Chapter 8

Bond Valuation and Risk

Financial Markets and Institutions, 7e, Jeff Madura

Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

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Chapter Outline
 Bond valuation process
 Relationships between coupon rate, required
return, and bond price
 Explaining bond price movements
 Sensitivity of bond prices to interest rate
movements
 Bond investment strategies used by investors
 Return and risk of international bonds

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Bond Valuation Process
 Bonds:
 Are debt obligations with long-term maturities issued by
government or corporations to obtain long-term funds
 Are commonly purchased by financial institutions that wish to
invest for long-term periods
 The appropriate bond price reflects the present value
of the cash flows generated by the bond (i.e., interest
payments and repayment of principal):
C C C  Par
PV of bond  1
 2
 ....
(1  k ) (1  k ) (1  k )n

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Computing the Current Price of
A Bond
A 2-year bond has a par value of $1,000 and a
coupon rate of 5 percent. The prevailing
annualized yield on other bonds with similar
characteristics is 7 percent. What is the
?appropriate market price of the bond
C C C  Par
PV of bond  1
 2
 ....
(1  k ) (1  k ) (1  k )n
50 1,050
 
1.07 1.07 2
 963 .84 4
Bond Valuation Process (cont’d)
 Bond valuation with a present value table
 Present value interest factors in Exhibit 8A.3 can be
multiplied by coupon payments and the par value to determine
the present value of the bond
 Impact of the discount rate on bond valuation
 The appropriate discount rate for valuing any asset is the yield
that could be earned on alternative investments with similar
risk and maturity
 Investors use higher discount rates to discount the future cash
flows of riskier securities
 The value of a high-risk security will be lower than the value of
a low-risk security

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Computing the Current Price of
A Bond Using PVIFs
A 2-year bond has a par value of $1,000 and a
coupon rate of 5 percent. The prevailing
annualized yield on other bonds is 7 percent.
What is the appropriate market price of the
?bond using PVIFs
PV of bond  $50(PVIFk 7%,n 1 )  $1,050(PVIFk 7%,n 2 )
 $50(.9346 )  $1,050(.8734 )
 $46.73  $917.07
 $963 .80
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Bond Valuation Process (cont’d)
 Impact of the timing of payments on bond valuation
 Funds received sooner can be reinvested to earn additional
returns
 A dollar to be received soon has a higher present value than
one to be received later
 Valuation of bonds with semiannual payments
 First, divide the annual coupon by two
 Second, divide the annual discount rate by two
 Third, double the number of years
C/2 C/2 C / 2  Par
PV of bond  1
 2
 ....
(1  k / 2) (1  k / 2) (1  k / 2)2n
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Computing the Current Price of
A Bond With Semiannual
Coupons
A 2-year bond has a par value of $1,000 and a
semiannual coupon rate of 5 percent. The
prevailing annualized yield on other bonds with
similar characteristics is 7 percent. What is the
?appropriate market price of the bond
C/2 C/2 C / 2  Par
PV of bond    ....
(1  k / 2)1 (1  k / 2)2 (1  k / 2)2n
25 25 25 1,025
   
1.0351 1.035 2 1.035 3 1.035 4
 963.27 8
Bond Valuation Process (cont’d)
 Use the annuity tables for valuation
A bond can be valued by separating its payments
into two components:
PV of bond = PV of coupon payments + PV of principal
 The bond’s coupon payments represent an annuity
(an even stream of payments over a given period of
time)
 The present value can be computed using PVIFAs

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Computing the Current Price of
A Bond Using PVIFs and PVIFAs
A 30-year bond has a par value of $1,000 and an annual
coupon rate of 10 percent. The prevailing annualized
yield on other bonds with similar characteristics is 9
percent. What is the appropriate market price of the
?bond
PV of coupon payments  C(PVIFA k 9%,n 30 )
 $100(10.274 )  $1,027.40
PV of principal  $1,000(PVIFk 9%,n 30 )
 $1,000(.0754)  $75.40
PV of bond  $1,027.40  $75.40  $1,102.80
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Relationship between Coupon
Rate, Required Return, and Price
 If the coupon rate of a bond is below the
investor’s required rate of return, the present
value of the bond should be below par value
(discount bond)
 If the coupon rate equals the required rate of
return, the price of the bond should be equal to
par value
 If the coupon rate of a bond is above the
required rate of return, the price of the bond
should be above par value

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 Relationship between Coupon
Rate, Required Return, and Price
$1,800.00
$1,600.00
$1,400.00
$1,200.00
5-Year Bond
Present Value

$1,000.00
10-Year Bond
$800.00
20-Year Bond
$600.00
$400.00
$200.00
$0.00
0.05 0.08 0.1 0.12 0.15
Required Return

