Bond features that affect interest rate risk, Financial Management

Assignment Help:

Various bond features largely affect the degree of correlation between the bond's prices and the bond's interest rates. Some of the bond features that affect bond's interest rate risk are - maturity, coupon rate and embedded options.

  • Maturity Period: The degree of bond price sensitivity to its interest rate changes depends upon its maturity period. Longer the maturity period of the bond, greater would be the price sensitivity to change in the interest rate of the bond, assuming that all other factors to be constant.

  • Coupon Rate: Assuming that all other factors are constant, the degree of bond price sensitivity to its interest rate changes depends upon its coupon rate. Higher the coupon rate, lower is the degree of sensitivity to changes in interest rates and vice versa. Further, zero coupon bonds tend to have higher price sensitivity to interest rate changes compared to the bonds having a coupon rate.

  • Embedded Options: The value of the bond with embedded option will depend on how the value of the embedded option changes with the interest rates. For example, let us consider a callable bond. We know that when interest rates decrease, the price of an option-free bond increases. However, in a callable bond, an increase in price is not as much as it is in an option-free bond. Let us try to understand this by separating the price of a callable bond into two parts.

Price of callable bond = Price of option-free bond - Price of embedded call option

The price of embedded call option is deducted because it is of value to issuer; but for an investor it is a disadvantage. Therefore, the price of a callable bond is less when compared to the price of an option-free bond. Now, when interest rates decrease, the call option value increases because it becomes more valuable to the issuer; and when interest rate decreases, both the price of option-free bond and the price of call option increase. This results in a relatively lesser change in the price of a callable bond when compared to the change in the price of option-free bond.


Related Discussions:- Bond features that affect interest rate risk

The financial services authority in the united kingdom, The Financial Servi...

The Financial Services Authority in the United Kingdom: The Financial Services Authority (FSA) in the United Kingdom (UK) is the financial watchdog. It is a company limited by

Partition of investment risk, Partition of Investment Risk The expecte...

Partition of Investment Risk The expected returns and the fluctuation in returns are two factors in evaluating investments. Expected Returns While the actual returns

Factors influencing capital structure, FACTORS INFLUENCING CAPITAL STRUCTUR...

FACTORS INFLUENCING CAPITAL STRUCTURE/DETERMINANTS OF THE CAPITAL STRUCTURE 1. Financial leverage (or) Trading on equity it is the make use of long term fixed interest bea

Basic assumptions of cost of capital, Basic Assumptions of Cost of Capital ...

Basic Assumptions of Cost of Capital The Cost of Capital is a dynamic concept affected by a multiplicity of economic and firm factors and assumes the following assumptions rela

Blade inc case study, what are the advantages blades could gain from import...

what are the advantages blades could gain from importing or exporting to a foreign country such azs thailand?

Determination of values price and volume, Determination of values The v...

Determination of values The values for which NPV turns into zero are found by calculating the break-even values for the selected variables. Once determined these give an indica

Capital structure theory, Capital structure theory: Use the following ...

Capital structure theory: Use the following information to answer the questions: Case I: Capital structure theory ( no tax ) Case II: Capital struct

Define the matching principle of working capital financing, What is the mat...

What is the matching principle of working capital financing?  What are the advantages of following this principle? The matching principle is while short-term financing is employe

Classification of budgets, CLASSIFICATION OF BUDGETS Budgets can be ca...

CLASSIFICATION OF BUDGETS Budgets can be categorized on the basis of several bases.  There are three important bases for classifying budgets.  They are - functions, time, and

Sources of return, When an investor invests in fixed income sec...

When an investor invests in fixed income securities, he receives returns from one or more of the following sources: Coupon Interest payment.

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd