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**A A bond bond is is aa contract contract that that requires requires the the borrower borrower to to
**

pay pay the the interest interest income income to to the the lender lender..

This This speciIic speciIic rate rate oI oI interest interest is is known known as as coupon coupon

rate rate..

Generally Generally stocks stocks are are considered considered risky risky but but bonds bonds

are are not not..

But But this this is is not not Iully Iully correct correct..

Bonds Bonds do do have have risk risk..

But But the the nature nature && types types oI oI risks risks may may be be diIIerent diIIerent..

So So we we can can discuss discuss the the nature nature oI oI bonds bonds with with

respect respect to to risk risk..

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

BONDS NATURE BONDS NATURE

. . Interest Interest Rate Rate Risk Risk::

W W 'ariability 'ariability in in the the return return Irom Irom the the debt debt instrument instrument to to investor investor is is

caused caused by by the the changes changes in in the the market market interest interest rate rate..

W W It It is is due due to to the the relationship relationship between between coupon coupon rate rate && market market rate rate..

2. 2. DeIault DeIault Risk Risk::

W W The The Iailure Iailure to to pay pay the the agreed agreed value value oI oI the the debt debt instrument instrument by by the the

issuer issuer..

3. 3. Marketability Marketability Risk Risk::

W W 'ariation 'ariation in in return return causes causes diIIiculty diIIiculty in in selling selling the the bonds bonds quickly quickly

without without having having any any substantial substantial reason reason Ior Ior price price concession concession..

4. 4. Call Call- -ability ability Risk Risk::

W W There There is is always always an an uncertainty uncertainty regarding regarding the the maturity maturity period, period,

because because issuer issuer can can call call the the bond bond any any time time by by redeeming redeeming it it. .

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Bond Basics

Two basic yield measures for a bond are

its coupon rate and its current yield.

Coupon Rate =

Current Yield =

Annual Coupon

Par value

Annual Coupon

Bond Price

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

The Bond Pricing Formula

Recall: The price oI a bond is Iound by adding together

two components

. The present value oI the bond`s coupon payments and

2. The present value oI the bond`s Iace value.

The formula is:

Bond Price =

here,

represents the annual coupon payments (in Rs),

' is the Iace value oI the bond (in Rs), and

is the maturity oI the bond, measured in years.

C

YTN

1

(1+YTN/2)

2N

+

Fv

(1+YTN/2)

2N

1·

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Example:

What is the price of a straight bond with:

Rs.1,000 face value, coupon rate of S%, YTN

of 6%, and a maturity of 10 years?

Bond Price =

=

= (833.33 X 0.44632) + SS3.68

= Rs.32S.61

C

YTN

1·

1

(1+YTN/2)

2N

+

Fv

(1+YTN/2)

2N

S0

0.06

1·

1

(1+0Ŧ06/2)

2x10

+

1000

(1+0Ŧ06/2)

2x10

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Premium and Discount Bonds

Bonds are given names according to the

relationship between the bond's selling price and

its par value.

Premium bonds: price > par value

YTN < coupon rate

Discount bonds:price < par value

YTN > coupon rate

Par bonds: price = par value

YTN = coupon rate

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Calculating Yield to Naturity

!t is a single discount factor that makes present

value of future cash flows from a bond equal to the

current price of the bond.

or

YTN is the rate of return, which an investor can

expect to earn if the bond is held till maturity.

To find out YTN the present value technique is

adopted i.e.

Present value =

Where,

y=YTN

Coupon

1

(1+y)

1

+

Coupon

2

(1+y)

2

+

Coupon

n

+ N.v.

(1+y)

n

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Example

A 10 years bond with 4.S% coupon rate S maturity

value Rs. 1000/· selling at Rs.300/·. What is its

YTN?

Solution Using Alternative formula:

YTN =

=

=

Annual coupon interest rate ¹ (Discount/Years to maturity)

(current price ¹ par price)/2

45¹(/)

(9¹)/2

45¹(/)

(9¹)/2

45¹

95

=

55

95

=

5.79°

=

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Calculating Yield to Naturity

Suppose we know the current price of a bond, its

coupon rate, and its time to maturity. How do we

calculate the YTN?

