Chapter 11. Managing Bond Portfolios. Interest Rate Sensitivity (Duration we will cover in Finc420). The concept: Any security that gives an investor more money back sooner (as a % of your investment) will have lower price volatility when interest rates change.
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Managing Bond Portfolios
D = Duration
Price change is proportional to duration and not to maturity
DP/P = -D x [Dy / (1+y)]
D* = modified duration
D*= D / (1+y)
DP/P = - D* x Dy
Interest rate risk is the possibility that an investor does not earn the promised ytm because of interest rate changes.
A bond investor faces two types of interest rate risk:
The two types of risk are potentially offsetting.
Where: CFt is the cash flow (interest and/or principal) at time t and y = ytm
The prediction model including convexity is: