Chapter 4

Introduction to the
Valuation of Debt Securities
 Major learning outcomes:

– The valuation – which is the best process of

determining the fair value of a fixed financial asset:
• Single discount rate
• Multiple discount rates

– This process is also called pricing or valuing.

– Only option-free bond valuation is presented in this

chapter.
 Key Learning Outcomes
• Describe the fundamental principles of bond valuation.

• Explain the steps in the valuation process (i.e., estimate expected cash
flows, determine an appropriate discount rate or rates, and compute the
present value of the cash flows).

• Define a bond’s cash flows.

• Describe the difficulties of estimating the expected cash flows for some
types of bonds.

• Compute the value of a bond, given the expected cash flows and the
appropriate discount rates.

• Explain how the value of a bond changes if the discount rate increases or
decreases.

• Explain how the price of a bond changes as the bond approaches its
maturity date.

• Compute the value of a zero-coupon bond.

 Key Learning Outcomes
• Compute the value of a bond that is between coupon payments. explain the
deficiency of the traditional approach to bond valuation.

• Explain the arbitrage-free bond valuation approach and the role of Treasury
spot rates in the valuation process.

• Explain how the process of stripping and reconstitution forces the price of a
bond towards its arbitrage-free value.

• Demonstrate how a dealer can generate an arbitrage profit if a bond is

mispriced.

• Compute the price of the bond given the term structure of default free spot
rates and the term structure of credit spreads.

• Explain the basic features common to models used to value bonds with
embedded options.
1. The Conventional Method for
Bond Pricing
• The Discounted Cash Flows (DCF) approach: the
conventional/traditional approach used for bond valuation,
which values a bond based on the cash flows to be
generated from holding a bond.
• Promised cash flows from buying an option-free fixed rate
bond:
– a series of coupon interest payments and
– repayment of the full principal at maturity, assuming
no default.
1. The Conventional Method for
Bond Pricing
1. The Conventional Method for
Bond Pricing

• Valuation of a financial asset involves the determination

of:
– The expected cash flows;
– The appropriate interest rate for discounting;
– The life of the asset;

• How each one of them affects the pricing of a bond?

 1. The Conventional Method for
Bond Pricing
• Notice that: A discount rate is used in the time-value-of-
money calculation to obtain the present value.

• The discount rate is the rate of return required by investors

given the risk of the investment in the bond, and therefor it
should be risk-adjusted It is also called the (risk-adjusted)
required yield or the required rate of return.

• How to adjust the discount rate for risks is a critical issue in

the valuation of financial securities.
 Cash Flows from a Bond
• Cash flows for a bond can become more complicated when:
– The issuer has the option to change the contractual due date
for the payment of the principal (callable, puttable,
mortgage-backed, and asset-backed securities);
– The coupon rate is reset periodically by a formula based on
come value or reference rates, prices, or exchange rates
(floating-rate securities); and
– The investor has the choice to convert or exchange the
bond into common stock (convertible bonds).
 Cash Flows from a Bond
• Whether or not callable, puttable, mortgage-backed, and
asset-backed securities are exercised early is determined by
the movement of interest rates;
– If rates fall far enough, the issuer will refinance
– If rates rise far enough, the borrower has an incentive to
refinance
• Therefore, to properly estimate cash flows it is necessary to
incorporate into the analysis how future changes in interest
rates and other factors might affect the embedded options.
 Cash Flows from a Bond

• For any fixed income security which neither the issuer nor
the investor can alter the payment of the principal before its
contractual due date, the cash flows can easily be
determined assuming that the issuer does not default.
• The difficulty in determining cash flows arises for securities
where either the issuer or the investor can alter the cash
flows, or the coupon rate is reset by a formula dependent on
some reference rate, price, or exchange rate.
1. The Conventional Method for
Bond Pricing
 Relationships between the Bond Price
and Bond Characteristics
• The price of a fixed-rate bond will change whenever the
market discount rate changes. A change in the discount rate
may cause the bond price to change in four ways, depending
on the characteristics of the bond:
• 1. The Inverse Effect: The bond price is inversely related to the
market discount rate. When the market discount rate increases,
the bond price decreases;
• 2. The Convexity Effect: For the same coupon rate and time-
to-maturity, the percentage price change is greater (in absolute
value, meaning without regard to the sign of the change) when
the market discount rate goes down than when it goes up;
 Relationships between the Bond Price
and Bond Characteristics
• Relationship 2 the Convexity Effect: For the same coupon rate
and time-to-maturity, the percentage price change is greater (in
absolute value) when the market discount rate goes down than
when it goes up.
• This implies that the relationship between bond prices and the
market discount rate is not linear, instead, it is curved.
Bond Coupon Maturity Price at Discount Rate Discount Rate
Rate 20% Lower Higher
Price at % Price Price at % Price
19% Change 21% Change
E 10% 20 years 51.304 54.092 5.43% 48.776 -4.93%

