Introduction
In this report, we will put into the use the bond valuation technique so learnt by us. In addition, for the purpose of valuation, we will use the excel spreadsheet as and when needed. In other part, we will discuss and compare the interest rate risk and re-investment risk followed by measures to manage each of them. We are hopeful that by the end of this report, we will be gaining a handful experience over the concepts of bond valuation and various risk associated with them.
Part A
Answer 1)
1.a) Using the Present Value function in the excel spreadsheet for cash flows to be received over the next 20 years, we find that the present value of the bond is $852.73. In addition, since the Coupon Rate of the bond, i.e. 6.5% is trading at the Yield to Maturity of 8%, this indicates that the bond is trading at discount and closer the difference between coupon rate and YTM rate, the bond will start moving towards the par value of $10000.
1.b) Using the present value function in the excel spreadsheet for semi-annual bond payments, we find that the value of the bond is $851.55. Important to note that since the coupon payment mode was changed to semi-annual, we made the following changes in the multiples used in 1.a)
- Compounding Periods: 20*2= 40
- Discount Rate= 8/2= 4%
- Cash Flow= 65/2= $32.5
1.c) Now with the decline in the discount rate to 5%, using the present value function in the excel spreadsheet, the price of the bond has increased to $1186.93.
Referring to our calculations in excel spreadsheet, we found that on account of decline in the yield rate to 5%, the price of the bond increased to $1186.93. This indicates negative relationship between price of the bond and interest rates. In other words, when the interest rate falls, the price of the bond increases as the existing bonds with higher interest rate will turn attractive to the investors. Important to note, at times when interest rate falls, existing bond-holders benefit from the situation.
Answer 2)
Current Yield= Annual Cash Flows/ Current Market Price
On applying payment formula in the excel spreadsheet, we found that the annual coupon to be $128.50 Hence, with the current market price of the bond= $1125, the current yield of the bond will be:
=128.50/1125
= 11.40%
Comparing Interest Rate Risk and Reinvestment Risk:
Interest Rate Risk is all about the risk of change in the price of the fixed income security on account of change in the interest rate. Important to note that price of the fixed income security and the interest rate carries inverse relationship, i.e. if the market rate of interest goes down the price of the fixed income security will increase. Such change in price on account of interest rate change is measured through Duration that is the ratio of percentage change in the price of the bond in response to 1% change in the yield of the bond.
Duration= Percentage Change in price/ Percentage Change in Yield
On the other hand, re-investment risk is a possible risk associated with the income stream to be received from the investment in the fixed income security. For Instance, it is possible that the borrower may redeem the money to the investors when the market rate of interest falls down so he could re-borrow at the lower rate of interest. This is something not good for the investor as he has to re-invest his money under lower rate of interest and thus exposed to re-investment risk. Important to note, re-investment risk is not restricted to bonds having call or prepayment options, but also to a coupon bond as the coupon interest payments so received must also be reinvested at lower rate of interest
Measures to manage Interest Rate Risk
Various hedging techniques are available so as to protect the investor from the interest rate risk. Some of them are discussed below:
i)Entering Forward or Future Agreement:
Investor can hedge the interest rate risk by entering into forward of future agreement. Under these types of derivate agreements, investor can opt for fixed interest rate payment against floating interest rate payment at a prefixed date in future.
ii)Buying bonds with Floor or Cap Position:
In order to hedge the interest rate risk, investors can buy securities with floor or cap position so that the level of interest rate does not cross any undesirable levels and the investor could be certain that his bond will be priced within a set range of interest rates.
Measures to manage re-investment risk
No security is free from re-investment risk. Even the treasury bills face this risk as the coupon payments has to be re-invested at the existing market interest rates. Hence, it is impossible to eliminate reinvestment risk from the security, but by investing in long-term bonds, the re-investment risk can at least be managed. Long-term bond funds hold large bond positions of varying positions and allow the interest payments to be distributed directly to the fund investors or be automatically reinvested.
Works Cited
Current Yield. (n.d.). Retrieved November 2, 2014, from Investopedia: http://www.investopedia.com/terms/c/currentyield.asp
Kaplan Inc. (2011). Risk Associated with Investing in Bonds. In K. Inc, Schweser Notes for CFA Exam-Fixed Income Securities (pp. 24-28). USA.
