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2. Interest Rates Risks and types of its
- 1. Established as perthe Section 2(f) of the UGC Act, 1956 Approved by AICTE, COA and BCI, New Delhi INTEREST RATES RISK S c h o o l o f L e g a l S t u d i e s AY 2024 -2025 D r. K u m a r a J N
- 2. RISK Dictionary meaning-is the possibility of loss or injury; the degree or probability of such loss. Here the probable outcome of all the possible events are listed. The investor can analyze and find out the possible range of returns from his investments. He can assign some subjective probability to his returns such as 50% of the time there is a likelihood of getting or possible dividend may be Rs. 2 / Rs. 3per share. Source:- Punithavathy Pandian, Security analysis and portfolio management, page no.140
- 3. Types of Risk SystematicRisk Unsystematic Risk Financial Risk Market Risk Interest Rate Risk Purchasing Power Risk Fluctuations in the sales Research & Development Business Risk Internal Business Risk External Business Risk Personal Management Fixed Cost Single Product Social & Regulatory Factors Political risk Business cycle
- 4. INTEREST RATE RISKS Interest rate risk is the potential for investment losses that result from a change in interest rates. IRR is the probability of a decline in the value of an asset resulting from unexpected fluctuations in interest rates. If interest rates rise, the value of a bond or other fixed-income investment will decline. (Source:- page no:375 investment analysis and portfolio management)
- 5. CONTI. IRR isassociated with fixed-income assets (e.g.,Bonds) rather than with equity investments. A security (financial instrument) is a claim on the issuer’s future income or assets. Bond markets are especially important to economic activity because they enable corporations and govt. to borrow in order to finance their activities,
- 6. CONTI. The lowerdemand also triggers lower prices on the secondary market. The market value of the bond may drop below its original purchase price. The reverse is also true. A bond yielding a 5% return holds more value, if interest rates decrease below this level since the bondholder receives a favorable fixed rate of return relative to the market.
- 7. INTEREST RATE SENSITIVITYOR BOND PRICE SENSITIVITY. When the market interest rate rises the value of existing fixed-income securities with different maturity dates declines by varying degrees. This known as “price sensitivity” and is measured by the bond's duration. suppose there are two fixed-income securities, 1. one that matures in one year 2. another that matures in 10 years.
- 8. ONE YEARMATURITY BOND HOLDER:- When market interest rates rise, the owner of the one-year security can reinvest in a higher-rate security after hanging into the bond with a lower return for only one year at most. But the owner of the 10-year security is stuck with a lower rate for nine more years. That justifies a lower price value for the longer-term security.
- 9. TEN YEAR MATURITYBOND HOLDER The longer a security's time to maturity, its price declines more relative to a given increase in interest rates. Note that this price sensitivity occurs at a decreasing rate. A 10-year bond is significantly more sensitive than a one-year bond but a 20-year bond is only slightly less sensitive than a 30-year one.
