Security Analysis and

Portfolio Management
BITS Pilani Dr. Yaganti & Dr. Shreya Biswas
Department of Economics and Finance
Hyderabad Campus
Framework for fundamental
analysis
• Top-down approach

• Approach to Fundamental Analysis

– Domestic and global economic analysis
– Industry analysis
– Company analysis

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Key economic variables

• Gross domestic product

• Employment

• Inflation

• Interest rates

• Consumer sentiment

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Economic Activity and
Security Markets

Stock Market as a Leading Indicator

– Stock prices reflect expectations of earnings, dividends, and interest rates
– Stock market reacts to various leading indicator series
– Stock prices consistently turn before the economy does.

Intrinsic value comes from its earnings prospects

determined by:
– The global/Macro economic environment
– Economic factors affecting the firm’s industry
– The position of the firm within its industry

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Business cycles and industry
analysis
• Recurring patterns of recession and recovery—business cycles
– Peak
– Trough

• Industry relationship to business cycles

– Cyclical
– Defensive

• Factors affecting sensitivity of earnings to business cycles

– Sensitivity of sales of the firm’s product to the business cycles
– Financial leverage

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Demand and supply shocks

Demand shocks
– An event that affects the demand for goods and services
• Reduction in tax rates
• Increases in government spending
• Increases in foreign export demand

Supply shock
– An event that influences production capacity and costs
• Changes in the price of imported oil
• Natural disasters – floods, draught, etc.
• Changes in the wage rates

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Economic indicators for
predicting business cycles
• Leading Indicators - tend to rise and fall in advance of the economy

• Examples
– Avg. weekly hours of production workers
– Stock Prices
– Initial claims for unemployment
– Manufacturer’s new orders

• Coincident Indicators - indicators that tend to change directly with

the economy

• Examples
– Industrial production
– Manufacturing and trade sales

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• Lagging Indicators - indicators that tend to follow the lag economic
performance

• Examples
– Ratio of trade inventories to sales
– Ratio of consumer installment credit outstanding to personal
income

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Indexes of Leading,
Coincident, and Lagging Indicators
A Stylized Depiction of the Business Cycle
Business cycles and rotation
Real estate
sector, natural
resources

Consumer peak
goods Pharma

Capital Goods
trough Excel

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Sector rotation strategies

• Selecting Industries in line with the stage of the business

cycle

• Rotation strategy - switches from one industry group to

another over the course of a business cycle (offsetting cyclical
changes using industry analysis)

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Sector Rotation

Portfolio is shifted into industries or sectors that should

outperform, according to the stage of the business cycle.

Peaks – natural resource extraction firms

Contraction – defensive industries such as pharmaceuticals

and food

Trough – capital goods industries

Expansion – cyclical industries such as consumer durables

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Figure Sector Rotation
Industry Life Cycles

Stage Sales Growth

• Start-up • Rapid and increasing
• Consolidation • Stable
• Maturity • Slowing
• Relative Decline • Minimal or negative

17-15
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Industry Life Cycles

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 Industry Structure and Performance:
Five Determinants of Competition

1. Threat of entry
2. Rivalry between existing competitors
3. Pressure from substitute products
4. Bargaining power of buyers
5. Bargaining power of suppliers

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Equity valuation models

• Intrinsic value versus market price

• Discounted cash flow approach

• Relative valuation approach –ratio analysis

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Expected holding period

The return on a stock investment comprises cash dividends and

capital gains or losses
–Assuming a one-year holding period

𝐸 𝐷 + 𝐸(𝑃 ) − 𝑃
𝐻𝑃𝑅 =
𝑃

HPR=Dividend yield+ capital gains

𝐷 -Expected dividend
𝑃 -Expected price at the end of year 1
𝑃 -Current market price

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Required rate of return

Capital asset pricing model gives the required return:

𝑘 = 𝑟 + 𝛽𝐸(𝑟 − 𝑟 )

If the stock is priced correctly (price=intrinsic value)

–Required return should equal expected return

Trading Signal
–HPR> k -Buy
–HPR < k Sell or Short Sell
–HPR= k -Hold or Fairly Priced

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Intrinsic Value and Market
Price
Market Price (MP)–Consensus value of all potential traders

Intrinsic value (IV)– The fair price of the security given

company characteristics.

Trading Signal
–IV > MP -Buy
–IV < MP Sell or Short Sell
–IV = MP -Hold or Fairly Priced

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Dividend Discount Models (DDM)
D1 D2 D3
V0     ...
1  k 1  k  1  k 
2 3

• V0 =current value; Dt=dividend at time t;

k = required rate of return
• The DDM says the stock price should
equal the present value of all expected
future dividends into perpetuity.
 Constant Growth DDM

D0 1  g  D1
V0  
kg kg
g=dividend growth rate
Dividend discount models

•Intrinsic value when holding period is one year:

𝐷 +𝑃
𝑉 =
1+𝑘
•How do we get 𝑃1?

•𝑃1should be equal to the intrinsic value at the end of year1

𝐷 +𝑃
𝑉 = =𝑃
1+𝑘

𝐷
𝑉 =
(1 + 𝑘)

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Zero growth model

• Let us assume that dividends are same every year

𝐷 =𝐷 =𝐷

• Example: Preferred stock

• Intrinsic value: 𝑉 =

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Constant or Gordon growth
model
Let us assume that dividends grows at the same rate ‘g’
every year
𝐷 = 𝐷 (1 + 𝑔) = 𝐷 (1 + 𝑔)

𝐷 = 𝐷 (1 + 𝑔)

•Intrinsic value:
𝐷 𝐷 (1 + 𝑔)
𝑉 = + + ⋯.
(1 + 𝑘) (1 + 𝑘)
𝐷
𝑉 =
𝑘−𝑔

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 Preferred Stock and the DDM

• No growth case
• Value a preferred stock paying a
fixed dividend of $2 per share when
the discount rate is 8%:

$2
Vo   $25
0.08  0
18-27
 Constant Growth DDM

• A stock just paid an annual dividend of

$3/share. The dividend is expected to
grow at 8% indefinitely, and the market
capitalization rate (from CAPM) is 14%.

