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BOND RISK MEASURE Lada Kyj November 19, 2003

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Bond Characteristics: Type of Issuer Governments (domestic, foreign, federal, and municipal), government agencies, and corporations can issue bonds. Risk associated with bond. Treasury bonds are regarded as most secure and serve as a benchmark against which all bonds are compared.

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Bond Characteristics: Maturity Maturity denotes the date the bond will be redeemed. Term-to-maturity denotes the number of years remaining until that date. Indicates the number of coupon interest payments the bond holder will receive. A factor in determining the yield of a bond.

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Bond Characteristics: Coupon and Principal Principal (Face, Par) is the amount of the debt. Coupon rate is the rate of interest. Coupon payment is calculated as the product of the coupon rate and the principal.

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Bond Characteristics: Provisions Provisions provide the issuer or holder the right to retire debt prematurely or require the issuer to retire a portion of outstanding debt according to a specified schedule. Examples: call provision, refunding provision, sinking-fund provision, put provisions, etc.

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Time Value of Money Time value of money. A dollar today is more valuable than a dollar in the future. Present Value: 1/(1+r); where r is the respective spot rate.

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Bond Pricing Price is the sum of discounted cash flows. Price = Σ[c(t)/(1+r t ) t ] - r is the spot rate, and c(t) is the payment at time t.

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Examples 1) Treasury zero expiring in a year, priced at $98. 98 = 100/(1+r1); r1= 0.0204 2) Treasury 4.25 expiring in 2 years, priced at $95. 95 = 4.25/(1+r1) + 104.25/(1+r2) 2 ; as r1= 0.0204, then r2 = 0.0713 Of Note: Can view coupon payments as a series of zero coupon bonds.

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Law of One Price The Law of One Price dictates that two securities with identical cash flows should sell at the same price. The spot rate extracted from one set of bonds may be used to to price any set of bonds with identical cash flows.

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Yield-to-Maturity Yield-to-Maturity is the single rate such that discounting a security’s cash flow at that rate produces the market price. Price = Σ[c(t)/(1+y) t ] Example: Treasury 4.25 expiring in 2 years, priced at $95. 95 = 4.25/(1+y) + 104.25/(1+y) 2 ; y = 0.0702

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Price Yield Relationship

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Duration and Convexity

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Duration Duration is the measure of the approximate sensitivity of a bond’s value to rate changes. Duration = -(1/P)(ΔP/Δy) Consider the first derivative of price divided by price: (ΔP/Δy)(1/P) = Σ[(-t)c(t)(1+y) -t ]/P(1/(1+y)) = D/(1+y) The first derivative is the modified duration and D is the Macaulay Duration.

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Types of Duration 1) Macaulay Duration – weighted average number of years until the bond’s cash flows occur, where the present values of each payment relative to the bond’s price are used as weights. 2) Modified Duration – Macaulay Duration divided by (1 + yield). Assumes that changes in yield do not influence cash flows. 3) Effective Duration – Recognition is given to the fact that yield changes may change the expected cash flows.

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Convexity Convexity – measures how interest rate sensitivity changes with rates. C = (d 2 P/dy 2 )(1/P) = Σ[(t)(t+1)c(t)(1+y) -t ]/P(1/(1+y) 2 ) - A decline in yields creates stronger convexity impacts than does an equivalent rise in yields.

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Second Order Taylor Approximation Approximate price-yield function: P(y+Δy) ≈ P(y) + (dP/dy)Δy + (1/2)(d 2 P/dy 2 )Δy 2 Subtract P from both sides, and then divide by P: ΔP/P ≈ (1/P)(dP/dy)Δy + (1/2)(d 2 P/dy 2 )Δy 2 = -DΔy + (1/2)C Δy 2

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Term Structure of Interest Rates Term Structure of Interest Rates measures the relationship among the yields on default-free securities that differ only in their term to maturity.

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Expectations Hypothesis Bonds are priced so that the implied forward rates are equal to the expected spot rates. The only reason for an upward-sloping term structure is that the investors expect future spot rates to be higher than current spot rates. Fama (1984) tested the US Treasury market from 1959 to 1982 and found that the forward premium on average preceded a rise in the spot rate, but less than would be predicted. Lutz

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Liquidity Preference Hypothesis Risk aversion will cause forward rates to be systematically greater than expected spot rates. The term premium is the increment required to induce investors to hold longer- term securities. Suggests that risk comes solely from uncertainty about the underlying real rate. Hicks

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Market Segmentation Hypothesis Postulates that individuals have strong maturity preferences and that bonds of different maturities trade in separate and distinct markets. A shortcoming of this hypothesis is that bonds of close maturities will act as substitutes. Culbertson

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Preferred Habitat Theory States that the shape of the yield curve is influenced by asset-liability management constraints. Modigliani and Sutch

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Curve Fitting: Linear Interpolation – Not differential at the nodes – Poor approximation for missing values.

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Curve Fitting: Piecewise Cubic cubics are determined by 4 parameters: Y=ax 3 +bx 2 +cx+d; there are m points, so m-1 intervals. 4(m-1) parameters 2(m-1)interpolation conditions, and m-2 first derivative matching conditions and m-2 second order matching condition, therefore two 2 natural boundary conditions

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Curve Fitting:Advances Ioannides, M. 2003 A comparison of yield curve estimation techniques using UK data. Journal of Banking and Finance 27, 1-26. -Comparison is made by computing abnormal returns in trading strategies. -Splines are rejected in favor of “parsimonious” functions.

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THE STRUCTURE OF INTEREST RATES

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