In: Finance
2. Understanding what maturity risk means for bonds is very important. Complete the following table by calculating the new bond prices and then the % price change that results for the two bonds given. For example, in the table if interest rates go up 1% on the short term bond, that means that the YTM would go from 4% to 5%. Then calculate the new price at a YTM of 5% and then calculate the % change in price from today's price of $1,000 to the new price.
Short term bond: Face value of $1,000 with an annual coupon rate of 4% with semi-annual payments, and a maturity in 2 years. Assume that today's YTM on a 2 year bond is 4% so therefore today's price is $1,000.
Long term bond: Face value of $1,000 with an annual coupon rate of 5% with semi-annual payments, and a maturity in 30 years. Assume that today's YTM on a 30 year bond is 5% so therefore today's price is $1,000.
Interest Rates go down by 2% |
Interest Rates go down by 1% |
Today's Price |
Interest Rates go up by 1% |
Interest Rates go up by 2% |
|||||
New $ Price |
% change from Today |
New $ Price |
% change from Today |
New $ Price |
% change from Today |
New $ Price |
% change from Today |
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Short Term Bond |
$1,000 |
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Long Term Bond |
$1,000 |
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Bond Price is equals to present value of all future cash flows discounted at YTM which means Bond's Price depends upon the YTM rate and Duration of Bond. A Bond with longer duration has high interest risk.
Please refer to below spreadsheet for calculation of Bond Price at different YTM.
Formula reference -
We can see in above table, % change in Price of Bond due to change in YTM of Long-term Bond is much higher than short-term bond. This prove that Bond with longer maturity duration has higher interest risk.