D1 $3.24
V0    $54
k  g .14  .08
Interpretation

• Higher growth rate of firm will imply higher intrinsic value

• Higher risk (beta risk), lower will be the intrinsic value of the firm

• Higher the expected dividend dividends, higher will be the intrinsic value

• Fairly priced stock will grow at the rate ‘g’ every year

• Constant growth model can be used for matured firms in the industry with stable
growth rates

• Growth rate ‘g’ should be less than market capitalization rate ‘k’

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DDM Implications
• The constant-growth rate DDM implies that a
stock’s value will be greater:
1. The larger its expected dividend per share.
2. The lower the market capitalization rate, k.
3. The higher the expected growth rate of
dividends.
• The stock price is expected to grow at the
same rate as dividends.
Estimating Dividend Growth Rates

g  ROE x b
g = growth rate in dividends
ROE = Return on Equity for the firm
b = plowback or retention percentage rate
(1- dividend payout percentage rate)
Dividend Growth for Two Earnings
Reinvestment Policies
Present Value of Growth Opportunities

• The value of the firm equals the value

of the assets already in place, the no-
growth value of the firm,
• Plus the NPV of its future investments,
• Which is called the present value of
growth opportunities or PVGO.
Present Value of Growth Opportunities

• Price = No-growth value per share +

PVGO
E1
P0   PVGO
k
 Example : Growth Opportunities
• Firm reinvests 60% of its earnings in
projects with ROE of 10%,
capitalization rate is 15%. Expected
year-end dividend is $2/share, paid out
of earnings of $5/share.

• g=ROE x b = 10% x .6 = 6%
$2
P0   $22.22
.15  .06
18-
 Example ...

$2
P0   $22.22
.15  .06

• PVGO =Price per share – no-growth value per

share
$5
PVGO  $22.22   $11.11
.15
Multistage growth models
• Consider a high growth firm growing at rate 𝑔 for T years and then enters the
phase of maturity and grows at a rate 𝑔 till perpetually

• Intrinsic value:

𝐷 (1 + 𝑔 ) 𝐷 (1 + 𝑔 ) 𝐷 1+𝑔
𝑉 = + + ⋯+ + 𝑃𝑉 𝑜𝑓 𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑉
1+𝑘 (1 + 𝑘) 1+𝑘

• Using the constant DDM result we get terminal value is intrinsic value at the end
of time period T
𝐷 𝐷 (1 + 𝑔 )
𝑉 = =
𝑘−𝑔 𝑘−𝑔

𝐷 (1 + 𝑔 )
𝑃𝑉 𝑜𝑓 𝑉 =
(𝑘 − 𝑔 ) 1 + 𝑘

• Intrinsic value:
( ) ( )
𝑉 =𝐷 ∑ +
( ) ( )

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Example

• Consider a firm with current dividend of $2.00 and current high

growth phase of 20% is likely to go on for next 3 years. From the 4 th
year onwards the firm is likely to enter the matured phase of growth
and grow at a rate of 5% perpetually. The market capitalization rate
is 15%. Find the intrinsic value of the share.

• Dividends in high growth phase:

• D1 = 2.40; D2 = 2.88; D3 = 3.46

• Terminal value:
• Dividend in D4 = 3.46 (1+0.05)=3.63
• V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3 +D4 / (.15 - .05) (1.15)3
• V0 = 2.09 + 2.18 + 2.27 + 23.88 = $30.42

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Multistage growth model
• Growth rates could be different in each time period during the high
growth phase lasting for T years

• Eventually, company is likely to enter the maturity phase and grow at

a constant rate

• Intrinsic value:
𝐷 𝐷 𝐷
𝑉 = + + ⋯+ + 𝑃𝑉 𝑜𝑓 𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑉
1 + 𝑘 (1 + 𝑘) 1+𝑘

𝐷 (1 + 𝑔)
𝑃𝑉 𝑜𝑓 𝑉 =
(𝑘 − 𝑔) 1 + 𝑘

g- can be average industry growth rate or nominal growth rate of the

economy

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Which growth assumption to
use?
• Constant growth model:
• If firm is large and growing at a rate more or less close to grow
rate of economy
• Reinvestment rate close to industry average

• Two stage model

• Firm is large and growing at rate higher than growth rate of
economy (less than +10%)

• Three or n-stage model

• Firm is small and growing at very high rate (greater than +10%)
• Significant entry barriers
• Firm characteristics very different from average firm in the
industry
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Motivation for free cash flow
approach to equity valuation
• This approach is particularly useful for firms that pay no dividend
• Value the firm by discounting free cash flow at WACC.
• Free cash flow to the firm, FCFF, equals:
After tax EBIT
Plus depreciation
Minus capital expenditures
Minus increase in net working capital

• FCFE=EBIT(1- tc) +Depreciation – Capital expenditures- Increase in

NWC
• Where EBIT= earnings before interest and taxes
• tc = the corporate tax rate
• NWC= net working capital

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Free cash flow to the equity
approach
• Alternatively , we can focus on cash flow available to equity holders. This
will differ from free cash flow to the firm by the after tax interest
expenditures, as well as by the cash flow associated with net issuance or
repurchase of debt(principal repayments minus proceeds from issuance of
new debt).

