BFW1001 Foundations of Finance

Lecture 6
Valuation of Fixed Income Securities
Dr. Keshab Shrestha, CFA
Professor of Banking and Finance
keshab.shrestha@monash.edu

2021

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Contents

1 Fixed Income Securities 3

1.1 Valuation of Fixed Income Security . . . . . . . . . . . . . . . . . . 9
1.1.1 Valuation of Annual Coupon Bond . . . . . . . . . . . . . . . . 11
1.1.2 Valuation of Semiannual Coupon Bond . . . . . . . . . . . . . . 14
1.2 Zero-Coupon Bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

2 Risk Neutral Valuation: Challenging Section 18

2.1 Risk-Neutral Valuation - Background . . . . . . . . . . . . . . . . . . . 20
2.2 Risk Neutral Probability of Default for Corporate Bonds . . . . . . . . . 25

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1. Fixed Income Securities

In general, fixed income securities, like bonds, promise to pay known or fixed amount on
regular intervals of time.

• For example, most of the corporate bonds and government bonds pay semiannual
coupon – coupons are paid every six months until maturity and it will pay face value
plus the final coupon on maturity.
+ Actually, the issuer of the bond would pay the semiannual coupons and final face
value provided the issuer is not bankrupt.
+ Therefore, better description is ”the issuer would promise to pay the semiannual
coupons and face value.
+ We will deal with bankruptcy when discussing the risk-neutral valuation.
• However, the Euro-bonds, in general, pay coupon once a year and on maturity pay
the face value plus the final coupon.1
1
Throughout this unit, we will assume that the bond used in the discussion has just paid the coupon and the next
coupon would be paid in exactly 6 months for the semi-annual bonds and in exactly one year for annual bonds.

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Bonds are issued by corporations, governments and other organizations to raise funds by
selling the bonds to market participants who wants to buy the bonds.
A bond must have the following information:

a. Maturity (N years from today) – the date when the final payment is made and after
which the bond ceases to exist.
b. Face value (Fv ) – this is the amount that will be paid at maturity together with
the last coupon if any.2 The face value is also referred as par value or principal
amount.
c. Coupon rate (Cr ) – this indicates what fraction or percentage of the face value is
the annual coupon.
d. Frequency of coupon payment –“are the coupons paid annually or semiannually?”
Sometimes, this is common knowledge.
– For example, it is common knowledge that corporate bonds pay semi-annual
coupon whereas the Euro-bonds pay annual coupon.
2
I used ’if any’ because a zero-coupon bond does not pay any coupon.

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 – This could change in the future.
e. Issuer of the bond – name of the organization who issued the bond. This is the
organization that will receive the bond price when the bond is originally issued and
will make the coupon and face value payments to the holder of the bonds.
– During the discussion on the valuation of a bond, the issuer may not be named
because it may not be relevant.
Consider a 10% 4-year Euro-bond with face value of $1,000 issued by ExxonMobil Cor-
poration.

a. The maturity of this bond is 4 years (N = 4).

b. The face value of the bond is $1,000 (Fv = 1, 000).
– ExxonMobil has promised to pay the face value plus the last coupon in 4 years.
c. The coupon rate is 10% (Cr = 0.10).
– Therefore, ExxonMobil has promised to pay $100 (0.10 × 1, 000) at the end of
every year for the next 4 years (it has promised to pay $100 in 1, 2, 3 and 4
years. )
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 – ExxonMobil has also promised to pay $1,000 (face value) in 4 years in addition
to the last coupon.
– See Figure 1 for the time line of the payments.
– Here I use the term promised because if ExxonMobil happens to be bankrupt
before the maturity of the bond, it will not be able to keep the promise (more
discussion on this issue later).

d. Coupon frequency is annual (once a year) - known because it is an Euro-bond.

e. The issuer of the bond is ExxonMobil Corporation.
In one year (after the coupon is paid), the bond will be a 10% 3-year bond with the
same face value of $1,000 - please make sure you understand what I am saying here.

