Chapters 10

Copyright 2010 by The McGraw-Hill Companies, I nc. All rights reserved. McGraw-Hill/I rwin
10.1 Bond Characteristics (revise FM)
Revise 2.1 and 2.2 of chapter 2 on your own.
Fixed income/debt securities = a claim on a
specified periodic stream of income
Face or par value or principal value
Maturity date
Coupon rate
Variable or fixed
Zero
Review with a video:
http://www.youtube.com/watch?v=ftsNgtx2haY
10.2 Bond Pricing & Yields

a) Bond Price for a corporate bond:
C = Coupon = 10%, interest rate r = YTM = 12%, Maturity = N
or T = 10 years, P = price, Par = $1,000
What is the bonds price using semiannual compounding?
2N
2N
1 T
T
r) (1
Par
r) (1
$C
P
+
+
)
`

+
=

=
{ } $885.30 $311.80 $573.50 P = + =
64.8%
35.2%
20
20
1 T
T
) 06 . (1
$1,000
) 06 . (1
$50
P
+
+
)
`

=

=
10-3
Bond Pricing Between Coupon Dates
The flat price or quoted price assumes the
bond is purchased on a coupon payment
date.

If the bond buyer purchases a bond
between payment dates the buyers
invoice price = flat price + accrued interest.

10-4
Bond Pricing Between Coupon
Dates


A bond has a flat price of $925.30 and an annual coupon of
$42.50. 160 days have passed since the last coupon
payment and there are 182 days separating the coupon
payments. What is the bonds invoice price?
Annual Coupon$ Days since last coupon payment
Accrued Interest *
2 Days between coupon payments
=
$42.50 160
Accrued Interest * $18.68
2 182
= =
Interest Accrued Price Flat price Invoice + =
$943.98 $18.68 $925.30 price Invoice = + =
10-5
1. Yield to Maturity (YTM): The discount rate
that makes the present value of a bonds
payments equal to its price
e.g. Find the YTM for a 8% coupon, 30-year
bond selling at $1,276.76





What are the assumptions of this calculation?
10.3 Bond Yields
2N
2N
1 T
T
r) (1
Par
r) (1
$C
P
+
+
)
`

+
=

=
60
60
1 T
T
r) (1
$1,000
r) (1
$40
76 . 276 , 1 $
+
+
)
`

+
=

=
% 2 3x r =
10-6
Q1. A coupon bond which pays interest of 4%
annually, has a par value of $1,000, matures in 5
years, and is selling today at $785. The actual
yield to maturity on this bond is _________.
1. 7.2%
2. 8.8%
3. 9.1%
4. 9.6%
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Q2. You purchased a 5-year annual interest coupon bond
one year ago. Its coupon interest rate was 6% and its par
value was $1,000. At the time you purchased the bond, the
yield to maturity was 4%. If you sold the bond after
receiving the first interest payment and the bond's yield to
maturity had changed to 3%, your annual total rate of
return on holding the bond for that year would have been
approximately _________.
1. 5%
2. 5.5%
3. 7.6%
4. 8.9%
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Alternative Measures of Yield
2. Current Yield
Annual dollar coupon divided by the price; excludes
capital gain or loss
3. Yield to Call
Call price replaces par
Call date replaces maturity
4. Holding Period Yield (HPY)
use actual reinvestment rate on coupons; instead of
YTM
Considers any change in price if the bond is sold prior
to maturity
10-9
Bond Prices and Yields
Prices and Yields (required rates of return)
have an inverse relationship (see fig. 10.3).
When yields get very high, the value of the bond
will be very low.
When yields approach zero, the value of the
bond approaches the sum of the cash flows.
Note the curvilinear relationship between bond
prices and yields.
10-10
Figure 10.3 The Inverse Relationship Between Bond Prices
and Yields:
10-11
Fig 10.4 Yield to Call Illustrated
10-12
Figure 10.5 . The future value of the coupons depends on the rate of
return when the coupons are reinvested. An investor will not earn the
promised yield unless they reinvest the coupons at the promised YTM.
10-13
Reinvestment Risk
10.4 Bond Prices Over Time
Premium Bond
Coupon rate exceeds yield to maturity
Bond price will decline to par over its maturity

Discount Bond
Yield to maturity exceeds coupon rate
Bond price will increase to par over its maturity

Can you explain why these price change will
occur?
Refer to figure 10.6
10-14
Figure 10.6 Premium and Discount
Bonds over Time
10-15
Q3.Consider a 5-year bond with a 10% coupon
rate selling at a YTM of 8%. If interest rates
remain constant, the price of the bond at maturity
will be __________.
0 of 40
1. Higher
2. The same
3. Lower
4. Face value
Zero-coupon bonds and Treasury Strips
Zero-coupon Bond
Sell at discount (Interest type = discount).
One cash-flow payment (= principal value) at maturity.
e.g. U.S. Treasury bills.

