# Valuation

Bond Valuation
Bond Par value (face value) Coupon rate Coupon or Coupon payment Maturity date Yield or Yield to maturity Provisions

Bond Valuation

1  1 (1 + r) t Bond Value = C  r   

  F + n  (1 + r)  

BV = C * PVIFA(r,t) + PVIF(r,n)

Consider a bond issued by XYZ corporation with a maturity date of 2020 and a stated coupon rate of 7% and a face value of Rs.1000. In 2000, with 20 years left to maturity, investors owning the bonds are requiring a 7.5% rate of return. What is the value of the bond? Rs. 949.00 Alaskan airlines bonds are maturing in 14 years that pay Rs.68.75 per year (but disbursed semi-annually) and a face value of Rs.1000. If the Investors required rate is 7.2%, what is the Value of this bond? Rs. 972.00

Yield to Maturity (YTM)
Rate of return investors earn if they buy the bond at P0 and hold it until maturity.

YTM is the discount rate that equates the PV of a bond’s cash flows with its price.

find YTM Suppose you are offered a 14-year . time to maturity – 8 yrs. find YTM. 10% annual coupon. .93. market price – Rs. 800. coupon rate – 9%. Rs.1000.1494.Computing Yield-to-maturity Yield-to-maturity is the rate implied by the current bond price Face Value – Rs.1000 par value bond at Rs.

93.YTC Suppose the bond stated above had a call provision. to call the bonds 10 years after the issue date at a price of 1100. causing the price of the bonds to rise to 1494. suppose further that the interest rates had fallen and one year after issuance the going interest rate had declined. the return to the investor is… Current Yield = I/MP . .

Par value – Rs. find the Value of the bond. 12% and 15%.Relationship / Theorem . Annual Interest – Rs. RRR – 9%. .1000. Time to maturity – 5 years.1 Bond prices and market interest rates move in opposite directions The Value of a bond is inversely related to changes in the investor’s present RRR. The Interest rate increases (decreases). the value of the bond decreases (increases) RRR – 12%. 120.

Graphical Relationship Between Price and Yield-to-maturity 1500 1400 1300 1200 1100 1000 900 800 700 600 0% 2% 4% 6% 8% 10% 12% 14% .

When coupon rate > YTM. price < par value (discount bond) .Relationship / Theorem .2 When a bond’s coupon rate is (greater than / equal to / less than) the market’s required return. price > par value (premium bond) When coupon rate < YTM. the bond’s market value will be (greater than / equal to / less than) its par value When coupon rate = YTM. price = par value.

1200 1100 When the YTM = coupon.1 Discount Rate When the YTM > coupon.09 0.04 0. the bond trades at a discount. 1000 800 0 0.YTM and Bond Value \$1400 Bond Value 1300 When the YTM < coupon.01 0.03 0.06 0. the bond trades at a premium.07 6 3/8 0.05 0.02 0. .08 0. the bond trades at par.

At maturity.4. the Market value of a bond approaches its Par Value.Relationship / Theorem .3.2. . find the value of both the premium and discount bonds (15% and 9% respectively) over time of 5.1 year to maturity.3 As the Maturity Date approaches. the value of any bond must equal its par value Assuming no changes in the current interest rate.

20 15 10 5 0 Years remaining to Maturity . rd = 10%.372 1.211 rd = 7%.000 837 775 30 25 M rd = 13%.Bond Value 1. 1.

All other features are identical .4 Long-term Bonds have greater Interest rate Risk than do Short term Bonds Given two bonds identical but for maturity. for a given change in market interest rates. the price of the longer-term bond will change more than that of the shorter-term bond.Relationship / Theorem . A bond with longer maturity has higher relative (%) price change than one with shorter maturity when interest rate (YTM) changes.

16 1000. 12% and 15%.28 .Find the Bond value if Face Value RS. Term to maturity.24 10yrs 1192. Scenario 1 – 5 years Scenario 2 – 10 years RRR – Current interest rate 9%.00 849.80 1000. Coupon Rate – 12% RRR 9% 12% 15% 5 yrs 1116.00 899. 1000.

Maturity and Bond Price Volatility Bond Value Consider two otherwise identical bonds. The long-maturity bond will have much more volatility with respect to changes in the discount rate Par Short Maturity Bond C Discount Rate Long Maturity Bond .

