ACST2001 Week 05: Financial Modelling

ACST2001 Week 05
Financial Modelling
Bonds:
Effects of Fees and charges
Reinvestment risk and
realised yield (TRCY)
(c) Macquarie University 2021 1
“I found applying knowledge to
problems not previously
encountered was of course
painful. Fear of this made me work
that much harder, and have to
think about things. But instead of
just learning steps in a process I
understand it better, so the reward
is greater.”
ACST2001 student

FEES & CHARGES … 1.
A $100 million 14% bond is issued
at par. The bond pays interest
annually in arrears and its term to
maturity is 10 years. The issuer
must pay fees and charges
amounting to $3.26 million on the
issue date. Find the borrowing
cost (as a j1 rate) allowing for fees
and charges.
BORROWING COST FOR A BOND
Issue Maturity
date date
$(100-fees) $114
14 14 …... 14 14 14
0 1 2 …..... 7 8 9 10
10 years
Income (issue price)

Outgo (fees, coupons & maturity amount)
Yield (i) is the rate of interest that makes:
PV of income = PV of outgo
To Sum up…
From the perspective of a bond issuer, the
borrowing cost can be adjusted to allow for
the impact of fees and charges

Bonds
Reinvestment Risk &

Total Realised Compound Yield
(TRCY)

The accumulation function sn
sn is the accumulated value at the
time of the last payment of a level
annuity of n payments of $1.
= 1+(1+i)+(1+i)2+….+(1+i)(n-2)+(1+i)(n-1)
= (1+i) n-1
i
Additional problem
An investor purchases a $100 10-
year 12% Treasury bond. On receipt
of each coupon the investor
deposits the coupon into a bank
account earning 9% p.a. convertible
half-yearly. What is the accumulated
value of the coupons at the end of
10 years?
Additional problem … cont
Accumulated value, at the

end of ten years of
reinvested coupons
(at j2 =9%)
= 6s20 at 4.5%
= $188.229
Additional problem … cont
Note: At the end of the ten
years the investor will
receive the maturity value of
the bond ($100) and he will
have the accumulated value
of the reinvested coupons.
$100 +$188.229 = $288.229
PROBLEM 1 ….. Part 1
An investor purchases a 15-

year 12% Treasury bond
when the market (purchase)
yield is j2 = 15%
(Find the price per $100 FV)
T-bond price:
6a30 + 100v 30 at 7.5%
= 70.862 + 11.422
= $82.284
(per $100 face value)
We say: “If you buy a 15-

year 12% T-bond for
$82.284, and hold it to
maturity, your expected
yield is j2 = 15%”
What does it really mean

to say this?
Let’s investigate the
meaning behind that
statement …...
EXAMPLE: T-BOND INVESTMENT
Purchase Maturity
date date
$82.284 $106
6 6 …... 6 6 6
0 1 2 …..... 27 28 29 30
30 half-years
Outgo (purchase price)

Income (coupons & maturity amount)
Yield (i) is the rate of interest that makes:
PV of outgo = PV of income
Investor’s outlay is the
price ($82.284) at
purchase. If you invest
$82.284 at j2 = 15% for 15
years, your maturity value
is ….. ?
82.284(1.075)30
= $720.396
How does the T-bond
investor achieve this
future value at maturity?
Accumulated value, at
maturity, of reinvested
coupons (at j2 =15%)
= 6s30 at 7.5%
= $620.396
the bond’s maturity amount
consists of
the capital gain (or loss) and the return

of original outlay (price)
i.e., 17.716 + 82.284 = 100.000

PROBLEM 1 ….. Part 8a
So, at maturity, total value of T-bond
investment consists of:
capital gain (100–82.284 = $17.716)
coupons (30×6 = $180)
interest on coupons (620.396–180 =
$440.396)
return of original outlay (price =
$82.284)
So, at maturity, total value of T-bond
investment is:
$17.716 +
$180.000 +
$440.396 +
$82.284;
a total of …… $720.396
How much has the investment
increased by?
800
700
600
500
400
720.396
300
200
100
82.284
0
1 2

The original investment (outlay) of
$82.284 has increased by $638.112
(720.396–82.284)
What proportion of the increase is
attributable to each component?
$17.716 3%
$180.000 28%
$440.396 69%
Total $638.112 100%
3%
Capital gain
28%
Coupons
69% Interest on
coupons

A high proportion (69%) of the return
from the T-bond comes from
reinvesting the coupons.
So, in this case, the investor’s return is
very much exposed to the risk of a fall
in the rates at which the coupons can
be reinvested.
This is reinvestment risk!
REINVESTMENT RISK
An investor who buys a bond and
holds it to maturity will have three
sources of return:
1 capital gain (or loss);
2 income from coupons;
3 interest from reinvestment of
coupons.

