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Bond Pricing - Back of The Envelope
Bond Pricing - Back of The Envelope
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Dirty Price: Price of a bond that the buyer must pay / seller gets = PV of all future cash flows from the
bond
Accrued Interest: Portion of the coupon accrued to the seller if the bond is sold after the issue date and
before a coupon payment date =
The fair price of a bond is given by its Dirty Price and the Clean Price is just the quoting convention that
avoids ‘spikes’ due to Accrued Interest.
Even though it’s merely a convention so not saddled with having to justify its logic, but one can try and
make sense of it in a certain way. (For those who do not want to bother with the whys and hows of it,
may safely ignore what follows.)
Now we show that the definition of the Clean Price as the Dirty Price net of the Accrued Interest is
equivalent to the PV of Coupons (as if) “deserved” by the buyer.
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All we need to do is explain the equivalence for the first coupon, since after the first coupon payment
there are no complications.
To the buyer what ma ers is the coupon received on the coupon payment date. While a part of that
coupon, the accrued interest, can be said to “deservedly” belong to the seller, that amount in our
discussion is deemed paid on the day of the transaction and not on the coupon payment date.
Another way to think about this is to say that we net the coupon amount due to the buyer by the accrued
Interest brought forward to the coupon payment date. Basically what we are doing is bringing both
payments on the same date, i.e. the coupon payment date.
Since Clean Price is the present value of the coupons “deserved” by the buyer, we have:
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Wri en by Vineet
Posted in Teaching: FM
with 2 comments
where is the annual coupon rate, is the yield to maturity, and is the maturity of the bond.
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This formula follows straight from the discounted cash flow model we encountered earlier. The only
difference is that instead of the dividends, we have known coupons from the Government of India. That
is, we are in a world of (default) risk-free interest rates.
I know the summation sign causes that queasy feeling in the stomach for at least a few of us, but, again,
it’s a very useful short-hand. I can only say that more you use it, the be er/more comfortable you’ll get at
it. But, still, in deference to those of us who are not so comfortable at using the summation sign, let’s take
the example of a simple two period bond.
Example: Consider two separate zero coupon bonds maturing at time and , with cash flows
and and prices and respectively. Assuming that the yield to maturity is the same for
both, we may write :
Let’s say our RBI governor Dr. Raghuram Rajan, raises the interest rates, as for example, a couple of days
back by basis points, i.e. by . The question we ask then is, by how much the PV of each cash
flow changes. The natural way to address this question is to use the technology of simple calculus. We
have:
i.e. the percentage change in bond-price to small changes in of of a single cash-flow at time is
. Since, this is also its time to maturity, the word duration is apt. That is, the percentage
change in a year zero coupon bond price to small changes in given by
.
Similarly, one can write the change in the PV of the second zero coupon bond for small changes in as:
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i.e. the percentage change in bond-price to small changes in of of a single cash-flow at time is
. Again, we notice that it is related to its time to maturity, or as can now start calling it,
duration. The duration of a single cash-flow at the end of time is , and then the percentage change
in the bond price to small changes in given by .
That is, irrespective of the cash-flow at time or time , the percentage change in the bond price is
given by . We can now generalize this result to say that the percentage change in the
bond price to small changes in (compounding times a year) is given by:
We define as the Modified Duration. The modified duration represents the percentage
Duration for a coupon-bearing bond can be thought of being as that average time all the money gets
received, i.e. as the weighted average time to maturity as:
The formula for Modified Duration holds not only for single cash-flow but also for a set of cash-
flows, and we can write the Modified Duration for a coupon bearing bond also as:
And now we can measure the percentage change in the bond price to small change in yields using:
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That is, if we know the Modified Duration/Duration of our bonds, to see the percentage change in the
value of the bonds we only need multiply the Modified Duration of our bonds by the change in yields
and we are done. No need to re-evaluate the price of all our bonds for new changed yields. And since
yield changes by the central banks are typically of the order of 25 – 50 basis points only, using Modified
Duration/Duration is not a bad first approximation (why do I say approximation?).
As should be clear, if yields are small, using either Modified Duration and Duration is ok – of course,
using Modified Duration is more precise.
