Financial Mathematics: Bond Pricing

Financial Mathematics
Bond Pricing
Van Quy NGUYEN
Actuary program - NEU
December 2022
Van Quy NGUYEN FM course December 2022 1 / 44

Contents
1 Basic Concepts
2 Bond Price
3 Bond Amortization Schedule
4 Callable Bonds
5 Bond Pricing under a General Term Structure
6 Risk of Bond Investment

Basic Concepts
A bond is a contract/certificate of debt for which the issuer promises

to pay the holder a sequence of interest payments over a specified
period of time, and to repay the principal at a specified terminal date
(called the maturity or redemption date).
Many entities issue bonds. For e.g. national/provincial governments,
large corporations ...
Governments issue bonds to fund public programs, infrastructure
projects or general government expenditures.
Corporations issue bonds for expansion, acquisitions, investments, etc.

Basic Features of Bonds
Face Value: Face value, denoted by F , also known as par or

principal value, is the amount printed on the bond.
Redemption Value: A bond’s redemption value or maturity value,
denoted by C , is the amount that the issuer promises to pay on the
redemption date. In most cases the redemption value is the same as
the face value.
Time to Maturity: Time to Maturity refers to the length of time
before the redemption value is repaid to the investor.
Coupon Rate: The coupon rate, denoted by r , is the rate at which
the bond pays interest on its face value at regular time intervals until
the redemption date.

Diagram of a coupon-paying bond

Example
The bond is a five-year Japanese government bond (JGB) with a coupon
rate of 0.4% and a par value of ¥10,000. Interest payments are made
semi-annually. The bond is priced at par when it is issued and is redeemed
at par.

Bond Prices

Bond prices
Bond value = Present value of coupons + Present value of

redemption value
With the flat interest rate
n
X Coupon Redemption value
P= +
(1 + i)t (1 + i)n
t=1
With the flat term structure and the flat interest rate
P = (Fr )a n + Cv n
1
where the discount factor v = 1+i and the annuity function a n are
calculated at the yield rate i.

Examples
Example
The following shows the results of a government bond auction:
Type of Bond Government bond

Issue Date February 15, 2010
Maturity Date February 15, 2040
Coupon Rate 4.500% payable semiannually
Yield Rate 4.530% convertible semiannually
Assume that the redemption value of the bond is the same as the face
value, which is $100. Find the price of the bond.

Examples
We have F = 100, C = 100, r = 0.0225, i = 0.02265, T = 30, n = 60.

Bond price is
P = 2.25a 60 0.02265 + 100(1, 02265)−60 = $99.51

Examples
Example
The following shows the information of a government bond traded in the
secondary market:
Type of Bond Government bond

Issue Date June 15, 2005
Date of Purchase June 15, 2009
Maturity Date June 15, 2020
Coupon Rate 4.2% payable semiannually
Yield Rate 4.0% convertible semiannually
Assume that the redemption value of the bond is the same as the face
value, which is $100. Find the purchase price of the bond immediately
after its 8th coupon payment on June 15, 2009.

Examples
We have F = 100, C = 100, r = 0.021, i = 0.020.

This is a 15-year bond at issue but there are only 22 remaining
couponpayment periods after its 8th coupon payment on June 15, 2009,
so n = 22.
Bond price is
P = 2.1a 22 0.02 + 100(1, 02)−22 = $101.77

Example
Find the coupon rate of a 5-year $100 par semi-annual coupon bond
redeemable at par, yielding 5.7% convertible semi-annually, if its price is
the same as that of a zero-coupon bond with face value $100 maturing in
5 years and yielding 3.5% compounded annually.

Makeham’s Formula
Proposition
Let K = Cv n be the present value of the redemption payment and
g = Fr /C be the modified coupon rate. Then the fair price P of the bond
is given by
g
P = K + (C − K ).
i

Example
Example
A 10-year $100 par value bond bearing a 10% coupon rate payable
semiannually, and redeemable at 105, is bought to yield 8% convertible
semiannually. Find the price. Verify that all four formulas produce the
same answer.

