Question

Question 2 - Duration and Interest Rates             

a)     Calculate the PV, RV, WV and Macaulay duration of a 5-year, $1,000 face value, 14 percent coupon bond yielding 15 percent with coupons paid annually.

b)      Why is interest rate risk important to a financial manager and how can a financial manager use the Macaulay duration to hedge against interest rate risk?

c)      Next, use the Macaulay duration to calculate what happens to the price of the bond when the yield to maturity falls to 14 percent.

d)      Why is the price of the bond you calculated using the Macaulay duration not equal to $1,000?

e)      Finally, how do you explain the appearance of a humped-shaped (or bell-shaped) yield curve in the 1990s?

Answer 1

(B) Interest rate risk lies in any interest bearing instrument beacuse of the risk of variability in the price because of interest risk . This has led to an increasing importance of interest risk management by the financial managers.for example if a bank is asset-sensitive, it generates increasing amounts of interest income – and the value of the bank's equity increases – as short-term rates increase. Hence interst rate risk affects an investors risk exposure so it is important for a financial manager to manage interest risk to keep in check the overall risk of the portfolio and making necessary adjustments regarding reconstitution and reallocation of assets in a portfolio