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Lecture 4-BONDS and Yield Curve

Lecture 4-BONDS and Yield Curve

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KVShenai, ia 07
1
Investment Management and Capital Markets
Lecture 4: Yield Curve and Bond Valuation
Definitions
Yield Curve
Bond Valuation
The term structure
A Bond is an instrument which pays fixed amounts (usually) of interest
(called a coupon) on a regular basis, over its life and is redeemed at par
value (usually) at maturity, by the issuer .
C1
C2
C3
C4
C5
Ct
R
0
1
2
3
4
5
t
P
t year coupon paying bond
As the cash flows on a fixed coupon paying bond are fixed in time, the
market price (present value) of such an instrument varies according to the
interest rate environment.
Money market securities have a maturity of < 1 year;
Capital market securities have a maturity of > 1 year.
Types of Bonds
The interest payment on bonds is referred to as `coupon’ and is fixed on the face
value of the bond at the time of issue. Coupon payments are semi-annual usually
(though you should assume one annual payment unless otherwise stated in this
course.)
The most common type of bonds pay fixed interest and such bonds are called
straights or vanillas.coupon
Some bonds do not pay any interest at all , and such bonds are called zero coupon
bonds. Zero coupon bonds sell at a deep discount to their par values because all the
benefit from holding the bond is realised at maturity.
Some Bonds link their coupons to market interest rates and such bonds are called
floating rate notes
KVShenai, ia 07
2
Some bonds link their interest payment to the retail price index and such bonds are
called index linked bonds. The return on Index linked bonds is closer to `real interest
rates.’
Bonds which allow the holder to exercise an option to convert into equity are called
convertible bonds.
Bonds which have no redemption date are called consols, irredeemables or
perpetuals.
Debentures are bonds secured against some assets.
Bonds redeemable at the option of the issuer are `callable’ while bonds redeemable at
the option of the holder are `puttable.
Gilts are Bonds issued by the British Government.
Bonds issued by corporates are corporate bonds.
Eurobonds are bonds sold internationally in the domestic currency of a country.
Strips are securities which result from breaking down a security into various
constituents which are sold off seperately. The usual way in which this is done is to
sell off each future coupon payment and the redemption amount for its present value.
Why are Gilts so much in demand?
Risks
The holder of a bond has default risk; ie the risk that the issuer will not honour
payments on the bond. It is also called the credit risk.
The two main credit rating agencies areM o o d y s and Standard and Poor’s.
The annexure is a typical extract.
Note the distinction between
`investment grade’:
> Baa, Moody’s or > BBB S&P
`non-investment grade’: < Ba , Moody’s or < BB S&P Bonds with lower credit
ratings have a higher default risk and risk premium.
Non-investment grade bonds are also known as junk bonds.
KVShenai, ia 07
3
Definitions of various yields terms
The Spot rate refers to the yield (IRR) of a `pure discount’ or zero coupon bond
of that maturity.
R
0
1
2
3
4
5
6
P
6 year zero
P = R / (1+ st)t
ie
st
=t
√√
( R/P) - 1
where
st = spot yield (rate) for period `t’
P = the Market Value of the Bond
R = the redemption amount on the bond (amount at maturity)
The yield curve is a plot of the spot yields of zero coupon bonds of different
maturity.
In general, a Bond makes regular payments of interest (coupon) to the holder over a
period of time.
R
C1
C2
C3
C4
C5
Ct
0
1
2
3
4
5
t
P
t year coupon paying bond
The Market price of a bond is the present value of various payments made by the
bond and is arrived at by discounting the various payments on the bond by the
related spot rate.
IeP
= C1/(1+ s1) + C2/( 1+ s2)2 + ….. (Ct + R)/ (1+ st)t
=Σ Cn/ (1+st)t
+ R / (1+st)t
Ct = the coupon payment at time `t’

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