Bond Valuation, Duration, and

Investment
Chapters 12 and 13
 Basic Bond Valuation

n
Ct Par
D0   
t 1(1  k D ) (1  kD )
t n

• Where
Ct is the annual coupon payment
M is the par value of the bond
kD is the required rate of return on the bond issue
n is the number of years to maturity (term to
maturity)
 Basic bond valuation
Example: Road king Company Ltd. issued a 10% annual coupon bond with
a 10-year maturity. The par value of the bond is Tk.1,000. What is the value
of the bond? The minimum required return on the bond is 12%.

n
100 1,000
D0   
t 1 (1  0.12) (1  0.12)
t 10

D0 = 100 x PVAnORD factor12% 10 yrs. + 1,000 x PVn factor12% 10th yr

.
= 100 x 5.6500 +1,000 x 0.322
= 565 + 322
= Tk.887
 Semi-annual Coupon Bond

2n
Ct / 2 Par
D0   
t 1(1  k D/2) (1  kD/2)
t 2n

• Where
Ct is the annual coupon payment
M is the par value of the bond
kD is the required rate of return on the bond issue
n is the number of years to maturity (term to
maturity)
 Basic bond valuation
Example: Road king Company Ltd. issued a 10% semi-annual coupon
bond with a 10-year maturity. The par value of the bond is Tk.1,000. What is
the value of the bond? The minimum required return on the bond is 12%.

20
50 1,000
D0   
t 1 (1  0.06) (1  0.06)
t 20

D0 = 50 x PVAnORD factor6% 20 yrs. + 1,000 x PVn factor6% 20th yr

.
= 50 x 11.47 +1,000 x 0.312
= 573 + 312
= Tk.885
 Rates of Return on Bonds

• Yield to Maturity (YTM)

n
Ct Par
Mkt. Pr .   
t 1 (1  ytm) (1  ytm)
t n

 Example: A 10-year, 10% annual coupon

bond with 10 years to maturity, currently
sells for Tk.950.
 Rates of Return on Bonds
Yield to Maturity (YTM)
10
100 1,000
950   
t 1 (1  ytm) (1  ytm)
t 10

10
100 1,000

t 1 (1  ytm)
t

(1  ytm)10
 950  0

 Trial 1: ytm = 10%

 100 X 6.1446 + 1,000 X 0.3855 – 950
 614.46 + 385.5 –950 = 49.96
 Rates of Return on Bonds
Yield to Maturity (YTM)

 Trial 2: ytm = 11%

 100 X 5.889 + 1,000 X 0.352 – 950
 588.9 + 352 –950 = - 9.1
rate of   JPPV 
ytm      
JP PV   JPPV  JNPV 
 
ytm  10%   
49.96
 49.96  9.1

 49.96 
ytm  10%   
 59.06 

ytm = 10.85%
 Rates of Return on Bonds

• Yield to Maturity (YTM)

– Semi-annual coupon bond
2n
Ct / 2 Par
Mkt. Pr .   
t 1 (1  ytm / 2) (1  ytm / 2)
t 2n

 Example: A 10-year, 10% semi-annual

coupon bond with 10 years to maturity,
currently sells for Tk.950.
 Rates of Return on Bonds
Yield to Maturity (YTM)

20
50 1,000

t 1 (1  ytm / 2)
t

(1  ytm / 2) 20
 950  0

 Trial 1: ytm/2 = 5%
 50 X 12.4622 + 1,000 X 0.3769 – 950
 623.11+ 376.9 –950 = 50.01

 Trial 2: ytm/2 = 6%
 50 X 11.4699 + 1,000 X 0.3118 – 950
 573.495 + 311.8 – 950 = 49.96 = - 9.1 = - 64.705
Rates of Return on Bonds
Yield to Maturity (YTM)

 
ytm  5%  
50.01
 50.01  64.705 


 50.01 
ytm  5%   
114.715 


Ytm/2 = 5.44%
Ytm = 10.88%
 Rates of Return on Bonds
Yield to Maturity (YTM): Approximate Yield
 Par  V 
 tC  
ytmapprox   n

 0.6V  0.4 Par 
 
 1,000  950 
 100  
ytmapprox   10

 0.6(950)  0 .4(1,000 ) 
 
= 105/970
10.824%
=

Basis point difference between two methods

10.85% - 10.824% = 2.6 B.P.
Yield to Maturity (YTM):Approximate Yield
Semi-annual

Rates of Return on Bonds

 Par  V 
C
 t / 2  
ytm approx   2 n
2
 0.6V  0.4 Par 
 
 1,000  950 
 50  
ytm approx   20
2
 0.6(950)  0.4(1,000 ) 
 
