Assignment
Introduction to the Measurement of Interest Rate Risk
a. Distinguish between the full valuation approach (the scenario analysis approach) and the duration/convexity approach for measuring interest rate risk, and explain the advantage of using the full valuation approach.
b. Compute the interest rate risk exposure of a bond position or of a bond portfolio, given a change in interest rates.
c. Demonstrate the price volatility characteristics for option-free bonds when interest rates change (including the concept of "positive convexity"), demonstrate the price volatility characteristics of callable bonds and prepayable securities when interest rates change (including the concept of "negative convexity"), describe the price volatility characteristics of putable bonds.
d. Compute the effective duration of a bond, given information about how the bond's price will increase and decrease for given changes in interest rates and compute the approximate percentage price change for a bond, given the bond's effective duration and a specified change in yield.
e. Distinguish among the alternative definitions of duration (modified, effective or option-adjusted, and Macaulay), explain why effective duration, rather than modified duration or Macaulay duration, should be used to measure the interest rate risk for bonds with embedded options, describe why duration is best interpreted as a measure of a bond's or portfolio's sensitivity to changes in interest rates, compute the duration of a portfolio, given the duration of the bonds comprising the portfolio and discuss the limitations of the portfolio duration measure.
f. Discuss the convexity measure of a bond and stimate a bond's percentage price change, given the bond's duration and convexity measure and a specified change in interest rates.
g. Differentiate between modified convexity and effective convexity.
h. Compute the price value of a basis point (PVBP), and explain its relationship to duration.
The response should include a reference list. Double-space, using Times New Roman 12 pnt font, one-inch margins, and APA style of writing and citations.