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Relationship between Coupon
Rate, Required Return, and Price
(cont’d)
 Implications for financial institutions
 The impact of interest rate movements depends on how the
institution’s asset and liability portfolios are structured
 Institutions with interest rate-sensitive liabilities that invest heavily in
bonds are exposed to interest rate risk
 Many institutions adjust the size of their bond portfolio according to
interest rate expectations
 When rates are expected to rise, bonds can be sold and the
proceeds used to purchase short-term securities
 When rates are expected to fall, the bond portfolio can be expanded
in order to capitalize on the expectations

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Explaining Bond Price Movements
 The price of a bond should reflect the present
value of future cash flows based on a
required rate of return:
Pb  f ( k )  f ( Rf , RP )
- - -
 An increase in either the risk-free rate or the
general level of the risk premium results in a
decrease in bond prices

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Explaining Bond Price Movements
(cont’d)
 Factors that affect the risk-free rate
 Inflationary
expectations
 Economic growth
 Money supply
 Budget deficit

Rf  f ( INF , ECON, MS, DEF )

  - 

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Explaining Bond Price Movements
(cont’d)
 Factors that affect the risk-free rate (cont’d)
 Impact of inflationary expectations
 An increase in expected inflation will increase the
required rate of return on bonds
 Indicators of inflation are closely monitored
 Consumer price index
 Producer price index
 Oil prices
 A weak dollar

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Explaining Bond Price Movements
(cont’d)
 Factors that affect the risk-free rate (cont’d)
 Impact of economic growth
 Strong economic growth places upward pressure on the
required rate of return
 Signals about future economic conditions affect bond
prices immediately
 Employment
 GDP
 Retail sales
 Industrial production
 Consumer confidence

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Explaining Bond Price Movements
(cont’d)
 Factors that affect the risk-free rate (cont’d)
 Impact of money supply growth
 If there is no simultaneous increase in the demand for
loanable funds, an increase in money supply growth
should place downward pressure on interest rates
 In high inflation environments, an increased money
supply may increase the demand for loanable funds and
place upward pressure on interest rates
 Impact of budget deficit
 An increase in the budget deficit places upward
pressure on interest rates

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Explaining Bond Price Movements
(cont’d)
 Factors that affect the credit (default) risk
premium
 The general level of credit risk on corporate or
municipal bonds can change in response to a
change in economic growth:
RP  f ( ECON )
-
 Strong economic growth tends to improve a firm’s cash
flows and reduce the probability that the firm will default
on its debt payments

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Explaining Bond Price Movements
(cont’d)
 Summary of factors affecting bond prices

Pb  f ( Rf , RP )

Rf  f ( INF , ECON, MS, DEF )
 ? - 
 Other factors are also changing, making the precise impact
of each factor on bond prices uncertain
 Impact of bond-specific characteristics
 Changes in the issuing firm’s capital structure and factors such
as call features can affect individual bond prices

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Explaining Bond Price Movements
(cont’d)
 Bond market efficiency
 In an efficient market, bond prices should fully
reflect all available information
 In general bond prices should reflect information
that is publicly available
 Prices may not reflect information about firms that is
known only by managers of the firms

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Sensitivity of Bond Prices to
Interest Rate Movements
 If bonds are not held to maturity, future
prices are most sensitive to changes in the
risk-free rate
 A measurement of bond price sensitivity
can indicate the degree to which the
market value of bond holdings may decline
in response to an increase in interest rates

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Sensitivity of Bond Prices to
Interest Rate Movements (cont’d)
 Bond price elasticity
 Measures the sensitivity of bond prices to changes
in the required rate of return:

e percent change in P
p 
percent change in k

 The price sensitivity is greater for declining interest

rates than rising interest rates
 Bond price elasticity is always negative

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Sensitivity of Bond Prices to
Interest Rate Movements (cont’d)
 Bond price elasticity (cont’d)
 Influence of coupon rate on bond price sensitivity
 The relationship between bond price elasticity and coupon rates
is inverse
 Zero-coupon bonds have the greatest price sensitivity
 Bonds yielding only coupon payments are least sensitive
 Financial institutions may restructure their bond portfolios to
contain higher-coupon bonds when they are concerned about a
possible increase in interest rates
 Influence of maturity on bond price sensitivity
 As interest rates decrease, long-term bond prices increase by a
greater degree than short-term bond prices

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Computing Bond Price Elasticity
A 15-year bond has a yield to maturity of 7 percent and a
coupon rate of 10 percent. The current price of this
bond is $1,273.24. If the yield to maturity increases to 9
percent, the new price of the bond is $1,080.61. What
?is this bond’s bond price elasticity
e percent change in P
p 
percent change in k
$1,080.61  $1,273.24
$1,273.24

9 %  7%
7%
 0.53 25
Sensitivity of Bond Prices to
Interest Rate Movements (cont’d)
 Duration
 Duration measures the life of a bond on a present
value basis
 The longer the bond’s duration, the greater its
sensitivity to interest rates
n
Ct ( t )
 (1  k ) t
DUR  t n1
Ct
t 1
 (1  k ) t