Now consider a 10% 4-year corporate bond with face value of $1,000 issued by IBM.

a. The maturity of the bond is 4 years (N = 4).

b. The face value of the bond is $1,000 (Fv = 1, 000).
c. The coupon rate is 10% (Cr = 0.10)
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 $100 $100 $100 $1, 100

0 1 2 3 4

Figure 1: Promised cash flows of a $1,000 face value 10% 4-year Euro-bond issued by ExxonMobil
(1-period is 1-year).

– IBM has promised to pay annual coupon equal to 10% of face value (which is
equal to $100).
– But, being semi-annual coupon bond, the half of annual coupon will be paid once
every six months for the next 4 years (IBM has promised to pay $100/2=$50 in
0.5, 1, 1.5, 2, 2.5, 3, 3.5 and 4 years).
– In addition to $50, IBM has promised to pay $1,000 in 4 years. Therefore, the
total payment at the end of fourth year will be $1,050 (coupon plus face value)
(see Figure 2).
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 $50 $50 $50 $50 $50 $50 $50 $1, 050

0 1 2 3 4 5 6 7 8

Figure 2: Promised cash flows of a 10% 4-year corporate bond issued by IBM (1-period is 6-month).

d. Coupon frequency is semi-annual (twice a year) - known because it is a corporate

bond.
e. The issuer of the bond is IBM.

The promised cash flows associated with bonds is equivalent to the sum of two cash flows:
(i) the coupon payment is an annuity and (ii) final principal or face value payment is a
single cash flow.

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1.1. Valuation of Fixed Income Security

Let us consider a general of a n-period bond with the random cash flows of C̃t due in
period t that includes face value on maturity.3

C̃1 C̃2 C̃2 ... C̃n

0 1 2 3 ... n
Figure 3: Cash flows of a Bond

• To value the bond, we may try to use valuation principle from Lecture 3 using the
cost-of-capital. If the 1-period cost-of-capital is k, then the fair value of the bond
today is given by4
3
Note that we use N to denote the number of years to maturity of the bond and n to denote the number of periods
to maturity. Therefore, if the bond pays semiannual coupon, n = 2N . If the bond pays annual coupon, n = N .
4
We need to use the cost-of-capital to discount the expected cash flows. Also, note that one period must be equal to
1 year for annual coupon bond and half year (6 months) for semiannual coupon bonds so the timing of the cash flow is
aligned with the end of periods.
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 n
X E(C̃t )
V0 = t (1)
t=1
(1 + k)
• However, we do not use the above equation to value bonds because it is difficult to
estimate the expected cash flows.
+ In order to compute expected cash flows we need to know the probability of
default, and
+ the recovery rate.
+ More on this later.
• The conventional way of valuing the bonds uses the so-called yield-to-maturity
instead of cost-of-capital for discounting.
• Also, when using the yield-to-maturity, instead of discounting the expected cash
flows, we discount the promised cash flows. In this case, the fair value of the bond
is given by
n
X C Fv
V0 = + (2)
(1 + y)t (1 + y)n
t=1
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 where y is the effective 1-period yield-to-maturity, C is the periodic coupon payment
and Fv is the face value.
• Above formula can be simplified as follows:

 
C 1 Fv
V0 = 1− n + (3)
y (1 + y) (1 + y)n

• The first term on right-hand side (RHS) of above equation is the value of n-period
annuity.
• Now, it is clear that to value the bond, all we need to know is the effective 1-period
yield-to-maturity (y) because we already know the other three variables (C, Fv and
n) on the RHS of equation (3) from the given description of the bond.

1.1.1. Valuation of Annual Coupon Bond

When we are dealing with annual coupon bonds like Euro-bonds, one period is equal to
one year. So we need to know the effective 1-year yield-to-maturity to apply equation
(3).
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 Example 1:
Consider a 8 percent, 10-year bond with $100 par value where the coupons are paid
once a year.5 If the effective 1-year yield-to-maturity is 10 percent, find the fair value
of the bond today.
Note the following Cr = 0.08, Fv = 100 and N = 10 years. Since one period is equal
to one year, n = 10.
C = coupon rate × Face value = Cr × Fv = 0.08 × 100 = 8

 
8 1 100
V0 = 1− 10
+ = 49.1565 + 38.5543 = 87.7109
0.1 (1 + 0.1) (1 + 0.1)10

Since the face value is taken to be 100, the fair value comes out as the percentage of
the face value, which in this case is 87.7109 percent.