• FCFE = FCFF – Interest expense (1- tc) + Increases in net debt

• FCFE=NI-(Capex-Dep)-change in WC+NDI-DR

• Net income is taken from income statement

• Dep is taken from CF statement

• Change in WC=Net change in (AR+inventory-AP)

• NDI – New debt issued

• DR- debt retired

• Discount factor – cost of equity (k)

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Valuation formula

• Intrinsic value for constant growth model

𝐹𝐶𝐹𝐸
𝑉 =
𝑘−𝑔

• Intrinsic value for multistage growth model

𝐹𝐶𝐹𝐸 𝐹𝐶𝐹𝐸 𝐹𝐶𝐹𝐸

𝑉 = + + ⋯+ + 𝑃𝑉 𝑜𝑓 𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑉
1 + 𝑘 (1 + 𝑘) 1+𝑘

𝐹𝐶𝐹𝐸
𝑉 =
𝑘−𝑔

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Relative valuation approach
• Value of asset is compared to the value assessed by the market

• For relative valuation-

• we need to identify comparable assets and obtain market values
for these assets.
• convert these market values into standardized values, since the
absolute prices cannot be compared This process of
standardizing creates price multiples.

• Over 80% of equity research reports are based on relative

valuation and almost 50% of acquisitions are also based on relative
valuation.

• Relative valuation generally requires less information than

discounted cash flow valuation

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P/E ratio and growth
opportunities
• Relative valuation approach-Extensive use in industry

• P/E Ratios are a function of two factors

– Required Rates of Return (k)
– Expected growth in Dividends

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Intrinsic P/E Ratio
𝐸
𝑃 =
𝑘

𝑃 1
=
𝐸 𝑘

E1 - expected earnings for next year

– E1 is equal to D1 under no growth

k - required rate of return

𝐷 (1 − 𝑏)𝐸
𝑃 = =
𝑘−𝑔 𝑘−𝑔
𝑃 (1 − 𝑏)
= − −𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑙𝑜𝑜𝑘𝑖𝑛𝑔 𝑃𝐸
𝐸 𝑘 − (𝑏 ∗ 𝑅𝑂𝐸)

• b = retention ration

• ROE = Return on Equity

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Intrinsic P/E (TTM)
∗( )
• Current/TTM PE: =
( ∗ )

• If valuation model is FCFE:

𝐹𝐶𝐹𝐸
𝑃 𝐸
=
𝐸 𝑘−𝑔

𝑃 (𝐹𝐶𝐹𝐸 ⁄𝐸 ) ∗ (1 + 𝑔)
=
𝐸 𝑘−𝑔

• Riskier stocks will have lower P/E multiples

• Riskier firms will have higher required rates of return (higher values
of k)

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Example

Consider a company with ROE of 15% and retention ratio of 60%,

current EPS of $2.5 and market capitalization rate of 12.5%. If the
forward looking P/E of the stock is 10, should you invest in the
stock? Also, find the intrinsic value of the stock.

g=0.6*.15=9%
P/E = (1 - .60) / (.125 - .09) = 11.4 > P/E=10 – underpriced security

E1 = $2.50 (1 +0.09) = $2.73

D1 = $2.73 (1-.6) = $1.09
P0 = 1.09/(.125-.09) = $31.14

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PE ratios and firm level and
macroeconomic factors
• PE is lower for riskier firms

• PE is higher for high growth firms

• Predict PE using a linear regression model:

𝑃
𝑝𝑟𝑒𝑑𝑖𝑐𝑡𝑒𝑑 = 𝑎 + 𝑎 𝐸𝑃𝑆 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 + 𝑎 𝐵𝑒𝑡𝑎 + 𝑎 𝑃𝑎𝑦 − 𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜
𝐸

• PE ratio is in general negatively correlated with the interest rates,

positively related to GDP growth rates and negatively related to
country risk

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Other Ratios

• PEG ratio is the PE ratio / expected growth rate of EPS –

when large differences in growth rates are present
across firms

• P/B ratio – financial services firms, earnings are

negative. This is the ratio of price per share divided by
book value per share

• P/S ratio – young and loss making firms, retail sector.

• Sales is subject to less manipulation than other financial data
• This ratio varies dramatically by industry
• Relative comparisons using P/S ratio should be between firms in similar
industries

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Other Ratios

• P/CF ratio – real estate sector

Why Price/CF Ratio
– Companies can manipulate earnings but Cash-flow is less prone to manipulation
– Cash-flow is important for fundamental valuation and in credit analysis

Summer term-2023 BITS Pilani, Hyderabad Campus

Implementing the Relative Valuation Technique

First Step: Compare the valuation ratio for a company to

the comparable ratio for the market, for stock’s industry
and to other stocks in the industry
– Is it similar to these other P/Es
– Is it consistently at a premium or discount

Second Step: Explain the relationship

– Understand what factors determine the specific valuation ratio for the stock being
valued
– Compare these factors versus the same factors for the market, industry, and
other stocks

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References

Zvi Bodie, Alex Kane, Alan Marcus, Pitabas Mohanty,

“Investments”, 10th edition, McGraw Hill, 2015.
Reilly Frank K and Keith C. Brown, Investment Analysis
and Portfolio Management, 10th edition Cengage
Learning, 2016.