We can use the straight bond formula, trying

different yields until we come across the one that

produces the current price of the bond.

1083.17=

This is tedious. So, to speed up the calculation,

financial calculators and spreadsheets are often

used.

30

YTN

1·

1

(1+YTN/2)

2XS

+

1000

(1+YTN/2)

2XS

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Yield to Call

Yield to call (YTC) is a yield measure that

assumes a bond will be called at its earliest

possible call date.

The formula to price a callable bond is:

Where,

is the annual coupon (in Rs),

P is the call price of the bond,

T is the time (in years) to the earliest possible call date,

YT is the yield to call, with semi·annual coupons.

@

1

(1+@/2)

2@

+

9

(1+@/2)

2@

1·

Callable Bond Price=

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Calculating the Price of a Coupon Bond

A Bond traded on 1 Narch 2008 matures in 20 years on 1

Narch 2028. Assuming an 8 percent coupon rate and 7%

yield to maturity. What is the price of this Bond?

Solution using excel function PR!E

=PR!E("3/1/2008", "3/1/2028",0.08,0.07,100,2,3)

Answer = 110.677S

For a bond with Rs.1000 face value multiply the price by 10 to get

Rs.1106.78

This function uses the following:

=PR!CE (Now, Naturity, Coupon, YTN,100,2,3)

Where,

100 indicates the redemption value as a percentage of face

value

2 indicates semi annual coupons.

3 specifies an actual day count with 36S days per year.

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Calculating Yield to maturity of a Bond

A Bond traded on 1 Narch 2008 matures in 8 years on 1

Narch 2016. Assuming an 8 percent coupon rate and a

price of Rs.110. What is the yield to maturity of this Bond?

Solution using excel function Y!ELD

=Y!ELD(¨3/1/2008",¨3/1/2016",0.08,110,100,2,3)

Answer = 6.38%

This function uses the following:

=yield(Now, Naturity, Coupon, Price,100,2,3)

Where,

Price is entered as a percentage of face value

100 indicates the redemption value as a percentage of face

value

2 indicates semi annual coupons.

3 specifies an actual day count with 36S days per year.

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Calculating Yield to call of a Bond

A Bond traded on 1 Narch 2008 matures in 1S years on 1

Narch 2023. And may be called any time after 1 Narch

2013 at a call price of Rs.10S. The Bond pays an 8.S%

coupon and currently trades at par. What are the yield to

maturity S yield to call for this bond?

Yield to maturity is based on 2023 maturity and current

price of Rs.100

=Y!ELD(¨3/1/2008",¨3/1/2023",0.08S,100,100,2,3)

Answer = 8.S%

Yield to call is based on 2013 maturity and current price of

Rs.100

=Y!ELD(¨3/1/2008",¨3/1/2013",0.08S,100,10S,2,3)

Answer = 3.308%

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Bond Theorems

Theorem 1:

!f the market price of the bond increases, the

yield would decline and vice versa

Bond B

Rs.1000

10%

2 Years

Rs.103S.66

Bond A

Rs.1000

10%

2 Years

Rs.874.7S

Example

Par value

Coupon rate

Naturity period

Narket Price

Yield

18% 8%

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Theorem 2:

!f bond's yield remains the same over its life, the

discount or premium depends on the maturity period.

Thus the Bond's with short term to maturity sells at a

lower discount than the bond with a long term to

maturity.

Example

Par value

Coupon rate

Yield

Naturity period

Narket Price

Discount

Bond B

Rs.1000

10%

1S%

3 Years

Bond A

Rs.1000

10%

1S%

2 Years

Rs.318.71 Rs.88S.86

Rs.81.23 Rs.114.14

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Theorem 3:

!f bond's yield remains constant over its

life.

The discount or premium decrease at an

increasing rate as its life gets shorter.

!t happens due to the concept of time

value of money.

For example:

!f !nvestor get a rupee at T+S period it

would value lesser if he get he get it at T

period

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Theorem 4:

A rise in the bond's price for a decline in the bond's

yield is reater than the fall in the bond's price for a

raise in the yield.

For Example:

A bond of 10% coupon rate, maturity period of five years

with face value of Rs.1000.