D 20% 20 years 100.000 105.101 5.10% 95.343 -4.66%

F 30% 20 years 148.696 156.109 4.99% 141.910 -4.56%

Price/Discount Relationship
 Relationships between the Bond Price
and Bond Characteristics

3. The Coupon Effect: For the same time-to-maturity, a lower-

coupon bond has a greater percentage price change than a higher-
coupon bond when their market discount rates change by the
same amount;
• Consider Bonds A, B, C, which have 10 years to maturity. For both
the decrease and increase in the YTM, Bond A has a large
percentage price change than Bond B, and Bond B has a larger
change than C.
 Relationships between the Bond Price
and Bond Characteristics

Bond Coupon Maturity Price at Discount Rate Discount Rate

Rate 20% Lower Higher

Price at % Price Price at % Price

19% Change 21% Change

A 10% 10 years 58.075 60.950 4.95% 55.405 -4.60%

B 20% 10 years 100.00 104.339 4.34% 95.946 -4.05%
C 30% 10 years 141.925 147.728 4.09% 136.487 -3.83%
 Relationships between the Bond Price
and Bond Characteristics
4. The Maturity Effect: In general, for the same coupon rate, a
longer-term bond has a greater percentage price change than a
shorter-term bond when their market discount rates change by the
same amount.
– The 20-year bonds have greater percentage price changes than
the 10-year bonds for either an increase or a decrease in the
market discount rate.
Bond Coupon Maturity Price at Discount Rate Discount Rate
Rate 20% Lower Higher
Price at % Price Price at % Price
19% Change 21% Change
B 20% 10 years 100.000 104.339 4.34% 95.946 -4.05%
E 20% 20 years 100.000 105.101 5.10% 95.343 -4.66%
H 20% 30 years 100.000 105.235 5.23% 95.254 -4.75%
 Relationships between the Bond Price
and Bond Characteristics
• Changes in Value of Bond toward Maturity: The Pull to Par
Effect
• The essential fact: At maturity, the bond price equals the face
value.
• As a bond gets closer to maturity, its value changes:
–Value decreases over time for bonds selling at a premium.
–Value increases over time for bonds selling at a discount.
– Value is unchanged if a bond is selling at par.
• At maturity as a bond is worth its par value, and so there is a
“pull to par value” over time.
Change in Value as Bond Moves
Toward Maturity
 The Price Path of a Bond

• What would happen to the value of a bond if its required rate

of return remained at 10%, or at 13%, or at 7% until
maturity? ”Pull to par”
VB

1,372 kd = 7%.
1,211
kd = 10%.
1,000
837
775 kd = 13%.
Years
to Maturity
30 25 20 15 10 5 0
 Relationships between the Bond Price
and Bond Characteristics

• An investor is considering the following six annual coupon

payment government bonds:
• 1. Based on the relationships between bond prices and bond
characteristics, which bond will go up in price the most on a
percentage basis if all yields go down from 5.00% to 4.90%?
• 2. Based on the relationships between the bond prices and
bond characteristics, which bond will go down in price the
least on a percentage basis if all yields go up from 5.00% to
5.10%?
Bond Coupon Time to Yield to
Rate Maturity Maturity
A 0% 2 years 5.00%
B 5% 2 years 5.00%
C 8% 2 years 5.00%
D 0% 4 years 5.00%
E 5% 4 years 5.00%
F 8% 4 years 5.00%
 Relationships between the Bond Price and
Bond Characteristics
• Solution:

• 1. Bond D will go up in price the most on a percentage basis because it

has the lowest coupon rate (the coupon effect) and the longer time-to-
maturity (the maturity effect). There is no exception to the maturity effect
in these bonds because there are no low-coupon bonds trading at a
discount.

