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Bond Valuation
Removal of errors and omissions, if any, in this ppt are your
responsibility
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Bond valuation
Definition
Terminology
Bond Valuation
Yield & YTM
Term Structure
Time & Interest Rate Changes
Malkiels Theorems
Duration
Convexity

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Definition
A bond is a security that offers a series of fixed
interest payments, and a fixed principal payment
at maturity

It is an IOU that obligates the issuer to pay to the
bondholder a fixed sum of money at the bond's
maturity (specified date) along with constant,
periodic interest payments

Bonds are also called fixed income securities

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Definition
Who are the issuers ?
Governments Central or State
Public Sector companies
Municipalities
Corporate entities
Annual rather than semi annual CFs
Coupons paid can be different every year
At maturity bond holder may bet the right to buy
stocks of the co.

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Terminology
Face value (par value, principal)
Lump sum amount owed to the bondholder when
the security matures
By tradition, most bonds in the U.S. have a face
value of $1,000
In India generally ` 100
Maturity (term to maturity)
Length of time before the principal has to be paid
Maturities usually range from months to 30 years,
with some long-term ones having maturities of 50
to 100 years
There are even a few perpetuities (consols)
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Terminology
Coupon rate (stated interest rate)
Is the interest rate that is paid to the bondholder
The coupon is set when the bond is issued and is
usually expressed as an annual percentage rate
of the par value
Usually rate is fixed for the life of the bond
Multiply par value by coupon rate to get the
interest amount
Interest (coupon) payments usually occur every
six months, but this can vary

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Terminology
Issue price
The price at which investors buy the bonds when
they are first issued
Issue date
The date of issue of the bond
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Terminology
Bond Risk

Safe investment but not totally risk free.
Default risk possibility of the issuer not making
the principal and interest payments

Inflation risk Since the coupon payments are
fixed bonds are subject to inflation risk

Interest rate risk - bond prices have an inverse
relationship to interest rates - when one rises, the
other falls
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Terminology
Bond Risk

Downgrade risk - more applicable to corporate
bond; sometimes credit rating agencies may lower
the rating based on the prospects of the firm.

Liquidity risk - the market for bonds is considerably
thinner than for stock and it is possible that when
you need to sell a bond, you wont be able to.

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Basis point
A basis point (bp) is 1% of 0.01 or 0.0001

The difference between a rate of 5.00% and 5.01%
is one basis point
The difference between a rate of 5.00% and 6.00%
is 100 basis point



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Bond Valuation
Like any financial asset the market value is the
present value of the expected cash flows

PV of the interest payments +
PV of the Principal

Need to use the appropriate rate for discounting the
cash flows
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Bond Valuation
Consider the following example

A companys bonds have a Rs.1,000 face value
The promised annual coupon is Rs.50
The bonds mature in 10 years
The markets required return on similar bonds is 5%
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Bond Valuation
The present value of the face amount (principal)
= Rs.1,000 x [1/1.05
10
] = Rs.1,000 x 0.6139 =
Rs.613.91

The present value of the coupon payments (annuity)
= Rs.50 x [1 - (1/1.05
10
)]/.05 = Rs.50 x 7.7217 =
Rs. 386.086

The value of each bond = Rs. 1,000 (barring rounding off
errors)
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Bond Valuation
Zero coupon bonds
Does not make coupon payments
Always sells at a discount (a price lower than face
value), so they are also called pure discount bonds
Treasury Bills are U.S. government zero-coupon bonds
with a maturity of up to one year
PV = FV/(1+ r)
n
where FV is the price at which the bond will be
redeemed (also the face value, par value)
r is the required rate of return, opportunity cost or
the rate on an alternate investment of similar risk
n is the number of years to maturity
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Bond Valuation
Suppose that a one-year, risk-free, zero-coupon
bond with a $100,000 face value has an initial
price of $96,618.36. The cash flows would be

Although the bond pays no interest, the
compensation is the difference between the initial
price and the face value
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Bond Valuation
n
k
M C
k
C
k
C
k
C
P
) 1 (
....
) 1 ( ) 1 (
) 1 (
3 2

Where

P = bond price at time zero (PV)
C = coupon payment
M = amount at maturity (principal)
k = appropriate required return (discount rate)
n = life of the bond

For a coupon paying bond
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Bond Valuation
n
k
M C
k
C
k
C
k
C
P
) 1 (
....
) 1 ( ) 1 (
) 1 (
3 2

Notice that the price of a bond can be obtained using

the annuity formula

All the coupon payments can be valued as annuity
and the principal amount can be discounted
appropriately for n time periods

For a coupon paying bond
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Bond Valuation
In general for a zero coupon bond with maturity n

required rate r = (FV/PV)
(1/n)
1

This rate is known as the yield to maturity (YTM) for
the zero coupon bond

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Yield & YTM
Definition:

Current yield = Annual coupon interest / Market price

For the example for an annual 10% coupon bond
selling at Rs.1250 the current yield =100/1250 = 8%

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Yield & YTM
Just as in the annuity we are solving for the rate
given the price, coupon and maturity

The rate or the yield to maturity is the compound
annual return to an investor and considers all
bond cash flows coupon and principal

