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# Lecture note 2

## Bond pricing and yields

(Ch 2 & 3)
Objectives
After reading this note, you will understand
the time value of money
how to calculate the price of a bond
why the price of a bond changes in the direction opposite to the change in
required yield
that the relationship between price and yield of an option-free bond is
convex
the relationship between coupon rate, required yield, and price
the complications of pricing bonds
how to calculate the yield on any investment
how to calculate the current yield, yield to maturity, yield to call, yield to put,
and cash flow yield
how to calculate the yield for a portfolio
Review of Time Value
Future Value
The future value (Pn) of any sum of money
invested today is:
Pn = P0(1+r)n
n = number of periods
Pn = future value n periods from now (in dollars)
P0 = original principal (in dollars)
r = interest rate per period (in decimal form)
(1 + r)n represents the future value of \$1 invested
today for n periods at a compounding rate of r
Review of Time Value (continued)

Future Value
When interest is paid more than one time per
year, both the interest rate and the number of
periods used to compute the future value must be
r = annual interest rate number of times
interest paid per year
n = number of times interest paid per year times
number of years
The higher future value when interest is paid
semiannually, as opposed to annually, reflects the
greater opportunity for reinvesting the interest
paid.
Review of Time Value (continued)

## Future Value of an Ordinary Annuity

When the same amount of money is invested periodically,
it is referred to as an annuity.
When the first investment occurs one period from now, it
is referred to as an ordinary annuity.
The equation for the future value of an ordinary annuity
(Pn) is:
1 r
n

1
Pn A
r

## A = the amount of the annuity (in dollars).

r = annual interest rate number of times interest paid
per year
n = number of times interest paid per year times number
Review of Time Value (continued)

## Example of Future Value of an Ordinary

Annuity Using Annual Interest:
If A = \$2,000,000, r = 0.08, and n = 15, then Pn = ?

1 r
n

1
Pn A r

1 0.08
15

1
Pn \$2, 000, 000 0.08

## Pn \$2, 000, 000 27.152125

\$54,304,250
Review of Time Value (continued)

## Example of Future Value of an Ordinary

Annuity Using Semiannual Interest:
If A = \$2,000,000/2 = \$1,000,000, r = 0.08/2 =
0.04, and n = 15(2) = 30, then Pn = ?
1 r
n

1
Pn A
r

1 0.04
30

1
Pn \$1, 000, 000
0.04

Pn \$1, 000, 000 56.085
\$56,085,000
PV and compounding frequency
Consider a 5% annual interest rate (APR)
Frequency m APR AER
Annual 1 5% 5.0000%
Semi-annual 2 5% 5.0625%
Quarterly 4 5% 5.0945%
Monthly 12 5% 5.1162%
Weekly 52 5% 5.1246%
Daily 365 5% 5.1267%
Continuous infinity 5% 5.1271%
Review of Time Value (continued)

Present Value
The present value is the future value process in reverse.
We have:
1

Pn
1 r
n

## r = annual interest rate number of times interest paid per

year
n = number of times interest paid per year times number of
years
For a given future value at a specified time in the future, the
higher the interest rate (or discount rate), the lower the
present value.
For a given interest rate, the further into the future that the
future value will be received, then the lower its present value.
Review of Time Value (continued)

## Present Value of a Series of Future Values

To determine the present value of a series of
future values, the present value of each future
value must first be computed.
Then these present values are added together to
obtain the present value of the entire series of
future values.
Review of Time Value (continued)

## Present Value of an Ordinary Annuity

When the same amount of money is received (or paid) each
period, it is referred to as an annuity.
When the first payment is received one period from now, the
annuity is called an ordinary annuity.
When the first payment is immediate, the annuity is called an
annuity due.
The present value of an ordinary annuity (PV) is:

n
11 / 1 r
PV A
r

## A = the amount of the annuity (in dollars)

r = annual interest rate number of times interest paid per year
Review of Time Value (continued)

## Example of Present Value of an Ordinary

Annuity (PV) Using Annual Interest:

## If A = \$100, r = 0.09, and n = 8, then PV= ?

n
11 / 1 r
PV A
r

PV \$100
11
/ 1 0.09 8
0.09

PV \$100 5.534811
\$553.48
PV and Fixed-Rate Mortgage
Suppose a 30-year \$100,000 mortgage loan is financed at a fixed interest rate
(APR) of 8%. What is the monthly payment?

