Fixed Income

Mathematics

1
 Valuation of Bonds
Any instrument in finance can be broken
down into two components
Amount and Timing of cashflow
Time value of money
Present Value
Future Value
Hence, valuing or pricing of a bond also boils
down to finding the value of cashflows and
finding the present values of these cash
flows
2
 Cash flows from a Bond

The Cashflows from a bond are:

Periodic interest payments called coupons
For example, a bond promising a coupon at the rate of
10%, payable semi-annually, will pay Rs.5 per 100
of face value every six months till the date maturity.

Face value of the bond on maturity

For example, a bond with a face value of Rs.100 will
pay the bond holder Rs.100 on the date of maturity
in addition to the last coupon payment.
3
 Calculating Bond Price
The price of a bond is equal to the present value of the
expected cash flows. The interest rate or discount rate
used to compute the present value is the market yield for
a comparable instrument.
Steps involved in calculating the price of a financial
instrument are:
1. Determining the cash flows
The cash flows for a typical coupon bearing bond would
be the periodic coupon, the par or maturity value and any
upfront discounts/premiums and redemption
discount/premium described in the terms and conditions
for the instrument.
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 Calculating Bond Price
2. Determining the required yield
The required yield depends on the yield offered on
comparable securities in the market. The
instruments are compared on the basis of maturity
and credit risk.

3. Determining the price

The price is determined by discounting the
cashflows by the appropriate discount rate.

5
Calculating Bond Price..

6
 Formula for Bond Pricing
We can summarize the bond valuation formula as:

P=
 ct + FV
(1+Y/k)^t*k (1+Y/k)^n*k
Where
P = Price of the bond
Ct = Coupon payment for period t
FV= Face value of the bond
Y = The yield to maturity of the bond
k = Frequency of coupon payment, e.g., k=4 for quarterly coupon payment
n = Maturity of the bond in years

7
 Relationship Between Coupon,
Yield and price
From the bond pricing formula, we can infer the
relationship between Coupon Rate, Required
Yield and Price:
Keeping the coupon rate constant, an increase in
yield will lead to a decrease in the price and vice
versa
Keeping the required yield constant, an increase in
coupon rate will lead to an increase in the price
and vice versa
Bond will be at par (ignoring up-front discounts)
when the coupon and the yield are same
8
How do I value a bond on a non-
coupon date?
The concept of Accrued Interest
Compensation paid by buyer to seller for the
period for which the seller has held the security
after the immediately preceding coupon date.

The concept of Day count convention

Method of counting days between coupon periods
for estimating the Accrued interest

9
 Clean Price Vs. Dirty Price
The Price arrived at by discounting on a date other
than the coupon payment date contains the accrued
interest component. This is the Dirty Price.
The Clean Price is arrived at by reducing the accrued
interest from the Dirty Price.
The advantage is that Clean Prices do not show
jumps or discontinuities on the coupon date or at
any time during its time path.

10
 The Time Path of a Bond

As the time to maturity approaches, bonds are

“pulled to par”
The price of the bond at maturity has to be equal to
its redemption value (“There is no Free Lunch”)
This has significant implications for fixed income
derivatives and as far as the volatility of bond
prices is concerned
11
 Pull to Par Effect

As the bonds move toward maturity, the

present value of the face value forms a
greater proportion of the bond price.
Hence, the discount or premium bonds will
converge to par value at maturity

12
 Why Bond Prices Change Over
time?
Bond Prices
Bond Prices approach their
1400 face value or maturity value
1200 C
overtime
1000 B
However, the price changes
800 A may not be smooth because of
600 changes in other factors
400
Sensitivity of price changes is
200
a function of Y, C, and T
5 4 3 2 1
Time Periods

13
 Bond Price Changes

Holding maturity constant, a

rate decrease will raise
prices a greater percent
than a corresponding
increase in rates will lower
prices

