Taming Volatility

By Pickering, C. J. | Independent Banker, January 1999 | Go to article overview

Taming Volatility

Pickering, C. J., Independent Banker

Avoid surprises by understanding price volatility before purchase

Price volatility is one of the most important characteristics of any bank's portfolio investments. In fact, with interest rates moving rapidly and erratically, price volatility has become an even more crucial factor in today's investment environment.

This month's column gives bank investment managers some rules-ofthumb to help determine relative price-volatility differences among various investment products.

TAKE A GUESS

First, under cover of darkness and strict secrecy (and without looking at someone else's answers!), take your best guess at how the following list of securities rank in terms of price volatility. Put a number 1 beside the most price-volatile instrument and a number 6 by the least volatile. The numbers that fall between 1 and 6 should indicate the corresponding degree of volatility for the remaining instruments.

Bond prices are determined by calculating the present values of the subject bond's cash flows. Table I shows the present values of a twoyear Treasury with a 4 percent coupon calculated at market rates of 4 percent and then at 5 percent. Columns A and B show semi-annual payments of \$2,000 in each of periods 1 through 4, plus the \$100,000 principal payment in period 4.

The present values calculated in Column C show that a two-year Treasury with a 4 percent coupon is worth \$100,000 (par) when two-year market rates are at 4 percent. Column D shows that the same two-year Treasury will be worth only \$98,096 (98.10) if two-year market rates go up to 5 percent.

Any bond price, regardless of how simple or complex the bond may be, is determined by calculating the present value of that bond's cash flows. The tricky part is that callable securities and amortizing securities can have changing cash flows with or without rate changes. In these cases, the prices are the present values of the projected cash flows.

EXAMPLES TO CHEW ON

The price volatility of tax-free municipal bonds is about two-thirds that of comparable taxables. Table II on page 15 illustrates the tax effect on prices. Assume that a 6 percent taxable and a comparable tax-free of 4 percent (6 percent minus 34 percent tax equals approximately 4 percent) are purchased at the same time. The next day, taxable rates go to 9 percent. The new, comparable tax-free rate will be 6 percent (9 percent minus 34 percent tax equals approximately 6 percent).

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