Tutorial 3: Bonds/Fixed Income Securities

1. Define Yield to Maturity (YTM). Explain the importance of YTM and

why it is less practical to use YTM for the valuation of bond in a callable
bond?
Yield to Maturity (YTM) is the total rate of return that will have been earned by
a bond when it makes all interest payments and repays the original principal.
The important of YTM is it enables investors to draw comparisons between
different securities and the returns they can expect from each.
It is less practical to use YTM for the valuation of bond in a callable bond is
because it assumes that all interest income is reinvested at rate equal to market
rate at time of YTM calculation, and no reinvestment risk.

2. Given two bonds with identical risk, coupons and maturity date, with the
only difference between the two being that one is callable, which bond will
sell for the higher price?
The non-callable bond will sell for a higher price compare to callable bond. It is
because non-callable bond does not have reinvestment risk and a callable bond
can be call back anytime so it have reinvestment risk and it is selling at a lower
price. The callable bond will have a higher yield which is yield to call compare
to non-callable bond, this is to compensate the investor for their high investment
risk.

3. Define two characteristics of a bond that determine its reinvestment rate

risk?
The first characteristics of a bond that determine its reinvestment rate risk is the
coupon rate. A bond with a higher coupon will have the higher reinvestment
risk. This is because higher amount of money needs to be reinvested to realize
the YTM.
Second characteristics is maturity. A bond with a higher maturity will have
higher reinvestment risk. This is because the interim coupon payments need to
be reinvested for a longer period of time to realize the YTM.

4. Explain the conditions that affect the bond to be sold at premium or

discount.
A bond will trade at a premium when the market value that is above par value.
This is occurred when market interest rates are below bond’s coupon rate.
A bond will trade at a discount when the market value that is below par value.
This occur when market interest rates are above bond’s coupon rate.

5. What is the value of a zero-coupon bond paying semiannually that

matures in 20 years, has a maturity of $1 million, and is selling to yield
7.6%? (CFA Question)
r = 7.6%/2 = 0.038
t = 20/2 = 40
BP = 1,000,000/(1+0.038)^40
BP = $ 224,960.29

6. Suppose a 10-year 9% coupon bond is selling for $112 with a par value of
$100. What is the current yield for the bond? What is the limitation of the
current yield measure? (CFA Question)
Current Yield = Annual interest income/Current market price of the bond
CY = (100*0.09)/(112)
CY = $ 8.036%
The limitation of current yield measure is that the total return also depends on
the price of sell the bond one year in the future. Market prices can change
within that time and this will affect the total return on the investment.

7. Determine whether the yield to maturity of a 6.5% 20-year bond that

pays interest semiannually and is selling for $90.68 is 7.2%, 7.4%, or 7.8%.
(CFA Question)

BPi = $90.68
BPi = 3.25(1-1/(1 + 0.037)^40/0.037) + (100/(1 + 0.037)^40)
When the rate is 7.4%, bond price = $90.68
8. What effect does the use of semiannual discounting have on the value of
a bond in relation to annual discounting?
In general, if the discount rate used in the valuation is higher than the coupon
rate, annual discounting will result in a higher present value than will
semiannual discounting.
- Discount rate > Coupon rate
- Annual PV > Semiannual PV

On the other hand, if the discount rate is less than the coupon rate, semiannual
discounting produces the higher present value.
- Discount rate < coupon rate
- Semiannual PV > Annual P

9. Explain the term bond immunization and how can it reduce the interest
rate risk.
Bond immunizations the strategy to derive a specified rate of return regardless
of what happens to market interest rates over holding period.
Bond immunizations reduce the interest rate risk by adjusting the portfolio
duration to match the investor's investment time horizon.

10. A 10-yr bond is paying 8% coupon compounded annually, with a par

value of RM1000. If it is yield at 6%, estimate the followings:
a) duration of the bond
Coupon rate
= 8% x RM1000
= RM80
N=10
YTM = 6%
FV= RM1000
PV = RM1147.20

Macaulay Duration
=
[(1x80/1.06^1)+(2x80/1.06^2)+(3x80/1.06^3)+(4x80/1.06^4)+(5x80/1.06^5)+(
6x80/1.06^6)+(7x80/1.06^7)+(8x80/1.06^8)+(9x80/1.06^9)+(10x80/1.06^10) /
1147.20]
= 8540.94/1147.20
=7.45 years
b) the changes of price for a 25 basis point changes in interest rate

25 basic point = 0.25%

Modified Macaulay Duration

= [7.45/(1+0.06)]
= 7.03

Percentage change in bond price

= -1 x Modified duration x change in interest rate
= -1 x 7.03 x 0.25%
= -1.76%

Original bond price= RM1147.20 then reduce by 1.76%

New bond price= RM1127.01
The bond price reduces by RM20.19

11. Calculate the price of a 30-year bond with 7% coupon rate which is
callable in 5 years at a price of RM1,030. Assume that the yield to call is
7% and coupon payments are made semi-annually.

Coupon rate
= 7%/2=3.5%
3.5%x RM1000
= RM35
N=10
FV= RM1,030

Bond Price
= 35[1-1/(1+0.035)^10/0.035] +[1030/(1.0350^10)]
= RM1021.27