Question

Name and describe the two sources of interest rate risk.  If an investor has a desired investment horizon (or holding period) of 5 years, and is invested in 20-year 6% coupon bonds priced to yield 6%, what bet is he or she making about the direction of interest rates?  Compute the 5-year holding period yield assuming that interest rates rise to 8% immediately after the bond is purchased.  Explain how this investor could immunize against interest rate risk.

Answer 1

. Sources of Interest Rate Risk

1. Repricing risk: As financial intermediaries, banks encounter interest rate risk in several ways. The primary and most often discussed form of interest rate risk arises from timing differences in the maturity (for fixed rate) and repricing (for floating rate) of bank assets, liabilities and off-balance-sheet (OBS) positions. While such repricing mismatches are fundamental to the business of banking, they can expose a bank's income and underlying economic value to unanticipated fluctuations as interest rates vary. For instance, a bank that funded a long-term fixed rate loan with a short-term deposit could face a decline in both the future income arising from the position and its underlying value if interest rates increase. These declines arise because the cash flows on the loan are fixed over its lifetime, while the interest paid on the funding is variable, and increases after the short-term deposit matures.

2. Yield curve risk: Repricing mismatches can also expose a bank to changes in the slope and shape of the yield curve. Yield curve risk arises when unanticipated shifts of the yield curve have adverse effects on a bank's income or underlying economic value. For instance, the underlying economic value of a long position in 10-year government bonds hedged by a short position in 5-year government notes could decline sharply if the yield curve steepens, even if the position is hedged against parallel movements in the yield curve.

​​​​​​(B) If some one purchase bond for 5 yrs holding period of bond 20yrs of 6% coupen rate having 6% yield

then he or she must be betting that INTREST RATE COULD RISE GOING FORWARD so he or she can take benifit of rising bond prices of his or her bonds and lowering yield of new bonds so in rising intrest rate environment his or her bond have competative advantage over other new bonds

(C) 5 yr holding yield =

= (1 + Interest rate) ^ Compounding Periods -1/no of years

= (1+0.08)^ 5 -1/5

5yrs holding yield = 9.38%

(D)

Bond immunization is an investment strategy used to minimize the interest rate risk of bond investments by adjusting the portfolio duration to match the investor's investment time horizon. It does this by locking in a fixed rate of return during the amount of time an investor plans to keep the investment without cashing it in. Immunization locks in a fixed rate of return during the amount of time an investor plans to keep the bond without cashing it in. Normally, interest rates affect bond prices inversely. When interest rates go up, bond prices go down. But when a bond portfolio is immunized, the investor receives a specific rate of return over a given time period regardless of what happens to interest rates during that time. In other words, the bond is "immune" to fluctuating interest rates. To immunize a bond portfolio, you need to know the duration of the bonds in the portfolio and adjust the portfolio so that the portfolio's duration equals the investment time horizon. For example, suppose you need to have $50,000 in five years for your child's education. You might decide to invest in bonds. You can immunize your bond portfolio by selecting bonds that will equal exactly $50,000 in five years regardless of interest rate changes. You can buy one zero-coupon bond that will mature in five years to equal $50,000, or several coupon bonds each with a five year duration, or several bonds that "average" a five-year duration. Duration measures a bond's market risk and price volatility in response to a given change in interest rates. Duration is a weighted average of the bond's cash flows over its life. The weights are the present value of each interest payment as a percentage of the bond's full price. The longer the duration of a bond, the greater its price volatility. Duration is used to determine how a bond will react to changing interest rates. For example, if interest rates rise 1%, a bond with a two-year duration will fall about 2% in value. You needn't worry about doing the calculations as you can obtain a bond's (or bond fund's) duration from a broker or advisor. Using bonds' durations, you can build a bond portfolio immune to interest rate risk.

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