=(\$100,0000.08/12)/(11/(1+0.08/12)^360)=\$733.76

Notice that you overall pay 733.763012=\$264,154 for this loan, the majority
of which -- \$164,154 -- constitutes interest payments.

What is the interest and principal payments in the first month and last month?

## What is the monthly fixed amount assuming APR=6%?

Review of Time Value (continued)

## Present Value When Payments Occur More Than Once Per

Year
If the future value to be received occurs more than once per year, then
the present value formula is modified so that
i. the annual interest rate is divided by the frequency per year
ii. the number of periods when the future value will be received is
adjusted by multiplying the number of years by the frequency per
year
Pricing a Bond

## Determining the price of any financial instrument requires

an estimate of
i. the expected cash flows
ii. the appropriate required yield
iii. the required yield reflects the yield for financial
instruments with comparable risk, or alternative
investments
. The cash flows for a bond that the issuer cannot retire
prior to its stated maturity date consist of
i. periodic coupon interest payments to the maturity date
ii. the par (or maturity) value at maturity

## Pricing a Bond (continued)

In general, the price of a bond (P) can be computed
using the following formula:
n
Ct Mt
P +
t=1 1 r t
1 rn
P = price (in dollars)
n = number of periods (number of years times 2)
t = time period when the payment is to be received
C = semiannual coupon payment (in dollars)
r = periodic interest rate (required annual yield
divided by 2)
M = maturity value

## Computing the Value of a Bond: An Example

Consider a 20-year 10% coupon bond with a par
value of \$1,000 and a required yield of 11%.
Given C = 0.1(\$1,000) / 2 = \$50, n = 2(20) = 40
and r = 0.11 / 2 = 0.055, the present value of the
coupon payments (P) is:
11 / 1 r n
P C r

11 / 1 0.055 40
P \$50
0.055

P \$50 16.046131
Pricing a Bond
(continued)

## Computing the Value of a Bond: An Example

The present value of the par or maturity value of
\$1,000 is:

M
\$1, 000
\$117.46
1 r 1 0.055
n 40

## Continuing the computation from the previous

slide:
The price of the bond (P) =
present value coupon payments + present value maturity
value =
Pricing a Bond (continued)
For zero-coupon bonds, the investor realizes interest
as the difference between the maturity value and the
purchase price. The equation is:
M
P t

1 r n

## P = price (in dollars)

M = maturity value
r = periodic interest rate (required annual yield divided
by 2)
n = number of periods (number of years times 2)

## Zero-Coupon Bond Example

Consider the price of a zero-coupon bond (P)
that matures 15 years from now, if the maturity
value is \$1,000 and the required yield is 9.4%.
Given M = \$1,000, r = 0.094 / 2 = 0.047, and
n = 2(15) = 30, what is P ?

M t \$ 1, 0 0 0
P \$252.12
1 r n
1 0 . 0 4 7 3 0
Pricing a Bond (continued)

Price-Yield Relationship
A fundamental property of a bond is that its price
changes in the opposite direction from the change
in the required yield. (See Overhead 2-21).
The reason is that the price of the bond is the
present value of the cash flows.
If we graph the price-yield relationship for any
option-free bond, we will find that it has the
bowed shape shown in Exhibit 2-2 (See

Exhibit 2-1
Price-Yield Relationship for a
20-Year 10% Coupon Bond

## Yield Price (\$) Yield Price (\$) Yield Price (\$)

0.050 1,627.57 0.085 1,143.08 0.120 849.54

## 0.080 1,197.93 0.115 883.50 0.150 685.14

Exhibit 2-2
Shape of Price-Yield Relationship for an
Option-Free Bond

Maximum
Price

Price

Yield
Pricing a Bond (continued)

## Relationship Between Coupon Rate, Required Yield, and Price

When yields in the marketplace rise above the coupon rate at a given point in
time, the price of the bond falls so that an investor buying the bond can realizes
capital appreciation.

## The appreciation represents a form of interest to a new investor to compensate

for a coupon rate that is lower than the required yield.

When a bond sells below its par value, it is said to be selling at a discount.

A bond whose price is above its par value is said to be selling at a premium.
Pricing a Bond (continued)

## Relationship Between Bond Price and Time

if Interest Rates Are Unchanged
For a bond selling at par value, the coupon rate equals the required yield.
As the bond moves closer to maturity, the bond continues to sell at par.
Its price will remain constant as the bond moves toward the maturity date.
The price of a bond will not remain constant for a bond selling at a premium or a
discount.
Exhibit 2-3 shows the time path of a 20-year 10% coupon bond selling at a discount
and the same bond selling at a premium as it approaches maturity. (See truncated
version of Exhibit 2-3 in Overhead 2-25.)
The discount bond increases in price as it approaches maturity, assuming that the
required yield does not change.
For a premium bond, the opposite occurs.
For both bonds, the price will equal par value at the maturity date.
Exhibit 2-3
Time Path for the Price of a 20-Year 10% Bond
Selling at a Discount and Premium as It
Approaches Maturity
Price of Discount Bond Price of Premium Bond
Year Selling to Yield 12% Selling to Yield 7.8%

## 4.0 937.90 1,074.37

0.0 1,000.00 1,000.00
Pricing a Bond (continued)

## Reasons for the Change in the Price of a Bond

The price of a bond can change for three reasons:
i. there is a change in the required yield owing to changes in the credit
quality of the issuer
ii. there is a change in the price of the bond selling at a premium or a discount,
without any change in the required yield, simply because the bond is
moving toward maturity
iii. there is a change in the required yield owing to a change in the yield on
comparable bonds (i.e., a change in the yield required by the market)
Example
There are three bonds, two zeros and one coupon bond.
One-year zero price is 96, two-year zero is 91, a two-
year bond price is 108 with coupon rate 10%. The par
value for all three bonds is 100 and coupon payment is
annual. Is there any arbitrage opportunity? How to
develop a strategy to take the arbitrage opportunity?
Ex ante vs. Ex post Measures

## The actual return can be computed only after selling

the bond
or after receiving the entire cash flow streams, coupon
and
principle payments, if the bond is held till maturity.

## Notice that the holding period return is an ex-post

measure while YTM is an ex ante concept.
Complications

## The framework for pricing a bond assumes the

following:
1. the next coupon payment is exactly six
months away
2. the cash flows are known
3. the appropriate required yield can be
determined
4. one rate is used to discount all cash flows
Complications (continued)

## 1. The next coupon payment is exactly six

months away
When an investor purchases a bond whose next
coupon payment is due in less than six months, the
n
accepted method C for computing the
M price of the
P +
bond is as follows:
t=1 1 r 1 r
v t 1
1 r 1 r
v t 1

## where v = (days between settlement and next

coupon) divided by (days in six-month period)
Example
Consider a 20-year 4% coupon bond with a par value of
\$1,000 and a required yield of 8%. The bond was issued
on June 6, 2016. What is the value of the bond two
months after June 6, 2016?
Complications (continued)

## Cash Flows May Not Be Known

For most bonds, the cash flows are not known with certainty.
This is because an issuer may call a bond before the maturity date.

## Determining the Appropriate Required Yield

All required yields are benchmarked off yields offered by Treasury securities.
From there, we must still decompose the required yield for a bond into its
component parts.

## One Discount Rate Applicable to All Cash Flows

A bond can be viewed as a package of zero-coupon bonds, in which case a
unique discount rate should be used to determine the present value of each cash
flow.
Pricing Floating-Rate and
Inverse-Floating-Rate Securities

## The cash flow is not known for either a floating-

rate or an inverse-floating-rate security; it
depends on the reference rate in the future.
Price of a Floater
The coupon rate of a floating-rate security (or
floater) is equal to a reference rate plus some
The price of a floater depends on
i. the spread over the reference rate
ii. any restrictions that may be imposed on the
resetting of the coupon rate
Example
Consider a bond selling at par (\$1000) with a coupon rate of 6% and 10
years to maturity.
(a) What is the price of this bond if the required yield is 15%?
(b)What is the price of this bond if the required yield increases from 15%
to 16%, and by what percentage did the price of this bond change?
(c) What is the price of this bond if the required yield is 5%?
(d)What is the price of this bond if the required yield increases from 5% to
6%, and by what percentage did the price of this bond change?
(e) From your answers to the Question, parts b and d, what can you say
about the relative price volatility of a bond in a high-interest-rate
environment compared to a low-interest-rate environment?
Conventional Yield
Measures
Bond yield measures commonly quoted by
dealers and used by portfolio managers are:
1) Current Yield
2) Yield To Maturity
3) Yield To Call
4) Yield To Put
5) Yield To Worst
6) Cash Flow Yield
7) Yield (Internal Rate of Return) for a Portfolio
8) Yield Spread Measures for Floating-Rate
Securities
Conventional Yield
Measures (continued)
1) Current Yield
Current yield relates the annual coupon interest to
the market price.
The formula for the current yield is:
current yield = annual dollar coupon interest /
price
The current yield calculation takes into account only
the coupon interest and no other source of return
that will affect an investors yield.
The time value of money is also ignored.
Conventional Yield Measures
(continued)
2) Yield To Maturity
The yield to maturity is the interest rate that will make the
present value of the cash flows equal to the price (or initial
investment).
For a semiannual pay bond, the yield to maturity is found by
first computing the periodic interest rate, y, which satisfies the
relationship: C C C C M
P 2 3 ... n
1 y 1 y 1 y 1 y 1 y n

## where P = price of the bond, C = semiannual coupon interest

(in dollars), M = maturity value
(in dollars), and n = number of periods (number of years
multiplied by 2).
Conventional Yield Measures
(continued)

## 2) Yield To Maturity (continued)

For a semiannual pay bond, doubling the periodic interest rate or
discount rate (y) gives the yield to maturity.

## The YTM calculations assume that :

A all cash flows received during the life of the bond are reinvested at
the YTM.
b. the bond is held until maturity.
c. all promised cash flows will be paid.
Computing the Yield or Internal Rate of Return
on any Investment

Annualizing Yields
To obtain an effective annual yield associated with a
periodic interest rate, the following formula is used:
effective annual yield = (1 + periodic interest
rate)m 1
where m is the frequency of payments per year.
To illustrate, if interest is paid quarterly and the
periodic interest rate is 0.08 / 4 = 0.02, then we have:
effective annual yield = (1.02)4 1 = 1.0824 1 = .0824
or 8.24%
Computing the Yield or Internal Rate of Return
on any Investment (continued)

Annualizing Yields
We can also determine the periodic interest rate that will
produce a given annual interest rate by solving the
effective annual yield equation for the periodic interest
rate .
Solving, we find that
periodic interest rate = (1 + effective annual yield )1/m 1
To illustrate, if the periodic quarterly interest rate that
would produce an effective annual yield of 12%, then we
have:
periodic interest rate = (1.12)1/4 1 = 1.0287 1 =
0.0287 or 2.87%
Exercise in class
1. A coupon bond which pays interest semi-annually, has a par value of \$1,000, matures in 5 years,
and has a yield to maturity of 8%. If the coupon rate is 10%, the intrinsic value of the bond today
will be __________.
A) \$855.55
B) \$1,000
C) \$1,081
D) \$1,100

2. A coupon bond which pays interest of \$40 annually, has a par value of \$1,000, matures in 5 years,
and is selling today at a \$159.71 discount from par value. The actual yield to maturity on this bond
is __________.
A) 5%
B) 6%
C) 7%
D) 8%
Conventional Yield
Measures (continued)
3) Yield To Call
The call price is the price at which the bond may be called .
There is a call schedule that specifies a call price for each call
date.
The yield to call assumes that the issuer will call the bond at
some assumed call date and the call price is specified in the
call schedule.
C C C ... C M*
P The
= computation for the yield to call begins with this
1 y
expression:
1
1 y 2
1 y 3
1 y n*
1 y n*

