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Definitions

Yield Curve

Bond Valuation

The term structure

(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

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.

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 1

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.

perpetuals.

Bonds redeemable at the option of the issuer are `callable’ while bonds redeemable at

the option of the holder are `puttable.’

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.

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 are Moody’s and Standard and Poor’s.

The annexure is a typical extract.

`non-investment grade’: < Ba , Moody’s or < BB S&P Bonds with lower credit

ratings have a higher default risk and risk premium.

KVShenai, ia 07 2

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

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.

KVShenai, ia 07 3

Redemption yield (also called the `yield to maturity’ or `ytm’ or the `gry’

gross redemption yield) of a bond is the IRR on the bond.

A strip is a coupon sold on its own. How will it be valued?

The Current Yield or Flat yield of a bond is simply its interest payment divided by

its market price.

CY = Ct / P

The Forward Rate of interest for the period t+1 is the one period

Investment rate between the end of period `t’ and end of period `t+1’.

Note alternatively that that the one period forward rate on a bond can be calculated

from the spot yield of two adjacent periods:

( 1 + S t) t

ie t-1 Ft = ---------------- - 1

( 1 + S t -1) t-1

Yield curves

The spot yield curve plots the spot yields (or zero coupon yields) against term to

maturity. The spot yield curve is also called the Term structure of interest rates.

The ytm curve is a plot of the ytms of bonds of the same maturity over time. It is

usually obtained by regression. ( You will notice in the tutorial how bonds of the same

maturity but different coupons have slightly different ytms based on their cash flows.)

Finally, the forward yield curve plots one period forward rates against term to

maturity.

KVShenai, ia 07 4

Valuing Bonds.

Q A company has issued bonds redeemable at the end of three years from now,

with a coupon of 6.0 % payable annually and redeemable at par. (The par value of a

bond is £ 100 unless mentioned otherwise.). The one year, two year and three year

spot rates are 6%, 8% and 10% respectively.

(ii) Calculate the ytm of the bond.

Answer:

(i) The market value of the bond is the present value of all its payments:

“” second “ : 6/ (1.08)2 = £ 5.14

“” third “ : 6/ (1. 10)3 = £ 4.51

Total £ 90.44

Locate the two rates between which the NPV changes sign and interpolate.

Redemption amount = 100 x 0.772 = 77.200

Total Value = 92.386

Redemption amount = 100 x 0.751 = 75.100

Total Value = 90.022

If you have an irredeemable bond with a 6.0% coupon, and the ytm is 9.823% what

will be its value?

KVShenai, ia 07 5

Theories of the term structure

The term structure of interest rates shows the relationship between short term

and long term spot rates.

interest rates is based on bond yields. Thus the forward interest rate between any

periods can be computed from the spot yields of two adjacent periods and the

spot yield for the period 0-t could be thought of as constructed from one period

forward rates as below:

(1+ S 2 ) 2 = ( 1+ S1 )( 1+ 1 F 2 ) ;

In general:

t-1 F t = one period forward rate between (t-1) and t.

This implies that if a contract is made to roll over one period investments, it is the

same as if an investment had been made for the entire period: ie there are no excess

profits to be made by following either strategy: ` perfect substitutability’. The theory

also states that forward rates are the best indicators of expected future

spot rates.

The Liquidity preference hypothesis states that investors have a preference for

liquidity and therefore they will prefer short term investments as compared to longer

term investments. Therefore they are prepared to accept lower rates of interest for the

short term. Conversely, borrowers have to pay a premium for longer term investors.

Here then a premium term, depending upon the maturity, has to be incorporated to

equate the `t’ period spot yield with the yield constructed from one period forward

rates.

Ie

where `Tn’ is a premium term which increases with the term to maturity.

KVShenai, ia 07 6

The Market Segmentation or preferred habitat theory states that the market is

segmented by different participants who have a preference for different maturities:

banks at the short end and pension funds at the long end. Supply and demand

conditions thus determine the shape of the term structure. This theory explains a

`hump’ noticed often in the yield curve, as there is often not much 09demand for n

medium term maturities.

The effects of inflation could also be kept in mind. A rising yield curve thus implies

higher expectations of inflation in the future (also called the Fisher effect).

Empirical evidence favours the former two theories: the expectations hypothesis

remains the basis of determining what interest rates could be expected to be

while liquidity premiums have been noticed from time to time.

X axis - `term to maturity’

- discount rates

- sourcing finance

KVShenai, ia 07 7

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