Market yield

14
 Yield Measures
Current Yield: The current yield relates the annual
coupon interest to the market price of the financial
instrument
Current yield = Annual coupon interest / Market price

Yield-to-Maturity: The yield-to-maturity is the

interest rate(internal rate of return) that will make
the present value of the cash flows equal to the price
of the financial instrument

15
 Yield Measures
Yield-to-Call: The Yield computed assuming the
bond is called on its first call date
Yield-to-Worst: If the bond has a number of call
options, then the worst yield-to-call
Yield for a Portfolio: The yield for a portfolio of
bonds is computed by determining the cash flows
for the portfolio and the interest that will make the
present value of cash flows equal to the market
value of the portfolio.

16
 Calculation of Yield to Maturity
(YTM)
The YTM on any investment is computed by
determining the interest rate that will make the
present value of the cash flow from the investment
equal to the price of the investment.

Yield to maturity on a bond is also the Internal Rate

of Return (IRR) on the cash flows of the portfolio

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 Calculation of Portfolio Yield

Weighted Average of Yields of the individual

yields is an approximation. The weights
used are the values of the individual
securities
Calculation of Actual Portfolio YTM can be
done using the XIRR function by writing
the cash flows
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 Realized Yield
The actual returns on a bond consist of the following
components
Coupon Income
Price Realized when the bond is sold
Re-investment returns from the coupons
Realized Yield will be different from the YTM even if
the Bond is held to Maturity
Consider a 12.50% 2004 held from 23-mar-00 to 23-mar-
01. It was bought at Rs. 107.42 and sold at Rs 108.5.
Reinvestment rates for the two coupons were 7.5%
(for 1 year) and 7% (for 6 months) respectively.
Compute the Realized Yield

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 Solution
Coupons Received = 12.50
First Coupon for 1 year at 7.5%: 6.7188
Second Coupon for 6 months at 7%: 6.4687
Hence Re-investment income = 0.6875
Capital Gain on Sale = 1.08
Total Cash Flows from Bond = 14.2675
Realised Yield = 14.2675/107.42 = 13.282%

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 Bond Pricing Relationships (1)

Inverse relationship between price and yield

An increase in a bond’s yield to maturity
results in a smaller price decline than the
gain associated with a decrease in yield
Long-term bonds tend to be more price
sensitive than short-term bonds

21
 Bond Pricing Relationships (2)

As maturity increases, price sensitivity

increases at a decreasing rate
Price sensitivity is inversely related to a
bond’s coupon rate
Bond prices are more sensitive to changes in
yields when the bond is selling at a lower
initial YTM

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 Maturity alone is not sufficient
These relationships confirm that maturity is a
major determinant of interest rate risk
However, maturity alone is not sufficient
Bonds with same maturity, but with different
coupon rates have different sensitivities
We need to know more than a bond’s maturity to
quantify its interest rate risk

23
 Measuring Bond Price Volatility
Important considerations
Different effects of yield changes on the prices and
rates of return for different bonds
Maturity inadequate measure of volatility
May not have identical economic lifetime
A measure is needed that accounts for both size and
timing of cash flows

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 Bond Risk Measures

Maturity is the simplest risk measure

Macaulay Duration
Modified Duration
PVBP (Price Value of a Basis Point)
Convexity

25
 Calculating Duration

Need to time-weight present value of cash flows

from bond
n PV(CFt )
D= t
t =1Market Price
Duration depends on three factors
Maturity of the bond
Coupon payments
Yield to maturity

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 Duration Relationships

Duration increases with time to maturity but at

a decreasing rate
For coupon paying bonds, duration is always less
than maturity
For zero coupon-bonds, duration equals time to
maturity
Duration increases with lower coupons
Duration increases with lower yield to maturity

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 Why is Duration Important?
Allows comparison of effective lives of bonds
that differ in maturity, coupon
Used in bond management strategies particularly
immunization
Measures bond price sensitivity to interest rate
movements, which is very important in any
bond analysis

