7 - Price, yield and interest rate risk I

Abstract

This chapter considers a more useful measure of the time period over which bond return is generated. It deals with interest rate risk concerning bonds, revisiting the bond price or yield relationship. Interest rate risk is also common to all bonds, and has an important effect on bond values. It is the risk that bond prices will fall if market interest rates rise, and is the main form of market risk for bonds and strips. The traditional measures of interest rate risk are duration, modified duration and convexity. The change in price for a given change in yields differs for each of the bonds. Understanding this price volatility is important when analyzing the properties of bonds that make up a portfolio. Given a set term to maturity and from the same initial yield level, bonds with lower coupon will exhibit higher price volatility than bonds with higher coupon. A plain vanilla coupon bond pays out a proportion of its return during the course of its life, in the form of coupon interest.