Professional Documents
Culture Documents
10-2
Bond Characteristics
10-3
Treasury Notes and Bonds
10-4
Figure 10.1 Listing of Treasury Issues
10-5
Corporate Bonds
Registered
Bearer bonds
Call provisions
Convertible provision
Put provision (putable bonds)
Floating rate bonds
Preferred Stock
10-6
Figure 10.2 Investment Grade Bonds
10-7
Other Domestic Issuers
10-8
Innovations in the Bond Market
Reverse floaters
Asset-backed bonds
Pay-in-kind bonds
Catastrophe bonds
Indexed bonds
– TIPS (Treasury Inflation Protected Securities)
10-9
10.2 BOND PRICING
10-10
Bond Pricing
T
P B = Ct T + Par Value T
(1+ r ) (1+ r )
T
t =1
10-11
Price of 8%, 10-yr. with yield at 6%
20
= 40
1 1
+ 1000
P B
t =1 (1 .03)
t
(1.03)
20
= 1,148 .77
P B
10-12
10.3 BOND YIELDS
10-13
Bond Prices and Yields
10-14
Yield to Maturity
60
$40 $1, 000
$1, 276.76 = +
t =1 (1 + r ) (1 + r )
t 60
10-15
Figure 10.3 The Inverse Relationship
Between Bond Prices and Yields
10-16
Alternative Measures of Yield
Current Yield
Yield to Call
– Call price replaces par
– Call date replaces maturity
Holding Period Yield
– Considers actual reinvestment of coupons
– Considers any change in price if the bond is
held less than its maturity
10-17
Figure 10.4 Bond Prices:
Callable and Straight Debt
10-18
Figure 10.5 Growth of Invested Funds
10-19
10.4 BOND PRICES OVER TIME
10-20
Premium and Discount Bonds
Premium Bond
– Coupon rate exceeds yield to maturity
– Bond price will decline to par over its maturity
Discount Bond
– Yield to maturity exceeds coupon rate
– Bond price will increase to par over its
maturity
10-21
Figure 10.6 Premium and Discount
Bonds over Time
10-22
Figure 10.7 The Price of a Zero-
Coupon Bond over Time
10-23
10.5 DEFAULT RISK AND BOND
PRICING
10-24
Default Risk and Ratings
Rating companies
– Moody’s Investor Service
– Standard & Poor’s
– Fitch
Rating Categories
– Investment grade
– Speculative grade
10-25
Figure 10.8 Definitions of Each Bond Rating
Class
10-26
Factors Used by Rating Companies
Coverage ratios
Leverage ratios
Liquidity ratios
Profitability ratios
Cash flow to debt
10-27
Protection Against Default
Sinking funds
Subordination of future debt
Dividend restrictions
Collateral
10-28
Figure 10.9 Callable Bond
Issued by Mobil
10-29
Accrued interest and clean price
30
10-30
Figure: Accrued interest
60 €
6,8 €
Accrued
Date of coupon pay
Interest at
the 31
10-31
valuation
Example
32
10-32
Example (solution)
Data of previous example. What is the date of
valuation in the schema?
n
6.8 = 6% 1000
365
n = 41 days
You are 228 days after last coupon payment, what is
the value of accrued interest?
228
6% 1000 = 37.48€
365
33
10-33
3. INTEREST RISK MEASURES
34
10-34
3.2. Interest risk
35
10-35
Concepts
Macaulay Duration:
– mean maturity of a bond with coupon payments,
– or generic description of the sensitivity of a bond’s price to
a change in yield in this case we also use the word
sensibility.
Modified duration:
– Modified: sensitivity assuming that the bond’s expected
cash flows do not change when yield changes, makes
sense for option free bonds,
Effective Duration
– Effective (option-adjusted or adjusted): takes into account
the fact that yield changes may change the expected cash
flows. 36
10-36
3.3. Modified/ Effective duration
37
10-37
Example
38
10-38
Example (Solution)
137.5888 − 131.8439
Deff = = 10.66
2 134.6722 0.002
39
10-39
3.4. Macauley Duration
Present value of
Time cash flows
N N
t C (1 + r )
t =1
t
−t
t C (1 + r )
t =1
t
−t
D= N
=
C (1 + r ) −t P
t
t =1
40
10-40
Example
41
10-41
Periods Flows Present value T*(discounted CF)
42
10-42
3.5. Sensitivity (modified duration)
43
10-43
Formula
dP / P 1 dP
S= =
dr P dr
44
10-44
Relationship between duration et
sensitivity
D
S =−
1+ r
Negative relationship
between price and
rates.
