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

Review of career plans, Review of career plans: career plans, emerging out ...

Review of career plans: career plans, emerging out of career planning exercise, have long term orientation. A career plan is developed based on assumptions about how the environmen

Capital structure, name the concept which increases the return on equity sh...

name the concept which increases the return on equity shares by changing the capital structure of the co.

What was the second ground of criticism, What was the Second ground of crit...

What was the Second ground of criticism of traditional treatment Second ground of criticism of the traditional treatment was that focus was on financing problems of corporate e

Investable capital market portfolio, The Total Investable Capital Market Po...

The Total Investable Capital Market Portfolio According to a report prepared by McKinsey in January 2007, World financial assets including bonds, stocks, corporate debt securit

Savings, This is the part of after-tax personal income that is not spent.

This is the part of after-tax personal income that is not spent.

Price/yield relationship in bonds, Bond Price is the purchase value o...

Bond Price is the purchase value of a bond. It can be priced either at a premium, discount or at par. It is important for the prospective buyer to know how to det

Lockbox system, how do we compute for benefits can derrive out of using loc...

how do we compute for benefits can derrive out of using lockbox system?

Discount rate determinants, Discount Rate Determinants The discount rat...

Discount Rate Determinants The discount rate is the firm weighted average cost of capital. It represents the opportunity cost of investing creditors and shareholders funds in o

Expansion financing, The securing of the working capital needed for the sup...

The securing of the working capital needed for the support of raises in accounts receivable and inventory related with an organizations initial expansion time.

Expalin npv decision rule in basril plc, The NPV decision rule needs that a...

The NPV decision rule needs that a company invest in all projects that have a positive net present value. This presumes that sufficient funds are available for all incremental proj

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