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US & China growth intertwined

, August 27, 2012, 0 Comments

The Basic

In Corporate Finance 101 course every MBA grad would have come across the price yield relationship graph under bond valuation section. As shown below the relationship between bond price and yield is inverseand it is quadratic in nature. The two major factors that determine the convexity of the relationship are the coupon rate and time to maturity. The curve becomes more convex as coupon and / or time to maturity increases and the curve flattens as these two factors decrease. Due to relationship of quadratic in nature the first derivative of the relationship doesn’t remain constant and as shown in the figure below the first derivative of the relationship keeps decreasing as the yield decreases. The slope at point A is steeper than the slope at point B which means that a basis point move in yield at A will have higher impact on bond price than a basis point move at B i.e. when yield increases bond price at A will fall at faster rate than at B.

The Yields

As on Friday close 5 year yield is at 0.72% while 10 year is quoting 1.68% and these are close to the lowest readings since 1990. The lowest yieldssince 1990 for 5 year and 10 year maturities are 0.56% and 1.43% respectively were registered on July 25th, 2012.Unless the economy slides dismally the chance of yield declining aggressively is very low. With talks of next round of QE and inflation, especially food inflation, creeping up the chances of yields increasing are on rise. Since currently yields are closer to point A as marked in the figure above we can expect bond prices to decline sharply when yield increases, a 100 basis point increase in yield of 10 year will wipe out 14% of bond’s price.