Example
We have F = 100, C = 105, r = 5%, i = 4%, n = 20.

Then one gets
Fr 1
g= C = 21
K = Cv n = 105(1.04)−20 = 47.92
Fr
G= i = 125
Using the basic formula we find
P = 5a 20 0.04 + 105(1.04)−20 = $115.87
Using the Makeham’s formula we find

100
P = 47.92 + (105 − 47.92) = $115.87
84

Some remarks
Usually the face value F and the redemption value C are the same.
Thus, the modified coupon rate is the same as the coupon rate.
It should be noted that g is the coupon interest per unit amount of
the redemption value, while r is the coupon interest per unit amount
of the face value.
If g = i then
g
P=K+ (C − K ) = K + (C − K ) = C .
i
If g > i then
g
P=K+ (C − K ) > K + (C − K ) = C .
i
If g < i then
g
P=K+ (C − K ) < K + (C − K ) = C .
i
Bond Amortization

The Discount/Premium Formula
Proposition
Let P be the fair price of an n-period coupon-paying bond whose face
value is F , redemption value is C , coupon and yield rates are r and i
respectively. The bond premium/discount is defined as P − C and is given
by
P − C = (Fr − Ci)a n = C (g − i)a n ,
where g = Fr /C is the modified coupon rate.

Bond Premium/Discount
If the selling price of a bond P is larger than its redemption value C ,

the bond is said to be traded at a premium of value
P − C = C (g − i)a n .
On the other hand, if the selling price P is less than its redemption
value C , the bond is said to be traded at a discount of amount
C − P = C (i − g )a n .
Therefore,
Traded Amount Condition
Premium P − C = C (g − i)a n g >i
Par P −C =0 g =i
Discount C − P = C (i − g )a n i >g

Bond Premium
In the bond premium situation the bondholder pays more than the
redemption value.
The premium represents an amount that the investor will not receive
at maturity.
This paid-in-advance premium (which is an asset for the bondholder)
will be refunded (amortized) periodically from the coupon payments
over the life of the bond.

Example: Bond Premium
Consider a $1,000 face value (same as the redemption value) 3-year

bond with semi-annual coupons at the rate of 5% per annum.
The current required rate of return for the bond is 4% convertible
semi-annually.
The price of the bond is
P = Fr a n + Cv n
1 − 1.02−6
= (1000 × 0.025) × + 1000 × 1.02−6
0.04
= 1028.01.
Therefore, the bond is traded at a premium of $28.01.

The amortization schedule of the bond premium is as follows.

A bond premium amortization schedule
Half Coupon Effective Amortized amount Book

year payment interest earned of premium value
0 1028.0072a
1 25b 20.5601c 4.4399d 1023.5673e
2 25 20.4713 4.5287 1019.0386
3 25 20.3808 4.6192 1014.4194
4 25 20.2884 4.7116 1009.7078
5 25 20.1942 4.8058 1004.9020
6 25 20.0980 4.9020 1000.0000
Total 150 121.9928 28.0072

a The purchase price is the beginning balance of the book value.
0.05
b The coupon payment is 1, 000 × 2 = $25.
c Effective interest earned in the first half-year is
1028.01 × 0.04
2 = $20.56.
d Amortized amount of premium in the first half-year is
25.00 − 20.56 = $4.44.
e The book value after amortization is 1028.01 − 4.44 = $1023.57.

Formulas for a general bond amortization schedule

Example
Fill in the missing values of the following bond amortization schedule for a
$100 par value 2-year bond with semi-annual coupons:

0
1
2 94.26
3 -1.05 95.31
4 3.34 -1.09 94.6

0 100
1 2.25 3.5 -1.15
2 2.25 94.26
3 2.25 3.30 -1.05 95.31
4 2.25 3.34 -1.09 94.6
Total 11 121.9928 28.0072

Callable Bonds

Callable Bonds
Callable bonds are bonds that can be redeemed by the issuer prior to
the bonds’ maturity date.
Investors whose bonds are called are paid a specified call price, which
was fixed at the issue date of the bond.
The call price may be the bond’s face value or higher.
The difference between the call price and the face value is called the
call premium.