A lower coupon bond has a higher relative price change than a higher coupon bond when YTM changes. All other features are identical .5 Given two bonds identical but for coupon. for a given change in market interest rates.Relationship / Theorem . the price of the lower-coupon bond will change more than that of the higher-coupon bond.

Coupon Rate and Bond Price Volatility Bond Value Consider two otherwise identical bonds. The low-coupon bond will have much more volatility with respect to changes in the discount rate High Coupon Bond Discount Rate Low Coupon Bond .

Interest Rate Risk Price Risk  Change in price due to changes in interest rates  Long-term bonds have more price risk than short-term bonds Reinvestment Rate Risk  Uncertainty concerning rates at which cash flows can be reinvested  Short-term bonds have more reinvestment rate risk than longterm bonds .

Maturity – 1 and 30 years . 15 and 20%. Interest rate – 5. Coupon rate – 10%. 10.If we take longer maturities and changes in interest rates. 1000. Face Value – Rs.

What is reinvestment rate risk? The risk that CFs will have to be reinvested in the future at lower rates. reducing income. You buy a 1-year bond with a YTM of 10%. Illustration: Suppose you just won 500. You’ll invest the money and live off the interest. .000 playing the lottery.

000. .000 to 15. Had you bought 30-year bonds.000. If rates fall to 3%.000 to reinvest. At year-end get back 500. income would have remained constant.Year 1 income = 50. income will drop from 50.

Long-term bonds: High interest rate risk. low reinvestment rate risk. high reinvestment rate risk. Nothing is riskless! . Short-term bonds: Low interest rate risk.

True or False: “All 10-year bonds have the same price and reinvestment rate risk.” False! Low coupon bonds have less reinvestment rate risk but more price risk than high coupon bonds. .

will be more sensitive to interest rate changes than bonds with earlier cash flows.Relationship with pattern of Cash Flow The sensitivity of a bond’s value to changing interest rates depends not only on the time to maturity. Bonds with cash flows coming later. But. but also on the pattern of cash flows A change in interest rates always has a greater impact on the PV of later cash flows than on earlier cash flows. How to measure this? .

Duration A measure of how responsive a bond’s price is to changing interest rates – estimate of price volatility. the longer the duration Calculation is based on the weighted average of the present values for all cash flows . Greater the relative percentage change in a bond price in response to a given percentage change in interest rate.

Macaulay Duration Duration = sum (t * Ct / (1+Y)^t)/P0 t – year the cash flow is to be received Ct – Cash flow to be recd in year t Y – Bond holders RRR P0 – the bond’s PV For all bonds. whose duration is equal to maturity . duration is shorter than maturity except zero coupon bonds.

1.45 7.000 after 10 years Annual coupon rate 0% 6 8 10 Semiannual coupon payment 0 30 40 50 Bond value Bond duration 456 864 1.135 10 years 7.000 1.77 .• Newly issued bond which makes semiannual coupon payments • Market interest rates for this bond demand 8 percent interest The bond makes a final repayment of Rs.07 6.

065 -9.3% 7.5 -6.8 -6.135 414 805 935 1.5 7.07 6.9 Initial price at 8 percent market rate Market rates rise to 9 percent Bond price Change in Price 0% 6 8 10 10 years 7.Market rate Drops to 7% Market rate rises to 9% Annual coupon rate Bond duratio n Market rates drop to 7 percent Bond price 503 929 1.000 1.77 456 864 1.45 7.1 6.071 1.2% -6.2 .213 Change in price 10.

In the above table. the percentage loss in a bond's value equals the bond's duration The same holds true for appreciation in a bond's price when interest rates fall . bonds with higher durations had a bigger gain when interest rates fell the rule of thumb for interest rate risk associated with bonds: When interest rates rise one percent. bonds with higher durations had a bigger loss when interest rates rose Similarly.

Modified Duration Mod. .Duration = Macaulay Duration / (1+yield/k)) K = number of compounding periods per year.

duration does a good job. the convex nature of the price/yield curve becomes apparent. When large changes in yield occur. the relationship is not linear – for small changes in yield. A measure of the curvature in the relationship between bond prices and bond yields . But.Convexity Bond prices and yields are inversely related.

