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A bond is a......... ....... security that obligates the issuer to make specified interest and principal payments to the holder on specified dates. Bonds are sometimes called fixed income securities

Issuers Government state as well as central govt.s Corporates

The bond terminology Par value: Face amount; paid at maturity 1. Coupon interest rate: 2. Multiply by par value to get interest in rupee terms. Generally fixed. Maturity: Years until bond must be repaid as 3. time elapses this declines. Issue date: Date when bond was issued. 4. Stated interest rate.

Basis point defined A basis point (bp) is 1% of 0.01 or 0.0001. The difference between a rate of 5.00% and 5.01% is one basis point

Basic Valuation premise The (market) value of any investment asset is simply the present value of expected cash flows .

A ZCB's value In the case of a zero coupon bond the value of the bond is given as V = FV/(1+ k)n where FV is the price at which the bond will be redeemed k is the required rate of return n is the number of years to maturity ....

...Bond Valuation contd. CM C P (1 k ) (1 k ) 2 (1 k ) 3 C C .. (1 k ) n Where: P = bond price at time zero C = coupon payment M = maturity amount k = appropriate required return (discount rate) n = life of the bond ...

76%. the nominal return is 10%. Let: R = the nominal return r = the real return h = the inflation rate According to the Fisher Effect: 1 + R = (1 + r) x (1 + h) For example. and the inflation rate is (1 + R) = 1.Inflation and returns The relationship between real and nominal returns is described by the Fisher Effect. the real return is 4.10 (1 + r) x (1 + h) = 1.10 and h = 5% .

.Bond Valuation contd..1.100 The bonds mature in 10 years The market's required return on similar bonds is 10% ..000 face value The promised annual coupon is Rs. Assume a company's bonds have a Rs.

1446 = Rs.. Calculate the present value of the face value = Rs.100 x [1 . 1.. Calculate the present value of the coupon payments = Rs.1010)]/.Bond Valuation contd.000 x 0. The value of each bond = Rs.10 = Rs. 1.46 3.000 x [1/1. 614.1.(1/1.1.1010 ] = Rs.100 x 6..385.3855 = Rs.000 (barring rounding off errors) .50 2.

Let's go a little deeper Suppose you purchase the G Sec described earlier and immediately thereafter expected inflation rose by 3%. the bond price will always go down.165 When the interest rate goes up.85 839. .315 295. causing k = 13%? PV of annuity PV of principal Bond value 543.

Contd. and k declined to 7%? PV of annuity PV of principal Bond value 702.4 508.0 1210.4 prices will always go up.. bond . When interest rates go down. What would happen if inflation fell..

Prices and Coupon Rates Price Yield .

. A bond sells at a premium if its coupon is above the required return. Bond prices are inversely related to interest rates (or yields).. A bond sells at a discount if its coupon is below the required return..Contd. A bond sells at par only if its coupon rate equals the required return (Coupon rate = required return).

Price Converges to Par at Maturity It is also important to note that a bond's price will approach par value as it approaches the maturity date. regardless of the interest rate and regardless of the coupon rate. .

Pulled to par Bond price Premium bond Par value Discount bond Maturity .

Current Yield Coupon Interest Current yield = Current market Price Face Value = Rs.1000 Interest rate = 8% Market Price = 800 Current yield = 80/800 = 0.10 or 10% .

e. (1 y) n This is the same equation we saw earlier when we solved for price. we know the market price but are solving for return. lets find out return on a bond given its price CM C P (1 y) (1 y) (1 y) 2 3 C C ....YTM We have seen how to value a bond can we reverse the dynamics?? i. . In this case..

In other words it is the single rate that when used to discount a bond's Cash flows produces the bond's market price .YTM The yield to maturity measures the compound annual return to an investor and considers all bond cash flows.

of years This formula was suggested by Gabriel A Hawawini and Ashok Vora. in an article published in the Journal of Finance.4M 0. .6P M = maturity value n = no.YTM: an approximation C = coupon P = current price C (M P)/n 0.

YTM is 13.Example Face Value = Rs.1000 Coupon interest = 9% Maturity = 8 years Current Market Price = 800/1200 After doing trial and error method.02% 90 (1000 800)/8 0.07 .6(800) = 115/880 = 13.4(1000) 0.

5 11.Type of Bond Coupon rate Current yield YTM Premium Bond (bonds selling above par value) Discount Bonds 9 9 7.25 6 13 .

the calculation assumes that all of the Rs. Of course. If market interest rates fall. resulting a realized YTM which is less than promised. . the investor may be forced to reinvest at something less than 8%. if rates rise. 100 coupon and the YTM is 8%. if the bond pays a Rs. however. 100 coupons are invested at that rate.The Reinvestment Rate Assumption It is important to note that the computation of the YTM implicitly assumes that interest rates are reinvested at the YTM. coupons may be reinvested at a higher rate resulting in a higher realized YTM. In other words.

99% ~ 12% 1337.9634 7..Reinvestment rate.44 1.44 @12% for 1year 112 @12% for 2 years 125.4049 1 11.9634 implying a YTM of 12%.9634 100 100 1100 133 .44 Return realized 13 951. A 3-year 10% bond trades at Rs. -951. 951..