Callable Bonds
If a bond is called between coupon dates, the issuer must pay the
investor accrued interest in addition to the call price.
An issuer may choose to call a bond when the current interest rate
drops below the coupon rate of the bond. In this circumstance, the
issuer will save money by paying off the bond and issuing another
bond at a lower interest rate.
Investors of callable bonds often require a higher yield to compensate
for the call risk as compared to non-callable bonds.
Some callable bonds offer a call protection period during which the
issuer is not allowed to call the bond.
The first call date is the date after which the bond is fully callable.

Guideline for investors
The issuer has an option whether or not to call the bond

The investor should assume that the issuer will exercise that option to
the disadvantage of the investor.
If the redemption value is the same at any call date, then the
following general principle will hold:
For bond selling at a premium: call date will most likely be at the
earliest date possible, which occurs when the yield rate is smaller than
the coupon rate.
For bond selling at a discount: call date will most likely be at the latest
date possible, which occurs when the yield rate is larger than the
coupon rate.
More general rule: To ensure that we earn a specified minimum yield
rate, determine the lowest price for all of the possible redemption
dates at this yield rate.

Example
A 20 year $100 par bond has 6% annual coupons and is callable at par
after 10 years. What is the price of the bond to yield 4% for the investor?

The bond is selling at premium so the earliest redemption date is the most
favorable for the issuer and the least favorable for the investor.
The price is the smallest of
100 + (6 − 4)a n 0.04
for 10 ≤ n ≤ 20; which clearly occurs when n = 10: Thus, the price is
1000 + (6 − 4)a 10 0.04 = $116.22

Example
A 20 year $100 par bond has 6% annual coupons and is callable at par
after 10 years. What is the price of the bond to yield 8% for the investor?

The bond is selling at premium so the earliest redemption date is the most
favorable for the issuer and the least favorable for the investor.
The price is the smallest of
100 + (6 − 8)a n 0.04
for 10 ≤ n ≤ 20; which clearly occurs when n = 20: Thus, the price is
1000 + (6 − 8)a 20 0.04 = $80.36

Example
Consider a $1,000 face value 15-year bond with coupon rate of 4%
convertible semi-annually. The bond is callable and the first call date is
the date immediately after the 15th coupon payment. Assume that the
issuer will only call the bond at a date immediately after the nth coupon
(15 ≤ n ≤ 30) and the call price (i.e., redemption value) is

1000 if 15 ≤ n ≤ 20
C (n) =
1000 + 10(n − 20) if 21 ≤ n ≤ 30
Find the price of the bond if the investor wants to achieve a yield of at
least 5% compounded semi-annually.

Solution:
Let P(n) be the price of the bond if it is called immediately after the nth
coupon payment. Then
P(n) = 1000 × 0.02a n + C (n)v n

1 − (1.025)−n
= 20 × + C (n) × (1.025)−n
0.025
800 + 200 × (1.025)−n if 15 ≤ n ≤ 20

=
800 + 10n × (1.025)−n if 21 ≤ n ≤ 30
Since the sequence (1.025)−n is decreasing and the sequence n × (1.025)−n

is increasing, the minimum value of the sequence {P(n)}30
n=15 is at
P(20) = 922.0542.
Thus, the minimum price is $922.05, which assumes the bond will be
called after the 20th coupon payment.
Bond Pricing under a General Term Structure

Bond Pricing under a General Term Structure
Suppose the term structure is not flat then the bond pricing formula
has to be modified.
Consider a bond with n coupon payments whose redemption value is
C , face value is F , coupon rate is r .
Suppose the spot rates are given by itS for t ≥ 0.
For an annual bond, the price P is given by
n
X 1 C
P = Fr S )k
+ .
(1 + ik
(1 + inS )n
k=1
For a semi-annual bond, the price P is given by

