURITIES
INTEREST RATE RISK
Bonds, bond prices and interest rates
Bond prices and yieldsBond market equilibriumBond risks
Bonds: 3 types
Zero coupon bondse.g. Tbills
Fixed payment loanse.g. mortgages, car loans
Coupon bondse.g. Tnotes, Tbonds
Zero coupon bonds
Discount bondspurchased price less than face value-- F > P
face value at maturityno interest payments
Example
91 day Tbill, P = Rs.9850, F = Rs.10,000YTM solves
36591)1(
000,10$9850$
i
36591)1(
000,10$9850$
i
9850
100001 365
91 i
91365
9850
100001
i
%25.619850
10000 91365
i
yield on a discount basis (127)
how Tbill yields are actually quotedapproximates the YTM
idb = F - P
Fx
360d
example
91 day Tbill, P = Rs.9850, F = Rs.10,000discount yield =
%93.591
360
000,10$
150$
idb < YTMwhy?
F in denominator 360 day year
Fixed-payment loan loan is repaid with equal (monthly) payments each payment is combination of principal and
interest
example 2: fixed pmt. loan
Rs.20,000 car loan, 5 yearsmonthly pmt. = Rs.500so Rs.15,000 is price todaycash flow is 60 pmts. of Rs.500what is i?
i is annual rate (effective annual interest rate)
but payments are monthly, & compound monthly
(1+im)12 = iim= i1/12-1im is the periodic ratenote: APR = im x 12
602 1
500...
1
500
1
50020000
mmm iii
im=1.44%i=(1+. 0144)12 – 1 =18.71%
%28.17120144. APR
how to solve for i? trial-and-error table financial calculator spreadsheet
Coupon Bond
Bond Yields
Yield to maturity (YTM) chapter 4
Current yieldHolding period return
Yield to Maturity (YTM)
a measure of interest rateinterest rate where
P =PV of cash flows
Current yield
approximation of YTM for coupon bonds
ic =annual coupon payment
bond price
better approximation when maturity is longer P is close to F
example
2 year Tnotes, F = Rs.10,000P = Rs.9750, coupon rate = 6%current yield
ic =600
9750= 6.15%
Current yield = 6.15%True YTM = 7.37%Lousy approximation
only 2 years to maturity selling 2.5% below F
Holding period return
sell bond before maturityreturn depends on
holding period interest payments resale price
example
2 year Tnotes, F = Rs.10,000P = Rs.9750, coupon rate = 6%sell right after 1 year for Rs.9900
Rs.300 at 6 mos. Rs.300 at 1 yr. Rs.9900 at 1 yr.
221
3009900
21
3009750
ii
i/2 = 3.83%i = 7.66%
why i/2?interest compounds annually not
semiannually
The Bond Market
Bond supplyBond demandBond market equilibrium
Bond supply
bond issuers/ borrowerslook at Qs as a function of price, yield
lower bond prices higher bond yields more expensive to borrow lower Qs of bonds
so bond supply slopes up with price
Bond price
Q of bonds
S
Changes in bond price/yield Move along the bond supply curve
What shifts bond supply?
Shifts in bond supply
Change in government borrowing Increase in gov’t borrowing
Increase in bond supply Bond supply shifts right
P
Qs
S
S’
a change in business conditions affects incentives to expand production
exp.profits
supply ofbonds(shift rt.)
exp. economic expansion shifts bond supply rt.
exp. economic expansion shifts bond supply rt.
a change in expected inflation rising inflation decreases real cost of borrowing
exp.inflation
supply ofbonds(shift rt.)
Bond Demand
bond buyers/ lenders/ saverslook at Qd as a function of bond price/yield
Bond yield
Qd ofbonds
priceof bond
Qd of bonds
so bond demand slopes down with respect to price
Bond price
Quantity of bonds
D
Changes in bond price/yield Move along the bond demand curve
What shifts bond demand?
Wealth Higher wealth increases asset demand
Bond demand increases Bond demand shifts right
P
Qd
DD
a change in expected inflation rising inflation decreases real return
inflationexpected to
demand forbonds(shift left)
a change in exp. interest rates rising interest rates decrease value of existing
bonds
int. ratesexpected to
demand forbonds(shift left)
a change in the risk of bonds relative to other assets
relativerisk of bonds
demand forbonds(shift left)
a change in liquidity of bonds relative to other assets
relative liquidityof bonds
demand forbonds(shift rt.)
Bond market equilibrium
changes when bond demand shifts,and/or bond supply shifts
shifts cause bond prices AND interest rates to change
Example 1: the Fisher effectexpected inflation 3%
exp. inflation rises to 4% bond demand
-- real return declines-- Bd decreases
bond supply-- real cost of borrowing declines-- Bs increases
bond price fallsinterest rate rises
Fisher effect
expected inflation rises,nominal interest rates rise
Example 2: economic slowdown
bond demand decline in income, wealth Bd decreases P falls, i rises
bond supply decline in exp. profits Bs decreases P rises, i falls
• shift Bs > shift in Bd
• interest rate falls• shift Bs > shift in Bd
• interest rate falls
Why shift Bs > shift Bd?
changes in wealth are smallresponse to change in exp. profits is large
large cyclical swings in investment
• interest rate is pro-cyclical• interest rate is pro-cyclical
Why are bonds risky?
3 sources of risk Default Inflation Interest rate
Default risk
Risk that the issuer fails to make promised payments on time
Zero for U.S. gov’t debtOther issuers: corporate, municipal, foreign
have some default riskGreater default risk means a greater yield
Inflation risk
Most bonds promise fixed dollar payments Inflation erodes the real value of these payments
Future inflation is unknownLarger for longer term bonds
Interest rate risk
Changing interest rates change the value (price) of a bond in the opposite direction.
All bonds have interest rate risk But it is larger for the long term bonds