## where M * = call price (in dollars) and n* = number of periods

until the assumed call date (number of years times 2)
For a semiannual pay bond, doubling the periodic interest rate
(y) gives the yield to call on a bond-equivalent basis.
Conventional Yield
Measures (continued)
4) Yield To Put
If an issue is putable, it means that the bondholder can
force the issuer to buy the issue at a specified price.
The put schedule specifies when the issue can be put
and the put price.
When an issue is putable, a yield to put is calculated.
The yield to put is the interest rate that makes the
present value of the cash flows to the assumed put
date plus the put price on that date as set forth in the
put schedule equal to the bonds price.
The formula for the yield to put is the same as for the
yield to call, but M * is now defined as the put price and
n* is the number of periods until the assumed put date.
The procedure is the same as calculating the yield to
maturity and the yield to call.
Conventional Yield
Measures
5) Yield To Worst
(continued)
A practice in the industry is for an investor to calculate the
yield to maturity, the yield to every possible call date, and
the yield to every possible put date.
The minimum of all of these yields is called the yield to
worst.
6) Cash Flow Yield
Amortizing securities involve cash flows that include
interest plus principal repayment and the cash flow each
period consists of three components: (i) coupon interest,
(ii) scheduled principal repayment, and (iii) prepayments.
For amortizing securities, market participants calculate a
cash flow yield, which is the interest rate that will make the
present value of the projected cash flows equal to the
market price.
Example:
Suppose the 8% coupon (semiannual payment),
30-year maturity bond sells for \$1,150 and is
callable in 10 years at a call price of \$1,100.
What is the yield to maturity, yield to call, and
yield to worst?
Conventional Yield Measures
(continued)
7) Yield (Internal Rate of Return) for a
Portfolio
The yield for a portfolio of bonds is not simply
the average or weighted average of the yield
to maturity of the individual bond issues in the
portfolio.
It is computed by determining the cash flows
for the portfolio and determining the interest
rate that will make the present value of the
cash flows equal to the market value of the
portfolio.
Exampl
e
If you construct a bond portfolio with 5 8% coupon (semiannual
payment), 5-year maturity bond sells for \$1,150 and 10 1-year zero
coupon bond sells for \$980. What is the yield for the portfolio?
Conventional Yield Measures
(continued)
8) Yield Spread Measures for Floating-
Rate Securities
The coupon rate for a floating-rate security
changes periodically based on the coupon
reset formula.
This formula consists of the reference rate and
the quoted margin.
Since the future value for the reference rate is
unknown, it is not possible to determine the
cash flows.
This means that a yield to maturity cannot be
computed.
Conventional Yield Measures
(continued)
9) Yield Spread Measures for Floating-Rate
Securities
There are several conventional measures used as margin
or spread measures cited by market participants for
floaters.
simple margin, adjusted total margin, and discount
margin.
The most popular of these measures is the discount
margin, which estimates the average margin over the
reference rate that the investor can expect to earn over
the life of the security.
Exhibit 3-1 shows the calculation of the discount margin
for a six-year floating-rate security. (See Overhead
3-20.)
Exhibit 3-1 Calculation of the Discount Margin for a Floating-Rate Security
Floating-rate security Maturity: six years;
Coupon rate: reference rate + 80 basis points Reset every six months

## Present Value of Cash Flow at Assumed Annual

Margin (basis points)

Reference Cash
Period Rate Flowa 80 84 88 96 100
1 10% 5.4 5.1233 5.1224 5.1214 5.1195 5.1185
2 10 5.4 4.8609 4.8590 4.8572 4.8535 4.8516
3 10 5.4 4.6118 4.6092 4.6066 4.6013 4.5987
4 10 5.4 4.3755 4.3722 4.3689 4.3623 4.3590
5 10 5.4 4.1514 4.1474 4.1435 4.1356 4.1317
6 10 5.4 3.9387 3.9342 3.9297 3.9208 3.9163
7 10 5.4 3.7369 3.7319 3.7270 3.7171 3.7122
8 10 5.4 3.5454 3.5401 3.5347 3.5240 3.5186
9 10 5.4 3.3638 3.3580 3.3523 3.3409 3.3352
10 10 5.4 3.1914 3.1854 3.1794 3.1673 3.1613
11 10 5.4 3.0279 3.0216 3.0153 3.0028 2.9965
12 10 105.4 56.0729 55.9454 55.8182 55.5647 55.4385
Present Value = 100.0000 99.8269 99.6541 99.3098 99.1381
a
For periods 111: cash flow = 100 (reference rate + assumed margin)(0.5); for period
12: cash flow = 100 (reference rate + assumed margin)(0.5) + 100.
Potential Sources of a
Bonds
Dollar Return
An investor who purchases a bond can expect to receive
a dollar return from one or more of these sources:
i. the periodic coupon interest payments made by
the issuer
ii. any capital gain (or capital loss negative dollar
return) when the bond matures, is called, or is sold
iii. interest income generated from reinvestment of
the periodic cash flows
. The current yield considers only the coupon interest
payments.
. The yield to maturity, yield to call, and cash flow yield
all take into account the three components.
Potential Sources of a
Bonds Dollar Return
(continued)
Determining the Interest-On-Interest
Dollar Return
The interest-on-interest component can represent a
substantial portion of a bonds potential return. The
coupon interest plus interest on interest 1 can n
1
r be
couponinterest
found by using interestoninterest C
the following equation:
r

