The ability to immunize a bond portfolio is very desirable for bond portfolio managers in some instances.
a. Discuss the components of interest rate risk—that is, assuming a change in interest rates over time, explain the two risks faced by the holder of a bond.
b. Define immunization and discuss why a bond manager would immunize his or her portfolio.
c. Explain why a duration-matching strategy is a superior technique to a maturity matching strategy for the minimization of interest rate risk.
a. Price risk and reinvestment rate risks
b. Structuring of bond’s portfolio for reaching a target
c. Sensitivity of bond’s equal duration with equal rate fluctuation
Price risk and reinvestment rate risks are two risks where the former denotes volatility in the bond’s price on interest rate fluctuation, while the latter denotes the uncertainty at which rate the coupon can be re-invested.
The process in which a bond’s portfolio is structured in such a manner that its value reaches a target irrespective of future rates fluctuation. Since this is a low-risk bond management strategy, bond managers would want to do this.
It is because the bonds of equal duration are equally sensitive to the interest rate fluctuations. This is not true for equal maturity.
Question: A newly issued 10-year maturity, 4% coupon bond making annual coupon payments is sold to the public at a price of $800. What will be an investor’s taxable income from the bond over the coming year? The bond will not be sold at the end of the year. The bond is treated as an original-issue discount bond.
a. Use a spreadsheet to calculate the duration of the two bonds in Spreadsheet 11.1 if the interest rate increases to 12%. Why does the duration of the coupon bond fall while that of the zero remains unchanged?
(Hint: Examine what happens to the weights computed in column E.)
b. Use the same spreadsheet to calculate the duration of the coupon bond if the coupon were 12% instead of 8%. Explain why the duration is lower. (Again, start by looking at column E.)
Return to Table 10.1 and calculate both the real and nominal rates of return on the TIPS bond in the second and third years.
Inflation in Year just ended
Coupon Payment + Principal payment
$ 1000 .00
$ 1050. 60
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