Valuation of Securities : Bonds

Dr Nishant Kumar
Assistant Professor
Department of Business Administration
University of Lucknow
Lucknow
( E Content meant for MBA III Sem. SECURITY ANALYSIS AND PORTFOLIO
MANAGEMENT)
Contents
• Return from a Bond: Yield to Maturity
• Reasons for Changes in Bond Prices
• Bond Price Volatility
• Measure of Price Volatility: Duration
• Modified Duration
• Convexity
Return from a Bond
Return from a Bond (option free bond) is defined as ‘ Yield to Maturity’, which is the interest rate that make the
present value of all cash flows equal to the market price of a bond.
For a Bond, the present value of all the cash flows can be shown by
P = [C/( 1+Y)] +[C/(1+Y)2] +[C/(1+Y)3] +…+[(C +M)/(1+Y)N]
Where P is the current market price of bond; C is the promised Coupon ; M is the Maturity value (equal to Face
Value ) and y is the effective Yield. N is the number of time periods (years, semi-annual periods or quarters).
The above equation can be transformed and written as (P/M) = (C/M) [ {1 – ( 1+y)-N}/y] + 1/ (1+Y)N
Where P/M is Par Value Relation and C/M is coupon rate normally shown in percent.
If P/M =1, the Bond is selling at Par; if its less than 1, the bond is selling at Discount and if its greater than
1,then bond is selling at Premium.
If Coupon on a Bond is paid Semi-annually, then the above equation for P/M can be written as
(P/M) = (C/2M) [ {1 – ( 1+y/2)-2N}/y/2] + 1/ (1+Y/2)2N
If a bond sells at Par, then its Yield to Maturity is equal to it Coupon rate (y = C/M)
Reasons for Changes in Bond Prices
Price of a Bond can change over time due to any of the following reasons:

1 A change in the level of Interest Rates in the economy

2 Bond price changes if its selling at a price other than its par value, as it move towards maturity
without any change in the yield. Over time, the price of a discount bond rises and the price of a
premium bond declines if interest rates remain stable.

3 If the ‘Yield Spreads’ between comparable treasury securities and non-treasury securities
change, then the prices of non-treasury securities tend to change.

4 If the perceived Credit quality of the bond issuer changes, then the bond prices also change.
Bond Price Volatility
Prices of all bonds move in the opposite direction of the change in yield. But the absolute change in
bond price and also the percentage price change for a given change in yield are not similar for
bonds differing in Coupon Rate and Maturity.

PRICE

YIELD
 Price- Yield Relationship for four hypothetical bonds (Par value 100)
TABLE 1

YIELD (%) 9%/5yr 9%/20yr 5%/5yr 5%/20yr

6.00 112.79 134.67 95.73 88.44
7.00 108.31 121.35 91.68 78.64
8.00 104.05 109.89 87.83 70.31
8.50 102.00 104.76 85.98 66.61
8.90 100.39 100.92 84.53 63.85
8.99 100.03 100.09 84.21 63.26
9.00 100.00 100.00 84.17 63.19
9.01 99.96 99.90 84.13 63.13
9.10 99.60 99.08 83.81 62.54
9.50 98.04 95.56 82.41 60.03
10.00 96.13 91.42 80.69 57.10
11.00 92.46 83.95 77.38 51.86
12.00 88.95 77.43 74.24 47.33
 Absolute Price Changes for four hypothetical bonds
TABLE 2
YIELD (%) Change in Basis 9%/5yr 9%/20yr 5%/5yr 5%/20yr
Points
6.00 -300 12.7953 34.6722 11.5603 25.2458
7.00 -200 8.3166 21.3551 7.5088 15.4481
8.00 -100 4.0554 9.8964 3.6591 7.1140
8.50 -50 2.0027 4.7693 1.8063 3.4180
8.90 -10 0.3966 0.9267 0.3576 0.6625
8.99 -1 0.0396 0.0921 0.0356 0.0658
9.00 0 0.0000 0.0000 0.0000 0.0000
9.01 1 -0.3960 -0.0919 -0.0357 -0.0657
9.10 10 -0.3947 -0.9135 -0.3559 -0.6523
9.50 50 -1.9541 -4.4408 -1.7614 -3.1636
10.00 100 -3.8609 -8.5795 -3.4789 -6.0945
11.00 200 -7.5376 -16.0461 -6.7875 -11.3352
12.00 300 -11.0401 -22.5694 -9.9349 -15.8588
Percentage Price Changes for four hypothetical bonds
TABLE 3
YIELD Change in 9%/5yr 9%/20yr 5%/5yr 5%/20r
(%) Basis
Points
6.00 -300 12.80% 34.67% 13.73% 39.95%
7.00 -200 8.32 21.36 9.92 24.44
8.00 -100 4.06 9.90 4.35 11.26
8.50 -50 2.00 4.77 2.15 5.41
8.90 -10 0.40 0.93 0.42 1.05
8.99 -1 0.04 0.09 0.04 0.10
9.00 0 0.00 0.00 0.00 0.00
9.01 1 -0.04 -0.09 -0.04 -0.10
9.10 10 -0.40 -0.91 -0.42 -1.03
9.50 50 -1.95 -4.44 -2.09 -5.01
10.00 100 -3.86 -8.58 -4.13 -9.64
11.00 200 -7.54 -16.05 -8.06 -17.94
12.00 300 -11.04 -22.57 -11.89 -25.09
Bond Price Volatility Cont…

