Measuring the Sensitivity of a Bond's Price to Changes in the Market Essay

Measuring the Sensitivity of a Bond's Price to Changes in the Market Interest Rates - Essay Example On the other hand, bonds issued by companies are used for long term financing of the firm since they mature after a long period of time, usually more than ten years. Coupons are mostly paid out twice in a year but some could be payable once in a year. On maturity of a given bond, the bondholders are entitled to the principal amount initially invested at the present value at maturity. A bond may be issued at a discount or at a premium. If it is issued at a discount, the amount realized from such an issue is less than the face value of the bond. This occurs mostly when the interest rates of the bonds are low; therefore the government or the firms have to induce investors to invest in such a bond by lowering the prices of the bonds. On the other hand, if the amounts of funds realized from a bond issue are more than the face value of the bond, the bond is said to have been issued at a premium. This mostly occurs when the rates of return of the bond in question are relatively high and the bond is expected to yield some high returns in terms of the coupons. Investors will take into account the high amount of returns expected in the future and many will be interested in buying the bonds. These investors will be willing to pay a higher price for the bond, higher than the bonds face value. A bond’s price will change with changes in the market interest rate. There are different reasons for the changes in price. One of the most significant reasons is the fact that increase in market price denotes a higher rate of return on a given bond. Investors will inject their funds in an investment that has potential of yielding maximum returns for them. Given that they are rational individuals, the investors will rank a bond with a high rate of return at a higher position in their priorities of investment. This will drive the price of the bond up since the demand for it has gone up. This leads to the bond being issued at high price. The sensitivity of a bond’s price to interest rate movements is dependent on the bonds characteristics (Madura 2001). This is clearly the case since there are many kinds of bonds and each of them exhibit different unique characteristics according to its nature. Some of these unique characteristics are the different maturity periods. Some bonds mature after only ten years while others might mature at thirty years. The frequencies at which bonds pay out coupons also differ accordingly. The convex relationship between bond price and yield illustrates that the changes in prices for a given change in interest rates is not constant and nor is it identical, for all but very small amounts, for both upward and downward change in yields (Cima 2000). The two common methods of assessing the sensitivity of a bond to a change in the required rate of return on bonds are: Bond price elasticity Duration The above methods are computed as follows: 1. Bond price elasticity The sensitivity of bond prices to changes in the required rate of return is commonly measured by the bond price elasticity (Madura 2001). The computation is given as follows; Pc = percentage change in p / percentage change in k where; Pc is the bond price elasticity P is the bond price K is the required rate of return This method is significant especially when measuring the sensitivity of a bonds price on the market inter