.Immunization The investment of the assets in such a way that the existing business is immune to a general change in the rate of interest. Immunization is accomplished by calculating the duration of the promised outflows and then investing in a portfolio of bonds that has identical duration.

The Bond Indenture Contract between the company and the bondholders and includes The basic terms of the bonds  The total amount of bonds issued  A description of property used as security. if applicable  Sinking fund provisions  Call provisions  Details of protective covenants  .

What factors affect default risk and bond ratings? Financial performance    Debt ratio Coverage ratios. such as interest coverage ratio or EBITDA coverage ratio Current ratios .

and Unsecured Bonds / Subordinated Debentures Transferability : Registered and Unregistered (bearer) Debentures Conversion: Convertible. Deep discount Bonds Credit rating : Junk / high-yield bonds . Eurobonds Coupon : very low coupon bonds. Zero coupon Bonds /Zeroes. partly convertible. Non-Convertible Debentures Country and Currency – Foreign Bonds.Types of Bonds Bonds Vs Debentures Security : Secured / Mortgaged bond.

ZIFCD. TOCD etc.. Warrants. SPN. .Redemption : Callable and Puttable Bonds LYONs.

Zero-Coupon Bonds Make no periodic interest payments (coupon rate = 0%) The entire yield-to-maturity comes from the difference between the purchase price and the par value Cannot sell for more than par value Sometimes called zeroes. or deep discount bonds Valuation of Zeros .

Valuation of Zeros Assume that the default-free 10 year interest rate on riskless investments is 4. If the 10-yr zero is trading at Rs.55% and that you are pricing a zero with a maturity of 10 yrs and a face value of Rs. price the zero.82.1000. what is 10yr default free rate? .593.

but generally low daily volume in single issues Makes getting up-to-date prices difficult. particularly on small company or municipal issues Treasury securities are an exception .Bond Markets Primarily over-the-counter transactions with dealers connected electronically Extremely large number of bond issues.

different coupons. Yield curve – graphical representation of the term structure  Normal – upward-sloping. etc. long-term yields are higher than short-term yields  Inverted – downward-sloping. long-term yields are lower than short-term yields . all else equal It is important to recognize that we pull out the effect of default risk.Term Structure of Interest Rates Term structure is the relationship between time to maturity and yields.

Upward-Sloping Yield Curve .

Downward-Sloping Yield Curve .

. Information on expected future short term rates can be implied from yield curve. Three major theories are proposed to explain the observed yield curve. The yield curve is a graph that displays the relationship between yield and maturity.Overview of Term Structure The relationship between yield to maturity and maturity.

an upward-sloping yield curve reflects expectations of higher future inflation and interest rates. the very strong relationship between inflation and interest rates supports this theory. • In general. .Theories of Term Structure Expectations Theory • This theory suggest that the shape of the yield curve reflects investors expectations about the future direction of inflation and interest rates. • Therefore.

Expectations Theory Observed long-term rate is a function of today’s short-term rate and expected future short-term rates. Long-term and short-term securities are perfect substitutes. . Forward rates that are calculated from the yield on long-term securities are market consensus expected future short-term rates.

Theories of Term Structure Liquidity Preference Theory • This theory contends that long term interest rates tend to be higher than short term rates for two reasons: – long-term securities are perceived to be riskier than short-term securities – borrowers are generally willing to pay more for longterm funds because they can lock in at a rate for a longer period of time and avoid the need to roll over the debt. .

Investors will demand a premium for the risk associated with long-term bonds. Forward rates contain a liquidity premium and are not equal to expected future shortterm rates. . The yield curve has an upward bias built into the long-term rates because of the risk premium.Liquidity Premium Theory Long-term bonds are more risky.

• As a result.Theories of Term Structure Market Segmentation Theory • This theory suggests that the market for debt at any point in time is segmented on the basis of maturity. the shape of the yield curve will depend on the supply and demand for a given maturity at a given point in time. .

Trading in the distinct segments determines the various rates. Observed rates are not directly influenced by expectations.and long-term bonds are traded in distinct markets.Market Segmentation and Preferred Habitat Short. . Preferred Habitat:   Modification of market segmentation Investors will switch out of preferred maturity segments if premiums are adequate.

Factors Affecting Bond Yields Key Issue: What factors affect observed bond yields? Real rate of interest Expected future inflation Interest rate risk Default risk premium Liquidity premium .