• 2. Bond C will go down in price the least on a percentage basis because it

has the highest coupon rate (the coupon effect) and the shorter time-to-
maturity (the maturity effect). There is no exception to the maturity effect
because Bonds c and F are priced at a premium above par value.
1. The Conventional Method for
Bond Pricing
1. The Conventional Method for
Bond Pricing
1. The Conventional Method for
Bond Pricing
 1. The Conventional Method for
Bond Pricing
• A Price-Face Value Relationship: For an option-free fixed-rate
coupon bond:
– If discount rate (r) = coupon rate (c), then bond price = par
value (par bonds); that is,
– r = c, Price = face value;
– If discount rate > coupon rate, then bond price < par value
(discount bonds); that is,
– r > c, Price < face value;
– If discount rate < coupon rate, the bond price > par value
(premium bonds); that is,
– r < c, Price > face value.
1. The Conventional Method for
Bond Pricing
1. The Conventional Method for
Bond Pricing
 1. The Conventional Method for
Bond Pricing
 EX: A 5-year, 4% annual coupon bond will pay investors $4
per year and $100 principal at maturity. The promised cash
flows if use the DCF approach:
0 1 2 T=5
k ...
P=? $4 $4 $4 + $100

 If the price is computed with deficiency, the cash flows:

 0 1 2 T=5
k ...
$4-$6=-$2 $4-$6=-$2
P=? $4-$6=-$2
1. The Conventional Method for
Bond Pricing
 1. The Conventional Method for
Bond Pricing
• Identify whether each of the following bonds is trading at a
discount, at par, or at a premium. If the coupon rate is
deficient or excessive compared with the market discount
rate, calculate the amount of the deficiency or excess per 100
of par value.

Bond Coupon Number of Market

Payment per Periods to Discount Rate
Period Maturity per Period
A 2 6 3%
B 6 4 4%
C 5 5 5%
D 0 10 2%
 2. Bond Pricing Between
Coupon Periods
• When a bond is purchased between coupon periods, the buyer pays a
price that includes accrued interest, called the full price or dirty price.
• Price paid to buy a bond between coupon periods
• = full price or dirty price
• = PV of cash flows at the coupon period + accrued interest
= flat price + accrued interest
• The clean price or simply price or flat price of a bond is the full price
minus accrued interest.
• Clean price
• = Full price – accrued interest
 2. Bond Pricing Between
Coupon Periods
• For coupon bonds, it is likely that a purchase or sale is going
to occur on a non-interest payment date.
• The amount that the buyer pays the seller in such cases is the
present value of the cash flow with the next payment
encompassing two components:
– Interest earned by seller
– Interest earned by the buyer

• The interest earned by the seller is the interest that has

accrued – called accrued interest. At the time of purchase, the
buyer must compensate the seller for the accrued interest.
 2. Bond Pricing Between
Coupon Periods
• In computing accrued interest, day count conventions are used to determine
the number of days in the coupon payment period and the number of days
since the last coupon payment date.

Two day-count conventions:

1. The Accrual/actual Convention: the actual number of days is used.

EX: A semiannual coupon bond pays interest on May 15th and November
15th. On June 27th,

 accrual days = 43 days (5/15 to 6/27)

 actual days = 184 days (5/15 to 11/15)

If the stated coupon rate is 4.375%, the AI is 0.511209 per 100 of par value:

 AI = (43/184)x(4.375%/2) = 0.511209%
 2. Flat Price, Accrued Interest, and the
Full Price

2. The 30/360 Convention: assumes that each month has 30

days and 360 days for one year.
 accrual days = 42 days (5/15 to 6/27)
 actual days = 180 days (5/15 to 11/15)
 AI = (42/180)x(4.375/2) = 0.511209%
2. Flat Price, Accrued Interest, and the
Full Price
2. Flat Price, Accrued Interest, and the
Full Price
2. Flat Price, Accrued Interest, and the
Full Price
2. Flat Price, Accrued Interest, and the
Full Price
2. Flat Price, Accrued Interest, and the
Full Price
 2. Flat Price, Accrued Interest, and the
Full Price

 A 6% German corporate bond is priced for settlement on 18

June 2015. The bond makes semiannual coupon payments on
19 March and 19 September of each year and matures on 19
September 2026. The corporate bond uses the 30/360 day-
count convention for accrued interest. Calculate the full price,
accrued interest, and the flat price per EUR 100 of par value
for three started annual yields-to-maturity: (A) 5.80%, (B)
6.00%, and (C) 6.20%.
2. Flat Price, Accrued Interest, and the
Full Price
 3. Matrix Pricing

 Some fixed-rate bonds are not actively traded, therefore there

is no market price available to calculate the rate of return
required by investors. In this situation, it is common to
estimate the market discount rate and price based on the
quoted or flat prices of more frequently traded comparable
bonds. These comparable bonds have similar times-to-
maturity, coupon rates, and credit quality. This estimation
process is called matrix pricing.
• Estimated yield = yield at lower maturity + (yield at higher
maturity – yield at lower maturity)/Number of years between
two observed maturity points
 3. Matrix Pricing
 To estimate a 3-year, 4% semiannual coupon bond X, assuming that Bond X
is not actively traded and that there are no recent transactions reported.
However, there are quoted prices for four corporate bonds that have very
similar credit quality:

 Bond A: 2-year, 3% semiannual bond traded at a price of 98.500;

 Bond B: 2-year, 5% semiannual bond traded at a price of 102.250;

 Bond C: 5-year, 2% semiannual bond traded at a price of 90.250;

 Bond D: 5-year, 4% semiannual bond traded at a price of 99.125.

