Always start with

a SMILING FACE!
Let’s start with some pieces
of wisdom about bonds.
Let’s see quickly what we
were talking about bonds in
the previous class!
Please note an interesting
thing about bond!
Let’s have a quick look
what we discussed in the
previous session.
So, let’s go ahead with the WORLD of
bonds.
What’s a bond?
BOND ………..???

 Bond is a financial instrument through which a

firm/Government/person raises funds and promised to pay a
rate of interest and is having a promised date of repayment.

 A BOND is an agreement in which an issuer is required to pay

the investor the amount borrowed plus interest over a period of
time. A bond is in effect an IOU which can be bought and sold.
 EVERY BOND SHOULD CARRY ...

a coupon rate and its schedule of payment (if a

bond is not carry any coupon, then it is called a ZERO-COUPON
BOND)

a face value; and

a maturity period. (some bonds are perpetual bonds.)
Please note that all bonds
are evaluated in terms of
return and risk.
First, let’s discuss
return on a bond.
Return on a bond is understood in
the sense of YIELD TO MATURITY ...
 YIELD TO MATURITY ...

 Return on a security (YTM) is that discount rate which makes

the present value of future cash inflows from a bond equal to the
present price of a bond over its maturity period.
c1 c2 c + RV
P = + + ... + n
(1 + r )1
(1 + r ) 2
(1 + r )n
where
P = price of bond
ci = coupon of ith period
RV = redemption value
r = discount rate or YTM
 Please note that …

 YTM is similar to IRR.

Yield on T-Bill…

 Yield on a T-Bill is calculated as –

Par Value - Market Price 365

Yield-to-Maturity on T-Bills = 
Market Price Actual Days
 What goes into the making of YTM?

Coupon
The following 3 elements:
▪ Coupon income
Reinvestme Yield-to-
▪ Reinvestment income on nt Income Maturity

coupon received
Capital
▪ Capital gains and losses. Gains and
Losses
Let’s see the yield curve
of different countries
How do you react to the different
yield curves of different countries?
Once we know how much YTM is to be
earned on a bond, then next question
arises is - “what price one should pay
for it?”
How to value a bond?

 Why does a person pay for bond?

 Because it gives future stream of cashflows.
 Therefore, the value of a bond should be equal to present value of
future cashflows.
c1 c2 c n + RV
P = + + ... +
(1 + r )1 (1 + r )2 (1 + r )n
where
P = price of bond
ci = coupon of ith period
RV = redemption value
r = discount rate or YTM
We also discussed some
relationship with regard to
bonds.
RELATION BETWEEN BOND PRICES AND COUPON

❑ For a given maturity period and given YTM, we observe the

following relation between bond price and coupon rate:

As coupon increases, the price of bond increases but

LINEARLY.
RELATION BETWEEN BOND PRICES AND YTM

❑ For a given maturity period, we observe the following

relation between bond price and YTM:

HIGHER THE YTM, LOWER THE BOND PRICE and

vice-versa.
RELATION BETWEEN BOND PRICES AND YTM (continued…)

 For a given maturity period, we observe the following

relation between bond price and YTM:

▪ If YTM is greater than coupon rate, then the bond is sold at a

discount.

▪ If YTM is less than coupon rate, then the bond is sold at a

premium.

▪ If YTM is equal to coupon rate, then the bond is sold at par.

RELATION BETWEEN BOND PRICES AND TIME
TO MATURITY
❑ Price of a bond changes with time!!!
❑ In this regard, we observe the following:
As a bond approaches to its maturity, its price approaches to
its terminal value.

It means that if a bond is being sold at premium at present,

its price will decrease over time; if it is being sold at a
discount, then its price will increase over a period of time; and
if it is being sold at par, then its price will remain at par over
a period of time.
RELATION BETWEEN BOND PRICES AND
DIFFERENT MATURITY PERIODS (continued…)

❑ For a given coupon rate and a given YTM, the different maturity
periods bonds have mixed impact on the prices of bonds.

 If the coupon is more than the YTM, then the bond with higher
maturity periods will have HIGHER PRICES.

 If the coupon is less than the YTM, then the bond with higher
maturity periods will have LOWER PRICES.

 If the coupon is equal to the YTM, then the bond prices remain
same AT PAR irrespective of maturity period.
 This was the point where we
stopped last time.

Any question regarding bonds?

Darker side of bonds…RISK!
There is no bond on this earth which is

having zero-risk!

Every bond is RISKY

 TYPES OF RISKS IN BONDS...

 A Bond may have the following types of risk :

 Interest Rate Risk SYSTEMATIC

 Price Risk
RISK
 Reinvestment Risk

 Purchasing Power Risk

 Exchange Rate Risk
 Political and Regulatory Risk

UNSYSTEMATIC
 Call Risk RISK
 Liquidity Risk
 Default Risk
Let’s start with interest rate risk …
 INTEREST RATE RISK…?

 Interest Rate Risk is understood in terms of sensitivity of bond price and

thereby of return with respect to change in interest rate.

