Thursday, March 29, 2018

Teaching Interest Rate Risk

Interest rate risk seems to puzzle some students when they first encounter it.  It's the idea that fixed-rate assets decline in value when interest rates rise.   I've started using a simplified bond trading exercise to help students get the concept quickly.  This is how it works. 

Give A Student A Bond

I find a few victims/volunteers and give them brightly colored pieces of paper.  These, I tell them, represent fixed rate bonds with a $10,000 value, paying 5% a year for the next twenty years.  We run through some basic questions.  How much money do they get each year ($500).  How much money will they get if they hold the bond to maturity?  ($20,000.  This is the amount of the bond plus another $10,000 in interest).  For the exercise, we keep it simple and just look at the cash flow coming off the one bond.

Change The Rates

After everyone gets the idea, I clap my hands and change the prevailing market interest rate from 5% to 8%.  This leaves our initial volunteer holding a 5% bond in an 8% market.  With a flourish, I pull out more brightly colored paper of a different shade and announce that I'm now a corporation selling a 20-year bond paying 8% a year to the general market (the class).  I round on our unfortunate volunteers and inform them that they have fallen on hard times and have a sudden need for more cash!  They have a child and, well, the baby needs braces, the roof requires repairs, or their wastrel nephew desperately needs funds to develop his plan to sell dehydrated water to the masses.  Putting the cause to the side, the students with 5% bonds now need to sell them to the open market.  Declaring that they paid $10,000 for the bond, I ask them how much they want to sell it?  Often, they respond that they want to get their money back and sell the bond for $10,000.  Such hopes!

Think of the Pensioners 

I designate another random student as a money manager for a pension fund and give a little backstory. She loves her job.  She invests to take care of municipal retirees.  Her steady work and prudent fiscal management means that retired firefighters with creaky knees live dignified, independent lives without the need to take odd jobs installing ceiling fans on precarious ladders.  It's a noble profession.  She's an unsung hero.

With the money manager understanding her role and her obligation to do right by her pensioners, I ask her if she wants to pay $10,000 for the 5% bonds held by our hapless initial volunteers, or if she would rather put her pensioners' money to work with the glorious 8% bond I hold in my hand.  It may help to pop the paper for effect.  Our diligent pension manager reliably opts for the better bond deal.

Back to the Initial Bondholders

Once their initial efforts to liquidate their 5% bonds have failed, I ask the bondholders about their options.  They still need to cash.  I ask if they want to lower the price on their bonds.  Often they do, frequently by significant amounts to $7,000 or $8,000.  As a class, we discuss the bargain!  An investor can pick up a $10,000 bond for $7,000.  What a deal!  It's practically free money.  Sometimes the money manager may be tempted to bite on this juicy reduction in price.

Run the Numbers

Before the money manger and 5% bondholders can close the deal, I renew my sales pitch.  I declare that the money manager is smart, diligent, and hardworking and note that she would never close a deal without running the numbers.  I ask if the 5% bond pays $500 a year, how much does the 8% bond pay?  The jump is easy and we can all agree that getting $800 is better than getting  $500 for our pensioners.  With a 3% difference, we're looking at an extra $300 a year coming off my splendid 8% bond.  What does that come out to over twenty years, I ask?  A moment as the gears turn and everyone fires up the more calculating parts of their brains.  Suddenly, we've got it.  It's a stunning extra $6,000. (This does not take into account the time value of that money.)

The Market Price

With that in mind I ask how much our initial bondholders need to discount their suddenly shabby wares to compete with magnificent 8% bond.  It's an ugly, ugly day for them and they're grumbling about how unfair selling $10,000 for $4,000 seems.

Discussion

Some points worth covering here for students with little familiarity with markets.  We talk about how bonds can be traded like stocks and how their prices change with prevailing interest rates.  I candidly admit that we're unlikely to see a sudden lurch from 5% to 8% and that most changes are smaller.  It seems to work well for helping students without much background knowledge of finance see the time value of money in a more approachable way.

It's worth pointing out that this is also a very simplified way of looking at it.  The ultimate returns to think about would also include the time value of the money received in each year from the bond's interest payments.  For example, the $800 in year three is worth much more than the $800 to come later in year 17.

If you want to cover call risk, simply run the exercise in reverse.  Start the bondholders out with an 8% bond and then change the rates to 5%.  Make the class the corporation and ask if they would like to refinance and keep more of that money for their shareholders.

 

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Comments

Aren't you ignoring the time value of money by simply discounting the original bond by $6000?

Posted by: Bondo | Mar 29, 2018 9:49:21 AM

Yes. It's definitely simplified. It just looks at the cash flow. I'll point that out.

Posted by: Ben Edwards | Mar 29, 2018 9:58:12 AM

Really, really great exercise. I slog through this every year, and I'm definitely going to steal this. Thanks!

Posted by: Frank Snyder | Mar 30, 2018 8:43:34 AM

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