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Interest Rate Risk Maturity Risk Coupon Rate Risk Reinvestment Risk Default Risk Credit Spread Risk Downgrade Risk Event Risk
MATURITY RISK
All other factors constant, the longer the bonds maturity, the greater the bonds price sensitivity to changes in market rates.
All other factors constant, the lower the coupon rate, the greater the bonds price sensitivity to changes in market rates.
If two bonds have the same characteristics, the one trading at a lower market rate is more sensitive to changes in the market rate. Price sensitity is higher when the level of market rates is low, and price sensitivity is lower when the level of market rates is high.
Which of the following bonds has the greatest market yield risk? Which one has the lowest credit rating?
Maturity 12 12 12
REINVESTMENT RISK
Reinvestment Risk is the possibility that the proceeds from payments of interest and principal will be reinvested at a lower market rates than the original invesment. Which of the following bonds has higher reinvestment risk?
Bond/Issuer Coupon Rate A 0.0% B 8.0% C 10.0% Maturity 5 5 5 Market Rate 5.00% 12.00% 10.00%
DEFAULT RISK
Risk that the issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and principal Default Rate is the percentage of a population of bonds that is expected to default . Recovery Rate is the percentage of a default investment that can be recovered.
DOWNGRADE RISK
A credit rating is an indicator of the potencial default risk associated with a bond A credit rating is an assessment of an issuers ability to meet the payment of principal and interest in accordance with the term of indenture. Bond market can be divided in: Investment grade AAA, AA, A and BBB Non-Investment grade Below BBB
DOWNGRADE RISK
Rating Agencies following up the credit quality of bonds can reassign a different credit rating. An improvement in the credit quality is rewarded with a better credit rating, and its referred to as an UPGRADE. A deterioration in the credit quality is penalized by the assignment of a lower credit rating, and its referred to as a DOWNGRADE.
Credit Spread Risk is measured in basis points Credit spread risk changes with industry, sector, and economic fluctuations. An anticipated downgrading increases the credit spread and results in a decline of the bonds price
EVENT RISK
Deterioration on the ability of an issuer to make interest and principal payments due to unexpected events outside of the issuer control. Natural disaster Takeovers Regulatory Changes
Yield Curve
plot of maturity vs. yield (spot rates) slope of curve indicates relationship between maturity and yield. A spot rate is the rate used to discount a single expected future cash flow.
BOND VALUATION
CF1 = i x P CF2= i x P CF3 = i x P t= 1 t= 2 t= 2 t= n CFn = i x P + P t= 0
Bond Price = ?
Bond Price
Bond Price
maturity
maturity
maturity
humped
yield
maturity
C C C P Value 1 2 n (1 y) (1 y) (1 y) (1 y) n
where: C = coupon payment P = principal payment y = market yield (typically Yield to Maturity,YTM) n = number of periods over life of bond
Any bond can be thought of as a package of zero-coupon bonds. Another way to view a 4-year, every 6 months, 6% coupon bond is as a package of zero-coupon bonds.
C C
C C
C C
C C
The 4-year security should be viewed as a package of 8 zerocoupon instruments that mature every six months for the next four years.
A spot rate is the rate used to discount a single expected future cash flow.
Suppose you observe the following data for three government bonds (default risk close to zero) :
Maturity 1 Year 2 Years 3 Years YTM Coupon Rate 3.6% 0.0% 3.8% 3.8% 4.0% 4.0% Price(% of par) 96.64% 100% 100%
In order to find the spot rates from this data, we need to strip the coupons from the bonds.
Since these bonds all have the same issuer, all cash flows received at t=1, must be discounted at the same rate. The 1-year zero coupon bond has only one cash flow, we can use its YTM as the discount factor for other t=1 cash flows, i.e. use 3.62% as the one-year spot rate Z1. (Z1 = 3.62%)
NOTE:
We can use the one-year spot rate to discount the cash flows for the 2-year bond as follows: 100.000 = 3.8/(1 + Z1)1 + 103.8/(1 + Z2)2 100.000 = 3.8/(1.0362)1 + 103.8/(1 + Z2)2
1.080547194 = (1 + Z2)2
1.03949372 = 1 + Z2 Z2 = 3.949372%
We can use the one- and two-year spot rates to discount the cash flows for the 3-year bond as follows: 100.000 = 4/(1 + Z1)1 + 4/(1 + Z2)2 + 104/(1 + Z3)3 100.000 = 4/(1.0362)1 + 4/(1.03949372)2 + 104/(1 + Z3)3 1.125079487 = (1 + Z3)3 Z3 = 4.0066406%
We can use the spot rates to value other bonds issued by the same entity or by adding a credit spread to value bonds issued by another entity. Recall, Z1 = 3.62%, Z2 = 3.949%, Z3 = 4.007% Use these spots rates to calculate the value of a three-year, annual-pay, 5% coupon bond with the same risk characteristics as the previous bond. Bond Value = 5/(1 + Z1)1 + 5/(1 + Z2)2 + 105/(1 + Z3)3 102.778 = 5/(1.0362)1 + 5/(1.03949)2 + 105/(1.04007)3