45
10-45
Example
46
10-46
Example (solution)
3.5
S =− = −3.24
1.08
dP = S dr P
48
10-48
Example
49
10-49
Exemple (solution)
1 − 1.081−4
P(0.081) = 10
100
+ 4
= 106.28
0.081 1.081
1 − 1.12 − 4 100
P(0.12 ) = 10 + 4
= 93.925
0.12 1.12
Effective losses:
– 8,500 € in the first case,
– 317,375 € in the second.
50
10-50
Duration of a portfolio
Price Duration
10-53
5
4 Portfolio duration
0.2 2.78 + 0.4 3.53 + 0.4 4.34 = 3.7 y
Periods Cash flow of Present t*(PCF)
the portfolio value
1 310 287.04 287.04
2 310 265.78 531.56
3 810 643 1 929
4 2 270 1 668.52 6 674.75
5 1 290 877.95 4 389.75
Value 3 742.28 13 811.43
Duration 3,7 years 10-54
Basic bond management
10-55
3.6. CONVEXITY
Price
Effective
variation
Estimated
Variation
Approximation
error
Variation rate
57
10-57
Generalized duration of order i is:
t C (1 + r )
i −t
t
D(i ) =
P
Formula of convexity:
N 2
C=
1 d 2P
=
1
2 t
−t
(
C (1 + r ) t + t =
1
) D(1) + D(2 )
P(1 + r ) t =1 (1 + r )
2 2
P dr
58
10-58
Interpretation
59
10-59
Convexity and price variations
Approximation is better and better when you go
further in the limited development (computation
of D(i)).
For order 2 (convexity) we have:
dP 1 d 2P 2
dP = dr + 2
dr
dr 2 dr
Dividing the equality by P, we obtain price variation in
function of sensibility and convexity.
dP 1
= Sdr + Cdr 2
P 2 60
10-60
Example
61
10-61
6
2
Example (solution)
Periods Flow PV t * (PV) t2 * (PV)
1 10 9.26 9.26 9.26
2 10 8.57 17.14 34.28
3 10 7.94 23.82 71.46
4 110 80.85 323.4 1 293.6
Price 106.62 373.62 1 408.6
Convexity 14.33
10-62
N 2
C=
1 d 2P
=
1
2 t
(
−t
)
C (1 + r ) t + t =
1
D(1) + D(2 )
P(1 + r ) t =1 (1 + r )
2 2
P dr
dP 1
= Sdr + Cdr 2
P 2
10-63
Example
1
dP = − 3.24 0.001 + 14.33 0.0012 106.62 = −0.34468
2
1 2
dP = − 3.24 0.04 + 14.33 0.04 106.62 = −12.59566
2
64
10-64
6
5
In short
10-65
10.6 THE YIELD CURVE
10-66
Term Structure of Interest Rates
10-67
Figure 10.10 Yields on
Long-Term Bonds
10-68
Figure 10.11 Treasury Yield Curves
10-69
Theories of Term Structure
Expectations
– Long term rates are a function of expected future
short term rates
– Upward slope means that the market is expecting
higher future short term rates
– Downward slope means that the market is expecting
lower future short term rates
Liquidity Preference
– Upward bias over expectations
– The observed long-term rate includes a risk premium
10-70
Figure 10.12 Returns to Two 2-year
Investment Strategies
10-71
Forward Rates Implied
in the Yield Curve
(1+ y n ) = (1+ y n −1) (1+ f n )
n n −1
2 1
(1 . 12 ) = (1 . 11 ) (1 . 1301 )
For example, using a 1-yr and 2-yr rates
Longer term rate, y(n) = 12%
Shorter term rate, y(n-1) = 11%
Forward rate, a one-year rate in one year = 13.01%
10-72
Figure 10.13 Illustrative Yield Curves
10-73
Figure 10.14 Term Spread
10-74