- 10. FOUR TYPES OFCREDIT MARKET INSTRUMENTS 1. A Simple Loan:- 2. A Fixed-payment Loan:- 3. A Coupon Bond 4. A Discount Bond (Zero –Coupon Bond) (Source:- Article - Financial markets and institutions , NINTH EDITION , Frederic S. Mishkin • Stanley G. Eakins , Pearson , www.rasabourse.com - Page 81)
- 11. YIELD TO MATURITY. On of the important and one of the common way of calculating interest rates. The interest rate that equates the present value of cash flows received from a debt instrument with its value today. We calculate for all credit market instruments The key in all these examples to understanding the calculation of the yield to maturity is equating today’s value of the debt instrument with the present value of all of its future cash flow payments
- 12. SIMPLE LOAN • Ifmanju borrows rs. 100 from his sister and next year she wants rs.110 back from him, what is the yield to maturity on this loan? • PV= PV= Amount borrowed = 100 CF= Cash flow in one year = 110 n= number of years = 1
- 13. CONTD. • 100 (1+i) 100= 110 (1+i) 1. i=1.10 – 1 =0.10 = 10%
- 14. FIXED-PAYMENT LOAN • Youdecide to purchase a new home and need a rs.100.000 mortgage. • You take out a loan from the bank that has an interest rate of 7% what is the yearly payment to the bank to pay off the loan in 20 years. • So the yearly payment to the bank is rs. 9,439.29 LV= + + + …………..+
- 15. CONTD. • LV= ++ + …………..+ • Where:- LV= loan value amount = 100,000 i = annual interest rate = 0.07 n = number of years = 20 100,000 = + + + …………..+ You can use financial calculator also
- 16. COUPON BOND Findthe price of a 10% coupon bond with a face value of rs.1,000 a 12.25% yield to maturity , and eight years to maturity FV = face value of the bond = 1000 I = annul interest rate = 12.25% N = years to maturity = 8 By using financial calculator …. The price of bond is Rs. 889.20
- 17. DISCOUND BOND. • Itis similar to the simple loan calculation. • Eg:- if discount bond such as treasury bill, which pays a face value of rs.1000 in one year time. • If the current purchasing price of this bill is rs.900, then price to the present value of the rs.1000 received in one year ? i = where F = Face value of the discount bond P = Current price of the discount bond i = = 0.111 = 11.1 %
- 18. INTEREST RATE PREMIUMSFOR RISK AND OTHER FACTORS Interest rate with supply and demand If we have two options to invest my money. I could put it in the bank offers 3% interest rate I could led it to my uncle for his new business venture offers 3%, but it is risk. If my uncle offers 7% IR. We can have a chance. We can think of this 7% consisting of the 3% base interest rate ( Risk free rate from the bank) plus a 4% uncle premium.
- 19. CONTI. Investor need compensationfor Inflation and various kinds of risk 1. Default risk:- some kind of assets have more risk than other. • Imagine you own a bond by American airlines. It could happen that the company goes out of business and cannot repay the bond. • If the company goes bankrupt, you get nothing. • If the company doesn’t go bankrupt, you get a higher payment.
- 20. CONTI. 2 . Maturityrisk:- • Say you have 30 year bond, if you held it the entire 30 years you would get the coupon and face value payments as no issue. • If you held the bond for only 5 years, before you decided to sell? • Then the price of the bond 5 years from now will be determined by interest rates at the time. • If bond prices are high you will gain, otherwise loss. • There is a risk to you for investing in bonds if you sell before mature.
- 21. CONTI. 3. Liquidity risk:- imaginethat you owned a rare collectable car the you want to sell It may take time to find a buyer. If you need to raise a cash today, you might have to drop your price in order to sell car quickly. Same principles holds for financial assets. Assets cannot sold quickly without reduction in price or liquidity. In order to hold these assets they need to pay more interest rate.
- 22. HOW TO ADJUSTINTEREST RATES FOR INFLATION - BBA - LLB - BA LLB When you looking for returns, it is important to adjust for the effects of inflation. Inflation reduces your value of earnings. Eg. If you deposited money in the bank and received a return of 5% & cost of everything went up by 5%, you haven’t gained anything. It is not adjusted with inflation is called the Nominal interest rate.
