Interest Rate Risk on Fixed-Rate Bonds
What else in relation to a fixed-rate bond changes over time and impacts the price?
Incorrect.
The coupons on a fixed-rate bond do not change.
Incorrect.
The principal on a fixed-rate bond does not change.
Correct!
The price of a bond is affected by changes in market yields and time to maturity, both of which change over time.
Which of the following bonds would you expect to be the most sensitive to changes in interest rates?
Incorrect.
A one-year bond does not have much risk because it matures in a short period of time.
Incorrect.
Based on the three bonds, a three-year bond is not the riskiest. This would be considered a short-term bond.
Correct!
Bonds with longer maturities are the most sensitive to changes in interest rates because they have more cash flows than bonds with shorter maturities.
Which of the bonds has a more linear price/yield line?
Incorrect.
The 4.00% 30-year bond is not more linear than the 10.00% 15-year bond.
Correct!
While they are both non-linear, the 10.00% 15-year bond is more linear than the 4.00% 30-year bond.
Incorrect.
They are both non-linear price/yield lines.
In summary:
[[summary]]
Since bond prices do not change in a linear manner, there is a second important measure of interest rate risk. This is referred to as __convexity__.
Duration captures the linear portion of interest rate risk. Convexity accounts for the nonlinear portion of interest rate risk.
Bond prices are the sum of the expected cash flows, coupons, and principal, received over time. Investors in bonds need to quantify the risk associated with changes in market yields.
Perhaps the most important fixed-income measurement of interest rate risk on fixed-rate bonds is referred to as __duration__. Duration is a measure of change in a bond's price for a change in the level of market yields.
It is difficult to compare two bonds in terms of interest rate risk based only on the bond characteristics. Bonds have unique coupons, maturity levels, and purchase prices.
Duration allows you to make comparisons among bonds because it quantifies risk. It is a way of identifying the effects of only interest rate risk. Duration has its limitations, though, because it is a linear measure of interest rate risk.
Measuring interest rate risk is not a simple task. This is because bond prices change at a different rate than market yields. That is to say, as market yields move further away from the coupon, price changes increase at an increasing rate.
Below are prices for two non-callable bonds at various yields: a 30-year 4.00% bond and a 10.00% 15-year bond. It is clear that the prices do not change in a linear manner:
The coupons
The principal
The time to maturity
One-year bond
Three-year bond
20-year bond
4.00% bond
10.00% bond
They are both linear
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