Below its a question from Schweser Qbank What will happen to interest rate risk for an option-free bond if market yields decrease? A) Interest rate risk will decrease. B) Interest rate risk will increase. C) Even if the term structure is flat, interest rate risk could go up or down based on the level of the term structure at the time market yields decrease. The correct answer was B) Interest rate risk will increase. If market yields decrease, interest risk will increase since the duration or the sensitivity of the bond to interest rate fluctuation will increase. Why choice B is correct??? I think choice A is right, since when the market yields decrease, in consequence, the risk of interest rate for bondholder will decrease too. AM I RIGHT???
interest rate risk = duration when yields drop (discount rate in bond valuation) then future cashflows (coupons) are worth more in present terms, therefore duration increased (interest rate risk increased) I’m not sure if this is the right way to think about it also but maybe this is another explanation: yields dropped (interest rates dropped) so all future cash flows have to be reinvested at lower rates, hence interest rate risk increased
if you look at the price-yield curve, the slope at lower yields is steeper than the slope at higher yields. this means at lower yields, a small change can lead to large price changes whereas the same yield change at higher yields leads to smaller price changes. interest rate risk is higher at lower yields
jaz Wrote: ------------------------------------------------------- > if you look at the price-yield curve, the slope at > lower yields is steeper than the slope at higher > yields. this means at lower yields, a small change > can lead to large price changes whereas the same > yield change at higher yields leads to smaller > price changes. interest rate risk is higher at > lower yields are you attempting to explain answer C? your explanation didn’t really answer the main question
Interest rate risk of a bond -> translation -> what happens to value of bond when interest rates change? this relationship is captured precisely by duration High duration (high interest rate risk) means that bond value will change by a lot for 1% change in interest rate Low duration (low interest rate risk) means that bond value will change very little for 1% change in interest rate So now that you understand Duration=interest rate risk of a bond, learn the relationships between different variables and duration (i.e. if one changes, what happens to Duration?) My finance prof once gave a very good analogy of how to think about duration, and if you use this tool you are guaranteed to answer correctly. Think of it as a weighting scale. Duration is the pivot point which balances the scale. Scale itself represents present value of each cashflow. C = coupon F = face value ^ = duration/balance point base case: C + C + C + C + C + C + C + (C+F) …^… ->> now imagine if coupon payments increased, the present value of all coupons would increase and the ones closer to the left (coupons coming in early) would become “heavier” Balance the scale, move the point to the left. C + C + C + C + C + C + C + (C+F) …^… effect: Duration decreased ->>Now imagine that maturity increased, the scale would stretch, the old payments (especialy the big chunk C+F) are coming in much later in time so their weight (present value) is less. Balance the scale, move the point to the left. C + C + C + C + C + C + C + (C+F) …^… effect: duration decreased Imagine that yields decreased, then present value of everything would go up, but the big chunk at the far end (C+F) would go up considerably more than the rest of the little Cs Balance the scale by moving point closer to the heavy piece on the right. C + C + C + C + C + C + C + (C+F) …^… effect: duration increase