• Borrowers like corporations, governments and financial institutions borrow by issuing

bonds to investors.
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This is equivalent to saying “Consider a 8% annual coupon bond with maturity of 10 years and face value of $100”
or ”Consider a 8% 10-year annual coupon bond with face value of $100”.
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• However, the face value of the bonds can vary, e.g., the face value could be 10,000,
100,000 or 1,000,000 in different currencies.
• Therefore, when quoting the bonds price, it is the yield-to-maturity that is mentioned
so that we can use the yield-to-maturity to price different face value bonds.
click for Yahoo Finance
• For example, if the face value of the bond, in Example 1, is $50,000 instead of $100.
Then its value is given by
 
50, 000 × 0.08 1 50, 000
V0 = 1− + = 43, 855.43
0.1 (1 + 0.1)10 (1 + 0.1)10
• Note that the face value of this bond is 500 times the face value of the bond in
Example 1.
• We could have obtained above price by multiplying 87.7109 by 500,i.e., 87.7109 ×
500 = 43, 855.45.
• Alternatively, we could have obtained this value by multiplying the face value by
87.7109 percent or 50, 000 × 0.877109 = 43, 855.45.
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 • The difference 43 cents and 45 cents is due to rounding.

1.1.2. Valuation of Semiannual Coupon Bond

When we are dealing with semi-annual bond, we have to note the following:

• Half of the annual coupon is paid once every six months. Thus, C = Cr × Fv /2.
• One period is equal to half year.6
• For N -year bond, the number of period is n = 2 × N .
• Finally, in the market the yield-to-maturity is quoted in nominal term. Therefore,
to get the effective semiannual yield-to-maturity (y), we need to divide the nominal
yield-to-maturity by 2.

Then, the fair value is given by

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If we still assume one period equal to one year, some coupons will be paid in the middle of a period. In such cases,
we cannot use our pricing formula where the cash flow, if any, should occur at the end of a period and not in between
periods. This is why we need to match the length of a period to the cash flow timing.

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C 1 Fv
V0 = 1− + (4)
y (1 + y)2N (1 + y)2N
where

Cr × Fv
C=
2
Note that in the above formula, y is the effective 6-month yield-to-maturity .

Example 2:
Consider a semi-annual, 8 percent, 10-year bond with $1,000 par value. Find the price
or fair value of this bond given that the (nominal) yield-to-maturity is 9.09 percent.7
This bond will pay 4 percent of par value ($40, in the form of regular coupons)
every six-month for the next 10 years (20 six-months or 20 periods with one period
equal to six months) and at the end of tenth year it will pay the par value of $1,000 in
7
The convention is that a nominal rate is used for quoting yield-to-maturity. Therefore, in the quotation, the term
nominal could be missing but it is implied.

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addition to the last coupon of $40. The effective 6-month yield-to-maturity is given by
y = 0.0909/2 = 0.04545.
The fair value of the bond is given by
 
40 1 1000
P = 1− + = 929.3824
0.0909/2 (1 + 0.0909/2)20 (1 + 0.0909/2)20
Note the following:

• If the yield-to-maturity is quoted at 8 percent (same as the coupon rate), the value
of this bond would be $1000 (same as the face value).
• If the yield-to-maturity is quoted at 6 percent (yield-to-maturity less than coupon
rate), the value of the bond would be equal $1,148.7747 (bond value greater than
face value).
• This shows a well-known negative relationship between the bond price and yield-to-
maturity.

The following relationship can be established

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 • If yield-to-maturity is less than coupon rate, the bond would be selling at premium
(value of the bond would be greater than its face value).
• If yield-to-maturity is equal to coupon rate, the bond would be selling at par (value
of the bond would be equal to its face value).
• If yield-to-maturity is greater than coupon rate, the bond would be selling at dis-
count (value of the bond would be less than its face value).