Wri en by Vineet
Posted in Teaching: FM
with 5 comments
Till we began our discussion on bond markets, we had been working with the following pricing
equation with a constant rate of interest, :
But clearly, in the real world we just don’t have one interest rate, but as a visit to any bank website will
tell you, there is a separate rate for each maturity.
Consider a bond that matures at time , pays a cash flow at time , and cash flow at time
. Then, if we knew the rate applicable for each maturity (called the spot rates), we could still price the
bond easily by writing:
where is the one period annualized rate for year, and is the annualized rate for years. A
constant rate that gives the same price as obtained using the correct spot rates is what the market
participants call the Yield to Maturity or YTM. That is, finding YTM involves finding the price of the
bond by using instead a constant rate , , and this gives the following equation:
But which is the ‘right’ way? What comes first, the rate for each maturity and or the YTM ?
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It is the spot rates which are the fundamental quantities, and not the YTM. In fact, just like IRR, YTM is
nothing but a rate that makes the NPV from investment in a bond . So, for our two-period bond
example, is that rate which solves the following equation:
Bootstrapping
In fact, even more fundamental than the rates and are the prices themselves. Because one buys
and sells bonds, and not interest rates. This brings us to the idea of bootstrapping.
(In case you are curious, bootstrap refers to the strap/loop provided in the shoes/boots. It was designed
to help people get in and out of the shoes easily. As this wiki entry will tell you, over time this came be
known as the metaphor to ‘pull oneself up’ without outside effort – a kind of ‘self-sustaining force’.)
Say, we have zero-coupon bonds of maturity and available in the bond market, with prices
respectively. Then, since the bonds are zero coupon bonds (i.e. there are no intervening
coupons, and only a final cash flow, say ), we can write their prices are:
If we observe , then it’s clear that we can find the spot rates as:
So, if there are zero coupon bonds in the market, finding the spot rates is easy.
Unfortunately in most countries, including India, there does not exist an active market in zero coupon
bonds across maturities. All long-term bonds issued by Government of India are coupon bearing bonds.
In that case, as you would guess, extracting spot rates is not as easy.
Let’s again consider two bonds – but this time we consider coupon bearing bonds (a more realistic
situation) rather than zero-coupon bonds.
Let’s call the price of coupon bond of maturity (with only a single cash flow ) as , and the
price of of coupon bond of maturity (with cash flow at time and cash flow at time ) as
. Then we have:
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Since is traded, given its coupon , we can still find as earlier as:
What is not so obvious now is finding , as instead of a single cash flow at time , we have cash flows
from a coupon bearing bond both at time . But since is known from the market, it turns out
we can still find . This is how:
Write
Since is known from , and is known from the market, given the cash flows and
from the bond, the only unknown remaining is , i.e. in:
the only variable unknown is . Since , we can now easily ‘bootstrap’ from the
above equation.
After finding , say, if we now had a third coupon bond with maturity , we can find out
similarly as:
This process of successively backing out spot rates from bond prices like this is called bootstrapping.
That is, even if there aren’t any zero coupon bonds in the market, one can still extract the spot rates by
the process of backing out, i.e. by bootstrapping, as above.
As should be clear, this process would only work if there are enough coupon bearing bonds across all
maturities in the bond market. As even if one bond is missing “in between”, that would mean all other
rates starting from that point would be indeterminate. So, for example, if there were no period bond,
i.e. in the market, one couldn’t have extracted . But not only that, in that case one couldn’t have
extracted even , as bootstrapping depends on knowing .
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Plo ing for a given maturity gives us a curve which is known as the Zero Coupon Yield Curve
(ZCYC) – or simply stated, just a yield curve (not to be confused with the plot of YTMs for different
maturities).
So in practice when one doesn’t have ‘nice’ sequential set of coupon bonds, one is forced to use fit the
term structure using curve fi ing techniques.
Wri en by Vineet
Posted in Teaching: FM
Tagged with Bond Pricing, Bootstrapping, FM-2014, Session-13, Term Structure, YTM, Zero-Coupon
Yield Curve
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