REINVESTMENT RISK
….. is the risk that the return on the
reinvested coupons is different from
the purchase yield, because of
changes in market interest rates
different: higher (because rates

rise), OR lower (because rates fall);
i.e., risk has up-side & down-side
PROBLEM 2
Suppose that, immediately after
the bond is purchased, interest
rates “across the board” drop to
13% (j2) and remain at that level
indefinitely.
Recalculate the total value of the
investment at maturity.
PROBLEM 2
Accumulated value of coupons at
maturity (at j2 = 13%) is:
6s30 at 6.5% = $518.249
Total value at maturity is
100+ $518.249 = $618.249

PROBLEM 2
What yield has the investor
actually earned?
Let i be actual yield per half-year
82.284(1+i)30 = 618.249
i = (618.249/82.284)(1/30) - 1
i = 0.06953
Actual yield (j2) is …. 13.91% pa
PROBLEM 2
So, investor’s actual yield is
13.91%, and not 15%
Shortfall is caused by the drop
in interest rates, resulting in
coupons being reinvested at a
lower rate than 15%

TERMINOLOGY
This yield (i.e., the yield to
maturity allowing for actual
coupon reinvestment rates) is
sometimes known as:
TOTAL REALISED COMPOUND
YIELD (TRCY)

TRCY
TOTAL REALISED COMPOUND YIELD
(TRCY)
on an investment is the rate of interest
(i) per period such that:
(Initial outlay)×(1+i)n =
(Total accumulated value at maturity,
allowing for reinvestment of income)

Problem 3
You purchase a 10-year 10%
Treasury bond when the
market yield is 10.15%.
Assume that you hold the bond
to maturity, and that the
market yield does not
change. Decompose your
return into its component
parts. (c) Macquarie University 2021 34
Problem 4
Find the price of a 5-year

10% Treasury bond to yield
12%. Confirm that if TRCY
is also 12%, then each
coupon is reinvested at the
same rate (j2 = 12%).
Problem 5
Calculate the TRCY if the

coupon reinvestment rate is:
(a) j2 = 6%
(b) j2 = 9%
(c) j2 = 15%

Problem 6
Consider a 10-year 10%

Treasury bond purchased to
yield j2 =12%.
Find the purchase price.

Problem 6 …. continued
Calculate the TRCY if the
coupon reinvestment rate is:
(a) j2 = 6%
(b) j2 = 9%
(c) j2 = 9%
(d) j2 = 15%
SUMMARY (So far … )
Reinvestment risk is the risk that coupons
may not be reinvested at the same rate as
the purchase yield
Purchase yield is only realised if each
coupon is reinvested at the same rate as the
purchase yield
Return on bond has 3 components (capital
gain/loss, coupons, interest on reinvested
coupons)
TRCY is the actual realised bond yield,
allowing for reinvestment of coupons

ACST2001 Week 05: Financial Modelling

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ACST2001 Week 05

(c) Macquarie University 2021 2

Income (issue price)

(c) Macquarie University 2021 5

Reinvestment Risk &

(c) Macquarie University 2021 6

Accumulated value, at the

An investor purchases a 15-

We say: “If you buy a 15-

What does it really mean

Outgo (purchase price)

the capital gain (or loss) and the return

i.e., 17.716 + 82.284 = 100.000

(c) Macquarie University 2021 19

(c) Macquarie University 2021 22

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different: higher (because rates

6s30 at 6.5% = $518.249

Total value at maturity is

100+ $518.249 = $618.249

(c) Macquarie University 2021 31

(c) Macquarie University 2021 32

(c) Macquarie University 2021 33

Find the price of a 5-year

Calculate the TRCY if the

(c) Macquarie University 2021 36

Consider a 10-year 10%

(c) Macquarie University 2021 37

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