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Thank you

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Chapter : Bond Portfolio Management
Strategies – Immunization

C H Yaganti & Shreya Biswas

Risks related to Bond investment
• Credit risk/ default risk

• Reinvestment risk – Risk of prevailing interest rate when reinvesting the proceeds

• Price risk – Risk of fall in bond prices when selling the bond

• If interest rates are higher, prices will be low (capital loss), but reinvestment will
be at a higher rate

• Price risk and reinvestment risk tend to offset each other

Bond Portfolio Performance, Style and Strategy
 Bond Portfolio Performance
 Fixed-income portfolios generally produce both less return and
less volatility than found in other asset classes (e.g., domestic
equity, foreign equity)
 Exhibit shows the average returns and standard deviations for
several performance indices over the 20-year period
 The low historical correlation between fixed-income and equity
securities— only 0.08 over this time period—has made bond
portfolios an excellent tool for diversifying risk
Exhibit

Source: Reilly Frank K and Keith C. Brown, Investment Analysis and Portfolio Management, 10 th edition Cengage Learning, 2015.
Bond Portfolio Performance, Style &Strategy
 Bond Portfolio Style
 The investment style of a bond portfolio can be summarized by
its two most important characteristics: credit quality and
interest rate sensitivity
 The average credit quality of the portfolio can be classified as
high, medium, and low grades
 The interest rate sensitivity of the bond portfolio can be
separated as short-term, intermediate-term, and long-term in
terms of duration
Exhibit

Source: Reilly Frank K and Keith C. Brown, Investment Analysis and Portfolio Management, 10 th edition Cengage Learning, 2015.
Bond Portfolio Performance Style and Strategy

 Bond Portfolio Strategies

 Passive Portfolio Strategies
 Active Management Strategies
 Core-plus Management Strategy
 Matched-funding Techniques- Immunization
 Contingent Procedure (Structured Active Management)
Source: Reilly Frank K and Keith C. Brown, Investment Analysis and Portfolio Management, 10 th edition Cengage Learning, 2015.
Active bond portfolio management strategies
 Substitution swap – Exchange of one bond for nearly identical bond (equal
coupon rate, maturity, call provision, credit risk) but different yield
indicating mispricing
 • Example: Consider 10-yr non-callable bonds of Toyota and Hyundai with YTM of 6%
and 6.2% respectively

 Intermarket spread swap – yield spreads between two sectors/ issuers are out
of sync then buy the sector/ type of bond with higher yield .
 • Example: Spread between AAA bank bond and T-bond is generally 200 basis points,
but is currently 225basis points – Higher default premium
Active Bond Management
 Rate anticipation swap – if investors believe that future spot rate will fall
then swap short term bonds for long term bonds.

 Long term bonds with higher duration will experience higher price rise

 Invest in more convex bonds if interest rates are likely to fall

 Portfolio convexity is the weighted convexities of the bonds in the

portfolio
Passive Bond Management Strategy
 Bond index funds – Risk exposure same as the bond market index
 Create a portfolio of bonds that mirrors the composition of index and weights
in proportion to the market value of the bond.
 Major bond market indexes – Barclays capital US, Merrill Lynch domestic
master index
 S&P India bond index – Government and corporate bonds
 Issues – many bonds are thinly traded and buying them at fair price could be
difficult
 Rebalancing issues – whenever the maturity of the bond fall below 1 year it is
dropped from the index
Bond management and interest rate sensitivity

 Active and passive strategies depend upon sensitivity of bond price to

interest rate changes

 Interest rate sensitivity of bond prices is of biggest concern for investor

 Duration helps in measuring sensitivity of bond prices to changes in

interest rates
Matched-Funding Techniques – Immunization Strategies
 Immunization Strategies
 The process is intended to eliminate interest rate risk that includes:
 Price Risk
 Coupon Reinvestment Risk
 A portfolio manager (after client consultation) may decide that the
optimal strategy is to immunize the portfolio from interest rate changes.
 The immunization techniques attempt to derive a specified rate of
return during a given investment horizon regardless of what happens to
market interest rates.
 Immunize a portfolio from interest rate risk by keeping the portfolio
duration equal to the investment horizon.
 Duration strategy superior to a strategy based since duration considers
both sources of interest rate risk
Immunization strategies

 Components of Interest Rate Risk

 Price Risk
 Coupon Reinvestment Risk
 If Duration ˃ Investment horizon, investor faces net price risk
 If Duration ˂ Investment horizon, investor faces net reinvestment risk
 If Duration = Investment horizon, investor is immunized.
Immunization strategy
 Interest rate risk of the bond portfolio is insulated

 Immunization is a risk management policy adopted by many financial

institutions with exposure to fixed income securities

 Banks have low duration liabilities (deposits) and high duration assets
(loans) –-- asset-liability duration mismatch

 An increase in interest rate will lead to a larger fall in value of asset portfolio
than the liability portfolio – decrease in net worth
 Pension funds investments are in short term instruments in lower duration
and their liabilities are for long duration. Fall in interest rates will increase
the PV of future liabilities more than the increase in value of assets

 Immunization strategy – If the portfolio duration is set to investor’s

horizon date, the accumulated value will be unaffected by interest rate
fluctuations

 Portfolio duration=∑ 𝑊𝑖𝐷𝑖

 Price risk/interest rate risk exactly offsets the reinvestment risk

 Need to rebalance immunized portfolios

 Every year the duration of the portfolio will change and need to match it
with the investment horizon
Example.
 Example: Consider an insurance company with collects premium of $10000
from its customers and promises to pay a lump sum amount after 5 years
(like a 5year zero coupon bond) at 8% p.a. The company funds its
obligation by buying $10000 worth 8% coupon paying bonds with 6 years to
maturity trading at par.

 Changes in interest rate will not affect the insurance company’s ability to
pay the customer
 Example 2
 Consider a company that makes a payment of $19487 in 7 years. The market interest
rate is 10%. The company’s CFO wishes to fund the obligation using 3-year zero
coupon bonds and perpetuities paying annual coupon. The duration of the
perpetuity is 11years. How can the CFO immunize the portfolio?

 PV of future obligations=19487/1.10^7=10000 (Approx)

 Duration of zero coupon bond=3

 Immunization strategy: duration of portfolio should be equal to 7 years 3w+(1-

w)11=7 i.e. w=0.5

 Invest $5000 in 3-year zero coupon bond and invest $5000 in perpetuity
Example contd.

 What should be the rebalancing strategy after 1 year if interest rate remains
unchanged?