where
C is the coupon interest
r is the semiannual reinvestment rate
n is the number of periods
Potential Sources of a Bonds
Dollar Return (continued)
Determining the Interest-On-Interest
Dollar Return
The total dollar amount of coupon interest is found by
multiplying the semiannual coupon interest by the
number of periods:
total coupon interest = nC
where C is the coupon interest, r is the semiannual
reinvestment rate, and n is the number of periods.
The interest-on-interest component is then the difference
between the coupon interest plus interest on interest
1 r n as
and the total dollar coupon interest, 1 expressed by the
interestoninterest C
formula nC
r
Potential Sources of a Bonds
Dollar Return (continued)

## Determining the Interest-On-Interest Dollar

Return
Example. Assume that the coupon interest (C) is
\$50, the semiannual reinvestment rate (r) is 4.5%,
and the number of periods 1 r(n)
n is1 40. What is the
interestoninterest C
interest-on-interest? nC
r
Using our equation for interest on interest and
inserting in our given values we get:
1 0.045 40 1
50 40 50 50 107.03032 1, 400 \$7,351.52
0.045
Potential Sources of a Bonds
Dollar Return (continued)
Yield To Maturity and Reinvestment Risk
The investor realizes the yield to maturity only
if the bond is held to maturity and the coupon
payments can be reinvested at the computed
yield to maturity.
Reinvestment risk is the risk that future
reinvestment rates will be less than the yield to
maturity at the time the bond is purchased.
There are two characteristics of a bond that
determine the importance of the interest-on-
interest component and therefore the degree of
reinvestment risk: maturity and coupon.
Total Return (continued)

## Computing the Total Return for a Bond

The idea underlying total return is simple.
i. The objective is first to compute the total
future dollars that will result from investing in
a bond assuming a particular reinvestment
rate.
ii. The total return is then computed as the
interest rate that will make the initial
investment in the bond grow to the computed
total future dollars.
Applications of the Total Return
Horizon Analysis

assess performance over some investment
horizon.
Horizon return refers to when a total return is
calculated over an investment horizon.
An often-cited objection to the total return
measure is that it requires the portfolio manager
rates and future yields as well as to think in terms
of an investment horizon.
Example on total return
You purchased a 5-year annual interest coupon bond one year
ago. Its coupon interest rate was 6% and its par value was
\$1,000. At the time you purchased the bond, the yield to
maturity was 4%. If you sold the bond after receiving the
first interest payment and the bond's yield to maturity had
changed to 3%, your annual total rate of return on holding
the bond for that year would have been __________.
A) 5.00%
B) 5.51%
C) 7.61%
D) 8.95%

59
Calculating Yield
Changes
The absolute yield change (or absolute rate
change) is measured in basis points and is the
absolute value of the difference between the two
yields as given by
absolute yield change = initial yield new yield 100.
The percentage change is computed as the natural
logarithm of the ratio of the change in yield as shown
by
percentage change yield = 100 ln (new yield / initial
yield)
where ln in the natural logarithm.
Consider the following bond: coupon rate =11%, maturity = 18 years, par
value = \$1,000, first par call in 13 years, and only put date in five years
and putable at par value. Suppose that the market price for this bond
\$1,169.
(a)Show that the yield to maturity for this bond is 9.077%.

## (c) Show that the yield to put is 6.942%.

(d) Suppose that the call schedule for this bond is as follows:
Can be called in eight years at \$1,055
Can be called in 13 years at \$1,000
And suppose this bond can only be put in five years. What is the yield to
worst for this bond?