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Interest Rate Risk: Comprehensive Analysis Interest Rate Risk Interest rate risk is one of the most significant risks associated with fixed income investing. Changes in interest rates can have profound effects on the values of outstanding bonds. You have likely heard the expression, “bond prices move inversely to interest rates.” Why does this occur? Examine the basic valuation formula of a coupon bond as shown below:
The value of a bond equals the present value of its future cash flows. To the find the present value, a bond’s cash flows are discounted at a discount rate. The discount rate is derived from, among other factors, market interest rates. An increase in market interest rates will increase the discount rate, decreasing the value of bond. In contrast, a decrease in market interest rates will cause the discount rate to decrease, effectively increasing the value of the bond. Measuring Interest Rate Risk Bonds have varying degrees of interest rate risk. Interest rate risk can be measured by calculating a bond’s price/interest rate volatility, or duration. Duration is the measurement of the percentage change in a bond’s price that results from a specific change in interest rates. A bond’s duration is dependent upon many factors including: length-to-maturity, coupon rate, discount rate, and options. Reference the tutorial, Measuring Interest Rate Risk, for a comprehensive overview of price volatility and duration. Questions: 1. Explain why a bond’s value will increase or decrease inversely to interest rates. 2. Define Duration. Answers: -Reference- All
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