• PV of future obligations=19487/1.1^6=11000 (Approx)

• Duration of zero coupon bond=2 years

• Duration of perpetuity=11years
• Immunization strategy: 2w+11(1-w)=6 i.e. w=5/9
• Investment in zero coupon bond= 5/9*11000=$6111.11
• Investment in perpetuity=4/9*11000=$4888.89
References
 Reilly Frank K and Keith C. Brown, Investment Analysis and
Portfolio Management, 10th edition Cengage Learning, 2016.
 Zvi Bodie, Alex Kane, Alan Marcus, Pitabas Mohanty,
“Investments”, 10th edition, McGraw Hill, 2015.
Chapter : Bond Fundamentals
Chapter : Analysis and valuation of Bonds
Basic Features of a Bond
 A bond is a debt instrument in which an investor loans
money to an entity (corporate or government) which
borrows the funds for a defined period of time at a variable or
fixed interest rate.

 Bonds are used by Companies, Municipalities, State

governments and sovereign governments to raise money to
finance a variety of projects and activities. Owners of bonds
are debt holders, or creditors, of the issuer.

 Bonds as fixed income securities

 Pay a fixed amount of interest periodically to the holder of
record (Coupon payments)
 Repay a fixed amount of principal at the date of maturity
 Bond market is divided by maturity
 Money Market: Short-term issues that mature within one
year. Eg: Treasury Bills
 Treasury bills or T-bills, which are money market instruments,
They are short term debt instruments issued by the Government
of India and are presently issued in three tenors, namely, 91 day,
182 day and 364 day.
 Treasury bills are zero coupon securities and pay no interest.
Instead, they are issued at a discount and redeemed at the face
value at maturity.
 For example, a 91 day Treasury bill of `100/- (face value) may be
issued at say ` 98.20, that is, at a discount of say, `1.80 and would
be redeemed at the face value of `100/-. The return to the
investors is the difference between the maturity value or the face
value (100) and the issue price.
 Long Term Bonds: Long-term obligations with maturity greater than
five years. Eg: Dated G-Secs.

 Dated G-Secs are securities which carry a fixed or floating coupon (interest
rate) which is paid on the face value, on half-yearly basis. Generally, the
tenor of dated securities ranges from 5 years to 40 years.

 The Public Debt Office (PDO) of the Reserve Bank of India acts as the
registry / depository of G-Secs and deals with the issue, interest payment
and repayment of principal at maturity. Most of the dated securities are fixed
coupon securities.

 The nomenclature of a typical dated fixed coupon G-Sec contains the

following features - coupon, name of the issuer, maturity year. For example, -
7.17% GS 2028 would mean:
 Coupon : 7.17% paid on face value
 Face Value : 1,000
 Name of Issuer : Government of India
 Date of Issue : January 8, 2018
 Maturity : January 8, 2028
 Coupon Payment Dates: Half-yearly (July 08 and January 08) every year
Types of Bonds
 Fixed Rate Bonds(Straight bond –plain vanilla bond-
Coupon bonds) – These are bonds on which the coupon
rate is fixed for the entire life (i.e. till maturity) of the
bond. Most Government bonds in India are issued as
fixed rate bonds.
 For example – 8.24%GS2018 was issued on April 22, 2008
for a tenor of 10 years maturing on April 22, 2018. Coupon
on this security will be paid half-yearly at 4.12% (half yearly
payment being half of the annual coupon of 8.24%) of the
face value on October 22 and April 22 of each year.
 Zero Coupon Bonds – Zero coupon bonds are bonds
with no coupon payments. However, like T- Bills, they
are issued at a discount and redeemed at face value.
 Floating Rate Bonds (FRB) – FRBs are securities which do
not have a fixed coupon rate. Instead it has a variable
coupon rate which is re-set at pre-announced intervals (say,
every six months or one year). FRBs were first issued in
September 1995 in India.
 Inflation Indexed Bonds (IIBs) - IIBs are bonds wherein
both coupon flows and Principal amounts are protected
against inflation. The inflation index used in IIBs may be
Whole Sale Price Index (WPI) or Consumer Price Index
(CPI). Globally, IIBs were first issued in 1981 in UK.
 In India, Government of India through RBI issued IIBs (linked
to WPI) in June 2013. Since then, they were issued on monthly
basis (on last Tuesday of each month) till December 2013.
Based on the success of these IIBs, Government of India in
consultation with RBI issued the IIBs (CPI based) exclusively
for the retail customers in December 2013.
Bonds with Embedded options
 Bonds may have options embedded in them. These
options give certain rights to investors and/or issuers.
The more common types of bonds with embedded
options are:
 Convertible Bonds: Convertible bonds give the bond
holder the right(option) to convert them into equity
shares on certain terms.
 Bonds with Call/ Put Options – Bonds can also be
issued with features of optionality wherein the issuer can
have the option to buy-back (call option-callable bond) or
the investor can have the option to sell the bond (put
option –puttable bond) to the issuer during life of the
bond. It may be noted that such bond may have put only
or call only or both options.
 Eg: The first G-Sec with both call and put option viz. 6.72%
GS 2012 was issued on July 18, 2002 for a maturity of 10 years
maturing on July 18, 2012. The optionality on the bond could
be exercised after completion of five years tenure from the
date of issuance on any coupon date falling thereafter. The
Government has the right to buy-back the bond (call
option) at par value (equal to the face value) while the
investor has the right to sell the bond (put option) to the
Government at par value on any of the half-yearly coupon
dates starting from July 18, 2007.
Why should one invest in G-Secs?
 Holding of cash in excess of the day-to-day needs (idle funds) does not
give any return. Investment in gold has attendant problems in regard to
appraising its purity, valuation, warehousing and safe custody, etc. In
comparison, investing in G-Secs has the following advantages:
 Besides providing a return in the form of coupons (interest), G-Secs offer
the maximum safety as they carry the Sovereign’s commitment for
payment of interest and repayment of principal.
 G-Secs are available in a wide range of maturities from 91 days to as
long as 40 years to suit the duration of varied liability structure of
various institutions.
 G-Secs can be sold easily in the secondary market to meet cash
requirements.
 G-Secs can also be used as collateral to borrow funds in the repo
market.
 G-Sec prices are readily available due to a liquid and active secondary
market and a transparent price dissemination mechanism.
 Besides banks, insurance companies and other large investors, smaller
investors like Co-operative banks, Regional Rural Banks, Provident
Funds are also required to statutory hold G-Secs.
Valuation of Bonds
Features:
1. Defined life
2. Defined cash flows

straight forward to value, but some risks are involved.