Analyzing the data presented in Tables 1,2 and 3 , the following general principles can be deduced
regarding the relationship between the change in Bond Price (absolute and percentage change) and
varying Coupon Rate and Maturities consequent to gradual change in Yield:

A) Lower the Coupon Rate , greater is the percentage change in Bond Price

B) Higher the Maturity of the Bond, greater is the percentage change in Bond Price

C) Higher the Maturity of the Bond, greater is the absolute change in Bond Price

D) Absolute change in Bond Price is not consistent with varying coupon rate
Measure of Price Volatility: Duration
Duration measures the ‘Price Sensitivity’ of a security (bond) to changes in the interest rates. The
changes in interest rates are supposed to take place only by very small amount at a time, for
example 5 to 10 basis points.
Duration = (V_ - V+)/2 V0 ∆y

Where,

∆y = change in the yield of a security (in decimal terms)

V0= initial value or price of a security (par value)

V_ = estimated value of the security if the yield is decreased by ∆y

V+ = estimated value of the security if the yield is increased by ∆y

Approximate % price change in the Bond Price = -Duration (∆y)100

Duration Cont…
Duration of a Coupon Bond is less than its maturity
For a Zero coupon bond the Duration is equal to its Maturity
Bond with the same maturity and selling at the same yield, lower the
coupon rate, higher will be the duration of the bond and its price
sensitivity
Bond with the same coupon rate and selling at the same yield, longer
its maturity, higher will be the duration of the bond and its price
sensitivity (these characteristics are consistent with the data discussed
in Tables 1,2 and 3 above)
Modified Duration (Macaulay Duration)
Macaulay Duration is the weighted average term to maturity of all the
components of bond’s cash-flows where the time of receipt of each payment is
weighted by the present value of that payment.
D(Modified Duration) = [ (1)C/(1+y) + (2)C/(1+y)2 + (3)C/(1+y)3 +……+ (n)(C+M)/(1+y)n ]/P

Where,

P = Bond’s current market price,

M = Bond’s maturity

∆P = Change in Bond’s price

y = yield; ∆y = Change in yield

Modified Duration = Macaulay Duration / (1+y) and the percentage change in Bond’s Price can be computed as
–Modified Duration (∆y)
Convexity
Convexity measure of a Bond security is the approximate percentage change in the
bond’s price that remains unexplained by Duration
Convexity = (V++V_ - 2 V0)/2 V0 (∆y)2

Where,∆y = change in the yield of a security (in decimal terms)

V0= initial value or price of a security (par value)

V_ = estimated value of the security if the yield is decreased by ∆y

V+ = estimated value of the security if the yield is increased by ∆y

Approximate (%) price change not explained by duration = CONVEXITY (∆y)2

Approximate percentage change in the Bond’s price for a given change in yield =

Approximate (%) change due to Duration +Approximate (%) price change not explained
by Duration
REFERENCES
1 Modern Investment Theory, Robert A Haugen, Pearson Education
2 Capital Markets: Institutions and Instruments, Fabozzi and Modigliani,Person
Education
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