Example 1 Consider a 12.5% bond redeemable on 1-7-1997 at a premium of 5%.

If the interest rate prevailing in the market on 1-7-1992 is 15%, at what price will this bond be traded in the market on 1-71992? Example 2 Consider what happens to an investor who needs money only after five years, and decides to hold the bond of Example 1 till maturity, and reinvest the annual interest payments. How much money will he have at the end of 5 years? What happens if immediately after the buys the bond, the interest rate drops to 14%? What if the interest rate rises to 16%? Example 3 Consider an investor who has a holding period of only 3 years. He buys the bond of Example 1 on 1-7-1992, reinvests all interest for three years and sells the bond on 1-7-1995. How much money will he have at the end of 3 years? What happens if immediately after he buys the bond, the interest rate rises to 16%? Example 4 Consider an investor who has a holding period of 4 years. He buys the bond of Example 1 on 1-7-1992, reinvests all interest for four years and sells the bond on 1-7-1996. How much money will he have at the end of 4 years? What happens if immediately after he buys the bond, the interest rate rises to 16%? What if the interest rates drop to 14%?

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Solution 1 The market price of the bond will be Rs. 94.11 which is the present value of the following sequence of cash flows : Date Cash Flow Present Value of cash flows at 15% Net Present Value Solution 2 At the current interest rate, he will have Rs. 189.28 at the end of the 5 years : Date 1-7-93 Cash Flow12.50 Terminal 21.86 Value (at 15%) 1-7-94 12.50 19.01 1-7-95 12.50 16.53 1-7-96 12.50 14.38 1-7-97 117.50 117.50 Total TV 189.28 1-7-93 12.50 10.87 94.11 1-7-94 12.50 9.45 1-7-95 12.50 8.22 1-7-96 12.50 7.15 1-7-97 117.50 58.42

Now assume that immediately after he buys the bond, the interest rate in the market falls to 14%. The terminal value that our investor will have at the end of 5 years now drops to Rs. 187.63 because the reinvestment of the annual interest fetches a lower rate of interest : Date 1-7-93 1-7-94 1-7-95 1-7-96 Cash Flow12.50 12.50 12.50 12.50 Terminal 21.11 18.52 16.25 14.25 Value (at 14%) Similarly, one can show that if interest rates investor will be better off having Rs. 190.96 at instead of Rs. 189.28 previously.
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1-7-97 117.50 117.50

Total TV 187.63

rise to 16%, our the end of 5 years

Solution 3 At the end of 3 years (i.e. on 1-7-95), he will have to sell the bond. What price can he expect to get? At that point the cash flows from the bond will look like this: Date Cash Flow Present Value on 1-7-95 Net Present Value 99.72 Therefore, the bond can be expected to fetch Rs. 99.72 when it is sold after 3 years. The 3 year investor can expect to receive a total of Rs. 143.12 at the end of 3 years. Date 1-7-93 Cash Flow 12.50 Terminal 16.53 Value (at 15%) 1-7-94 12.50 14.38 1-7-95 12.50 12.50 1-7-95 99.72 99.72 Total TV 143.12 1-7-96 12.50 (at 15%) 10.87 1-7-97 117.50 88.85

What happens when the interest rate rises to 16%? It is reasonable to expect that bond prices drop when interest rates rise and vice versa. In this example, the price of the bond at the end of 3 years would drop to 98.10: Date Cash Flow Present Value on 1-7-95 (at 16%) Net Present Value 98.10 The investor can, now expect to receive a total of only Rs. 141.92 at the end of 3 years as against Rs. 143.12 previously : Date Cash Flow Terminal Value (at 16%) 1-7-93 12.50 16.82 1-7-94 12.50 14.50 1-7-95 12.50 12.50 1-7-95 98.10 98.10 Total TV 141.92 1-7-96 12.50 10.78 1-7-97 117.50 87.32

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Solution 4 His sale value on 1-7-96 is simply the present value of Rs. 117.50 receivable after one year; at 15%, this is Rs. 102.17. His terminal value is : Date 1-7-93 Cash Flow12.50 Terminal 19.01 Value (at 15%) 1-7-94 12.50 16.53 1-7-95 12.50 14.38 1-7-96 12.50 12.50 1-7-96 102.17 102.17 Total TV 164.59

If interest rates were to rise to 16%, the sale value of the bond will drop to Rs. 101.29, but he gains from reinvestment of annual interest. The terminal value of the 4-year investor is left virtually unchanged : Date 1-7-93 Cash Flow12.50 Terminal 19.51 Value (at 16%) 1-7-94 12.50 16.82 1-7-95 12.50 14.50 1-7-96 12.50 12.50 1-7-96 101.29 101.29 Total TV 164.62

If interest rates drop to 14%. The 4-year investor gains from a higher sale price of the bond (Rs. 103.07) but his reinvestments fetch him less. Once again, his terminal value is unchanged : Date 1-7-93 Cash Flow12.50 Terminal 18.52 Value (at 14%) 1-7-94 12.50 16.25 1-7-95 12.50 14.25 1-7-96 12.50 12.50 1-7-96 103.07 103.07 Total TV 164.58

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Example Compute the duration of the bond of Example 1 Solution Date 1-7-93 No. of Years 1 Cash Flow12.50 Present 10.87 Value Year x PV 10.87 1-7-94 2 12.50 9.45 18.90 1-7-95 3 12.50 8.22 24.66 1-7-96 4 12.50 7.1 28.59 1-7-97 5 117.50 58.42 292.09 Total

94.11 375.11

We devide the sum of the products (375.11) by the present value (94.11) to get the duration. Duration = 375.11/94.11 = 3.99

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