The holder is subject to interest rate risk , inflation

risk, currency risk, duration risk, convexity risk,
repayment of principal risk, liquidity risk, default
risk(corporate Bonds), maturity risk, reinvestment
risk, market risk, political risk, and taxation
adjustment risk.
 Fundamentals of Bond Valuation
 The present-value model
2n
Ci 2 M
Pm   
t 1 (1  i 2 ) t
(1  i 2 ) 2n

Where:
Pm = the current market price of the bond
n = the number of years to maturity
Ci = the annual coupon payment for bond i
i = the prevailing yield to maturity for this bond issue
Pp = the par value of the bond

*The present-value model - Calculate the price of the bond

  The yield model

2n
Ci 2 M
Pm   
t 1 (1  i 2) (1  i 2)
t 2n

Where:
i = the discount rate that will discount the cash flows to equal the
current market price of the bond

*The yield model - Calculate the yield of the bond

 An easier formula for bond price calculation

1  (1  i )  n  par
P  Ci  
 (1  i )
n
 i
 Or Semi-annual payment

Ci 1  1  i / 2 
 2 n
par
P  
2  i/2  1  i / 2 2n

Price = PV of interest payments + PV of par value

 Example : An 8% coupon bond, maturing in 20
years, has a par value of Rs.1,000. Assume that a
prevailing yield to maturity (YTM) for this bond is
10% (the market’s required rate of return on the
bond), calculate the value of the bond.
Example : An 8% coupon bond, maturing in 20 years, has a
par value of Rs.1,000. Assume that a prevailing yield to
maturity (YTM) for this bond is 10% (the market’s required
rate of return on the bond), calculate the value of the bond.

  0.10   ( 2 x 20) 
1  1   
Rs.80   2   Rs.1000
P 
2  0.10   0.10  ( 2 x 20)
 2  1  
   2 

1  1  0.05 40  Rs.1000

P  Rs.40 
 0 .05  1  0.0540

Price = PV of interest payments + PV of par value

= Rs.686.36 + Rs.142
= Rs.828.36
Example2
 Find the price of a 10 year 8% semi-annual coupon bond
with par value $1000 if discount rate is
 (a) 4%; (b) 8%

 (a) Bond price=(40/.02)*[1-(1/1.02)^20)]+1000/1.02^20

=654.0573+672.9713= 1327.03

 (b) Bond price=(40/0.04)*[1-(1/1.04)^20)]+1000/(1.04)^20

=543.6131+456.3869=1000
Par, Premium and Discount bonds
 If coupon rate and discount rate are equal then bond
price is equal to par value.
 Corporate bonds are generally issued at par value.
 Zero coupon bonds are issued at below par.
 Premium bonds - Bond price trading at a price
greater than par value
 Discount bonds – Bonds selling at a price below par
valu
The Fundamentals of Bond Valuation
 The Price-Yield Curve: There exists a inverse
relationship between bond price and bond yield to
maturity-its required rate of return
 If yield < coupon rate, bond will be priced at a premium to
its par value
 If yield > coupon rate, bond will be priced at a discount to
its par value
 Price-yield relationship is convex (not a straight line)
 The price-yield curve
Price
2500

2000

1500

1000

500

0
2 4 6 8 10 12 14 16
Required yield

19
Exhibit

Source: Reilly Frank K and Keith C. Brown, Investment Analysis and Portfolio Management, 10 th edition Cengage Learning, 2015.
Computing Bond Yields
 Measures of Bond Yield
Yield Measure Purpose

Current yield (CY) Measures current income rate

Yield to Maturity(YTM) Measures expected rate of return

for bond held to maturity
Promised yield to call Measures expected rate of
return for bond, if Bond is
callable

Realised (horizon) yield Measures expected rate of

return for a bond if coupon
reinvestment changes.
Computing Bond Yields –Current Yield

 Current Yield
 Similar to dividend yield for stocks
CY = Ci/Pm
where:
CY = the current yield on a bond
Ci = the annual coupon payment of Bond i
Pm = the current market price of the bond
Computing Bond Yields - Yield to Maturity (YTM)

 Yield to maturity (YTM) is a measure of return on bonds

 YTM is defined as the discount rate/interest rate that makes the PV of bond’s
payment equal to its price.
 This rate is interpreted as the average rate of return that will be earned if it is
bought now and held till maturity.
 It is more comprehensive and widely used measure of return calculation of Bond
yield than current yield. This method takes into consideration all future cash flows
coming from the bond (coupons plus the principal repayment) and equates the
present values of these cash flows to the prevailing market price of the bond.
 The YTM can be calculated by trial and error method by substituting in different
rates in the equation and arriving at the one that equates the market price of bond to
the present value of the expected cash flows from the bond.
 It assumes
 Investor holds bond to maturity
 All the bond’s cash flow is reinvested at the computed yield to maturity
Computing Bond Yields
2n
Ct / 2 M
YTM   
t 1 (1  i 2) (1  i 2)
t 2n
What Determines Interest Rates
 Inverse relationship with bond prices
 Forecasting interest rates
 Fundamental determinants of interest rates
i = RFR + I + RP
where:
RFR = real risk-free rate of interest
I = expected rate of inflation
RP = risk premium
 Conceptually
i = f (Economic Forces + Issue Characteristics)
What Determines Interest Rates
 Effect of Economic Factors
 Real growth rate
 Tightness or ease of capital market
 Expected inflation
 Supply and demand of loanable funds
 Impact of Bond Characteristics
 Credit quality as determined by its risk of default relative
to other bonds
 Term to maturity, which can affect price volatility
 Indenture provisions, including collateral, call features
and sinking fund provisions
 Foreign bond risk including exchange rate risk and
country risk
Bond price is a function of (1) par value (2) Coupon (3) Years to
maturity (4) Prevailing market interest rate
Bond price change or volatility is measured as the percentage
change in bond price

