Bond Volatility

3 Key excerpts on "Bond Volatility"

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  eBook - PDF

  Financial Institutions, Markets, and Money

  • David S. Kidwell, David W. Blackwell, David A. Whidbee, Richard W. Sias(Authors)
  • 2016(Publication Date)
  • Wiley

    (Publisher)

  144 CHAPTER 5 Bond Prices and Interest Rate Risk for both the zero and the 10 percent coupon bonds the slopes of the lines are greater at lower interest rates and the lines flatten out at higher interest rates. Thus, price volatility is greater at lower interest rates and is less at higher starting interest rates. In short, interest rate volatility is inversely related to the level of the starting interest rate. This result occurs because at higher interest rates the present value of more distant cash flows is reduced, and a greater percentage of the value of the bond is received from near term cash flows. As a result, the bond effectively has a shorter maturity in present value terms at higher interest rates and returns a greater percentage of the investment more quickly. Recall that any time you get a higher percentage of your money back sooner the investment will be less price volatile. SUMMARY OF IMPORTANT BOND PRICING RELATIONSHIPS You should remember three relationships between bond prices and yields: 1. Bond prices are inversely related to bond yields. 2. The price volatility of a long‐term bond is greater than that of a short‐term bond, hold- ing the coupon rate constant. Although price volatility increases with maturity, it does so at a decreasing rate. 3. The price volatility of a low‐coupon bond is greater than that of a high‐coupon bond, holding maturity constant. 4. Price volatility is inversely related to the starting market interest rate. We call on these relationships to help us explain interest rate risk in the next section, and later in the book, they also help us explain how interest rate risk affects financial institutions. 5.5 INTEREST RATE RISK AND DURATION By now, you should be catching on that investing in bonds can be risky. Market yields on bonds fluctuate on a daily basis, and these fluctuations cause bond prices to change through the mechanics of the bond‐pricing formula (Equation 5.3).

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  eBook - ePub

  Introduction to Fixed Income Analytics

  Relative Value Analysis, Risk Measures and Valuation

  • Frank J. Fabozzi, Steven V. Mann(Authors)
  • 2010(Publication Date)
  • Wiley

    (Publisher)

  In summary, we can use the full valuation approach to assess the exposure of a bond or portfolio to interest rate shocks, assuming—and this cannot be stressed enough—that the manager has a good valuation model to estimate what the price of the bond will be in each interest rate scenario. Moreover, we recommend use of the full valuation approach for assessing the position of a single bond or a portfolio of a few bonds. For a portfolio with a large number of bonds and/or the bonds containing embedded options, the full valuation process may be too time consuming. In its stead, managers want a single measure that they can employ to estimate how a portfolio or even a single bond will change if interest rates change in a parallel fashion rather than having to revalue an entire portfolio to obtain that answer. Duration is such a measure and we will discuss it as well as a supplementary measure called convexity later in the chapter. We describe the basic price volatility characteristics of bonds in the next section. It should come as no surprise that there are limitations of using one or two measures to describe the interest rate exposure of a position or portfolio. Nevertheless, these measures provide us with some important intuition about assessing interest rate risk.

  EXHIBIT 12.5 Illustration of Full Valuation Approach to Assess the Interest Rate Risk of a Bond Portfolio for Four Scenarios Assuming a Parallel Shift in the Yield Curve Two bond portfolio (both bonds are option-free)

  EXHIBIT 12.6

  Illustration of Full Valuation Approach to Assess the Interest Rate Risk of a Bond Portfolio for Four Scenarios Assuming a Nonparallel Shift in the Yield Curve Two bond portfolio (both bonds are option-free)

  PRICE VOLATILITY CHARACTERISTICS OF BONDS

  There are four characteristics of a bond that affect its price volatility: (1) term to maturity, (2) coupon rate, (3) the level of yields, and (4) the presence of embedded options. In this section, we examine each of these price volatility characteristics.

  Price Volatility Characteristics of Option-Free Bonds

  Let’s begin by focusing on option-free bonds (i.e., bonds that do not have embedded options). A fundamental characteristic of an option-free bond is that the price of the bond changes in the opposite direction from a change in the bond’s required yield. Exhibit 12.7 illustrates this property for four hypothetical bonds assuming a par value of $100.

  When the price/yield relationship for any hypothetical option-free bond is graphed, it exhibits the basic shape shown in Exhibit 12.8 . Notice that as the required yield decreases, the price of an option-free bond increases. Conversely, as the required yield decreases, the price of an option-free bond increases. In other words, the price/yield relationship is negatively sloped. In addition, the price/yield relationship is not linear (i.e., not a straight line) for reasons mentioned in Chapter 4. The shape of the price/yield relationship for any option-free bond is referred to as convex

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  Managing a Corporate Bond Portfolio

  • Frank J. Fabozzi, Leland E. Crabbe(Authors)
  • 2003(Publication Date)
  • Wiley

    (Publisher)

  3 The importance of credit risk in the valuation of embedded options is the subject of Chapter 17. Chapter 7 115 CONCLUSIONS When using option valuation models, investors must be careful in interpreting the volatility input. Yield volatility is not the same as spread volatility. Spread vola- tility is nearly always higher for low-rated bonds than for high-rated bonds. Yield volatility, by contrast, is often lower for lower-rated, higher-yielding bonds. This does not mean that we can be complacent about the spread risk of corporate bonds, in general, and lower-rated bonds, in particular. Rather, it simply means that yield volatility implicitly allows for some spread volatility because it is mea- sured on a percentage basis. 117 Chapter 8 Liquidity, Trading, and Trading Costs goal of active portfolio management is to achieve a better performance than a portfolio that is simply diversified broadly. To this end, portfolio managers make informed judgments about bond market risks and expected returns, and align their portfolios accordingly by trading bonds in the secondary market. By definition, portfolios that are actively managed are portfo- lios that are actively traded. While trading can improve performance, any active portfolio strategy must account for the cost of trading and for the vagaries of liquidity. In this chap- ter, we show that trading costs and liquidity are inextricably linked though the cor- porate bond bid-ask spread. The cost of trading depends on that bid-ask spread, as well as duration and the frequency of turnover. While trading costs can be mea- sured, they cannot be known with certainty because the bid-ask spread could be wide or narrow when trades are executed. In fact, the bid-ask spread changes over time, it varies across issuers, and it depends on the size of the transaction. That uncertainty about the cost of trading creates risk—liquidity risk—and that liquid- ity risk, in turn, gives rise to a risk premium.

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