Risk Associated with Investing in Bonds

Pratik Bhagat PGDMG13054

3/14/2014 IFIM B School 1

Risk Associated with Investing in Bonds

Interest rate risk Yield curve risk Reinvestment risk Credit risk Liquidity risk Exchange rate risk Volatility risk Event risk
IFIM B School 2

3/14/2014

Interest Rate Risk

The price of the bond changes in the opposite direction to the change in interest rates or yield

Interest Rate
Interest Rate Bond Price

1 Bond Price

Interest Rate Bond Price

3/14/2014

IFIM B School

Example
Yield 6% 6.50% 5.50% Price 100 94.4479 106.0195 % Change 5.55% 6.02%

Risk that an investor faces is that the price of a bond will decline if market interest rates rise. This risk referred to as interest rate risk

3/14/2014

IFIM B School

Measuring Interest Rate Risk

Yield 6% 6.25% 5.75% Price 90 88 92.7 % % Avg (% Change change/bp change/bp) 2.22% 3% 0.0889% 0.1200% For 100bp 0.1045% 10.44%

Approximate % price change for a 100bp change in yield is

( ) ( ) . . = . () (. )

Estimation of % price change for a 100bp is called Duration . So duration is a measure of the price sensitivity of a bond to a change in yield
3/14/2014 IFIM B School 5

Yield Curve Risk

The graphical relationship between the yield and maturity is called yield curve. One of the factors that will affect how sensitive a bonds price is to change in yield is the bonds maturity.

3/14/2014

IFIM B School

Parallel Shift in Yield Curve

maturity 2 5 20 30
6.2 6 5.8 5.6 5.4 5.2 5 4.8 0
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Original yield (%) 5 5.25 5.5 5.75

maturity 2 5 20 30

New Yield 5.25 5.5 5.75 6

original yeild(%) maturity Power (original yeild(%)) Power (maturity)

Flattening of the Yield curve

10

15

20

25
IFIM B School

30

35
7

Non-Parallel Shift in Yield Curve

maturity 2 5 20 30 Original Yield (%) 5 5.25 5.5 5.75 maturity 2 5 20 30 New Yield (%) 5.05 5.4 5.75 6.1
original yeild(%) maturity Power (maturity) Power (maturity)

5.8

Steepening of the Yield curve

4.8 0 5 10 15 20 25 30 35

3/14/2014

IFIM B School

Risk
When the yield curve shifts, the price of the bond, which was initially priced based on the initial yield curve, will change in price. If the yield curve flattens, then the yield spread between long- and short-term interest rates narrows, and the price of the bond will change accordingly. If the yield curve steepens, this means that the spread between long- and short-term interest rates increases. Therefore, long-term bond prices will decrease relative to short-term bonds.

3/14/2014

IFIM B School