= (52.5/970) X 2
= 5.41% X 2
=10.82%
 Rates of Return on Bonds
Yield to Call (YTC)

n
Ct Call price
Mkt. Pr .   
t 1 (1  ytc ) (1  ytc )
t n

 C. Pr .  V 
 Ct  n 
ytcapprox  
 0.6V  0.4 C . Pr . 
 
 Rates of Return on Bonds
Anticipated Realisable Yield (ARY)

n
Ct Re alisable price
Mkt. Pr .   
t 1 (1  ary) (1  ary)
t n

 R. Pr .  V 
 Ct  n 
ytcapprox  
 0.6V  0.4 R . Pr . 
 
 Bond price relations
• Generally,
– Higher the coupon rate, higher the price
– Lower the yield, higher the price
– What is the relationship between the maturity
and yield?
 The term structure of interest rates
• Depicts the relationship between maturity
and interest rates (yield).
• Often called the yield curve because yields on
existing securities having maturities from 3
months to 30 years are plotted on graph.
• Securities analysed are usually treasury issues
to eliminate business risk considerations.
 Case One
• Shows an ascending Yield
pattern of yield,
increasing with term to
maturity.
• A general signal that
interest rate will rise.

Maturity
 Case Two
• Shows an declining Yield
pattern of yield,
decreasing with term to
maturity.
• A general signal that
interest rate will fall.

Maturity
 Case Three
• Shows a hump Yield
representing a rise in
intermediate term
interest rates and then
gradually declining with
lengthening of maturity.
• A general signal that
interest rate will rise.

Maturity
 Case Four
• Shows a flat term Yield
structure indicating
investors’ indifference
between yield and
maturity
• Signals that it is not
possible to anticipate
the pattern for the
future interest rates.

Maturity
Theories explaining the Shape of the Yield curve.
• Expectations Hypothesis:
– Any long-term rate is an average of the expectations of
the future short-term rates over the applicable time
horizon.
• Expectations of rise in short-term rates will cause investors
to expect higher long-term rates.
• Expectations of increasing future rates cause investors to
lend short-term and avoid long-term to reduce losses when
the rate goes up.
• Borrowers have the opposite incentive. They tend to borrow
long-term to lock in lower rates.
• Opposite desires of the lenders and borrowers equilibrate
the expected pattern of interest rates.
• Opposite motivations are in effect when interest rates are
expected to fall.
Theories explaining the Shape of the Yield curve.

• Liquidity Preference Theory:

– Yield curve tends to be upward sloping more than
any other pattern.
• Increased risk of holding longer-term maturities, causes
investors demand higher long-term return.
• Ability of short-term bonds to be be more easily turned
into cash (without the risk of large price changes)
motivates investors to pay a higher price for short-term
bonds and thus receive a lower yield.
 Theories explaining the Shape of the Yield curve.
• Market Segmentation Theory:
– Different maturity preferences by different institutional
investors.
• Banks tend to prefer short-term bonds to match the nature
of their deposits.
• Life insurance companies prefer long-term bonds to match
long-term obligations.
• Behaviour of these institutional investors often create
pressure on short-term and long-term yield but very little in
the intermediate market of 5 to 7-year maturities.
– Focus on the accumulation or liquidation of securities
by institutional investors during the different phases of
the business cycle and the resultant impact on the
yield curve.
Theories explaining the Shape of the Yield curve.

• Expectations hypothesis is probably the

most dominant.
• All three theories have some part in the
creation of the term structure of interest
rates.
• Curve takes on many different shapes over
time.
 Investment Strategy: Interest Rate
Considerations

• Expectations of falling interest rates prompts

investors to take a bullish position in the market
by buying long-term bonds and try to maximise
from the price movement pattern associated with
interest rate changes.
• Because the impact of an interest rate change is
much greater on long-term securities, the investor
will look for extended maturity when interest
rates are expected to fall.
 Bond Price Rules

1. Prices of existing bonds have a

relationship to maturities, coupons, and
market yields for bond of equal risks.
2. Bond prices and interest rates (yield) are
inversely related.
3. Prices of long-term bonds are more
sensitive to a change in yield than short-
term bonds.
 Bond Price Sensitivity.

• Prices of long-term bond is more sensitive to changes

in the YTM than short-term bonds.
• Bond price sensitivity increases as the term to
maturity increases.
• Bond prices are more sensitive to a decline in market
rate than a rise in the market rate.
• Prices of low coupon bonds are more sensitive to a
change in YTM than high-coupon bonds.
• Bond prices are sensitive when YTM is low than when
YTM is high.
 Effective life of the bond
• Term to maturity gives equal weight to all payments
during the life of the bond. However the earlier
payments are more valuable than the later payments
offering more value to the investor.
• The effective life of a bond is shorter than the term to
maturity.
• The calculation of effective life requires higher
weights given to earlier payments than later
payments.
• Two methods of calculating the effective life of a bond
are 1. Simple weighted average life, and 2. Duration.
 Duration