Treasury STRIPS are longer-term zero-coupon
bonds.
eg. A 20-year bond with face value of $20,000 and 10%
coupon rate is stripped into its principal and 40-semi-
annual coupon payments.
Each of the 41 securities have its own maturity date and trades
separately with distinct ID until its maturity date at prices determined
by the market.
10-17
10.5 Default Risk and Bond Pricing
Default risk
Credit rating: Investment grade versus
speculative grade

Determinants of bond credit rating
Coverage ratio: times-interest-earned ratio
Leverage ratio : Debt to equity ratio
Liquidity ratios: current ratio and quick ratio
Profitability ratios: ROA, ROE
Cash flow-to-debt ratio
10-18
Credit Default Swap
Skip bond indentures and yield-to-maturity and
default risk

Credit Default Swap (CDS)
Insurance policy on the default risk of a corporate
bond.
Suppose a BB-rated bond bundled with CDS is
effectively equivalent to a AAA-rated bond.
Price of CDS approximates the yield differences
between the BB-rated bond and the AAA-rated bond.
10-19
Q4. Which of the following changes will increase
the YTM on a bond?
0 of 40
1. Increase in times-interest-
earned ratio.
2. Decrease in debt-equity
ratio.
3. Decrease in quick ratio.
4. Increase in current ratio.
Q5. Which of the following will NOT improve the
credit rating of a bond?
0 of 40
1. Add a CDS to the bond.
2. Increase in equity value
relative to debt value.
3. Decrease in current ratio.
4. Increase in ROA.
10.6 Term structure of interest rates
asianbondsonline.adb.org/singapore.php
Singapore Treasury Bills and Bonds
10.6 Theories of the Term Structure
Expectations
Long term rates are a function of expected future short
term rates
Upward slope means that the market is expecting higher
future short term rates
Downward slope means that the market is expecting
lower future short term rates

Liquidity Preference
Upward bias over expectations
The observed long-term rate includes a risk premium

10-23
Figure 10.13 Returns to Two 2-
year Investment Strategies
10-24
Forward Rates Implied
in the Yield Curve
) 1301 . 1 ( ) 11 . 1 ( ) 12 . 1 (
) 1 ( ) 1 ( ) 1 (
1 2
1
1
=

= + + +

f y y
n n n
n n
For example, using 1-yr and 2-yr rates
Longer term rate, y
n
= 12%
Shorter term rate, y
n-1
= 11%
Forward rate, a one-year rate in one year
from now = 13.01%
10-25
Figure 10.14 Illustrative Yield Curves
10-26
Figure 10.15 Term Spread

10-27
Q6. The yield curve is upward-sloping. Which of
the following statements could be valid?
I. Investors expect short-term interest rates to be flat
according to the expectations hypothesis.
II. Investors expect a larger liquidity premium for longer-
term investments.

0 of 40
1. I only
2. II only.
3. I and II only.
4. None of the above
Q7. One, two and three year maturity, default-free,
zero-coupon bonds have yields-to-maturity of 7%,
8% and 9% respectively. What is the implied one-
year forward rate for the second year?
1. 2%
2. 8%
3. 9%
4. 11%
0 of 40
Q8. One, two and three year maturity, default-free,
zero-coupon bonds have yields-to-maturity of 7%,
8% and 9% respectively. What is the implied one-
year forward rate for the third year?
0 of 40
1. 9%
2. 10%
3. 11%
4. 12%
Q9. One, two and three year maturity, default-free,
zero-coupon bonds have yields-to-maturity of 7%,
8% and 9% respectively. What is the implied two-
year forward rate for year 2?
0 of 40
1. 8%
2. 9%
3. 10%
4. 11%
Q10. Based on your answers to Q7- Q9. Which of the
following statements are true?
I. The yield curve is rising due to falling future short-term rates.
II. The yield curve is rising due to constant future short-term
rates.
III. The yield curve is rising due to rising future short-term rates.

0 of 40
1. I only
2. II only
3. III only
4. None of the above