Bond features that affect interest rate risk, Financial Management

Various bond features largely affect the degree of correlation between the bond's prices and the bond's interest rates. Some of the bond features that affect bond's interest rate risk are - maturity, coupon rate and embedded options.

  • Maturity Period: The degree of bond price sensitivity to its interest rate changes depends upon its maturity period. Longer the maturity period of the bond, greater would be the price sensitivity to change in the interest rate of the bond, assuming that all other factors to be constant.

  • Coupon Rate: Assuming that all other factors are constant, the degree of bond price sensitivity to its interest rate changes depends upon its coupon rate. Higher the coupon rate, lower is the degree of sensitivity to changes in interest rates and vice versa. Further, zero coupon bonds tend to have higher price sensitivity to interest rate changes compared to the bonds having a coupon rate.

  • Embedded Options: The value of the bond with embedded option will depend on how the value of the embedded option changes with the interest rates. For example, let us consider a callable bond. We know that when interest rates decrease, the price of an option-free bond increases. However, in a callable bond, an increase in price is not as much as it is in an option-free bond. Let us try to understand this by separating the price of a callable bond into two parts.

Price of callable bond = Price of option-free bond - Price of embedded call option

The price of embedded call option is deducted because it is of value to issuer; but for an investor it is a disadvantage. Therefore, the price of a callable bond is less when compared to the price of an option-free bond. Now, when interest rates decrease, the call option value increases because it becomes more valuable to the issuer; and when interest rate decreases, both the price of option-free bond and the price of call option increase. This results in a relatively lesser change in the price of a callable bond when compared to the change in the price of option-free bond.

Posted Date: 9/10/2012 1:01:17 AM | Location : United States







Related Discussions:- Bond features that affect interest rate risk, Assignment Help, Ask Question on Bond features that affect interest rate risk, Get Answer, Expert's Help, Bond features that affect interest rate risk Discussions

Write discussion on Bond features that affect interest rate risk
Your posts are moderated
Related Questions
Q. Importance of Capital Budgeting Decision? 1. Such Decision affect the profitability of the Firm: - Capital Budgeting decision influences the long-term profitability of a fir

Government intervention The government might look for intervene in the take-over bid because of fears that the market share of the combined group would constitute a monopoly wh

Sovereign debt is a debt instrument guaranteed by the government. The other names for sovereign debts are sovereign bonds or government bonds. They are issued in

Q. Define the Constructive Receipt? Constructive Receipt - A taxpayer is considered to have received income even though monies are not in hand, it may have been set aside or ot

Silvana Zhang of Sajjad Jafri & Geopeng Li Limited is considering purchasing a new widget making machine. She would like to know the maximum price she should pay for the new machin

What are the major sections of the statement of cash flows? a.Cash flows from Operations b.Cash flows from investing activities c.Cash flows from financing activities

Automatic Reinvestment Plan Like in the US, UTI India has also started this plan where the amount of dividend and other income accrued on mutual fund investments is automatical

What are financial crises in financial markets? Financial crises: Financial crises are described as major disruptions in financial markets which are characterised by shar

(a) These are merely the differences of the two prices. Consequently the mark to market losses are given by { Q 1 - Q 0 ,Q 2 - Q 0 ,Q 3 - Q 0 ,Q 4 - Q

1) According to the IFE (RIP), if U.S. investors expect a 3% rate of domestic inflation over one year, and a 6% rate of inflation in European countries that use the EUR, and requir