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Chapter 4: Understanding fixed- income risk and return (Sources of return,…
Chapter 4: Understanding fixed- income risk and return
Sources of return
2.
Reinvestment
of coupon payments
Potential
capital gain/ loss on the sale of the bond
prior to maturity
Coupon + Principal Payments
on the scheduled date
A
horizon yield
: internal rate of return (IRR) between the total return for the investment horizon and the purchase price of the bond (example 1-7 in the text book)
A carrying value: the purchase price
plus/ minus
the
amortized amount
of the
discount/ premium
if the bond is purchased at a price
below/ above
par value
Factors that affect return on a fixed- rate bond
credit risk (potential default on the payments)
interest rate risk (varying coupon reinvestment rate and sale price)
Investment horizon
and interest rate risk
Interest rate risk
Coupon reinvestment risk
Coupon reinvestment income decrease when the interest rate decrease
Coupon reinvestment income increase when interest rate increase (directly related to each other)
Market price risk (capital gain/ loss of selling the bond prior to maturity) - inversely related with the interest rate
Interest rate risk on fixed- rate bonds
duration
: sensitivity of the bond's full price to change in the bond's YTM (or to change in benchmark interest rates)
Yield duration: with respect to YTM
Curve duration: respect to benchmark yield curve
Yield duration statistics
Modified duration: direct measure of the interest rate
sensitivity
of the bond (assume: yield changes do not change the expected CF - no default). It also provides a
linear estimates
(approximately equal) of the % price change given a change in YTM
Money duration
Macaulay duration
Price value of a basis point (PVBP)
Duration principles
Maturity increases => duration increases => bond becomes more volatile
Coupon increases => duration decreases => bond becomes less volatile
Interest rates increase => duration decreases and bond's sensitivity goes down