!F the yield declines by 2%, that is to 8% then the bond

price will be Rs.1073.87. (using bond pricing formula,

slide·2)

!f the yield increases by 2% the, the bond price will be

Rs.327.88. (using bond pricing formula, slide·2)

Now fall in yield has resulted in raise of Rs.73.87 but raise

in the yield caused a variation of Rs.72.22 in the price.

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Theorem S:

The change in the price will be lesser for a percentage

change in bond's yield if its coupon rate is higher.

Example

Coupon Rate

Yield

Naturity period

Price

Face value

Yield Raise (YR)

Price after YR

% change in Price

Bond A

10%

8%

3 Years

Rs.10S.1S Rs.100

Rs.100 Rs.100

Bond B

8%

8%

3 Years

1% 1%

Rs.102.S3 Rs.37.47

2.4% 2.S3%

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Term Structure of !nterest Rate Term Structure of !nterest Rate

The The relationship relationship between between the the yield yield and and time time

is is called called term term structure structure. .

!t !t is is also also known known as as yield yield curve curve. .

!n !n analyzing analyzing the the effect effect of of maturity maturity on on yield yield

all all other other influences influences are are held held constant constant. .

The The maturity maturity dates dates for for bonds bonds are are different different. .

But But the the risks, risks, tax tax liabilities liabilities SS redemption redemption

possibilities possibilities are are similar similar. .

There There are are some some theories theories that that explains explains the the

term term structure structure of of interest interest rates rates. .

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Theories oI term structure oI Interest Rates Theories oI term structure oI Interest Rates

. . Expectation Expectation Theory Theory

2. 2. Liquidity Liquidity PreIerence PreIerence Theory Theory

3. 3. Segmentation Segmentation Theory Theory

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Expectation Theory Expectation Theory

This This theory theory is is based based on on the the expectations expectations of of

the the investors investors. .

Under Under this this theory theory the the shape shape of of yield yield curve curve is is

studied studied. .

As As it it gives gives an an idea idea of of future future interest interest rate rate

change change SS economic economic activity activity. .

There There are are three three main main types types of of yield yield curve curve

shapes shapes i i. .ee. .

Normal Normal

Flat Flat

!nverted !nverted

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Normal Yield Curve Normal Yield Curve

!f !f investor investor expects expects that that there there would would be be aa

continuous continuous rise rise in in market market interest interest rates rates. .

Then Then the the bond's bond's price price will will decrease decrease. .

Thus Thus the the yield yield will will increase increase. .

Craphical Craphical presentation presentation

Years to Naturity

Y

i

e

l

d

t

o

m

a

t

u

r

i

t

y

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Flat Yield Curve Flat Yield Curve

!f !f investor investor expects expects that that there there would would be be no no

change change market market interest interest rates rates. .

Then Then the the bond's bond's price price will will remain remain

constant constant. .

Thus Thus the the yield yield will will also also remain remain constant constant. .

Craphical Craphical presentation presentation

Years to Naturity

Y

i

e

l

d

t

o

m

a

t

u

r

i

t

y

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

!nverted/Falling yield Curve !nverted/Falling yield Curve

Years to Naturity

Y

i

e

l

d

t

o

m

a

t

u

r

i

t

y

!f !f investor investor expects expects that that there there would would be be aa

decline decline in in market market interest interest rates rates. .

Then Then the the bond's bond's price price will will increase increase. .

Thus Thus the the yield yield will will decrease decrease. .

Craphical Craphical presentation presentation

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Conclusion of Expectation Theory Conclusion of Expectation Theory

There are only three types There are only three types

of returns i.e. of returns i.e.

1. 1. Normal Normal

2. 2. Flat Flat

3. 3. !nverted !nverted

As indicated by the graph As indicated by the graph

Years to Naturity

Y

i

e

l

d

t

o

m

a

t

u

r

i

t

y

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

iquidity Preference Theory iquidity Preference Theory

According According to to this this theory theory Investor Investor preIers preIers the the

liquidity liquidity..

So, So, he he preIers preIers short short term term bonds bonds over over long long term term

bonds bonds due due to to liquidity liquidity..

II II no no premium premium exists exists Ior Ior holding holding the the long long term term bond bond

Investor Investor would would preIer preIer to to hold hold short short term term bonds bonds..