1.2. Zero-Coupon Bond

Zero-coupon bonds (ZCB) are those bonds which does not pay any coupon. In this case,
the fair value is given by
 
Cr Fv 1 Fv Fv
V0 = 1− + n =
y (1 + y)n Cr =0 (1 + y) (1 + y)n
Or,

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 Fv
V0 = (5)
(1 + y)n

Above formula is equivalent to valuation of single payment. These bonds are also
called pure-discount bonds.

2. Risk Neutral Valuation: Challenging Section

Recall from Lecture 3 the following:

1. Risk-free cash flows valuation: If a security pays a risk-free cash flow in the amount
of Vn in n periods and the effective 1-period risk-free interest rate is rf , then the
fair value of the security is give by

Vn
V0 =
n (L3.1)
1 + rf

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2. Risky cash flows valuation: Consider a security that pays a risky cash flow in the
amount of Ṽn in n periods. If the 1-period cost-of-capital is k, then the fair value of
the security is give by  
E Ṽn
V0 = (L3.3)
(1 + k)n
3. Risk-Neutral valuation method:
This is an alternate valuation method.
– When we went from risk-free valuation to risky valuation, we modified the
risk-free valuation equation by
(i) replacing the numerator by expected cash flow, and
(ii) replacing the risk-free rate by the cost-of-capital in the denominator.
– In risk-neutral valuation, we
(i) keep the denominator unchanged (i.e., use the same risk-free rate rf or do
not replace the risk-free rate by cost-of-capital), and
(ii) change the numerator by expected value using artificial probabilities instead
of true probabilities. The artificial probabilities are called risk-neutral prob-
abilities
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 – How do we find the risk-neutral probabilities? We answer this question in the
next Section.

2.1. Risk-Neutral Valuation - Background

Consider a security that pays $100 in one period with probability 60 percent (π = 0.60)
and $50 with probability 40 percent ((1 − π) = 0.4) (see Figure 3). Suppose the effective
1-period cost-of-capital for this risky cash flow is 5.5% and the risk-free rate is 3%.

• Note that π and 1 − π are the true probabilities of payments $100 and $50 respec-
tively.
• The expected cash flow in one year is equal to 100 × 0.6 + 50 × 0.4 = 80. Therefore,
the fair value of the security today is given by

E [V1 ] 100 × π + 50 (1 − π) 80
V0 = = = = 75.8294 (6)
(1 + k) 1+k 1.055
• If we insist on discounting expected cash flow using risk-free rate instead of the
cost-of-capital, we will NOT get the correct fair value of 75.8294 as shown below
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 s $100 with probability 0.6 (π)



80
V0 = s

1+k Q
Q
Q
Q
QQ s
$50 with probability 0.4 (1 − π)

t=0 t=1
Figure 3: Valuation of Risky Cash Flow due in 1 year.

80 80
= = 77.6699 (7)
1 + rf 1.03

• Therefore, if we insist on discounting the expected cash flow by risk-free rate (rf ),
we need to change the numerator to get the true value down to $75.8294 from
$77.6699.
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One way to change the numerator is to use artificial probabilities instead of true proba-
bilities in computing the end-of-period expected cash flows as follows:

• Use artificial probability πn instead of true probability π for the payment of $100.
• Therefore, the artificial probability of payment $50 is given 1 − πn .
Note that the two probabilities must sum to 1.
• At this point we do not know what the artificial probabilities (πn and (1 − πn )) are.
• Now, choose the artificial probabilities (πn and 1 − πn ) such that when we discount
the expected cash flow based on artificial probabilities using the risk-free rate, we
get the correct fair value.
That means we are trying to solve the following equation for πn :

100 × πn + 50 (1 − πn )
= 75.8294
1 + rf
Or, after substituting for rf = 0.03, we solve the following equation for πn :

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 100 × πn + 50 (1 − πn )
= 75.8294 (8)
1 + 0.03

s $100 with probability πn =?




s

75.8294 Q
Q
Q
Q
QQ s
$50 with probability 1 − πn =?

t=0 t=1
Figure 4: Finding Risk-Neutral Probabilities.

