Pre ClassPPT 7
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Transcript of Pre ClassPPT 7
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Interest Rate Risk-3
Objective
The objective of the session is to comprehend
the following variants of interest rate risk. Price Risk.
Reinvestment risk
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Price Risk
The values of investments change inversely tointerest rates.
If the interest rate in the market increase,
investment suffer depreciation. If the interest rate decline, investments in thebanksportfolio gain in value.
The price change in investments are on accountof the present values of the cash flows in thebond being altered when discounted by the newinterest rate.
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Price Risk
Thus all bonds are subject to price risk whichis the potential loss in value on account ofchanges in interest rates.
This concept can be generalized and can beextended to all items of assets and liabilities ina banks balance sheet which conceptuallyconstitutes series of expected cash flows.
As such ,have present values (market values)which vary with market interest rates.
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Price Risk
Thus all items of assets and liabilities are
exposed to price risk.
Price risk will impact the values of assets and
liabilities of bank .
In turn impact market value of net worth
which is the difference between the market
value of assets and liabilities.
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Reinvestment risk
The expected yield on investments, generallyindicated by yield to maturity.
It is based on the important assumption that thebond will be held till maturity
It is also assumed that during the life of the bond,the periodic coupons received will be reinvestedat an interest rate equal to the YTM.
This assumption can go wrong in which caseincome from investments by way of coupons getsreinvested at lower rates in case the interest ratesdecline.
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Reinvestment Risk
Uncertainty with regard to interest rate at which the futurecash flows can be reinvested is called reinvestment risk.
The bond pricing formula assumes that all couponpayments are reinvested at the bonds Yield to
Maturity.(YTM). However in reality the interest rates can never be static in
the market.
Nevertheless as the coupon payments are to be reinvestedfor shorter maturity than the original tenure of the bond
(to synchronize with the maturity of the Bond ),the interestrates for such remaining tenure would be naturallydifferent from the interest rates (YTM) originally estimated.
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Reinvestment Risk
If the interest rate goes up in the market during the life of a bond ,interestflows will be reinvested at higher yields thereby increasing thereinvestment income. The increase in reinvestment income will increasethe realized yield of the bond which would be more than the YTMexpected at the time of purchase of the Bond.
On the other hand, when the interest rate declines during the life of the
Bond, the coupons will be reinvested at lower yields which reduce thereinvestment income. This would result in reduction in realized yield ofthe Bond which would be less than the YTM originally estimated at thetime of purchase.
However as the Price of the Bond is inversely proportion to the interestrates, the bond price would depreciate in the rising interest rate scenario
and bond price would appreciate in the falling interest rate scenario. Thisdepreciation or appreciation in bond price would result in a capital lossgain thereby partially setting off the increased reinvestment income orreduced reinvestment income in the respective scenarios.
Thus price risk and reinvestment risk partially off set one another.
