Assessing the Risk of a Bond
by MaestriInterest Rate Risk
As we saw in Chapter 1, interest rates go up and down over time, and an increase in interest rates leads to a decline in the value of outstanding bonds. This risk of a decline in bond values due to rising interest rates is called interest rate risk. To illustrate, suppose you bought some 10 percent MicroDrive bonds at a price of $1,000, and interest rates in the following year rose to 15 percent. As we saw earlier, the price of the bonds would fall to $713.78, so you would have a loss of $286.22 per bond.10 Interest rates can and do rise, and rising rates cause a loss of value for bondholders. Thus, people or firms who invest in bonds are exposed to risk from changing interest rates.
One’s exposure to interest rate risk is higher on bonds with long maturities than on those maturing in the near future.11 This point can be demonstrated by showing how the value of a 1-year bond with a 10 percent annual coupon fluctuates with changes in rd, and then comparing these changes with those on a 14-year bond as calculated previously.
You would obtain the first value with a financial calculator by entering N 1, I 5, PMT 100, and FV 1000, and then pressing PV to get $1,047.62. With everything still in your calculator, enter I 10 to override the old I 5, and press PV to find the bond’s value at rd I 10; it is $1,000. Then enter I 15 and press the PV key to
find the last bond value, $956.52.
Taken From : Five-Minute MBA – Corporate Finance
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