2% Coupon 3% Coupon 4% Coupon 5% Coupon
Two Years 98.500 (price) 102.250 (price)
3.786% (YTM) 3.821% (YTM)
Three Years Bond X
Four Years
Five Years 90.250 (price) 99.125 (price)
4.181% (YTM) 4.196% (YTM)
3. Matrix Pricing
 3. Matrix Pricing

An analyst needs to assign a value to an illiquid 4-year

4.5% annual coupon bond. The analyst identifies two
corporate bonds that have similar credit quality: one is
a 3-year 5.50% annual coupon bond priced at 107.500,
and the other is a 5-year 4.50% annual coupon bond at
104.750. Using matrix pricing, the estimated price of
the illiquid bond per 100 of par value.
3. Matrix Pricing
4. Pricing Bonds with Spot Rates
(The Arbitrage-Free Approach to Bond Valuation)

1. Pricing bonds with spot rates is considered to be the correct

approach for pricing bonds. The approach will produce an
arbitrage-free bond price that doesn’t allow for an arbitrage.

2. A more complete description about the arbitrage-free

approach of bond pricing is provided in a supplementary set of
slides.
 4. Pricing Bonds with Spot Rates
 When a fixed-rate bond is priced using the market discount rate,
the same discount rate is used on each cash flow.
 A more fundamental approach to calculate the price of a bond is to
use a sequence of market discount rates that correspond to the cash
flow dates. These market discount rates are called spot rates.
 Spot rates are yields-to-maturity on zero-coupon bonds maturing at
the date of each cash flow. Sometimes these are called “zero rates”.
 Bond price determined using the spot rates is sometimes referred to
as the bond’s “no-arbitrage value”. If a bond’s price differs from
its non-arbitrage value, an arbitrage opportunity exists.
4. Pricing Bonds with Spot Rates
 4. Pricing Bonds with Spot Rates

• This is the proper way to value a securities because it doesn’t

allow arbitrage profit by taking apart or “ stripping” a security
and selling off the stripped securities at a higher aggregate
value than it would cost to purchase the security in the
market.
 4. Pricing Bonds with Spot Rates

• Arbitrage-free pricing approach – Assumes that no arbitrage

profits are possible in the pricing of the bond.
– Each of the bond’s cash flow (coupons and principal) is
priced separately and is discounted at the same rate as the
corresponding zero-coupon government bond.
– Since each bond’s cash flow is known with certainty, the
bond price today must be equal to the sum of each of its cash
flows discounted at the corresponding spot rate – or otherwise
arbitrage is possible.
 4. Pricing Bonds with Spot Rates
• Arbitrage is the simultaneous buying and selling of an asset at
two different prices in two different markets.
– The arbitrageur buys low in one market and sells for a
higher price in another.
– The fundamental principle of finance is the “law of one
price.”
• If arbitrage is possible, it will be immediately exploited
by arbitrageurs.
• If a synthetic asset can be created to replicate anther asset,
the two assets must be priced identically or else arbitrage
is possible.
 4. Pricing Bonds with Spot Rates
• It is possible to value the bond as a package of zero-coupon bonds.

– If they are priced differently, arbitrage profits would be possible.

• To implement the arbitrage-free approach, it is necessary to

determine the interest rate (spot rate) for each coupon for each
maturity:

– The Treasury spot rate is used to discount a default-free cash flow

with the same maturity.

– Adding a credit spread for an issuer to the Treasury spot rate curve
gives the benchmark spot rate curve used to value that issuer’s
security.

