Bonds

Definition. The bond is a debt security, under which the issuer

owes the holders a debt and (depending on the terms of the bond) is
obliged to pay them interest (the coupon) and to repay the face value
at a later date, termed the maturity date.
Characteristics:
1) F – a face value (par value, principal), the sum paid at the
maturity date;
2) n – time to maturity;
3) c – a coupon rate;
4) C – a coupon
C = cF ;
5) i – yield to maturity.
A bond as Cash Flow Stream:
CF = ( C ; 1) ; ; ( C ; n − 1) ; ( C + F ; n ) .

Definition. If C = 0 then a bond is called zero-coupon.

CF = ( F ; n ) .

Remark. A coupon bond is the sum of two Cash Flow

Streams: the annuity
CF1 = ( C ; 1) ; ; ( C ; n )

and the zero-coupon bond

CF2 = ( F ; n ) .

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 Present Value (Price P )

P = PV = cF
(1 − (1 + i ) )
+
−n
F
. (1)
(1 + i )
n
i

Remark. If a bond is zero-coupon (a bond where the face val-

ue is repaid at the time of maturity.) then
F
P = PV = .
(1 + i )
n

Theorem. PV (i ) is a decreasing function ( PV (i )  ) .

Example. n = 3; F = 1000; c = 8%; i1 = 10%; i2 = 12% .

PV1 = ? PV2 = ?
Solution.

PV = 1000  0,08
(1 − (1 + 0,1) )
−3

+
1000
= 950, 26 .
(1 + 0,1)
1 3
0,1

PV2 = 1000  0,08

(1 − (1 + 0,12 ) )
−3

+
1000
= 903,93 .
(1 + 0,12 )
3
0,12

Conclusion: i1  i2  PV1  PV2 .

Theorem. There are three possibilities:
1) if c  i then PV  F ;
2) if c  i then PV  F ;
3) if c = i then PV = F .
Let Pt be the sequence of bond prices at the time t years from

the moment the bond was issued ( t  ).

Theorem. If i(t ) = const then there are three possibilities:

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 1) if c  i then Pt is a decreasing sequence ( Pt  ) ;

2) if c  i then Pt is a increasing sequence ( Pt  ) ;

3) if c = i then Pt is a constant sequence.

Remark. If i(t ) = const then Pt +1 + C = Pt (1 + i ) ; t .

Example. n = 5; F = 1000; c = 8%; i = 10% .

P0 = PV0 = ?; P1 = PV1 = ?
Solution.

P0 = PV0 = 1000  0,08

(1 − (1 + 0,1) )
−5

+
1000
= 924,18 .
(1 + 0,1)
5
0,1

P = PV = 1000  0,08
(1 − (1 + 0,1) )
−4

+
1000
= 936,60 .
(1 + 0,1)
1 1 4
0,1

Conclusion: c  i  PV  F ; c  i  P0  P1 .
Example. n = 5; F = 1000; c = 12%; i = 10% . P = PV = ?
Solution.

P = PV = 1000  0,12
(1 − (1 + 0,1) )
−5

+
1000
= 1 075,82 ;
(1 + 0,1)
0 1 5
0,1

P = PV = 1000  0,12
(1 − (1 + 0,1) )
−4

+
1000
= 1 063, 40 .
(1 + 0,1)
1 1 4
0,1

Conclusion: c  i  PV  F ; c  i  P0  P1 .
Example. n0 = 5; n1 =4; F = 1000; c = 10%; i = 10% .
P = PV = ?
Solution.

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 P0 = PV0 = 1000  0,1
( 1 − (1 + 0,1)
−5
)+ 1000
= 1 000 ;
(1 + 0,1)
5
0,1

P1 = PV1 = 1000  0,1

(
1 − (1 + 0,1)
−4
)+ 1000
= 1 000 .
(1 + 0,1)
4
0,1

Conclusion: c = i  PV = F ; c = i  P0 = P1 .
Example The investor bought the 5-year bond with the face
F = 1000 , the annually coupon of the rate c = 8% , the yield to ma-
turity i = 12% and sold the bond a year later when the yield to ma-
turity was 10% . Find a return on the investment.
Solution.

