FIN 413 Lecture Notes - Lecture 4: Interest Rate Risk

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limecricket928

4 Sep 2016

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Fixed income securities make up most assets and liabilities of financial institutions when interest rates go up, the value of these fixed income securities goes down. Market value accounting marked-to-market on a regular basis. How to evaluate the market value effect of interest rate risk. Bond value = pmt [1/r 1/r(1+r)^t] + fv/(1+r)^t. Bond pricing factors market interest rate (yield to maturity), time to maturity: when yield goes up, bond value goes down, when time to maturity is greater, the bond value is less. For a given change in interest rate, the longer the maturity of a fixed income security, the larger the market value effect (change in equity or net worth = change in assets less change in liabilities) Financial institutions are exposed to risk due to maturity mismatches between assets and liabilities. Mi = weighted-average maturity of an asset / liability. Positive maturity gap = ma > ml, net effect drop in net worth when rates go up.

Related Questions

Please can someone help me with this :

Minicase 1

Interest Rates, Bond Yields, and Duration

CONCEPTS IN THIS CASE

simple loans
fixed-payment loans
coupon bonds
present value
yield-to-maturity
current yield
nominal and real interest rates
rate of return
capital gain
interest-rate and reinvestment risk
duration

You have been hired to analyze the debt securities of your organization. The firm has outstanding loans and bonds. A quick review of the balance sheet shows the following:

	Liability Amount ($)	Nominal Interest (coupon) Rate	Years to Maturity
Selected Liabilities of the firm
Simple Loans	800	5%	1
Fixed-Payment Loans	5,000	12%	19
Long-term Bonds #1	500,000	10%	4
Long-term Bonds #2	1,080,000	10%	10
Liabilities Total	1,585,800

Market Price for Bond #1	930.50
Market Price for Bond #2	859.50
Face Value of Each Bond	1,000.00
Selected Current Assets of the firm
Marketable Securities:
Treasury Bills	100,000

Note: Treasury Bills have a $10,000 face value, which matures in one year. Each Treasury Bill has a cost of $9,580.00

How much interest would the firm pay each year on the simple-interest loan?

How much would you write a cheque for to pay off the loan in one year?

What is the monthly payment needed to pay off the fixed-payment loans?

What is the current yield for each bond if the current price is:

$930.50 for Bond #1?

$859.50 for Bond #2?

What is the expected yield to maturity for each bond?

Bond #1 selling for $930.50?

Bond #2 selling for $859.50

What is the rate of capital gain if both bonds sell for $900.00 in one year?

Bond #1 selling for $930.50 today?

Bond #2 selling for $859.50 today?

If the Yield to Maturity expected by investors changes to 11%:

What will be the market price of Bond #1?

What will be the market price for Bond #2?

What will be the dollar change in price for Bond #1?

What will be the dollar change in price for Bond #2?

What will be the percent change in price for Bond #1?

What will be the percent change in price for Bond #2?

Since the change in expected yield to maturity is the same, why is the amount of change different between the bonds?

If investors holding our 4-year bonds (Bond #1) receive interest income annually for four years, plus the face value of the bonds at maturity,

What will be the total interest earned on the bond over the next four years?

What will be the face value received at maturity?

Given the following projected income stream for Bond #1:

			Projected Reinvestment Rates
Year	Coupon Interest ($)	Face Value ($)	10%	5%
1	100
2	100		10.00	5.00
3	100		21.00	10.25
4	100	1000	33.10	15.76
Total Income	400	1000	64.10	31.01

What is the total cash available over the next four years to the bond holder earning

10%

15%

What is the average annual rate of return for the bond holder earning

10%

15%

Why does the reinvestment rate affect the annual rate of return for the same bond?

If the expected rate of return on our bonds is 10%, what is the duration of Bond #1?

What is the yield to maturity on the Treasury Bills (a discount bond)?