Thus Thus they they must must be be motivated motivated to to buy buy the the long long term term

bond bond by by some some sort sort oI oI premium premium..

As As the the Iorward Iorward rates rates are are actually actually higher higher than than the the

proiected proiected interest interest rate rate..

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Segmentation Theory Segmentation Theory

According According to to this this theory theory liquidity liquidity can can not not be be the the main main

consideration consideration Ior Ior all all classes classes oI oI investors investors..

For For example example

Insurance Insurance companies companies

Pension Pension Funds Funds

Retired Retired Persons Persons

All All oI oI above above preIer preIer the the long long term term rather rather than than short short term term

securities securities to to avoid avoid the the possible possible Iluctuations Iluctuations in in the the interest interest rate rate..

On On the the other other hand hand there there are are corporate corporate who who preIers preIers liquidity liquidity..

They They preIer preIer short short term term bonds bonds

Supply Supply and and demand demand Ior Ior Iund Iund are are segmented segmented in in sub sub- -markets markets

because because oI oI the the preIerred preIerred habitats habitats oI oI the the individuals individuals..

Thus Thus yield yield is is determined determined by by the the demand demand and and supply supply oI oI the the Iunds Iunds..

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Duration Duration

The The term term duration duration has has aa special special meaning meaning

in in the the context context of of bonds bonds. .

!t !t is is aa measurement measurement of of how how long long (in (in

years), years), it it takes takes for for the the price price of of aa bond bond to to

be be repaid repaid by by its its internal internal cash cash flow flow. .

!t !t is is important important to to consider consider

As As bonds bonds with with higher higher durations durations carry carry more more risk risk

and and have have higher higher price price volatility volatility than than bonds bonds

with with lower lower duration duration. .

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Types of Bonds Types of Bonds w.r.t w.r.t. Duration . Duration

For For each each of of the the two two basic basic types types of of bonds bonds

the the duration duration is is following following: :

Zero Zero coupon coupon Bond Bond: :··

Duration Duration is is equal equal to to its its time time to to maturity maturity

vanilla vanilla Bond Bond: :··

Duration Duration will will always always be be less less than than its its time time

to to maturity maturity. .

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Types Duration Types Duration

There There are are four four main main types types of of duration duration

calculations calculations. .

Each Each of of which which differ differ in in the the way way they they

account account for for factors factors such such as as

!nterest !nterest rate rate changes changes

Bonds Bonds redemption redemption feature feature

The The four four types types of of durations durations are are: :

1. 1. Nacaulay Nacaulay duration duration

2. 2. Nodified Nodified duration duration

3. 3. Effective Effective duration duration

4. 4. Key Key rate rate duration duration

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Nacaulay Duration Nacaulay Duration

The The formula formula of of Nacaulay Nacaulay duration duration was was

created created by by Frederick Frederick Nacaulay Nacaulay in in 1338 1338. .

!t !t is is calculated calculated by by adding adding the the results results of of

multiplying multiplying the the present present value value of of each each cash cash

flow flow by by the the time time it it is is received received and and dividing dividing

by by the the total total price price of of security security. .

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Nacaulay Duration Nacaulay Duration

Nacaulay Nacaulay Duration= Duration=

n

l t X C n X N

t=1 (1+i)

t

(1+i)

n

Price of the Bond

+

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Recall Recall

Bond price Bond price

Bond price = Bond price =

C

YTN

1

(1+YTN/2)

2N

+

Fv

(1+YTN/2)

2N

1·

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Thus Nacaulay Duration (ND) Thus Nacaulay Duration (ND)

ND= ND=

n

l t X C n X N

t=1 (1+i)

t

(1+i)

n

+

C

YTN

1

(1+YTN/2)

2N

+

Fv

(1+YTN/2)

2N

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

For Example For Example

Nr Nr. . BB holds holds aa five five year year bond bond with with aa par par

value value of of Rs Rs. . 1000 1000 and and coupon coupon rate rate of of SS% %. .

For For simplicity, simplicity, let's let's assume assume that that the the coupon coupon

is is paid paid annually annually and and that that interest interest rates rates are are

SS% %. . What What is is the the Nacaulay Nacaulay Duration Duration of of the the

Bond Bond. .