n
X 1 C
P = Fr k + S
n .
S
ik/2 in/2
k=1 1 + 1+ 2
2

Example
Consider a $100 par bond with coupon rate of 4.0% per annum paid
semi-annually. The spot rates of interest in the market are given by
j (years) 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0
ijS (%) 3.0 3.0 3.5 3.5 4.0 4.0 4.5 4.5 5.0 5.0
Find the price of the bond if it matures in

a) 3 years,
b) 5 years.
Answer:
a) 100.0608
b) 95.9328

Risk of Bond Investment

Risks of Bond Investment
Interest-rate risk: After the investor purchases the bond, if the

prevailing interest rate rises, the price of the bond will fall as the bond
is less attractive to the investors.
Default risk: is the risk that the bond issuer is unable to make
interest and/or redemption payments.
Reinvestment risk: For coupon-paying bonds, investors receive
interest payments periodically before the redemption date. The
reinvestment of these interest payments depends on the prevailing
interest-rate level at the time of reinvestment. Volatility in the
reinvestment rate of return due to changes in market interest rates is
called reinvestment risk.

Call risk: The issuer of a callable bond has the right to redeem the
bond prior to its maturity date at a pre-set call price. The call risk
has three impacts on a bond investor:
the cashflow pattern becomes uncertain,
the investor becomes exposed to reinvestment risk,
the capital appreciation potential of the bond will be reduced.
Inflation risk arises because of the uncertainty in the real value (i.e.,
purchasing power) of the cash flows from a bond due to inflation.
Market risk is the risk that the bond market as a whole declines.
Event risk arises when some events occur and they have negative
impacts on a specific class of bonds.
Liquidity risk is the risk that investors may have difficulty finding a
buyer when they want to sell and may be forced to sell at a significant
discount to the bond’s fair value.

Financial Mathematics: Bond Pricing

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Financial Mathematics: Bond Pricing

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Financial Mathematics

Van Quy NGUYEN

Actuary program - NEU

Van Quy NGUYEN FM course December 2022 1 / 44

3 Bond Amortization Schedule

5 Bond Pricing under a General Term Structure

6 Risk of Bond Investment

Van Quy NGUYEN FM course December 2022 2 / 44

A bond is a contract/certificate of debt for which the issuer promises

Van Quy NGUYEN FM course December 2022 3 / 44

Face Value: Face value, denoted by F , also known as par or

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Van Quy NGUYEN FM course December 2022 6 / 44

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Bond value = Present value of coupons + Present value of

Van Quy NGUYEN FM course December 2022 8 / 44

Type of Bond Government bond

Van Quy NGUYEN FM course December 2022 9 / 44

We have F = 100, C = 100, r = 0.0225, i = 0.02265, T = 30, n = 60.

P = 2.25a 60 0.02265 + 100(1, 02265)−60 = $99.51

Van Quy NGUYEN FM course December 2022 10 / 44

Type of Bond Government bond

Van Quy NGUYEN FM course December 2022 11 / 44

We have F = 100, C = 100, r = 0.021, i = 0.020.

P = 2.1a 22 0.02 + 100(1, 02)−22 = $101.77

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Van Quy NGUYEN FM course December 2022 13 / 44

Van Quy NGUYEN FM course December 2022 14 / 44

Van Quy NGUYEN FM course December 2022 15 / 44

We have F = 100, C = 105, r = 5%, i = 4%, n = 20.

P = 5a 20 0.04 + 105(1.04)−20 = $115.87

Using the Makeham’s formula we find

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If the selling price of a bond P is larger than its redemption value C ,

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Van Quy NGUYEN FM course December 2022 21 / 44

Consider a $1,000 face value (same as the redemption value) 3-year

Therefore, the bond is traded at a premium of $28.01.

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Half Coupon Effective Amortized amount Book

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Half Coupon Effective Amortized amount Book

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The issuer has an option whether or not to call the bond

Van Quy NGUYEN FM course December 2022 31 / 44

Van Quy NGUYEN FM course December 2022 32 / 44

100 + (6 − 4)a n 0.04

1000 + (6 − 4)a 10 0.04 = $116.22

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100 + (6 − 8)a n 0.04

1000 + (6 − 8)a 20 0.04 = $80.36

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