Question

Fixed rate bonds with longer maturities are more sensitive to changes in interest rates than bonds with shorter maturities.

1. How are bonds valued?
2. Explain why longer maturities should be more sensitive to changes in interest rates. Be sure to include in your answer a discussion of Duration.
3. If you strongly believe that interest rates are bound to fall, what trading strategy should you implement? Explain why this strategy you are proposing would be superior by comparing it to another strategy that you would consider inferior. On the Philippine Peso Government Securities Yield Curve, which tenor would you (probably) choose (ignoring other possible issues such as availability of bonds)? Be sure to include in your answer, where you found the Yield Curve.

Answer 1

a. Bond valuation is a technique for determining the theoretical fair value of a particular bond. The bond valuation includes calculating the present value of the bond's future interest payments, also known as its cash flow, and the bond's value upon maturity, also known as its face value or par value. Because a bond's par value and interest payments are fixed, an investor uses bond valuation to determine what rate of return is required for a bond investment to be worthwhile.

b.

• There is a greater probability that interest rates will rise (and thus negatively affect a bond's market price) within a longer time period than within a shorter period. As a result, investors who buy long-term bonds but then attempt to sell them before maturity may be faced with a deeply discounted market price when they want to sell their bonds. With short-term bonds, this risk is not as significant because interest rates are less likely to substantially change in the short term. Short-term bonds are also easier to hold until maturity, thereby alleviating an investor's concern about the effect of interest rate driven changes in the price of bonds.
• Long-term bonds have greater duration than short-term bonds. Because of this, a given interest rate change will have a greater effect on long-term bonds than on short-term bonds. This concept of duration can be difficult to conceptualize but just think of it as the length of time that your bond will be affected by an interest rate change.

c.

Fixed-Income Arbitrage with Changing Interest Rates

The price of a fixed-income instrument such as a bond is essentially the present value of its income streams, which consist of periodic coupon payments and repayment of principal at bond maturity. As is well known, bond prices and interest rates have an inverse relationship. As interest rates rise, bond prices fall so that their yields reflect the new interest rates; and as interest rates fall, bond prices rise.