It is the bonds IRR based on current prices

In other words it is the single rate that when used
to discount a bonds cash flows (coupons and
principal) gives us the bonds market price
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Yield & YTM
YTM can be computed by

Interpolation (trial and error by yourself) - start
with a value and keep changing it

Financial calculator (may be like Excel) can
use solver or IRR function

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Yield & YTM
YTM approximation
0.6P 0.4M
P)/n (M C

Approx. formula.
Used to determine if you are
in the range
C = coupon
M = maturity value
P = current price
n = no. of years
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Yield & YTM
The computation of the YTM implicitly assumes that the
received interest is reinvested at the same rate

In other words, if the bond pays a Rs.100 coupon and
the YTM is 8%, the calculation assumes that all of the
Rs.100 coupons are invested at that 8% rate

If market interest rate falls, reinvestment would be at a
lower rate resulting in a realized YTM lesser than
promised/assumed in the beginning

If market interest rates rise, reinvestment would be at a
higher rate resulting in a realized YTM higher than
promised/assumed in the beginning
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Term Structure
Why do we see different rates for different
maturities?

Specifically, why is the one-year rate different from
the two-year rate and so on.

These are called the spot rates

These spot rates are a way of expressing the interest
rates over a period of time (also called zero coupon
yield curve)
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Term Structure
Term Structure (ZCYC) of Interest rates is the
relationship between interest rates in an economy and
the term to maturity; this forms the basis for valuation of
all Fixed Income Securities (FIS)
Each CF is thus discounted at the interest rate
associated with the relevant time to maturity
There is only one pricing kernel in the economy the
zero coupon curve
Everyday you get a new yield curve
This has become more important since the reforms in
1991 which marked a gradual shift to market related
interest rates for government borrowings


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Term Structure
Basically for a coupon paying bond

This means that the coupon payments are
discounted at different rates
However, the YTM provides that one rate that
produces the same PV as produced by r
1
,r
2
, r
n
YTM is sort of an average of the spot rates but
like any average it may hide some important
information (eg. in the book on why YTM may be misleading, if not
used correctly)
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Term Structure
Spot Rate - The actual interest rate today (t=0)
Forward Rate - The interest rate, fixed today, on a loan
made in the future at a fixed time
Future Rate - The spot rate that is expected in the future
Yield To Maturity (YTM) - The IRR of the bond
YTM (r)
Year
1981
1987 & Normal
1976
1 5 10 20 30
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Effect of Inflation
What happens when you have inflation?

The r (rate, opportunity cost) is in nominal terms and
moves in sync with inflation

When inflation increases or decreases r moves by
the same amount

This change in r alters the present value (price) of
the bond


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Time & Interest Rate Changes
Consider the following example

A companys bonds have a Rs.1,000 face value
The promised annual coupon is Rs.50
The bonds mature in 10 years
The markets required return on similar bonds is 5%
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Time and Interest Rate Changes
Suppose immediately after the purchase, inflation
goes up by 4% - what happens to the discount rate
(opportunity cost of capital)?

Goes up the same amount. So the discount rate
is (approx. 9%) 9.2%(using the actual formula)

The PV of the annuity = 318.077
The PV of the face amount (principal) = 414.738
Bond vale = 732.815

When the interest rate goes up the bond price
will go down
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Time and Interest Rate Changes
Suppose immediately after the purchase, there is
deflation by 2% - what happens to the discount rate
(opportunity cost of capital)?

Goes down the same amount. So the discount
rate is (approx. 3%) 2.9% (using the actual
formula)....

The PV of the annuity = 428.695
The PV of the face amount (principal) = 751.357
Bond vale = 1180.52

When the interest rate goes down the bond price
will go up
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Time and Interest Rate Changes
Bond prices are inversely related to interest
rates (required rate, opportunity cost)

A bond sells at par only if its coupon rate equals
the required return

A bond sells at a premium if its coupon is above
the required return

A bond sells at a discount if its coupon is below
the required return
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Time and Interest Rate Changes
Bond price approaches par as the bond
approaches maturity, irrespective of the coupon
rate or the interest rate
Maturity
Bond price
Par
value
Premium bond
Discount bond
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Malkiels Theorems
Consider the following four bonds priced initially to
yield 8%

8% coupon, 10 years to maturity, initial price = 1000
8% coupon, 25 years to maturity, initial price = 1000
5% coupon, 10 years to maturity, initial price = 798
5 % coupon, 25 years to maturity initial price = 656