EPB
1
BPB
where:
EPB = the ending price of the bond
BPB = the beginning price of the bond
Price Volatility for Bonds
• Five Important Relationships
– Bond prices move inversely to bond yields.
– For a given change in yields(interest rates), longer
maturity bonds post larger price changes, thus bond
price volatility is directly related to maturity.
– Price volatility increases at a diminishing rate as
term to maturity increases.
– Price movements resulting from equal absolute
increases or decreases in yield are not
symmetrical. A decrease in yield raises bond
prices by more than an increase in yield of the
same amount lower prices.
– Higher coupon issues show smaller percentage price
fluctuation for a given change in yield, thus bond
price volatility is inversely related to coupon rate.
Price Volatility for Bonds: Interest rate sensitivity

 The Maturity Effect

 The price of long term bonds are more sensitive to
interest rate changes than the prices of short term
bonds.

 The Coupon Effect

 Prices of low coupon bonds are more sensitive to
interest rate changes than the prices of high coupon
bonds.
Source: Reilly Frank K and Keith C. Brown, Investment Analysis and Portfolio Management, 10 th edition Cengage Learning, 2015.
Source: Reilly Frank K and Keith C. Brown, Investment Analysis and Portfolio Management, 10 th edition Cengage Learning, 2015.
Price Volatility for Bonds
 The Yield Level Effect (See Exhibit 18.14)
 If yield changes by a constant percentage, the change in
the bond price is larger when the yields are at a higher level
 If yield changes by a constant basis-point, the change in
the bond price is larger when the yields are at a lower level
Exhibit 18.14

Source: Reilly Frank K and Keith C. Brown, Investment Analysis and Portfolio Management, 10 th edition Cengage Learning, 2015.
Thus, the price volatility of a bond for a given change in
yield(i.e., its interest rate sensitivity) is affected by bond’s
coupon, its term to maturity, the levels of yields( depending
on what kind of change in yield),and the direction of yield
change.
However, although both level and direction of change in
yields affect price volatility , they can not be used for
trading strategies because portfolio manager cannot
control these variables.
When yields change, two variables that have a dramatic
effect on a bond’s interest sensitivity are coupon and
maturity.
Trading Strategies
Knowing that coupon and maturity are major variables that
influence a bond’s interest rate sensitivity , we can develop
some strategies for maximizing rates of return when interest
rates change.
 If interest rates are expected to decline, bonds with higher
interest rate sensitivity should be selected – will enjoy
maximum price change (capital gains) from change in
interest rates. You should attempt to built a portfolio of
long maturity bonds with low coupons.
 If interest rates are expected to increase, bonds with lower
interest rate sensitivity should be chosen – to minimize
capital losses caused by the increase in rates. You should
attempt to change your portfolio of short maturity bonds
with high coupons.
Duration Measures
 The price volatility (interest rate sensitivity) of a bond
varies inversely with its coupon and positively with its
term to maturity.
 It is necessary to determine the best combination of these
two variables to achieve your objective. This effort would
benefit from a composite measure that considered both
coupon and maturity.
 A composite measure of the interest rate sensitivity of a
bond is refereed to as Duration.
 Duration as a measure of interest rate risk.
 Macaulay Duration- developed by Frederick Macaulay(1938)
 Modified Duration- modification to Macaulay duration
value.
 Duration

 A measure of the effective maturity of a bond

 The weighted average of the times until each
payment is received, with the weights
proportional to the present value of the
payment
 Duration is shorter than maturity for all
bonds except zero coupon bonds.
 Duration is equal to maturity for zero
coupon bonds.
 n
C t (t ) n
t 1 (1  i )
t  t  PV (C t )
D n  t 1
Ct price
t 1 (1  i )
t

The Formula
where:
t = time period in which the coupon or principal payment
occurs
Ct = interest or principal payment that occurs in period t
i = yield to maturity on the bond

18-38
Macaulay Duration
 The Characteristics
 Duration of a bond with coupons is always less
than its term to maturity
 A zero-coupon bond’s duration equals its
maturity
 Duration and coupon is inversely related
 There is a positive relationship between term to
maturity and duration, but duration increases
at a decreasing rate with maturity
 YTM and duration is inversely related.
Why Duration is Valuable?