9634 100 100 @10% for 1year 1100 1331 110 @10% for 2 years 121 1.If reinvestment rate = 10% -951.3981 1 11.9634 .81% 1331 Return realized 13 951.

change for a given change in interest rates The price sensitivity of bonds increases with maturity but it 4. increases at a decreasing rate (maturity effect) Bonds with lower coupon rates experience more % changes for 5.Malkiel's theorems Bond prices move inversely with interest rates 1. fall in yields will exceed the price decrease caused by an increase in yields of the same magnitude Bonds with longer maturity experience greater percentage 3. For a given bond the absolute rupee price increase caused by a 2. a given change in interest rates (coupon effect) .

Four bonds priced initially to yield 9% 1) 9% coupon.1968 . initial price = 100 3) 5% coupon. 20 years to maturity initial price = 63. initial price = 84. 5 years to maturity. 5 years to maturity. 20 years to maturity. initial price = 100 2) 9% coupon.1746 4) 5 % coupon.

73 39.13 -9.0 9 Note : The initial yield is 9% and the first two columns indicate the illusatrat ive new yields (1%) and the change in yield (bp). 5 year 5%.00) 4. 5 year 9%.58 -4.9 .1 (-1.35 11.00) -3. 20 year 5%.Bond price volatility Percentage price change for bonds with differe nt Change in yield from 9% to : 6.80 34.99 0 9.04 -22.00 6 8.04 -0.90 4.1 (-100.04 0.01 0 10.6 (1.86 -8.67 13.00) 0.09 0.00 5 8.06 9.00 4 12. 20 year 12.00) coupon and maturity 1 2 3 4 9%.00 (-300.09 -0.00) -0.00) -11.89 -25.2 Change (bp) (-300.04 0.57 -11. Columns (1) -(4) show the percentage change in bond price for different coupons and maturities (100.04 -0.

Price change (volatility) is greater the lower the coupon rate Price change is greater the longer the term to maturity .

Implications of Malkiel's theorems A bond buyer in order to receive the maximum price impact of an expected change in interest rates should purchase low coupon long maturity bonds If an increase in interest rates is expected an investor contemplating their purchase should consider those bonds with large coupons or short maturities or both .

From Malkiel's theorems to .. .5% 8 yr bond and B 11% 9 yr bond Which one is more interest rate sensitive? To address such questions Malkiel's theorems may not be sufficient. Consider two bonds A 9..

Duration Duration Combines the effects of differences in coupon rates and differences in maturity .

Macaulay's duration n t.M (1 y)t (1 y)n Duration t 1 P Where t = number of periods in the future C = cash flow to be delivered in t periods n= term-to-maturity & y = yield to maturity. .c n.

(weighted by respective fraction of the PV of the bond as a whole). duration equals maturity since 100% of its present value is generated by the payment of the face value. . at maturity. For a zero coupon bond.Duration Weighted sum of the number of periods in the future of each cash flow.

Computation of duration .

Duration contd.. Duration is shorter than maturity for all bonds except zero coupon bonds Duration of a zero-coupon bond is equal to its maturity .

Understanding duration .

What is the use of Duration? No Use .

increase the average duration of your bond portfolio to experience maximum price volatility If you expect an increase in interest rates.Trading Strategies Using Duration Longest-duration security provides the maximum price variation If you expect a decline in interest rates. reduce the average duration to minimize your price decline Note that the duration of your portfolio is the market-valueweighted average of the duration of the individual bonds in the portfolio .

Modified duration dp 1 1 Mac Dur 1 y dy p Modified duration MD can be interpreted as the approximate percentage change in price for a 100bp change in yield .

Modified duration (MD) DMacualey MD 1 y Direct measure of price sensitivity to interest rate changes Can be used to estimate percentage price volatility of a bond dp MD dy P .

10 If yields increase to 10.1 =0.1698 MD 1.7907 .37907 3. how does the bond price change? The percentage price change of this bond is given by: = 3.Example Modified duration of the earlier bond: 4.7907 X 0.10%.

7907 *100 * 0.1% 0.6219 Reasonable approximation! . MD dy p dp MD * P * dy 3.379079 New predicted price: 100 0.62091 Actual dollar price (using PV equation):99.37909 = 99.What is the predicted change in rupee terms? dp 1 .

Step 3: Recall that when interest rates change. Step 2: Find modified duration of bond.finding the predicted price change Step 1: Find Macaulay duration of bond. the change in a bond's price can be related to the change in yield according to the rule: dp MD dy P .

Duration and Convexity Price Pricing Error from convexity Duration Yield .

Convexity The convexity is the measure of the curvature and is the second derivative of price with respect to yield (d2P/di2) divided by price Convexity is the percentage change in dP/dy for a given change in yield d 2P 2 dy Convexity measure P .

Convexity t t CF 2 n 1 y t 1 Convexity P(1 y ) 2 t .

Convexity Adjustment dP MD dy dy 1 convexity measure (dy) 2 2 .

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