P = 1000  0,08
(1 − (1 + 0,12 ) )
+
−5
1000
= 855,81 ;
(1 + 0,12 )
0 5
0,12

P = 1000  0,08
(1 − (1 + 0,1) )
+
−4
1000
= 936,60 ;
(1 + 0,1)
1 4
0,1

P1 + C − P0 936,60 + 80 − 855,81
r= = = 0,1879 = 18,79% .
P0 855,81

Yield to Maturity

To find YTM i we should solve the equation

P = cF
(1 − (1 + i ) )
+
−n
F
.
(1 + i )
n
i

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 2(c  F  n + F − PV )
i .
PV − F + n( PV + F )
Example. n = 5; F = 1000; c = 8%; P = 1100 . YTM = i = ?
Solution.
2(0,08 1000  5 + 1000 − 1100
i = 0,0566 = 5,66%
1100 − 1000 + 5(1000 + 1100)

Bonds with m coupons per year

Usually m = 2 or m = 4 . In this case the coupon per period

C F c
Cp = = .
m m
 C 1  C 1  C 
CF =  ;  ; ;  ; n −  ;  + F ; n 
 m m  m m m 
1. Present Value (Price P )
  i  
− nm

1 − 1 +  
 m 
P = PV = cF 
F
+ nm
.
i  i 
1 + 
 m
Or

P = PV = C p
(1 − (1 + i p )
− np
)+ F
.
(1 + i )
np
ip
p

Example. n = 5; F = 1000; c = 8%; i = 10%; m = 2 .

P = PV = ?
Solution.

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 P = PV = 1000  0,08
( 1 − (1 + 0,05 )
−10
)+ 1000
= 922,78 .
(1 + 0,05 )
10
0,1

2. Yield to maturity
2(c p  F  n p + F − PV )
ip  .
PV − F + n p ( PV + F )

Dirty and Clean Prices

Let now be t years to maturity of the bond and  years have passed
since the last coupon payment. Then n p = (t + )m will be an integer

number of coupon periods. Thus,

P(−) = C
( 1 − (1 + i p )
−np
)+ F
(1 + i )
p np
ip
p

Where P(−) is the price of the bond at the moment of the last cou-
pon payment (at the moment − ). The dirty price Pd (0) , that is the
price now, we can calculate as follows

Pd (0) = (1 + i p )  P (−) .
m

Accrued Interest
AI = C .
Clean Price
Pc = Pd − AI .
Example Find the clean price of a 5-year bond if the face val-
ue F = 1000 , the coupon rate c = 9% , the yield to maturity i = 10% ,

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the coupon is paid 2 times a year and 3,2 years have passed since the
issue.
Solution.
The last coupon payment was made 3 years after the bond was is-
sued (i.e. 2 years before maturity) and 0,2 years before the bond pur-
chase ( = 0,2) . Let us find the bond price P(−0,2) at the moment of
the last coupon payment (i.e. at 2 years before maturity).

1000  0,09 (1 − (1 + 0,05 ) )

−22
1000
P (−0, 2) = + = 982, 27 .
(1 + 0, 05 )
22
2 0,05

The dirty price

Pd (0) = 982,27  (1 + 0, 05)
0,22
= 1 001,63 .
Accrued Interest
AI = 90  0,2 = 18 .
The clean price
Pc = 1 001,63 − 18 = 983,63 .
Example Find the clean price of the bond if the face value
F = 1000 , the coupon rate c = 8% , the yield to maturity i = 10% , the
coupon is paid 2 times a year, the purchase date is 25.03.2015, and
the maturity date is 15.01.2019 ( 30/360).
Solution.
The coupon is paid 2 times a year: 15.01 and 15.07. Thus, the last
70
coupon payment was made 15.01.2015, it was at  = = 0,19444
360
years before the bond was purchased and 4 years before maturity. Let

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us find the bond price P(−0,19444) at the moment of the last coupon
payment (i.e. at 4 years before maturity).

1000  0,08 (1 − (1 + 0,05 ) )

−42
1000
P (−0,19444) = + = 935, 37
(1 + 0,05 )
42
2 0,05
.
The dirty price
Pd (0) = 935,37  (1 + 0,05)
20,19444
= 953, 28 .
Accrued Interest
AI = 80  0,19444 = 15,56 .
The clean price
Pc = 953,28 − 15,56 = 937,72 .