– The value of a bond based on spot rates if called the arbitrage-free

value.
4. Pricing Bonds with Spot Rates
4. Pricing Bonds with Spot Rates

0 1 2 T=3

P = $105.6572 $5 $5 $105

0 1 2 T=3

P = $102.960 $5 $5 $105
 4. Pricing Bonds with Spot Rates

• For the 3-year 10% bond,

• If the traditional valuation approach is used, assuming that
the 3-year yield is 12%:
• Price = $10/(1+12%) + $10/(1+12%)2 +
$110/(1+12%) 3
• = $95.1963
• If the Arbitrage-Free approach is used, assuming spot rates
(Treasury zero-coupon rates) of 10%, 12%, and 14% for 1, 2,
and 3-year yields:
• Price = $10/(1+10%) + $10/(1+12%)2 + $110/(1+14%) 3
• = $91.3097
Ex: Determination of Arbitrage Free Value of a 8%, 10-year
Treasury
Period Year Cash Flow ($) Spot Rate (%) Present Value ($)
1 0.5 4 3.0000 3.9409
2 1.0 4 3.3000 3.8712
3 1.5 4 3.5053 3.7968
4 2.0 4 3.9164. 3.7014
5 2.5 4 4.3764 3.5843
6 3.0 4 4.7520 3.4743
7 3.5 4 4.9622 3.3694
8 4.0 4 5.0650 3.2747
9 4.5 4 5.1701 3.1971
10 5.0 4 5.2772 3.0829
11 5.5 4 5.3864 2.9861
12 6.0 4 5.4976 2.8889
13 6.5 4 5.6108 2.7916
14 7.0 4 5.6643 2.7055
15 7.5 4 5.7193 2.6205
16 8.0 4 5.7755 2.5365
17 8.5 4 5.8331 2.4536
18 9.0 4 5.9584 2.3581
19 9.5 4 6.0863 2.2631
20 10.0 104 6.2169 56.3830
Total $115.2621
Ex: Price of 8%10-year Treasury valued at 6% discount rate
Period Year Cash Flow ($) Discount Present Value ($)
Rate (%)
1 0.5 4 3.0000 3.8835
2 1.0 4 3.0000 3.7704
3 1.5 4 3.0000 3.6606
4 2.0 4 3.0000 3.5539
5 2.5 4 3.0000 3.4504
6 3.0 4 3.0000 3.3499
7 3.5 4 3.0000 3.2524
8 4.0 4 3.0000 3.1576
9 4.5 4 3.0000 3.0657
10 5.0 4 3.0000 2.9764
11 5.5 4 3.0000 2.8897
12 6.0 4 3.0000 2.8055
13 6.5 4 3.0000 2.7238
14 7.0 4 3.0000 2.6445
15 7.5 4 3.0000 2.5674
16 8.0 4 3.0000 2.4927
17 8.5 4 3.0000 2.4201
18 9.0 4 3.0000 2.3496
19 9.5 4 3.0000 2.2811
20 10.0 104 3.0000 57.5823
Total $114.8775
 4. Pricing Bonds with Spot Rates
 Calculate the price (per 100 of par value) and the YTM for a
four-year , 3% annual coupon payment bond given the
following two sequences of spot rates:

Time-to-Maturity Spot Rates A Spot Rates B

1 year 0.39% 4.08%

2 years 1.40% 4.01%
3 years 2.50% 3.70%
4 years 3.60% 3.50%
4 Pricing Bonds with Spot Rates
 Credit Spreads and the Valuation
of Non-Treasury Securities
• For a non-Treasury bond, the theoretical value is slightly more
difficult to determine.
• The value of a non-Treasury bond is found by discounting the
cash flows by the Treasury spot rates plus a yield spread to reflect
the additional risks:
CF1
Value of a non - Treasury 
(1  Treasury Spot Rate1  Yield Spread1 )1
CF2

(1  Treasury Spot Rate 2  Yield Spread 2 ) 2
CFn
 ... 
(1  Treasury Spot Rate n  Yield Spread n ) n
 Credit Spreads and the Valuation
of Non-Treasury Securities
• One approach is to discount the non-Treasury bond by the
appropriate maturity Treasury spot rate plus a constant credit
spread.
– The problem with this approach is that the credit spread
might be different depending upon when the cash flow is
received.
– Credit spreads typically increase with maturity there is a
term structure of credit spreads.
 Treasury Bill Pricing

• T-bills are offered by the Treasury in minimum

denominations of $10,000.
• T-bills are issued and priced at a discount from face value
and are redeemed at par value.
• The difference between the discounted purchase price and the
face value of the T-bill is the interest income which the
purchaser receives.
• The yield on a T-bill is a function of this interest income and
the maturity of the T-bill.
 Treasury Bill Pricing
• T-bills (and other short-term securities) are priced at a discount:

• T-Bill Price = 100*(1 - %discount)

• = 100 * (1-Yield*(days/365))

• A 28-day T-bill is yielding 4.757%, its price will be:

T-bill price = 100 *(1-4.757%*(28/365)) = 99.636

• Alternatively, if a 28-day T-bill priced at 99.636, the yield will be :

• Yield = (100 – T-bill Price)*(365/days)

T-bill Yield = (100-99.636)*(365/28) = 4.757%