BOND DURATION The Term bond duration is a measurement of how long in years it takes for the price of a bond

to be repaid by its internal cash flows. Zero coupon bonds do not pay any intermediate cash flows and the entire money is available only on maturity. Therefore duration of a zero-coupon bond is equal to maturity period. In the case of intermediate interest payment, bond holder get price much earlier to maturity period. Therefore, duration of such bonds will always be less than its maturity period. The formula for computing duration d is,

I3 I1 I2 In + MV d = 1 +2 +3 + .......... ....... + n / PO 1 2 3 (1 + k ) (1 + k ) (1 + k ) n (1 + k )
The equation consists of setting out the series of cash flows, discounting them and multiplying each discounted flow by the time period in which it occurs. The sum of these cash flows is then divided by the price of the bond obtained using the present value model. Where, I: MV: n: k: Po: Annual cash flow interest Maturity Value Holding period Discount rate Present value

Example:
1. A bond with 12% coupon rate issued three years ago is redeemable after five

years from now at a premium of five percent. The interest rate prevailing in the market currently is 14%. Calculate the duration of this bond.
2. A new bond is issued by a company. The coupon rate is 15% and maturity

period is 5 years. The bond has a face value of Rs.100 redeemable after 5 years at par. Calculate the duration of this bond.

Investors generally pay less attention to debt securities as an investment avenue. Bond returns are less than stock returns, but then bond investment involves less risk. Historically, there has been a low correlation between the returns from stocks and

corporate bonds. This implies that combining stocks and bonds in a portfolio can help to reduce the portfolios risk as a whole. Thus, bonds can play a strategic role in portfolio management. Moreover, investors can capitalize on bond price movements by trading in bonds. For this the investor needs to have a proper understanding of bonds, their returns, risks and valuations or pricing procedures.

YIELD VS. REQUIRED RATE OF RETURN Having determined the yield of a bond, the investor can compare this with his own required rate of return. The investors required return represents the minimum return the investor demands from investing in a particular bond. As in the valuation of bonds, depending on the relationship between the yield and the required return, the following inferences can be made about the value of a bond. Yield vs. Required Return Yield > Require Return Yield < Require Return Yield = Require Return Value of the Bond Undervalued Overvalued Fairly valued Attractive investment Should be avoided

If Yield > Require Return, the bond is undervalued and considered an attractive investment. This is because the investor can expect to earn a higher return than required. If Yield < Require Return, the bond does not compensate the investor adequately. Such bonds should be avoided. INTRINSIC VALUE VS. MARKET PRICE Intrinsic value is the bond value given the future cash flows and the minimum return required by the investor from investing in the bond. In other words, it is the maximum price that the investor should be prepared to pay to buy the bond. This intrinsic value must be compared with the market price, which is the price at which it is traded in a secondary market such as the Colombo stock exchange or the primary dealer system. The market price is determined by the aggregate demand for and supply of bonds in the market. Depending on the relationship between the intrinsic value and the market price, the following inferences can be made about the value of a bond. Yield vs. Required Return Yield > Require Return Yield < Require Return Yield = Require Return Value of the Bond Undervalued Overvalued Fairly valued Good Investment