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. The 1-year bond’s values at different interest rates are shown below:
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.
The values of the 1-year and 14-year bonds at several current market interest rates are summarized and plotted in Figure 4-3. Note how much more sensitive the price of the 14-year bond is to changes in interest rates. At a 10 percent interest rate, both the 14-year and the 1-year bonds are valued at $1,000. When rates rise to 15 percent, the 14-year bond falls to $713.78, but the 1-year bond only falls to $956.52.
Taken From : Five-Minute MBA – Corporate Finance
Related posts:
- Stock Market Equilibrium Recall that ri, the required return on Stock i, can...
- Estimating Inputs for the DCF Approach (2) Equation 6-6 produces a constant growth rate, but when we...
- Changes in Equilibrium Stock Prices Stock prices are not constant—they undergo violent changes at times....
Related posts brought to you by Yet Another Related Posts Plugin.
