Understanding Interest Rates

1
Understanding Interest Rates

• Lecture 2 Part IV
• Measurement of Interest Rate Risk
• Duration

2
Main Contents

• How to measure the interest rate risk Duration
  (??)
• Calculation of duration

3
Interest Risk

• Interest Risk
• A bond holder suffers uncertainty as the
  interest rate changes from time to time.
• How much does the interest risk affect your bond
  portfolio?
• Now
  Future

?
4
Interest Risk

• One mathematical tool Derivative
• For very small ,
• carries the information how sensitive a
  bond price is to the change of the underlying
  interest rate.

5
Duration

• For a bond with face value , maturity in
  years and coupon rate ,
• In the terminology of bonds,
• is called the duration of a bond.

6
Calculating Duration

• Duration is a weighted average of all cash time
  of a bond. Duration reflects how fast a bond
  holder can receive the redemption back.
• Use Excel to calculate the duration of a bond
• For example, the interest rate is 10 per
  year

7
Duration Properties

• All else being equal,
• The longer the maturity of a bond, the longer its
  duration
• The higher the interest rates, the lower its
  duration
• The higher the coupon rate, the shorter its
  duration.

8
Interest Risk and Duration

• The measurement of interest risk
• The longer the duration is, the more sensitive a
  bond is to the interest changes.

9
Interest Risk and Duration

• Example
• A pension fund manager is holding a 10-year
  10 coupon bond and the interest rate is 10
  currently. What loss would the fund be exposed to
  if the interest rate rises to 11 tomorrow?