Discount rate is the rate of interest used to determine the present value of the future cash flows of a project. For projects with average risk, it equals the weighted average cost of capital but for project with different risk exposure it should be estimated keeping in view the project risk.
Yield spread is the difference between the yield to maturity on different debt instruments. Common examples of yield spreads are g-spread, i-spread, zero-volatility spread (z-spread) and option-adjusted spread. Higher yield spread means higher credit risk and vice versa.
Credit risk is a risk that a borrower fails to pay any scheduled interest or principal payment on its debt on time. It depends on the probability of default and the expected loss to the debt holder if default occurs. A debt with higher credit risk has higher yield and lower price.
Black-Scholes option pricing model (also called Black-Scholes-Merton Model) values a European-style call or put option based on the current price of the underlying (asset), the option’s exercise price, the underlying’s volatility, the option’s time to expiration and the annual risk-free rate of return.
An interest rate swap is an over-the-counter derivative contract in which counterparties exchange cash flows based on two different fixed or floating interest rates. The swap contract in which one party pays cash flows at the fixed rate and receives cash flows at the floating rate is the most widely used interest rate swap and is called the plain-vanilla swap or just vanilla swap.
A price-weighted index is a stock market index in which the constituent securities are weighted in proportion to their stock price per share. Price movement of companies with higher stock price have greater influence on the overall movement of the index.
Modified duration is a measure of a bond price sensitivity to changes in its yield to maturity. It is calculated by dividing the Macaulay’s duration of the bond by a factor of (1 + y/m) where y is the annual yield to maturity and m is the total number of coupon payments per period.
Convexity of a bond is the phenomena that causes the increase in bond price due to a decrease in interest rates to be higher than the decrease in bond price owing to an increase in interest rates. It represents the change in duration that occurs due to change in bond yield. High convexity means higher sensitivity of bond price to interest rate changes.
Macaulay’s duration is a measure of a bond price sensitivity to changes in market interest rates. It is calculated as the weighted-average of the time difference of the bond cash flows from time 0. A high duration means the bond has a high interest rate risk and vice versa.
Duration-matching is a strategy used to manage interest rate risk that involves matching the duration of the loan with the duration of the asset. Duration is the weighted-average maturity of the cash flows of the debt or asset. While duration-matching doesn’t eliminate the interest rate risk, it can manage the exposure for relatively minor changes in interest rates.