What is the real rate of interest if the nominal rate is 10% and the inflation rate is 3%?

amethystcrow453

You have been hired to analyze the debt securities of your organization. The firm has outstanding loans and bonds. A quick review of the balance sheet shows the following:

	Liability Amount ($)	Nominal Interest (coupon) Rate	Years to Maturity
Selected Liabilities of the firm
Simple Loans	800	5%	1
Fixed-Payment Loans	5,000	12%	19
Long-term Bonds #1	500,000	10%	4
Long-term Bonds #2	1,080,000	10%	10
Liabilities Total	1,585,800

Market Price for Bond #1	930.50
Market Price for Bond #2	859.50
Face Value of Each Bond	1,000.00
Selected Current Assets of the firm
Marketable Securities:
Treasury Bills	100,000

Note: Treasury Bills have a $10,000 face value, which matures in one year. Each Treasury Bill has a cost of $9,580.00

1-How much interest would the firm pay each year on the simple-interest loan?

2-How much would you write a cheque for to pay off the loan in one year?

3-What is the monthly payment needed to pay off the fixed-payment loans?

4-What is the current yield for each bond if the current price is:

a-$930.50 for Bond #1?

b-$859.50 for Bond #2?

5-What is the expected yield to maturity for each bond?

a-Bond #1 selling for $930.50?

b-Bond #2 selling for $859.50

6-What is the rate of capital gain if both bonds sell for $900.00 in one year?

a-Bond #1 selling for $930.50 today?

b-Bond #2 selling for $859.50 today?

7-If the Yield to Maturity expected by investors changes to 11%:

a-What will be the market price of Bond #1?

b-What will be the market price for Bond #2?

c-What will be the dollar change in price for Bond #1?

d-What will be the dollar change in price for Bond #2?

e-What will be the percent change in price for Bond #1?

f-What will be the percent change in price for Bond #2?

g-Since the change in expected yield to maturity is the same, why is the amount of change different between the bonds?

8-If investors holding our 4-year bonds (Bond #1) receive interest income annually for four years, plus the face value of the bonds at maturity,

a-What will be the total interest earned on the bond over the next four years?

b-What will be the face value received at maturity?

Given the following projected income stream for Bond #1:

			Projected Reinvestment Rates
Year	Coupon Interest ($)	Face Value ($)	10%	5%
1	100
2	100		10.00	5.00
3	100		21.00	10.25
4	100	1000	33.10	15.76
Total Income	400	1000	64.10	31.01

c-What is the total cash available over the next four years to the bond holder earning

ii-10%

iii-15%

d-What is the average annual rate of return for the bond holder earning

ii-10%

iii-15%

e-Why does the reinvestment rate affect the annual rate of return for the same bond?

f-If the expected rate of return on our bonds is 10%, what is the duration of Bond #1?

raspberryalligator692

Fill in the blank using a number of terms listed below (@1 point per question).

Beta coefficient, Bonds, CAPM, Cash flows, Change, CV, Convertible bonds, Correlation, Correlation coefficient, Debenture, Discount, Diversifiable risk, Expected return, Interest rate risk, Inverted, Junk Bonds, Market risk, More, Normal, Opposite, Probability distribution, Ratings, Reinvestment rate risk, Risk, Risk averse investor, Risk premium, Standard deviation

When interest rates move up or down, bond prices move in the _________________ direction.

_____________ are referred to as non-amortized debt, which means interest is paid regularly during the term, usually semiannually, whereas repayment of principal does not occur until the maturity date.

The longer a bond has to maturity, _______________ sensitive the bondâs price is to changes in market interest rates. This is called ________________________.

Bonds with short maturities expose investors to high ____________________, which is the risk that income from a bond portfolio will decline because cash flows received from bonds will be rolled over at lower interest rates.

A bond with an annual coupon payment of $100 originally sold at par for $1,000. Market interest rates are currently 12%. This bond would be selling at a _____________ in order to compensate the purchaser for the below market coupon rate.

Once a bond has been issued, if the holder of the bond retains it until maturity the market value of the bond may ________________, but the ________________ will not.

An unsecured bond is referred to as a(n) __________________.

____________________ can generally be issued at somewhat lower interest rates than regular bonds.

Double-B and lower bonds are speculative, to be called _______________.

Bonds are assigned _____________ that reflect the probability of their going into default. The higher it is, the lower its risk and therefore its interest rate.

When the yield curve slopes upward, it is said to be _______________, because it is like this most of the time. Conversely, a downward-slopping yield curve is termed ______________.

FIN 413 Lecture Notes - Lecture 4: Interest Rate Risk

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