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confidential, legally privileged and protected by law; and may not, without the prior written consent of the chief executive officer of the Exchange, be disclosed to
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Copyright Bond Exchange of South Africa











AN INTRODUCTION TO BOND PRICING
IN LAYMANS TERMS













Submitted to Bond Exchange of South Africa
Prepared by Mark Raffaelli
Date August 2005
Document type Working Paper / Report
Status Final
Version 0.1


Bond Exchange of South Africa Page 2 of 7
An Introduction to Bond Pricing in Laymans Terms
August 2005
AN INTRODUCTION TO BOND PRICING IN LAYMANS TERMS
A bond can simply be described as a long term loan. Most people will have borrowed money
at some stage in their lives and will have paid interest on the amount that they borrowed.
When a person lends or invests money he or she is giving up the opportunity to convert those
funds into goods and services immediately which must be compensated for. The concept of
interest is the basis of how the borrower compensates the lender for the amount borrowed.

Furthermore the lender faces uncertainty with respect to when the money is repaid. This
uncertainty is called risk which has to be included in the compensation amount. There are
several types of risks the lender will face; some of these risks are:
Inflation
Default of the borrower. Default is the failure of the borrower to repay the debt for
reasons that are not technical or temporary but usually as a result of bankruptcy.
Government policy e.g. taxation on interest etc
The amount of time to repay the debt i.e. the longer the period, the higher the
compensation one would require.

In South Africa, when one traditionally borrows money, we are used to having the interest rate
vary with the Prime rate. Therefore, if the interest rates go up we have to pay more based
on the amount we borrowed. Reciprocally, if interest rates should reduce, we would pay less
on the amount we borrowed. However, in the bond market the norm is for the interest rate to
be fixed over the term of the loan (although many bonds do exist whose interest rate
fluctuates with an index.) Therefore, with a fixed interest rate, the payments made by the
borrower would remain the same irrespective of an increase or decrease in interest rates. In
the bond market, the interest rate that that the issuer (borrower) pays to the bondholder
(lender) is referred to as the coupon rate of the bond.

The coupon rate is generally set when the bond is issued. Naturally, when an issuer seeks
to borrow money, they want to pay the lowest possible interest. Similarly, the investor wants
to receive the higher possible interest rate given the relative risk of the issuer. It is
important to stress the relative risk of an issuer, because with bonds, our key concern is
whether we are going to get our money back. Therefore issuers are typically graded and
grouped into categories based to their perceived capacity to repay the debt. In addition, the
issuer has to take into account the opportunity cost of the investor i.e. they need to look at the
prevailing interest rate returns in the economy for a similar issuer for a loan with a similar
maturity date.

Generally, issuers set the coupon to where the investor \ market would be prepared to lend
money (buy the bond) such that the issuer would have to pay the same amount back on the
maturity date (not forgetting the interest payments). One has to ask the question of if the
prevailing rates in the economy are at 10% for a specific maturity (taking into account the
relative risk of an issuer), and the issuer issues the bond with a coupon of 6%, would anyone
buy the bond (lend the money)? Naturally, one would normally answer No, because you can
get 10% interest rate from a similar issuer at a similar maturity in the market. However, the
actual answer to the question in practice is a qualified Yes! Since the investor can receive a
Bond Exchange of South Africa Page 3 of 7
An Introduction to Bond Pricing in Laymans Terms
August 2005
higher interest rate in the market, instead of lending R100 (buying the bond for R100) and
receiving R100 back at maturity with coupon payments of R6 (6% of R100), the investor will
instead only lend the issuer say R90, still receive the fixed coupons of R6 but will receive
R100 back at maturity. Quite clearly the opposite can also happen, where the same issuer
issues a bond at a rate of say 15% when the prevailing rates in the economy are at 10% for a
specific maturity (taking into account the relative risk of an issuer). In this case, the investor \
market would be willing to pay more (lend more) for the bond now, say R109, receive
coupons of 15% (R15) and only receive R100 back on maturity date.

In the financial markets, we use the term future value to refer to how much R1 will grow to
after one or more periods given a certain interest rate. Reciprocally, we use the term present
value to refer to how much, we need to invest today, given the prevailing interest rate, to
reach a certain sum of money in the future. Present Value is just the reverse of future value
whereby we establish what the future value of a sum of money promised is worth in todays
terms - this process is known as discounting i.e. we would discount the amount of cash
back to the present given a specific interest rate. Another way of looking at it is that the
present value is that value which, if invested at the currently available interest rate until the
date of promised payment, would result in a future value equal to the sum promised.

The price of any bond is equal to the present value of the expected cash flows. In bond
terminology, it is the present value of the coupons and the principal (the principal is also
known as the nominal amount or the amount the bondholder will receive at maturity).

The interest rate used to determine the present value of the coupons and the principal is
known as the yield to maturity of the bond. Dont forget, with fixed coupon bonds, the coupon
is set at issuance date and remains fixed for the life of the bond, however, the relative risk of
the issuer can change on any day and the prevailing interest rates based on demand and
supply change all of the time. Therefore, the interest rate which reflects the required return \
yield of the investor, taking into account the changing risk profile of the issuer and demand
and supply is that of the yield to maturity. The yield to Maturity is the same as the Internal
Rate of Return (IRR) of the investment i.e. it is the interest rate that will make the present
value of the cash flows equal to the price or the initial investment.















