Interest Rate Risk Assignment

FIN2BFI

Topic 3 – Interest Rate Risk Assignment

Question 1

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Question 2

As can be seen, the yield curve has shaped as the “normal” yield curve (an upward sloping)

 Divide the yield into 3 main periods: 15/Jun/14 to 21/Oct/18, 21/Oct/18 to 15/Mar/19, and 15/Mar/19 to 21/Apr/33

- During the first and third period, the yield is an upward-sloping

- For the short period between 21/Oct/18 to 15/Mar/19, the yield is referred to as flat yield curve due to there is little different between short-term and long-term yield.

The yield has shaped as “normal” yield curve because of the term structure theories, such as the pure expectation theory, the liquidity premium theory, the inflation premium theory, and the market segmentation theory.

• Under the pure expectation hypothesis, if there is difference between long-term rates and expected average short-term rates, borrowers and investors will tend to invest or borrow either short-term or long-term whenever they perceive an advantage, for instance lower borrowing costs or higher returns. Market forces will tend to move long-term rates until they are geometric average of expected short term rates.
• Regarding liquidity premium hypothesis, the yield curve has an upward bias due to investors see long-term investment is riskier than short-term, and hence they tend to prefer short-term. This could be because long-term investments are more sensitive to interest rate changes. Borrowers who need to borrow long-term will need to offer slightly higher rates (higher than what would be indicated by pure expectations) in order to attract investors to borrow long-term.
• In terms of the inflation premium hypothesis, the yield curve’s implications is similar to the liquidity premium theory, the uncertainty regards to future levels of inflation leads to a preference for short-term investments. Issuers of securities therefore would have to offer an inflation premium to entice long-term investors.
• The market segmentation hypothesis predicts that borrowers and lenders have specific preferences for securities with different maturities, and would not swap from one to another. As a result, the yield for each maturity will be determined by demand and supply for securities of that maturity.

Question 3 & 4

Question 5

• Bond A

Face value = $1,000

Yield (y) = 2.51% = 0.0251

Days to maturity (d) = 31 days (from 15/5/14 – 15/6/14)

Price of Bond A

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Duration of Bond A 

Because bond A is a short-term security that there is only one future cash flow, and hence the duration is its term to maturity

The number of duration day at maturity date 15 June 2014 is 31 days or 0.0849 years.

[pic 3]

• Bond B

Price of Bond B

Face Value = $1,000

Coupon payment (CPN) = $1000 x () = $28.75[pic 4]

Semi-annual yield=  =1.73%= 0.0173[pic 5]

Discount Factor = 1 + 0.0173 = 1.0173

Number of coupon payments from 15/05/14 to 15/05/21 = 7 x 2 = 14 payments

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Duration of Bond B

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Question 6

Question 7: Assuming an increase in the yields 0f 0.01%