What Solutions Are Possible to the Free Rider Problem, Both Insid...

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What Solutions Are Possible to the Free Rider Problem, Both Inside and Outside of Government

By | May 2013
Page 1 of 11


Outline of the Chapter
• Bond pricing and sensitivity of bond pricing to interest rate changes • Duration analysis – What is duration? – What determines duration?

• Convexity • Passive bond management
– Immunization

• Active bond management


Interest Rate Risk
• There is an inverse relationship between interest rates (yields) and price of the bonds. • The changes in interest rates cause capital gains or losses. • This makes fixed-income investments risky.


Interest Rate Risk (Continued)


Interest Rate Risk (Continued)
• What factors affect the sensitivity of the bonds to interest rate fluctuations? • Malkiel’s (1962) bond-pricing relationships – Bond prices and yields are inversely related. – An increase in a bond’s YTM results in a smaller price change than a decrease in yield of equal magnitude. – Prices of long-term bonds tend to be more sensitive to interest rate changes than prices of short-term bonds.


Interest Rate Risk (Continued)
– The sensitivity of bond prices to changes in yields increases at a decreasing rate as maturity increases. – Interest rate risk is inversely related to the bond’s coupon rate.

• Homer and Liebowitz’s (1972) bond-pricing relationship – The sensitivity of a bond’s price to change in its yield is inversely related to the YTM at which the bond currently is selling. 16-6

Interest Rate Risk (Continued)
• Why and how different bond characteristics affect interest rate sensitivity?


Interest Rate Risk (Continued)
• Duration
– Macaulay’s duration: the weighted average of the times to each coupon or principal payment made by the bond. • Weight applied to each payment is the present value of the payment divided by the bond price.

wt D

CFt /(1 y ) t , Bondprice


t 1


t * wt
t 1


Interest Rate Risk (Continued)
• Example:


Interest Rate Risk (Continued)
– Duration is shorter...

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