1 Measuring Interest Rate Risk

The Relationship between Interest Rates and Option-Free Bond Prices

A typical option-free bond has the following feature:

i. A par or face value that represents the return of principal at maturity

ii. A coupon payment that is fixed over the life of the bond
iii. There is market price and market interest rate

These bonds are initially sold in the primary market at prices close to par or face value. The
fixed coupon rates determine the amount of coupon interest that is paid periodically until
final maturity. After issuance, the bonds trade in the secondary market, at that time their
price reflect current market conditions. Thus, current market prices reflect the size of fixed
coupon payment versus the coupon interest paid on a newly issued bond with similar
features.

1. Bond prices and interest rates vary inversely:

Market interest rates and prices of fixed income securities are inversely related. As such,
price declines when interest rate rises and price rises when interest rate declines. The
sensitivity of the price move relative to the change in interest rates is determined by the size
and timing of the cash flows on the underlying securities.

Example: Consider a bond with $ 10,000 face value that makes semi-annual coupon
payments of $ 470 and matures in exactly three years. If the current market interest rate
equals to 4.7% (9.4% annually), then the prevailing price of the bond equals to $ 10,000.

 If the annual market interest rate increases to 10% immediately (5% semiannually),
what would be the bond’s price?
 If the annual market interest rate fell to 8.8%, what would be the bond’s price?

2. Maturity influences bond price sensitivity:

Short-term bonds and long-term bonds exhibit different price volatility. For bonds that pay
the same coupon interest rate, long-term bonds change proportionately more in price than
do short-term bonds for a given change in interest rate.

Example: Consider another bond with the same coupon payments with a maturity of six
years.

 The effect of maturity on the relationship between price and interest rate on
option-free bonds with 3-years and 6-years maturities

Market Interest Rates

5% 4.4%
Price of 3 year’s bond $ 9,847.73 $ 1,0155.24
Price of 6 year’s bond 9,734.10 10,275.13
2 Measuring Interest Rate Risk

3. The size of coupon influences bond price sensitivity:

High-coupon bonds and low-coupon bond exhibit different price volatility. Supposed two
bonds are priced to yield the same yield to maturity. For a given change in market rate, the
bond with the lower coupon will change more in price than the bond with the higher
coupon.

Example: Two identical bonds with three years maturity, one is zero coupon bond and
another is a coupon bond. Coupon bond has the same features mentioned in the above
example.

 The effects of coupon on the relationship between price and interest rate of
option-free bonds.

Market Rate Price of 9.4% Bond Price of Zero Coupon Bond

8.8% $ 10,155.24 $ 7,723.20
10% 9,847.73 7,462.15

Duration and Price Volatility

Duration:

Duration is a measure of effective maturity that incorporates the timing and size of
security’s cash flows. It captures the overall impact of market rates, the size of all payments
and maturity on a security’s price volatility. There are two important interpretations of
duration analysis:

i. Duration is a measure of how price sensitivity of a security to a change in

interest rates
ii. The greater (shorter) is duration, the greater (lesser) is price sensitivity

Measuring Duration:

Duration is measured in units of time and represents a security’s effective maturity. It is the
weighted average of time until expected cash flows from a security will be received, relative
to the current price of the security. The weights are the present values of each cash flow
divided by the current price. Macaulay’s duration (D) is:

𝐶𝐹𝑡 (𝑡)
∑𝑛
𝑡=1(1+𝑖)𝑡
𝐷= 𝐶𝐹𝑡
∑𝑛
𝑡=1(1+𝑖)𝑡

Example: Consider a three years coupon bond with a face value of $ 10,000 and the semi-
annual coupon rate is 4.7%. What would be the duration if annual market rate is 9.4%?
3 Measuring Interest Rate Risk

Money Market Yields

Many short-term consumers and commercial loans have maturities less than one year. The
borrowers make periodic interest payments and repay the principal at maturity. The
effective annual rate of interest depends on the term of the loan and the compounding
frequency. Suppose, a one-year loan that requires monthly interest payments at 12%
annually carries an effective yield of 12.68%.

Suppose, the same loan was made for 90 days at an annualized rate of 12%. This is now
more than one compounding period in one year. Then the effective annual yield assuming
365-day year is:

𝑖
𝑖∗ = [ 1 + 365 ]365/ℎ - 1
( )
ℎ

To convert a 360-day rate to a 365-day rate can be done by using the following formula:

365
𝑖365 = 𝑖360 ( )
360
Discount Yield:

Some money market instruments (such as treasury bills, repurchase agreements, commercial
paper, bankers’ acceptance etc.) are pure discount instruments. This means the purchase
price is always less than the par value at maturity. The difference between the purchase
price and the par value equals the periodic interest. Yields on discounting instruments are
calculated and quoted on a discount basis assuming a 360-day year. The pricing equation for
discount instruments is:

𝑃𝑓 −𝑃𝑜 360
𝑖𝑑𝑟 = [ ][ ]
𝑃𝑓 ℎ
In order to obtain an effective yield, the formula must be modified to reflect a 365- day year.
This modified yield is called bond equivalent rate.

𝑃𝑓 −𝑃𝑜 365
𝑖𝑏𝑒 = [ ][ ]
𝑃𝑓 ℎ
Example: consider a $ 1 million par value treasury bill with exactly 182 days to maturity,
priced at $ 964,500. What would be the discount yield and bond equivalent rate?