Financial Income Markets (MFM850)

Bond Pricing

Leben Johnson
15th Oct. 2019
Bond Pricing 1
 Fixed Income - Basics
• Time value of Money
• Future Value (FV)
• Annuity (ordinary & due)
• Present Value (PV)
– Higher interest rate, lower the PV for a given FV
– Longer the maturity, for given interest rate, lower PV
• PV of Annuity
• Effective Annual Yield

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 Pricing a Bond

• Expected cash flows

• Yield Requirement

Expected Bond Cash Flow

• Principal/Par value on maturity
• Interest payments
• Interest on reinvested interest

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 Pricing a Bond Coupon + Principal Payments
Coupon / Interest Payments

0 1 2 3 4 5
Interest Reinvestment Payments

Expected Bond Cash Flow

• Principal/Par value on maturity = Principal
• Interest payments = Coupon Rate * Par Value * years
OR
• Principal/Par value on maturity = Principal
• Interest on reinvested interest (Annuity) ie.

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 Present Value of Cash Flow Coupon + Principal Payments
Coupon / Interest Payments

0 1 2 3 4 5
Interest Reinvestment Payments

Present Value

Expected Bond Cash Flow

• Principal/Par value on maturity , PV = Principal * (1+r)^-n
• Interest payments for each coupon = Coupon Rate * Par Value * (1+r)^-n
OR
• Principal/Par value on maturity , PV = Principal * (1+r)^-n
• Interest on reinvested interest (Annuity) PV ie.

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 Bond Yield and Price Relationship

• When
Required yield > Coupon rate, Bond price < Par Value : Discount Bond
Required yield < Coupon rate, Bond price > Par Value : Premium Bond
Required yield = Coupon rate, Bond price = Par Value

Microsoft Office
Excel Worksheet

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 Price Quotes
Price = % of Par Value
97 = .97 * 1000 = 970
Price quote = Clean Price

Full or Dirty Price = Clean Price + Accrued Interest

For
Par Value = 1000,
Coupon = 10%,
Coupon payment = 6 months (180 days)
Coupon value = 50
Bond Purchased = 100 days past coupon date
Accrued Interest = ( 50 * 100 ) / 180 = 27.77
Dirty Price = 970 + 27.77 = 997.77

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 Yield or Internal Rate of Return
Yield or Interest rate is the rate at which the PV of future cash flows =
Price of bond

Price of bond, P = C1 (1+y)^-1 + C2 (1+y)^-2 + ….. + Principal (1+y)^-n

Current Yield
Current Yield = Annual Coupon Value / Invested Price
- Simple to calculate as only coupon value is used
- Does not consider capital gains / loss
- Time value of money is not considered

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 Yield To Maturity (YTM)
Price of bond, P = C1 (1+y)^-1 + C2 (1+y)^-2 + ….. + Par (1+y)^-n

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 Yield Spreads
The yield difference between two bonds
Yield Spread = Yield of bond A - Yield of bond B
Benchmark Yield
Benchmark Spread = Yield of benchmark bond - Yield of bond

Relative Yield Spread

Relative Yield Spread = (Yield A - Yield B) / Yield B

Equivalent Taxable Yield

Equivalent Taxable Yield = Tax-exempt yield on Bond / (1-TaxRate)

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 Yield Curves

Inverted Positive (Normal)

Yield

Maturity

Flat

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 Factors Impacting Bond Yields
- The type of issuer
- Credit worthiness of the issue
- Maturity of issue
- Taxability of issue
- Inclusion of options

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 Duration
Sensitivity of the bond price for a change in interest rate, in years
It is the weighted average time of bond payment

Macaulay Duration =

Modified Duration is price sensitivity due to change in Yield to Maturity

Modified Duration = Macaulay Duration / (1+ y)

Duration in years = Duration of m periods per year / m periods

Microsoft Office
Excel Worksheet

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 Convexity
Duration measure is a good approximation to small changes in yield.
When yield changes are bigger, duration is nor a measure as it does not
measure the curvature of the bond, which is done using convexity.

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 Measuring Convexity
•  Ut the sdsdasdsd

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 Measuring Convexity (approximation)

Convexity Approximation = {P(+) + P(-) – 2 * P(0)} / (2 * P(0) * dy2)

Where: P(+) = bond price when interest rate is decreased
P(-) = bond price when interest rate is increased
P(0) = bond price
dy = change in interest rate in decimal

Example:
Bond current price = 1000. Interest rate decrease = 1%, new price = 1035
Interest rate increase = 1%, new price = 970. What is the convexity
Convexity = (1035 + 970 – 2* 1000) / (2 * 1000 * 0.01^2) = 5/0.2 = 25
Convexity adjustment = Convexity * 100 * dy2
Ie Convexity adjustment = 25 * 100 *(0.01)^2 = 0.25

Bond price change = duration * yield change + convexity adjustment

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 Properties of Convexity
- As yield increase (decreases), Convexity of bond decreased (increases)
- For a given yield and maturity, lower the coupon, greater convexity

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