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Malkiels Theorems
1 2 3 4
Chg in yield
from 8%
Chg (bp) 8%, 10yrs 8%, 25yrs 5%, 10 yrs 5%, 25 yrs
5.00% -300 23.17% 40.15% 25.20% 45.33%
7.00% -100 7.02% 11.13% 7.62% 12.39%
7.99% -1 0.07% 0.10% 0.07% 0.11%
8.01% 1 -0.07% -0.10% -0.07% -0.11%
9.00% 100 -6.42% -9.43% -6.94% -10.36%
11.00% 300 -17.67% -24.37% -19.04% -26.47%
Percentage price change for bonds with different
The initial yield is 9%
The first two columns indicate the illustrative new yield (%) and change in yield (bp)
Columns 1-4 show the percentage change in bon price for different coupons and maturities
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Malkiels Theorems
a. Bond prices move inversely with interest rates
b. For a given bond the absolute rupee price
increase caused by a fall in yields will exceed
the price decrease caused by an increase in
yields of the same magnitude
c. Bonds with longer maturity experience greater
percentage change for a given change in
interest rates
d. The price sensitivity of bonds increases with
maturity but it increases at a decreasing rate
e. Bonds with lower coupon rates experience
more % changes for a given change in interest
rates
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Malkiels Theorems
Price change (volatility) is greater the lower the
coupon rate

Price change is greater the longer the term to
maturity
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Malkiels Theorems
Implication of Malkiels Theorem

A bond buyer in order to receive the maximum
price impact of an expected decrease in interest
rates should purchase low coupon long maturity
bonds

If an increase in interest rates is expected an
investor contemplating their purchase should
consider those bonds with large coupons or short
maturities or both
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Malkiels Theorems
Consider two bonds
A 9.5% 8 yr bond and
B 11% 9 yr bond
Both have an YTM = 10%
Which one is more interest rate sensitive?

To address such questions Malkiels theorems
may not be sufficient
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Duration
Duration

Combines the effects of differences in coupon
rates and differences in maturity

Measures the sensitivity of the bond to small
changes in the underlying risk factors


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Duration
P
y) (1
.
y) (1
t.c
Duration
1 t
n t

n
M n
Where
t = number of periods in the future
C = cash flow to be delivered in t periods
n= term-to-maturity &
y = yield to maturity
M= par value
P = current price
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Duration
Weighted sum of the number of periods in the future of each
cash flow, (weighted by respective fraction of the PV of the
bond as a whole): cash flows are weights and time is weighted
by cash flows

Note that for a zero coupon bond, duration equals maturity
since 100% of its present value is generated by the payment
of the face value, at maturity

Duration is shorter than maturity for all bonds except zero
coupon bonds

Solve for the previous example
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Duration
Trading strategies using Duration

Longest-duration security provides the maximum price
variation
If you expect a decline in interest rates, increase the
average duration of your bond portfolio to experience
maximum price volatility
If you expect an increase in interest rates, reduce the
average duration to minimize your price decline
Note that the duration of your portfolio is the market-value-
weighted average of the duration of the individual bonds in
the portfolio
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Duration
Dur Mac
1
1 1

y p dy
dp
(Modified Duration)
MD can be interpreted as the approximate percentage
change in the price of a bond per unit change in yield
when the change in the yield is small

Can be considered as a change in the duration for
small changes in the yield
Modified Duration
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Duration
(Dollar Duration)
dy P MD dp
y
y p dy
dp
* *
) 1 (
duration Macaulay
MD
duration Mac
1
1 1

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Time & Interest Rate Changes
Consider the following example

A companys bonds have a Rs.100 face value
The promised annual coupon is Rs.10
The bonds mature in 5 years
The markets required return on similar bonds is 10%
Compute the Mac Duration
Compute the Modified Duration
If yield increases to 10.10%, how does the bond
price change?

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Duration
Calculation steps

Find Macaulay duration of bond

Find modified duration of bond

Recall that when interest rates change, the
change in a bonds price can be related to the
change in yield according to the rule:
dy MD
P
dp

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Convexity
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Convexity
The convexity is the measure of the curvature and is the
second derivative of price with respect to yield (d
2
P/dy
2
)
divided by price

Convexity is the percentage change in dP/dy for a given
change in yield
P
dy
P d
2
2
measure Convexity
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Convexity


2
n
1 t
2
) 1 (
1
Convexity
y P
y
CF t t
t

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Convexity
2
) ( measure convexity
2
1
dy dy MD
dy
dP

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Convexity
Application of Convexity

Convexity is also useful for comparing bonds

If two bonds offer the same duration and YTM but one
exhibits greater convexity, changes in interest rates will
affect each bond differently
Also, bonds with greater convexity will have a higher price
than bonds with a lower convexity, regardless of whether
interest rates rise or fall
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Problems
Banu wishes to estimate the value of an asset expected to provide
cash inflows of Rs.3,000 per year at the end of years 1 through 4 and
Rs.15,000 at the end of year 5
Her research indicates that she must earn 10 percent on low-risk
assets, 15 percent on average -risk assets, and 22 percent on high-
risk assets

(a) Determine what is the most that Banu should pay for the asset if it
is classified as (1) low risk,(2) average risk, and (3) high risk

(b) Suppose Banu is unable to assess the risk of the asset and wants
to be certain shes making a good deal, on the basis of your findings
in part (a), what is the most she should pay? Why?

(c) All else being the same, what effect does increasing risk have on
the value of an asset? Explain in light of your findings in part (a)
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Problems
Trico bonds have a coupon rate of 8%, a par value of
$1000, and will mature in 20 years. Coupons are paid
yearly. You require a return of 7%
What price would you be willing to pay for the bond?
What happens if you pay more for the bond?
What happens if you pay less for the bond?
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Thank you!