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investment chapter 11.2 (Bond Duration (Measuring Duration (Step 1: Find…
investment chapter 11.2
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Yield-to-Maturity
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Assumes all interest income is reinvested at rate equal to market rate at time of YTM calculation—no reinvestment risk
Calculates value based upon PV of interest received and the appreciation of the bond if held until maturity
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Expected Return
Used by investors who expect to actively trade in and out of bonds rather than hold until maturity date
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Bond Duration
A measure of bond price volatility, which captures both price and reinvestment risk and which is used to indicate how a bond will react in different interest rate environments
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Calculates the weighted average of the cash flows (interest and principal payments) of the bond, discounted to the present time
The Concept of Duration
Generally speaking, bond duration possesses the following properties:
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Bond duration is a better indicator than bond maturity of impact of interest rates on bond price (price volatility)
If interest rates are going up, hold bonds with short durations
If interest rates are going down, hold bonds with long durations
Measuring Duration
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Step 4: Repeat steps 1 through 3 for each year in the life of the bond then add up the values computed in Step 3
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Bond Immunization
Strategy to derive a specified rate of return regardless of what happens to market interest rates over holding period
Seeks to offset the opposite changes in bond valuation caused by price effect and reinvestment effect
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Reinvestment effect: as coupon payments are received, they are reinvested at higher or lower rates than original coupon rate
Bond immunization occurs when the average duration of the bond portfolio just equals the investment time horizon.
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