Multiply both sides of equation (8) by 1.03 to get

100 × πn + 50 (1 − πn ) = 75.8294 (1.03)

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 Or,
πn (100 − 50) = 75.8294 (1.03) − 50

Therefore,
75.8294 (1.03) − 50
πn = = 0.56209
50
Therefore, if we use the artificial probability to compute the expected value and discount
this expected value by risk-free rate, we get the correct fair value:

100 × 0.56209 + 50 × (1 − 0.56209)

= 75.8294
1 + 0.03
These artificial probabilities πn (of payment $100) and (1 − πn ) (of payment $50) are
known as the risk-neutral probabilities.
The risk-neutral pricing involves the following

• Find the risk-neutral probabilities. These probabilities may be given to you. If not,
you can compute these probabilities from the price of the security.
• Use these artificial probabilities to compute the expected cash flow in the future.
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 • Discount the expected cash flow with risk-free rate. You will get the correct price or
fair value.
• As you will see, the risk-neutral pricing is frequently used in the valuation of options.

2.2. Risk Neutral Probability of Default for Corporate Bonds

Consider a zero-coupon corporate bond with maturity of 1 year and face value equal to
Fv .
If we know the market price of this bond, we can find the risk-neutral probability that
the bond will default within one year.

• Assume that if the Corporation issuing the bond defaults, the value of the bond
would be Rrec Fv , where Rrec is called recovery rate.
– For example, if the face value of the bond is $1,000 (Fv = 1, 000) and recovery
rate is 60 percent (Rrec = 0.6), then in the event of default the bond will provide
a cash flow equal to 60 percent of $1,000 or $600 (Rrec Fv = 0.6×1, 000 = 600)
at maturity.
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 • Let πn be the risk-neutral probability of default during the maturity of the ZCB.
• Then, the expected value of cash flow from this bond based on the risk-neutral
probability is given by (see Table 1 or Figure 5):

Rrec Fv πn + Fv (1 − πn ) (9)

Default State Cash flow Probability Cash Flow × Prob.

Default Rrec × Fv πn Rrec Fv πn
No Default Fv 1 − πn Fv (1 − πn )
Expected C.F.⇒ Rrec Fv πn + Fv (1 − πn )

Table 1: Expected Cash Flow in 1 Year

• The fair value of this bond (V0 ) today, using risk-neutral valuation, is given by

Rrec Fv πn + Fv (1 − πn )
V0 =
(10)
1 + rf
.
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 s Survive: Fv prob. (1 − πn )



s

V0 = P0 Q
Q
Q
Q
QQ s
Default: Rrec Fv prob. πn

t=0 t=1
Figure 5: Risk-Neutral Valuation of ZCB with maturity of 1 year and face value Fv .

• If we know the risk-neutral probability of default, πn , we can price the corporate

bond given the recovery rate using equation (10).
• If we do not know the risk-neutral probability but know the price of this bond, we
can find the risk-neutral probability of default (πn ) using the same equation, where
the fair value is replaced by the market price (P0 ) and solve for the risk-neutral
probability (πn ).

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 Rrec Fv πn + Fv (1 − πn )
P0 =
(11)
1 + rf
.
• For financial institutions like Banks, the probability of default is an im-
portant risk measurement. You will probably encounter this in you take
BFW2401 Commercial Banking and Finance.

Example 3:
Consider a zero-coupon bond with maturity of 1 year and face value equal to $100.
This bond is issued by Zeta Corporation. Assume that the recovery rate is 60 percent. If
the bond is currently selling at $95 and risk-free rate is 3 percent, find the risk-neutral
probability of default within one year.

Solution:

(0.6)100πn + 100 (1 − πn )
95 =
(1 + 0.03)
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Multiply both sides by 1.03 to get

(95)(1.03) = 60πn + 100 − 100πn

100 − 95 × 1.03
πn = = 0.05375 = 5.375%
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Therefore, the risk-neutral probability of default within a year is equal to 5.375 percent.

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