hey all… i’m having a difficult time keeping things straight in my head when it comes to remembering how higher or lower yields have effects on duration, reinvestment risk, and px volatility… does anyone have any suggestions? thanks…
I use “L” Low Coupon, YTM = High Duration Long Maturity = High Duration
It’s not completely mathematically accurate, but think of duration as time. Low coupons = more time = more duration Low Maturity = more time= more duration.
thanks guys… and how to high/lo coupons/yields affect price volatility?
duration is another way to say interest rate senstivity. The easiest way to remember for me is to equate duration with time it takes to recover your investment in the bond. Obviously the longer the maturity, the longer it will take to recover your investment. If the coupon is low, the longer it will take to recover your investment. This makes the bond more sensitive to fluctuations in price due to IR changes. Reinvestment risk is similar except with coupons. The longer the maturity, the more coupons you have to reinvest so risk is higher. The higher the coupon, the more $$ you have to reinvest so risk is higher. A common question is how does IR volatility affect callable vs putable bonds. In both cases the option itself(not the bond, key point) has a direct relationship with volatility. If it increases the option value increases. Here’s the kicker and how I remember: Putable Price = Price of Bond + Put Option or P + p Callable Price = Price of Bond - Call Option or C - c Obviously, if the option increases in value if IR volatility increases, the putable price would increase since you’re adding it. For a call, you’re subtracting it so it would decrease in value. This should make intuitive sense as well. If you’re going to buy a bond but IR’s are jumping all over the place, you’d probably pay less for a bond that the borrower can call back at any point(usually when rates are low) which forces you to reinvest at a lower rate. However, you’d pay more to be able to put the bond back on the borrower if rates were all over the place since if they rose high enough, you could put it back to the borrower and reinvest at a higher rate.
that was exactly the kind of explanation i was looking for… thanks so much