Bonds Bonds

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..
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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. .
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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
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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

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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+YTN/2)
2N
+
Fv
(1+YTN/2)
2N
S0
0.06

1
(1+0Ŧ06/2)
2x10
+
1000
(1+0Ŧ06/2)
2x10
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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
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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
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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°
=
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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+YTN/2)
2XS
+
1000
(1+YTN/2)
2XS
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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@

Callable Bond Price=
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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.
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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.
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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%
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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%
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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
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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
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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.
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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%
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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. .
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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
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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
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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
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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
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!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
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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
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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..
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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..
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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. .
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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. .
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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
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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. .
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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
+
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Recall Recall
Bond price Bond price
Bond price = Bond price =
C
YTN
1
(1+YTN/2)
2N
+
Fv
(1+YTN/2)
2N

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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
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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. .
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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
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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. .
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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+
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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+
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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
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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%
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