What Solutions Are Possible to the Free Rider Problem, Both Inside and Outside of Government

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CHAPTER 16 MANAGING BOND PORTFOLIOS 16-1 Outline of the Chapter • Bond pricing and sensitivity of bond pricing to interest rate changes • Duration analysis – What is duration? – What determines duration? • Convexity • Passive bond management – Immunization • Active bond management 16-2 Interest Rate Risk • There is an inverse relationship between interest rates (yields) and price of the bonds. • The changes in interest rates cause capital gains or losses. • This makes fixed-income investments risky. 16-3 Interest Rate Risk (Continued) 16-4 Interest Rate Risk (Continued) • What factors affect the sensitivity of the bonds to interest rate fluctuations? • Malkiel’s (1962) bond-pricing relationships – Bond prices and yields are…show more content…
16-16 Convexity (Continued) • The duration rule is a good approximation for small changes in bond yields. • The duration approximation always understates the value of the bond. • It underestimates the increase in price when yields fall. • It overestimates the decline in prices when yields rise. •Due to the curvature of the true price-yield relationshipconvexity 16-17 Convexity (Continued) • Convexity is the rate of change of the slope of the price-yield curve, expressed as a fraction of the bond price. – Higher convexity refers to higher curvature in the price-yield relationship. – The convexity of noncallable bonds are usually positive. – The slope of the cuve that shows the price-yield relation increases at higher yields. Convexity 1 P (1 y ) 2 n t 1 CFt (t 2 t ) (1 y )t 16-18 Convexity (Continued) • We can improve the duration approximation for bond price changes by taking into account for convexity. • The new equation becomes: P P D y 1 [Convexity ( y ) 2 ] 2 • The convexity becomes more important when potential interest rate changes are larger. 16-19 Convexity (Continued) • Why convexity is important? • In the figure bond A is more convex than bond B. •The price increases are more in A when interest rates fall. •The price decreases are less in A when interest rates rise. 16-20 •

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