- 23. CONTI. The realinterest rate:- is the interest rate adjusted for inflation. There are two way ex post & ex ant Ex post:- Real returns you get after you find out what inflation is called ex post interest rate (in Latin ‘afterwards’). Formula- r = i = 𝝅, Example:- You invested in bond which paid an 8% nominal return, this time inflation was 2.5%, how much your money increased after adjusting for inflation? Answer:- 8 – 2.5 = 5.5% return r = Real interest, i = nominal interest rate, = rate of inflation. 𝝅
- 24. CONTI. Ex anteReal Interest Rate: (in Latin Beforehand) If you are interested in the real return expect to get before you make the investment, is called Ex ante RIR. Now use expected rate of inflation (𝝅e ) formula – r = i = 𝝅e Eg. Making on investment in bond that paid an interest rate of 3%, if you expect inflation to be 2%, what real return do you expect to get? Answer is : 3% - 2% =1% r = Real interest, i = nominal interest rate, = rate of inflation. 𝝅
- 25. UNDERSTANDING INTEREST RATESRISKS •INTEREST RATE RISK is the potential for investment losses that may result due to changes in interest rates •A change in overall interest rates will reduce the value of a bond or other fixed-rate investment • if interest rates rises, the value of fixed-investment or bond will decline. •The change in a bond's price given a change in interest rates is known as its ”Duration”. •This means that the market price of existing bonds drops to adjust the more attractive rates of new bond issues
- 26. CONTD. •Interest rate riskis measured by a fixed income security's Duration, with longer- term bonds with price sensitivity(responsive) with rate of interest. •Interest rate changes can affect many investments, •so bondholders will have to carefully monitor interest rates changes to make decisions. •The prices of Fixed-income securities fall as interest rates rises and vice versa •This is because of the Opportunity Cost of holding those bonds
- 27. CONTD. • If abond paying a fixed rate of 5%, • is trading at its par value of Rs.1,000/- • when prevailing interest rates are also at 5%, • it becomes far less attractive to earn that same 5% when rates elsewhere start to rise to say 6% or 7%. • so, the value of these bonds must fall - • then we own a 5% interest rate bond
- 28. EXAMPLE OF INTERESTRATE RISK • An investor buys a 5 year, Rs.500 bond with a 3% coupon. • if, interest rates rise to 4%. •The investor will have trouble selling the bond •The lower demand also triggers lower prices on the secondary market as well •The market value of the bond may drop below its original purchase price also. •The reverse is also true. A bond yielding 5% return holds more value if interest rates decrease below this level since the bondholder receives a favorable fixed rate of return relative to the market.
- 29. CONTD. •Various economic forcesaffect the level and direction of interest rates in the economy. • Interest rates typically climb when the economy is growing, and • fall during economic downturns. •Similarly, rising inflation leads to rising interest rates and • Moderating inflation leads to lower interest rates. •Inflation is one of the most influential forces on interest rates
- 30. THE MATURITY RISKPREMIUM • A maturity risk premium is the amount of extra return you'll get on your investment by purchasing a bond with a longer maturity date . • The larger the Duration of long-term securities means higher interest rate risk for those securities . • To compensate the investors for taking on more risk, the expected rates of return on longer-term securities are typically higher than rates on shorter- term securities • • This is known as the Maturity Risk Premium
- 31. DURATION Duration isa measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows. At the same time, duration is a measure of sensitivity of a bond's or fixed income portfolio's price to changes in interest rates. The higher the duration, the more a bond's price will drop as interest rates rise (and the greater the interest rate risk).
- 32. CONTI. As ageneral rule, for every 1% change in interest rates (increase or decrease), a bond’s price will change approximately 1% in the opposite direction, for every year of duration. If a bond has a duration of 5 years and interest rates increase 1%, the bond’s price will drop by approximately 5% (1% X 5 years). Likewise. if interest rates fall by 1%, the same bond’s price will increase by about 5% (1% X 5 years).
- 33. CERTAIN FACTORS CANAFFECT A BOND’S DURATION Time to maturity:- The longer the maturity, the higher the duration, and the greater the interest rate risk. Coupon rate:- A bond’s Coupon rate is a key factor in calculation duration. If we have two bonds that are identical with the exception on their coupon rates, One bond with the higher coupon rate will pay back its original costs faster than the bond with a lower yield. The higher the coupon rate, the lower the duration, and the lower the interest rate risk.
- 34. REFEREMCES L MBhole and Jitendra Mahakud, Financial Institutions and Markets, TataMcGraw-Hill, 2009. F S Mishkin, The Economics of Money, Banking, and Financial Markets, Prentice Hall, 2007. H.R Appannaiah and P.N Reddy, Indian Financial System E. Gorden and K. Natarajan, Banking Theory, Law and Practice Preethi Singh, Investment Management ( Security Analysis and Portfolio Management). Frederic S. Mishkin, Stanley G. Eakins, Global Edition, Ninth Edition -Financial Markets & institutions
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