The The above above formula formula is is very very complex complex. .

Alternatively Alternatively we we can can use use the the following following table table

to to find find out out Nacaulay Nacaulay Duration Duration. .

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Solution Solution

Years (t)

1

2

3

4

S

!nflow

S0

S0

S0

S0

10S0

PvF @S%

0.3S3

0.307

0.863

0.822

0.784

!nflow (t)

S0

100

1S0

200

S2S0

P.v. of

inflow (t)

47.6

30.7

123.4S

164.4

4116

4S63.1S

Price of the

Bond

(column 2 X4)

47.6

4S.3S

43.1S

41.1

823.2

1000

Duration =

P.v. of inflow (t)

Price of the Bond

4S63.1S

1000

=4.S6 Years

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Nodified Duration Nodified Duration

!t !t is is aa modified modified version version of of the the Nacaulay Nacaulay

model model that that accounts accounts for for changing changing interest interest

rates rates. .

As As interest interest rate rate affect affect the the yield yield. .

The The fluctuating fluctuating interest interest rates rates will will affect affect

duration duration. .

This This modified modified formula formula shows shows that that: :

How How much much the the duration duration changes changes for for each each

percentage percentage change change in in the the yield yield. .

So So there there is is an an inverse inverse relationship relationship between between

modified modified duration duration and and change change in in yield yield. .

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Formula Formula

Nodified Nodified Duration Duration = =

Nodified Nodified Duration Duration = =

Nacaulay Duration

Yield to Naturity

Number of coupon periods per Year

1+

Nacaulay Duration

YTN

n

1+

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Example Example

et's et's consider consider the the example example of of Nr Nr. . B's B's bond bond and and run run

through through the the calculation calculation of of his his modified modified duration duration. .

Currently Currently his his bond bond is is selling selling at at Rs Rs. .1000 1000//·· or or par par

Which Which translates translates to to yield yield to to maturity maturity of of SS% %. .

Recall, Recall, we we calculated calculated aa Nacaulay Nacaulay duration duration of of 44. .S6 S6

Nodified Nodified Duration Duration = =

= =44. .33 33 years years

Nodified Nodified duration duration will will always always be be lower lower than than Nacaulay Nacaulay Duration Duration. .

4.S6

0.0S

1

1+

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Effective Duration Effective Duration

Nodified Nodified duration duration assumes assumes that that the the expected expected cash cash

flows flows will will remain remain constant constant even even if if prevailing prevailing

interest interest rates rates change change. . Such Such as as: :

Option Option free free fixed fixed income income bonds bonds

Effective Effective duration duration is is used used when when expected expected cash cash

flows flows also also changes changes with with aa change change in in interest interest rates rates. .

Effective Effective duration duration requires requires the the use use of of binomial binomial

trees trees to to calculate calculate the the option option adjusted adjusted spread spread (OAS) (OAS)

There There are are entire entire courses courses build build around around just just those those

two two topics topics. .

So So calculations calculations involved involved for for effective effective duration duration are are

beyond beyond the the scope scope of of our our syllabus syllabus

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

Key Rate Duration Key Rate Duration

!t !t is is used used for for portfolios portfolios which which consists consists of of fixed fixed

income income securities securities with with differing differing maturities maturities. .

!t !t allows allows the the duration duration of of aa portfolio portfolio to to be be calculated calculated

for for one one basis basis point point change change in in interest interest rates rates. .

!t !t calculates calculates the the spot spot durations durations of of each each of of 11 11 key key

maturities maturities i i. .ee. .

33 months, months, 11, , 22, , 33, , SS, , 77, , 10 10, , 1S 1S, , 20 20, , 2S 2S, , and and 30 30 years years

The The formula formula for for key key rate rate duration duration is is as as follows follows: :

The The sum sum of of the the key key rate rate duration duration is is equal equal to to the the

effective effective duration duration. .

Price of security after 1% decrease in yield · Price of security after 1% increase in yield

2 X (!nitial price of security) 1%

SANDEEP KAPOOR SANDEEP KAPOOR

N!ET, NEERUT N!ET, NEERUT

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