 When interest rate changes, the price of bond changes and reinvestment rate
also changes. Thus, interest rate risk means -
 Price Risk; and

 Reinvestment Risk

 When interest rate changes, its impact on price and reinvestment rate is
opposite and to some extent neutralize the effect of each other.
Remember…
that interest rate risk is always understood in the
sense of SENSITIVITY of bond prices with respect to
yield-to-maturity.
A measure of interest rate risk is based on the
concept of duration and therefore, let’s talk
about duration now...
Now the challenge is …

… how to quantify the change in prices due

to change in YTM?
 DURATION ...

 DURATION is understood in SOME sense of sensitivity

in bond prices with respect to changes in interest rate or
YTM.

 If this sensitivity is higher, duration is higher and so is

the interest rate risk!!!
EVERY BOND HAS A DURATION!!!

 Duration may be-

Macaulay’s Duration [D]

Modified Duration [Dm]

First, we shall talk about
Macaulay’s Duration
 MACAULAY’S DURATION

 MACULAY’S DURATION of a bond means:

 Itis Percentage change in Price with respect to percentage

change in yield.

A measure which is based on the first derivative of the price

function of a bond.
MACAULAY’S DURATION…continued

 MACULAY’S DURATION of a bond is calculated as thus:

n
Ct
(1 + y ) p
 (1 + y )t
t =1
Duration = −  =
P y P
MACAULAY’S DURATION …

 MACAULAY'S DURATION HAS CLOSED FORM

(1 + y ) dP 1 + y (1 + y ) + ( c − y )  n
D=− = −
P d (1 + y ) y c [(1 + y )n − 1] + y
Time to appreciate relation…

… between duration and its determinants.

 Duration of a Zero – Coupon Bond…

 It’s maturity is equal to its duration.

…Now, we take relation between Duration
of a Coupon bearing Bond (without
embedded options) and its determinants…
 MACAULAY’S DURATION (Some Implications ...)

 There is negative relation between coupon and duration – higher

coupon  lower duration.
 There is negative relation between YTM and duration – higher YTM 
lower duration.
 Duration of a coupon-bearing bond with perpetuity is (1+y)/y
 If a bond is selling at a premium or at par, then maturity and
duration are positively related and if a bond is selling at a discount,
then maturity and duration are positively as well as negatively related.
 MODIFIED DURATION

 MODIFIED DURATION of a bond means:

 Percentage change in bond price due to change in yield

1 dP
 It is defined as Dm = − = D /(1 + y )
P dy

 It helps in prediction of future bond prices if yields are changing.

 We can predict percent change in
price using Modified Duration!!!

 By using the concept of Modified Duration, we can predict

proportionate change in Bond prices by using the following
formula:
P
 (-Modified Duration) y
P
 DURATION OF PORTFOLIO...

 Bonds Portfolio can also have DURATION!!!

 It is equal to weighted average of duration of bonds where

weights are proportionate to the value of a bond in the
portfolio, that is n
DP =   i Di
i =1
where
Ni Pi
i =
Total Price of Portfolio
What NEXT?
Your
comments
about the
shape of the
curve.
BONDS HAVE

CONVEXITY !!!!
 CONVEXITY

 Convexity measures how fast the slope of the bond’s price curve changes
when the interest rate is changed.

 It is a measure that is based on second derivative and since second

derivative of bond price with respect to interest rate is positive, it is called
CONVEXITY.

 Convexity can be rewarding for bond’s owner: the greater the convexity, the
higher the return if interest rates drop; the smaller the loss if interest rate
rises.
CONVEXITY is measured as...

1 d 2P
CONVEXITY = 2
P dy
1 n
t (t + 1)ct
=
P(1 + y ) 2

t =1 (1 + y ) t
CLOSED FORM FORMULA FOR
CONVEXITY...

  C
 n(n + 1)F −  
1 2C  1  2nC  Y
CONVEXITY =  3 1 − − +
P  Y  (1 + Y)n  Y 2 (1 + Y)n+1 (1 + Y)n+2 
 
 

Where C is the Coupon

Amount and not the
Coupon Rate.
 PROPERTIES OF CONVEXITY...

 Convexity of non-callable bond is always positive and its

dimension is (years2).

 Convexity is positively related to duration.

 Convexity is inversely related to yield-to-maturity.

 PROPERTIES OF CONVEXITY
(continued…)

 Convexity is inversely related to coupon.(This property is not applicable in

case of zero-coupon bond)

 Lower the maturity, given the coupon and YTM, lower the convexity of a bond
for par or premium bonds and for discounted bonds, it has mixed impact.

 A zero-coupon bond has a convexity which is equal to –

𝑛(𝑛 + 1)
𝐶𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 =
1+𝑌 2
 PROPERTIES OF CONVEXITY
(continued…)

 A coupon bearing bond trading a par has a convexity which is

equal to –

2 1 1 𝑛
𝐶𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 = 1− 𝑛
− 𝑛+1
𝑌 𝑌 1+𝑌 1+𝑌

 When maturity tends to infinity, convexity tends to a value -

2
Y2
 CONVEXITY OF PORTFOLIO...

 Bonds Portfolio also have CONVEXITY!!!

 It is equal to weighted average of convexity of bonds

where weights are proportionate to the value of a bond in
n
the portfolio, that is C P =   i Ci
i =1

where
N i Pi
i =
Total Price of Portfolio
Any question or any doubt?
What next?
That’s all for day!
ENJOY AND
HAVE FUN!

THANK
YOU
VERY
MUCH