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Macaulay Duration

29
 Estimating Price Changes Using
Duration
Modified duration =D*=D/(1+r)
D*can be used to calculate the bond’s
percentage price change for a given change in
interest rates

-D
%  in bond price  r
(1 + r)

30
 Duration Conclusions

To obtain maximum price volatility, investors

should choose bonds with the longest
duration
Duration is additive
Portfolio duration is just a weighted average
Duration measures volatility which isn’t the
only aspect of risk in bonds

31
 Modified Duration as Interest
Rate Sensitivity
For a bond, the basic pricing equation is


P = Ct/(1+y)^t
Differentiating price with respect to the yield y, we
get
dP/dy = - C *t / (1+y)^(t+1)
t

= - {C *t / (1+y)^t}/(1+y)
t

Using the formula for duration

dP/dy = -(MD)*P

32
 Modified Duration as Interest
Rate Sensitivity
This can be written as
MD = -(dP/P)/dy
It can be seen from the above that MD is
equal to minus of percentage change in
price for a unit change in the yield.
Hence, MD can directly be used as an interest
rate risk measure for bonds.

33
 Factors Affecting Duration
Time to maturity
Higher the time to maturity higher the duration and
hence higher the interest rate risk of the bond
Coupon rate
Lower the coupon rate higher the duration and
hence higher the interest rate risk of the bond
Current level of interest rates (yield)
Lower the yield higher is the duration and hence
higher the interest rate risk of the bond
Thus, Modified Duration is a very convenient
interest rate risk measure for bonds. Higher the
duration higher the interest rate risk of the bond

34
 Modified Duration as Interest
Rate Sensitivity
Let the initial price of a bond be P0

If the yield moves by dy, the new price P1 is

approximately given by

P1  P0 + (dP/dy) (y - y0)

P1  P0 + (-MD)*P*(y-y0)

Using the formula for MD as derived earlier.

35
 Example
At a yield of 10%, a 5 year 5% annual
coupon bond has a value of $81.05 and a
Modified Duration of 4.08 year.

Assume the bond's yield increases from 10%

to 10.01%.
Use its duration to calculate the bond's change in
value.
Calculate the new value longhand, using the
new yield.

36
 Example
Using the duration

DP = (-MD) x P x D y

= - 4.08 x 81.05 x 0.0001

= - $0.033
Thus the changed price is = $81.05 - $0.033
= $81.017

37
 Dollar Duration
Modified Duration can also be expressed as the
change in dollar value of the bond for a unit
change in yield. This is called Dollar duration.

Dollar duration is defined by

$D = -(dP/dy) = -MD*P

38
 Dollar Duration
From its definition, the change in price of a
bond due to a change in yield dy is given
by

dP  - $ D x dy

Dollar duration gives the dollar change in

value for a 100 basis point change in
interest rates.

39
 Price Value of a Basis Point
The Price Value of a Basis Point (PVBP) is the dollar
price change of a security for a one basis point
change in yield.

It is equal to Dollar Duration divided by 100.

PVBP = $D/100

For example, the 5 year bond we looked at earlier,

has
Dollar duration of $3.31
PVBP of 3.31 / 100 = $0.0331
40
Modified Duration of a Portfolio
Let P be the total value of a portfolio, and Pi the
price, xi be the number and MDi be the Modified
Duration of security i in the portfolio. The MD of
the portfolio is defined as

MD(portfolio) = (  Pi*xi*Mdi )/ P

Similarly,
$D (portfolio) =  xi*$Di
PVBP (portfolio) =  xi*PVBPi

41
Price-Yield Relationship and
Reinvestment Income

42
 Convexity

Refers to the degree to which duration changes as

the yield to maturity changes
Price-yield relationship is convex
Duration equation assumes a linear relationship
between price and yield
Convexity largest for low coupon, long-maturity
bonds, and low yield to maturity

43
 Duration and Convexity
Price

Pricing Error
from convexity

Duration

Yield

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