What Increases The Price Sensitivity Of A Bond To Changes In Interest Rates

What is Interest Rate Sensitivity?

Involvement rate sensitivity is the analysis of fixed income security price fluctuations to changes in the market involvement rate. The higher the security's interest charge per unit sensitivity, the greater the price fluctuations.

Interest Rate Sensitivity

Summary

Interest rate sensitivity is the analysis of fixed income security price fluctuations to changes in the market interest rate.
It is an of import consideration when selling and ownership fixed income on the secondary market.
Interest rate sensitivity is affected by factors such as the asset's maturity length and coupon rate.

Understanding Interest Rate Sensitivity

Fixed income is i of the major asset classes available to investors. Investors profit from fixed income through the interest (coupon) rate and price appreciation. Fixed income coupon payments are fixed over the life of the security, while toll fluctuations are a direct effect of market place interest charge per unit changes.

Stock-still income securities are created and initially sold on the master market. Next, investors can choose to hold the fixed income security until maturity or resell it on the secondary market. Fixed income cost is negatively correlated with the market involvement rate – this is known as interest rate risk.

At issuance, coupon bonds are sold at par value Par Value Par Value is the nominal or face value of a bond, or stock, or coupon as indicated on a bond or stock certificate. Information technology is a static value based on the prevailing marketplace involvement rate. Once the bond is issued, the coupon payments are fixed over the life of the loan, but the market interest rate fluctuates continuously.

When the marketplace interest rate increases, the outstanding stock-still-income security prices depreciate because newly issued fixed-income securities will pay higher coupon payments. Vice versa, if the market interest charge per unit decreases, the outstanding fixed income prices capeesh considering its coupon payments are college than newly issued fixed income securities.

Therefore, understanding involvement rate sensitivity becomes an important consideration in selecting stock-still-income securities. Certain characteristics affect a security's interest rate sensitivity, such as:

ane. Maturity Length

The longer the maturity is, the college the security's interest rate sensitivity. This is considering longer-term securities have college exposure to interest rate gamble Interest Rate Run a risk Interest rate risk is the probability of a pass up in the value of an nugget resulting from unexpected fluctuations in interest rates. Interest rate gamble is by and large associated with fixed-income assets (e.g., bonds) rather than with equity investments. .

ii. Coupon Rate

The lower the coupon rate, the higher the security's interest rate sensitivity considering information technology will have higher involvement rate take chances.

How to Measure Interest Rate Sensitivity

To measure involvement rate sensitivity, duration is a keen metric considering it takes such characteristics into consideration. The general dominion of thumb is the higher the duration, the higher the interest rate sensitivity. The 3 almost common types of elapsing are:

1. Macaulay Duration

The Macaulay duration represents the length of time the investor must hold the security until its total greenbacks flows can repay the bond'south price. For coupon-paying bonds, the Macaulay duration is always shorter than its fourth dimension to maturity. With nil-coupon bonds Nothing-Coupon Bond A zero-coupon bond is a bond that pays no involvement and trades at a discount to its face value. It is also called a pure discount bond or deep disbelieve bond. (bonds without coupon payments that are sold at a discount), the Macaulay duration is equal to its fourth dimension to maturity.

Interest Rate Sensitivity - Macaulay Duration

2. Modified Duration

The Modified duration builds on the Macaulay duration by integrating the yield to maturity. Information technology represents the percentage change in bail price in relation to the pct change in the interest charge per unit.

Interest Rate Sensitivity - Modified Duration

iii. Effective Duration

The constructive duration Effective Duration Effective duration is the sensitivity of a bond'southward price confronting the benchmark yield bend. One way to assess the hazard of a bond is to estimate the is practical specifically to bonds with embedded options to account for its uncertainty of future cash flows. The effective duration serves as the percentage change in price relative to the percentage change in yield to maturity.

Interest Rate Sensitivity - Effective Duration

Applied Example

Suppose an investor purchases a $two,000 par value bond with a 2.5% coupon rate compounded annually. The maturity appointment is iv years from today, on which the principal $2,000 will be returned. What is the Macaulay elapsing of the bond?

Sample Data

While the formula may look intimidating, the numerator and the denominator are almost identical, except each cash flow in the numerator is multiplied by its respective time flow t. For the discount rate r, we are using the coupon rate of the bond.

Sample Calculation

With the numerator and denominator solved, nosotros put those together to get a Macaulay duration of three.856. It means that it will have approximately 3.856 years of holding the bail for its greenbacks flows to cover its price. Considering the bond pays coupon payments, the Macaulay duration is shorter than its time to maturity of four years.

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