• Duration calculates effective life of a bond on

the weighted average of the present value of
the individual payments on the bond
discounted at the YTM.
n
PVCFt
Duration   n
t 1

t 1

PVCFt
 Duration
1.Time 2.Cash 3.PV 4.PVCFt 5. Weight 6.
Year flow factor 2. X 3. 4./sum 4. = 1.X5
CFt @ 12%
1 80 0.893 71.44 0.0835 0.0835
2 80 0.797 63.76 0.0745 0.1490
3 80 0.712 56.96 0.0666 0.1998
4 80 0.636 50.88 0.0595 0.2380
5 1,080 0.567 612.36 0.7159 3.5795
855.40 1.000 4.2498
 Duration (assuming semi-annual)

PV Factor PV of
Time Cash weight X
Year @ ytm/2 cash Weight
period flow year
= 6% flow

1 0.50 40 0.9434 37.7358 0.0442 0.022125

2 1.00 40 0.8900 35.5999 0.0417 0.041745
3 1.50 40 0.8396 33.5848 0.0394 0.059073
4 2.00 40 0.7921 31.6837 0.0372 0.074305
5 2.50 40 0.7473 29.8903 0.0350 0.087624
6 3.00 40 0.7050 28.1984 0.0331 0.099197
7 3.50 40 0.6651 26.6023 0.0312 0.109179
8 4.00 40 0.6274 25.0965 0.0294 0.117714
9 4.50 40 0.5919 23.6759 0.0278 0.124932
10 5.00 1040 0.5584 580.7306 0.6810 3.404853
852.7983 1.0000 4.140747
 Duration and Maturity
• Table 13.3.
• $1,000 par, 8% annual coupon bond and
12%YTM with term to maturities of 1, 5, and
10 years.
– Maturity: 1 year Duration: 1.0000 year
– 5 years : 4.2498 years
– 10 years : 6.8381 years
• Thus duration increases at a decreasing rate as
the term to maturity increases.
 Duration and Price Sensitivity
• The most important use of duration is the
determination of price sensitivity.
– As a rough measure of price sensitivity, one can
multiply duration by the change in the YTM to
determine the percentage change in the value of
the bond.
– E.g. Duration = 7.2470 years
Decrease in YTM 2%
Approximate increase in price = 7.2470 X 2%
=14.494%
• As price α 1/YTM, YTM decreases and price
increases, and vice versa.
 Duration and Market Rates

• Duration is inversely related to YTM, and

therefore the market rate.

• This is because of the present value effect that

is a p art of duration. Higher market rates, or
YTM means lower duration.
 Duration and Coupon Rates

• Higher periodic cash flows before maturity carry

higher weight thereby creating a reducing effect on
duration.
• Therefore duration is also inversely related to
coupon rate.
 Bringing together the influence of duration

• Thus three factors determine the magnitude of

duration.
– Maturity of bonds:
• The longer the term to maturity, the higher the price
sensitivity, vice versa.
– Market rate/YTM:
• The The higher the YTM the lower the duration, the
higher the coupon rate.
– Coupon rate:
• The higher the coupon rate the lower the duration, the
lowerr the price sensitivity.
 Question
• There are two bonds
– Bond A. 8% 20-yr. annual coupon bond @ 12%
YTM, Tk.1,000 par.
– Bond B. 12% 25-yr. annual coupon bond @ 12%
YTM, Tk.1,000 par.
• Bond A
– Lower coupon rate higher duration
– Lower maturity lower duration
• Bond B
– Higher coupon rate lower duration
– Higher maturity higher duration
 Question
• Duration:
– Bond A: 8.939 years
– Bond B: 8.784 years
• If market rates are to go down by 2% bond
price change
– Bond A: 8.939 X 2% = +17.878%
– Bond B: 8.784 X 2% = +17.569%
• Bond A is a better investment option when
YTM is expected to fall.
• Vice versa when YTM expected to rise.
 Problem 13-6
• Ted Bear thinks that recent federal reserve policy is
going to push interest rates up. He is considering
keeping only one of the following bonds in his
portfolio. He knows that bond A has a duration of
5.3128, bond B has a duration of 3.2056, and bond C
has the following characteristics.
– Par Value $1,000
– Coupon rate 5percent
– Discount rate (ytm) 10 percent
– Life remaining 4 years
• Which one of these three bonds should he keep?
Duration bond A 5.3128
Duration bond B 3.2056
Duration bond C ?

PV Factor weight X
Time PV of
Year Cash flow @ ytm = Weight time
period cash flow
10% period
1 1 50 0.909091 45.45455 0.054016 0.054016
2 2 50 0.826446 41.32231 0.049105 0.09821
3 3 50 0.751315 37.56574 0.044641 0.133923
4 4 1050 0.683013 717.1641 0.852238 3.408953
841.5067 3.695102
•Interest rates expected to rise
•Therefore bond value expected to fall
•Bond B having the lowest duration is expected to have
least decline in price