Risk Management #3 : Interest Rate Risk

Bonds

A certificate issued by a government or private company which promises to pay back with interest the money borrowed from the buyer of the certificate: The city issued bonds to raise money for putting in new sewers.

Coupons

the promised interest payments of a bond, paid periodically until the maturity date of the bond

Face value

Notional amount used to compute the interest payments. Different from the market price which is what it trades for today.

What changes over time ?

Not the coupon rate, nor the maturity. It's the present value : price of a bond : extremely liquid.

What happens when bond prices go up ?

The Yield To Maturity ( internal interest rate of YTM) goes down, it's an inverted relationship (bc maths).

Bond Payment Structure

PV = (Coupon rate * Face value) / ( 1+YTM)^n

Yield curve

Curve showing several interest rates across different contract lengths for a similar credit risk.

Yield to Maturity (YTM)

The true annual return you earn if you buy the bond today and keep it until it ends, it's the bond's overall interest rate (internal interest rate)