FINM2003 Study Guide - Final Guide: Yield Curve, Weighted Arithmetic Mean, Inverse Relation
Managing Bond Portfolios
Interest rate Risk
- All bonds are risky despite guaranteed coupon and par value repayments
- Concerned with sensitivity of bond prices to change in interest rates
Important
Malkiel’s rules
1. Inverse relationship b/w bond prices and yields
2. A decrease in a bond’s YTM causes a larger change in Price than an increase in
yield of the same size
3. The price of long-term bonds has greater sensitivity to interest rate movements
than short term
4. Sensitivity of bond prices to yield changes with their maturities at a decreasing
rate
5. Negative relationship b/w sensitivity of Price to interest rate changes and the rate
at which they pay coupons
6. Homer and Liebowitz rule: Bonds with higher YTM are less sensitive to changes
in yields than bonds with lower YTM
Duration
- it measures the effective average maturity of a bond’s cash flows
- useful for measuring the sensitivity of a bond’s price to interest rates, as sensitivity
and time to maturity are positively related
-Macaulay’s Duration , D, is the weighted average of the times to each payment a
bond makes , where is the weight of each CF and t is time until its receipt
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Document Summary
All bonds are risky despite guaranteed coupon and par value repayments. Concerned with sensitivity of bond prices to change in interest rates. Duration it measures the effective average maturity of a bond"s cash flows useful for measuring the sensitivity of a bond"s price to interest rates, as sensitivity and time to maturity are positively related. Macaulay"s duration , d, is the weighted average of the times to each payment a bond makes , where is the weight of each cf and t is time until its receipt. Modified duration to see how sensitive a bond"s price is to interest rate movement. The change in bond"s price is directly proportional to the modified duration measure. Modified duration measures the slope of the bond"s price yield curve for prices. Properties of duration: zero coupon bond: d=maturity, d and coupon rate inversely related. As yield increases, a larger proportion of its total value is provided by earlier payments , so reducing effectivity maturity.
