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MGT338H5 Lecture Notes - Interest Rate Risk, Nominal Interest Rate, Credit Risk

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Tanya Kirsch

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MGT338- Prof: Tanya
1. The Risk-Free Interest Rate
- The risk-free rate is an abstract concept, and usually the yield on short-term
government treasury bills is used as a proxy for practical purposes
- The Nominal risk-free rate is comprised of two components
-> The real rate, which is compensation for deferring consumption
-> The expected inflation rate, which is compensation for the expected loss of
purchasing power over the term of the short-term T-bill (the Fisher effect)
2. Bond price sensitivity: Interest rate risk factors
- Lower coupon bond --> bond is more sensitive to changes in interest rates
- Lower maturity --> more sensitive
- Lower YTM level --> more sensitive --> greater price change
3. Risks for bondholders
- Interest rate risk (change in price due to change in interest rates)
- Inflation risk (Fisher effect, i.e. Nominal interest rate = Real rate + Inflation)
- Default risk (Measured as yield spread, or default risk premium)
- Liquidity risk
- Exchange rate risk
4. Three Theories of the Term Structure
- Liquidity preference theory: LT bonds are more risky, therefore investors demand
greater return for the higher risk of LT bonds
- Expectations theory suggests that longer-term interest rates are the result of
expectations of future short-term interest rates
- Market segmentation theory suggests that different markets exist for securities of
different maturities
5. Current Yield = annual coupon payment/current bond price
6. Cash vs. Quoted price
- The quoted price is the price reported by the media (clean price)
- The cash price is the price paid by an investor, and includes both the quoted price
plus any interest that has accrued since the last coupon payment date (dirty price)
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