1. An important survey statistic to tell the effective

maturity
2. Immunize portfolios for interest rate risk
3. Can be used as a measure of interest rate sensitivity
(helps in trading strategies)
Example :
Computation of Macaulay Duration @ 8% market yield
Bond A: FV Rs.1,000, mature in 10 yr, 4% coupon

(1) (2) (3) (4) (5) (6)

Year CF PV@8% PV of CF PV as % of P (1)x(5)
1 40 0.9259 37.04 0.0506 0.0506
2 40 0.8573 34.29 0.0469 0.0938
3 40 0.7938 31.75 0.0434 0.1302
4 40 0.7350 29.40 0.0402 0.1608
5 40 0.6806 27.22 0.0372 0.1860
6 40 0.6302 25.21 0.0345 0.2070
7 40 0.5835 23.34 0.0319 0.2233
8 40 0.5403 21.61 0.0295 0.2360
9 40 0.5002 20.01 0.0274 0.2466
10 1,040 0.4632 481.73 0.6585 6.5850
Sum Rs.731.58 1.0000 8.1193
Duration = 8.12 years
 Cross sectional variation in the interest rate
sensitivity: Modified Duration
We know that
C C C F
P   ...  
1  y  1  y  1  y  1  y 
1 2 T T

where C is the coupon, F is the face value,

y is the yield of the bond, and T the maturity.
Differentiating with respect to y we get that

P

 1 C   2  C  ...   T  C   T  F
1  y  1  y  1  y  1  y 
T 1 T 1
y 2 3

1  1* C 2*C T *C T *F 
    ...   
1  y   1  y 

1
1  y 
2
1  y 
T
1  y 
T



Dividing with P on both sides we get that

P 1 1  1* C 2*C T *C T *F  1
    ...   
y P 1  y   1  y 

1
1  y 
2
1  y 
T
1  y 
T
P

 Cash flow at time t  / 1  y 
t
1

1  y   t*
Bond Price
1
 * D   D*
1  y 

43
Modified Duration and Bond Price Volatility
Bond price movements will vary proportionally with
modified duration for small changes in yields
An estimate of the percentage change in bond prices
equals the change in yield multiplied by modified
duration

P
  Dmod  y
P

P = change in price for the bond

P = beginning price for the bond
Dmod = the modified duration of the bond
y = yield change
 Macaulay Duration
Dmod 
Modified Duration Formula (D mod) 1 y
As a Measure of Bond Price Volatility
Bond price movements will vary proportionally with modified duration
for small changes in yields

P
100   Dmod  y
P
where:
P = change in price for the bond
P = beginning price for the bond
Dmod = the modified duration of the bond
y = yield change in basis points divided by 100
Example : Modified duration calculation
A bond with a Macaulay duration of 10 years, a YTM of
8%, and semi-annual payments would have modified
duration of:
Macaulay duration
Modified Duration 
YTM
1
m

10
Dmod   9.62
(1  0.08 / 2)
Example : Modified duration & price volatility
A bond with Macaulay D = 8 yrs, i = 0.10, assume you
expect Bond’s YTM to decline by 75 basis point (eg from
10% to 9.25%), calculate the estimated % change in price.

8
Dmod   7.62
(1  0.1 / 2)
(75)
%P  (7.62) x  5.72%
100
 The bond price should increase by approx. 5.72% in
response to the 75 basis-point decline in YTM.
Modified Duration and Bond Price Volatility
 Trading Strategies Using Modified Duration
 Longest-duration security provides the maximum
price variation
 If you expect a decline in interest rates, increase the
average modified duration of your bond portfolio to
experience maximum price volatility
 If you expect an increase in interest rates, reduce the
average modified duration to minimize your price
decline
 Note that the modified duration of your portfolio is
the market-value-weighted average of the modified
durations of the individual bonds in the portfolio
 Bond Convexity
 The relationship between bond prices and
yields is not linear.
 Duration rule is a good approximation for
only small changes in bond yields.
 Bonds with greater convexity have more
curvature in the price-yield relationship
and the curvature of the price – yield curve
is called Convexity of Bond.
Modified duration is a linear approximation of bond price
change for small changes in market yields

P
100   Dmod  y
P
However, price changes are not linear, but a curvilinear (convex)
function of bond yields
Different bonds have different convex price-yield curve
Problem with First order Approximation

 Duration providers a first order approximation of the price-yield curve.

 Approximating a curve with a straight line

Price

Approximation Error

slope   Dmod P

Yield
Bond Convexity
The convexity is the measure of the curvature and is
the second derivative of price with respect to yield
(d2P/dy2) divided by price
Convexity is the percentage change in dP/dy for a
given change in yield

2
d P
2
dy
Convexity 
P
Why do Investors Like Convexity?

 Bonds with greater curvature gain more in price when

yields fall than they lose when yields rise.
 The more volatile interest rates, the more attractive
this asymmetry.
 Bonds with greater convexity tend to have higher
prices and/or lower yields, all else equal.
Bond Convexity
 The Desirability of Convexity
 As yield increases, the rate at which the price of the bond
declines becomes slower
 Similarly, when yields decline, the rate at which the price
of the bond increases becomes faster
 For bonds with equal durations, bond with greater
convexity would have better price performance
 The estimate using only modified duration will
underestimate the actual price increase caused by a yield
decline and overestimate the actual price decline caused
by an increase in yields
 See Exhibit
Bond Convexity
 The Determinants of Convexity
 The Formula
d 2P
2
Convexity  di
P
 Important Relationships
 Inverse relationship between coupon and convexity

 Direct relationship between maturity and convexity

 Inverse relationship between yield and convexity

 Computation of Convexity
 See Exhibit 18.22

18-57
 Convexity
1 n
 CFt 
Convexity 
P  (1  y ) 2
  (1  y ) t (t  t )
t 1 
2

% Price Change due to D* and C

P
  D  y  1 [Convexity  (y ) 2 ]
P 2
Convexity of Bonds

Portfolio

0
Duration +
Duration Convexity
Change in yield to maturity (%)

60
Duration-Convexity Effects

 Changes in a bond’s price resulting from a change in

yields are due to:
 Bond’s modified duration
 Bond’s convexity
 Relative effect of these two factors depends on the
characteristics of the bond (its convexity) and the size
of the yield change
 Convexity is desirable

61
References
 Reilly Frank K and Keith C. Brown, Investment
Analysis and Portfolio Management, 10th edition
Cengage Learning, 2016.
 Zvi Bodie, Alex Kane, Alan Marcus, Pitabas Mohanty,
“Investments”, 10th edition, McGraw Hill, 2015.