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Computing the Duration of A
Bond
A bond has two years remaining to maturity, a $1,000 par
value, a 9 percent coupon rate, and a 10 percent yield
?to maturity. What is the duration of this bond
n
Ct ( t )
 (1  k ) t
DUR  t n1
Ct
t 1
 (1  k ) t

$90 $1,090(2)
1

(1.10 ) (1.10 )2

$90 $1,090

(1.10 )1 (1.10 )2
 1.92 years
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Sensitivity of Bond Prices to
Interest Rate Movements (cont’d)
 Duration (cont’d)
 Duration of a portfolio
 Bond portfolio managers commonly immunize their
portfolio from the effects of interest rate movements
 A bond portfolio’s duration is the weighted average of
bond durations, weighted according to relative market
value:
m
DUR p   w DUR
j 1
j j

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Sensitivity of Bond Prices to
Interest Rate Movements (cont’d)
 Duration (cont’d)
 Modified duration
 Duration can be used to estimate the percentage change in a
bond’s price in response to a 1 percentage point change in
bond yields:
DUR
DUR* 
(1  k )
 The estimate of modified duration should be applied such that
the bond price moves in the opposite direction from the change
in bond yields
 The percentage change in a bond’s price in response to a
change in yield is:

%P  -DUR *  y
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Computing the Modified Duration
of A Bond
A bond has two years remaining to maturity, a $1,000 par value, a
9 percent coupon rate, and a 10 percent yield to maturity. What
is the modified duration of this bond? Interpret the modified
.duration for this bond

DUR
DUR* 
(1  k )
1.92
  1.75
1.10leads to a 1.75 percent decline
A 1 percent increase in bond yields
.in the price of the bond

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Computing the Price Change of
A Bond in Response to A
Change in Yield
In the previous example, assume that bond yields rise by
0.30%. What is an estimate of the percentage drop in
?the bond’s price
%P  -DUR *  y
 1.75  0.003
 .53%

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Sensitivity of Bond Prices to
Interest Rate Movements (cont’d)
 Duration (cont’d)
 Estimation errors from using modified duration
 If investors rely only on modified duration to estimate
percentage price changes in bonds, they will tend to
overestimate price declines and underestimate price
increases
 To accurately estimate the percentage change in price,
bond convexity must also be considered

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Sensitivity of Bond Prices to
Interest Rate Movements (cont’d)
 Duration (cont’d)
 Bond convexity
 Modified duration estimates assume a linear relationship
between bond prices and yields
 The actual relationship between bond prices and yields is convex
 How the estimation errors from modified duration can vary
 For high-coupon, short-maturity bonds, price change estimates
based on modified duration will be very close to actual price
changes
 For low-coupon, long-maturity bonds, price change estimates
based on modified duration can give large estimation errors

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Bond Investment Strategies Used
by Investors
 Matching strategy
 The bond portfolio generates periodic income that can
match expected periodic expenses
 Involves estimating future cash outflows and
developing a bond portfolio that can generate
sufficient payments to cover those outflows
 Laddered strategy
 Funds are evenly allocated to bonds in each of
several different maturity classes
 Achieves diversified maturities and different
sensitivities to interest rate risk

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Bond Investment Strategies Used
by Investors (cont’d)
 Barbell strategy
 Funds are allocated to bonds with a short term to
maturity and bonds with a long term to maturity
 Allocates some funds to achieving relatively high returns and
other funds to cover liquidity needs
 Interest rate strategy
 Funds are allocated to capitalize on interest rate
forecasts
 Requires frequent adjustment in the bond portfolio to
reflect current forecasts

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Return and Risk of International
Bonds
 The value of an international bond is
influenced by:
 Changes in the risk-free rate of the currency
denominating the bond
 Changes in the perceived credit risk of the
bond
 Exchange rate risk

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Return and Risk of International
Bonds (cont’d)
 Influence of foreign interest rate movements
 An increase in the risk-free rate of the foreign currency results in
a lower value for bonds denominated in that currency
 Influence of credit risk
 An increase in risk causes a higher required rate of return on the
bond and lowers the present value of the bond
 Influence of exchange rate fluctuations
 The most attractive foreign bonds offer a high coupon rate and
are denominated in a currency that strengthens over the
investment horizon

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Return and Risk of International
Bonds (cont’d)
 International bond diversification
 Reduction of interest rate risk
 International diversification of bonds reduces the sensitivity of the
overall bond portfolio to any single country’s interest rate
movements
 Reduction of credit risk
 Because economic cycles differ across countries, there is less
chance of a systematic increase in the credit risk of internationally
diversified bonds
 Reduction of exchange rate risk
 Financial institutions attempt to reduce their exchange rate risk by
diversifying among foreign securities denominated in various foreign
currencies

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