Investment Theory and Risk Management, + Website

Interest Rate Risk

Consider again the bond pricing formula for an n period coupon-paying bond (assume only one coupon payment per year for mathematical simplicity).

Clearly for fixed C, then r, the yield to maturity, equates the present value of this stream to the price P. Note that for fixed C, changes in the price of the bond (through supply and demand shifts in the bond market) will reflect changes in r. The relative attractiveness of bonds in investors’ portfolios makes bond prices variable and, therefore, bond yields variable as well. Fiscal policy that requires deficit financing, for example, will increase the supply of bonds that the Treasury auctions and these actions, in general, will cause bond prices to fluctuate. Similarly, monetary policy executed by central banks in the form of money supply growth (Fed easing) will have implications for interest rates (and therefore discount rates). Together, market forces, policy induced or not, will cause bond yields to move around over time, which will produce compensating variations in bond prices. Investors who hold bonds in their portfolios will therefore see the value of their bond holdings, and therefore the return on bonds in their portfolios, respond to these factors. Bonds are therefore risky even if their cash flows are not. This is what we refer to as interest rate risk, also known as capital risk. It is not a risk if ...