Reading 56: Interest Rate Risk and Return

Book 3: Fixed Income

Three Sources of Returns from Bonds

coupon and principal payments

reinvesting coupons

selling at a gain or loss before maturity

What does an investor earn if he holds to maturity and the YTM remains constant?

YTM

What does an investor return if the YTM increases before the first coupon and holds to maturity?

return that is greater than the original YTM

What does an investor return if the YTM increases before the first coupon and holds for a short period?

return that is lower than original YTM

What does an investor return if the YTM decreases before the first coupon and holds for a long time?

a return that is lower than the original YTM

What does an investor return if the YTM remains constant but sells before maturity?

YTM

When investment horizon is long, which is greater—price risk or reinvestment risk?

reinvestment risk

price goes to par at maturity no matter how much YTM changes

When investment horizon is short, which is greater—price risk or reinvestment risk?

price risk

can’t reinvestment a coupon you don’t earn if you sell before the first coupon date

Macaulay Duration

finding the investment horizon that is neither too long nor too short where increases/decreases in price risk or equally offset by decreases/increases in reinvestment risk

Duration Gap

the difference between the Macaulay Duration and the bondholder’s investment horizon

Positive Duration Gap =

price risk

Negative Price Gap =

reinvestment risk