Bond Exchange of South Africa Page 4 of 7
An Introduction to Bond Pricing in Laymans Terms
August 2005








By discounting the coupons and the principal back to the present using the yield to maturity
and adding up the values, we find the market price of the bond. The Market Price is the
amount of cash we pay to purchase the bonds (also known as the Consideration). In the
above example, we discount each coupon (R5) as well as the R100 nominal amount back to
the present using the YTM of 10%. Mathematically this is represented as:

5 4 3 2 1
2
% 10
1
5 100
2
% 10
1
5
2
% 10
1
5
2
% 10
1
5
2
% 10
1
5
100
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R R R R R R
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We express the price of a bond in South Africa per R100. This makes life very easy to
calculate the value of say R1 million bond because we simply multiply the price of bond by R1
million and divide by R100.In Bond terminology, the market Price expressed per R100
nominal, is known as the All in Price of the Bond (AIP). The All in Price is also called the
dirty price of full price.


R105
+R4.76
0 1 2 3 4 5
R5 R5 R5 R5
+R4.54
+R4.32
+R4.11
+R82.27
R100
10% YTM, maturity = 2.5 years, 10% coupon (i.e. 5%of
R100 every 6 months), nominal amount of R100
Bond Exchange of South Africa Page 5 of 7
An Introduction to Bond Pricing in Laymans Terms
August 2005
In the above example, the coupon rate of the bond equals the YTM; when this happens, we
say that the bond is trading at par i.e. the price equals the nominal value \ par value (that is
the principal amount we are due to receive at maturity).

When the YTM is greater than the coupon rate, the price will be less than the par value and
we say that the bond is trading at a discount.





When the YTM is less than the coupon rate, the price is greater than the par value (trading at
a premium.)


+R4.71
0 1 2 3 4 5
R5 R5 R5 R5
+R4.45
+R4.20
+R3.96
+R78.46
R95.78
10% coupon & YTM = 12% for a 2.5 year bond.
Bond Exchange of South Africa Page 6 of 7
An Introduction to Bond Pricing in Laymans Terms
August 2005

It is important to note that the YTM is not necessarily the same as the actual return you may
receive on a bond. You will only receive a return on a bond equal to the YTM if you hold the
bond to maturity and invest the coupons at the same rate as the YTM you bought the bond at!

It is also important to note that there is an inverse relationship between the yield and the price
of a bond i.e. as the yield goes up, the price of the bond goes down. This leads to the rule
with bonds when trading on yield Buy high and Sell low!

Whenever we determine the value of a bond between coupon dates, it is customary to say
that we are pricing the bond in the BROKEN PERIOD. This broken period has however added
complications to our lives because taxation treats capital differently from that of interest.
Therefore, if I sell a bond between coupon dates, exactly how much of the All in Price is
interest already accrued from the next coupon? Accrued interest is a backward looking
measure and is loosely viewed as the amount the buyer must compensate the seller for the
interest earned on the days they owned the bond since the last coupon date, but will not get
as they will not own the bond on the next coupon date (refer to the CUM EX interest period for
the exception) If we subtract the Accrued Interest from the AIP, we are left with the clean
price i.e.
Clean Price (CP) = All in Price Accrued Interest.

In the days before computers, the administration required by an issuer or a depository was
quite onerous with respect to establishing who owned the bond at any one time and therefore
who needs to receive the coupon payment. In order to make this administration easier, a
+R4.81
0 1 2 3 4 5
R5 R5 R5 R5
R105
+R4.62
+R4.44
+R4.27
+R86.30
R104.44
10% coupon & YTM = 8% for a 2.5 year bond.
Bond Exchange of South Africa Page 7 of 7
An Introduction to Bond Pricing in Laymans Terms
August 2005
books closed period was introduced. The books closed period simply allowed the issuers or
central depositaries enough time to establish who the owner of a bond was on a certain date.

In South Africa the books closed period was one month prior to the coupon payment date. It is
now 10 days for most bonds. Therefore if the coupon date was the 31st August, the books
closed date would be listed as the 21st August (there are exceptions). The day prior to the
Books Closed date is known as the last date to register (LDR) - this is the date on which the
holders of the bond are designated to receive the coupon. Essentially, the issuer or central
depositary (or settlement agent) will establish who owns the bond on the LDR date and the
coupon will be paid to this person on the coupon date irrespective of whether they actually
own the bond on Coupon payment date.







This books closed period is referred to as the ex-interest period (or just ex period) i.e. the date
when the purchaser of the bond is not entitled to the next coupon. A bond which is trading
cum interest simply means that the purchaser will receive the next coupon the whole
amount.

LCD BCD LDR NCD
EX- Interest CUM Interest
Where:
LDR = Last date to register
LCD = Last coupon date
NCD = Next coupon date
BCD = Books closed date