FIN4002

Fixed Income Securities

Part Two: Bond Mathematics

Topic 2: Bond Price & Yield

1
Outline

• Definition and Example of a Bond

• Time Value of Money Concept – See Topic 2
Supplementary powerpoint
• How to Value Bonds
- Estimate Fair Price, Valuing a bond between coupon
dates, Clean and Accrued Price
• Yields (or return)
- Current yield, Yield to maturity, Yield to Call, Realised
Compound Yield (or Horizon Yield)
• Summary and Conclusions

2
Definition of a Bond

3
Valuation of Bonds

• Two commonly used equations

4
Valuation of Bonds

• Bond Valuation Principle – Calculate Intrinsic Value

(actual value)
- Bond Value = PV of expected future cash flows
• To value bonds (or any interest bearing instruments), we
need to:
- Estimate future cash flows:
• Size (how much) and
• Timing (when)
- Discount future cash flows at an appropriate rate:
• The rate should be appropriate to the risk
presented by the security.

5
Valuation of Bonds – Fair Price
Information needed to value fixed-coupon bonds:
- Coupon payment dates and time to maturity (T)
- Coupon payment (C) per period and Face value (F)
- Discount rate
C C C C+F

1 2 3 T

P = C/(1+r)1 + C/(1+r)2 + C/(1+r)3 + … + C/(1+r)T + F/(1+r)T

6
Valuation of Bonds – Fair Price
Bond Value
= PV of coupon payment annuity + PV of face value

P = C/(1+r)1 + C/(1+r)2 + C/(1+r)3 + … + C/(1+r)T + F/(1+r)T

C 1  F
P 1   
r  1  r T  1  r T

This is a fairly crude measure as it assumes:

• interest rates do not change, and therefore the same
discount rate is applied over the life of the bond (see
Term Structure later).
7
Bond Cashflow Example
• Consider a U.S. government bond listed as “6 3/8”
3/8 (p.a.) of December 2009.
- The Par Value of the bond is $1,000.
- Coupon payments are made semi-annually (June 30 and December 31 for this
particular bond).
- Since the coupon rate is 6 3/8% the payment is $31.875.
- On January 1, 2002, the size and timing of cash flows with yield to maturity
(YTM) at 5%p.a. are:

6.375%/2 * 1000

0 $31.875 $31.875 $31.875 $1031.875

6/30/09 12/31/09
1/1/02 6/30/02 12/30/02

P = 31.875/(1+5%/2)1 + 31.875/(1+5%/2)2 + … + 31.875/(1+5%/2)16 + 1000/(1+5%/2)16

C 1  F 31.875  1  1000
P 1    P 1  16 
  1089.75
r  1  r T  1  r T 5%/2  1  5%/2   1  5% / 2 16

8
Exercise
All US Treasuries pay coupon semi-annually.
a) It is 22 November 1994. Treasury 10%(p.a.) 1996 matures on
21 November 1996. Calculate the fair price of this bond when
the redemption yield (or Yield to Maturity) is:
10% pa and 5% pa.
(b) It is 22 November 1994. Treasury 5%(p.a.) 1996 matures on
21 November 1996. Calculate the fair price of this bond when
the redemption yield (or Yield to Maturity) is :
10% pa and 5% pa.
c) It is 22 November 1994. A zero coupon bond matures on 21
November 1996. Calculate the fair price of this bond when the
redemption yield is (or Yield to Maturity) :
10% pa and (ii) 5% pa.

9
Answer
a) It is 22 November 1994. Treasury 10%p.a. 1996 matures on
21 November 1996. Calculate the fair price of this bond when
the redemption yield (or Yield to Maturity) is:
10% pa and 5% pa.
Answer
10% Yield
P = 5/(1.05) + 5/(1.05)2 + 5/(1.05)3 + 105/(1.05)4
= 4.76 + 4.54 + 4.32 + 86.38 = 100
5% Yield
P = 5/(1.025) + 5/(1.025)2 + 5/(1.025)3 + 105/(1.025)4
= 4.87 + 4.76 + 4.64 + 95.12 = 109.40

10
Answer

b) It is 22 November 1994. Treasury 5% (p.a.) 1996 matures on

21 November 1996. Calculate the fair price of this bond when
the redemption yield (or Yield to Maturity) is :
10% pa and 5% pa.
Answer
10% Yield
P = 2.5/(1.05) + 2.5/(1.05)2 + 2.5/(1.05)3 + 102.5/(1.05)4
= 2.38 + 2.27 + 2.16 + 84.33 = 91.14
5% Yield
P = 2.5/(1.025) + 2.5/(1.025)2 + 2.5/(1.025)3 + 102.5/(1.025)4
= 2.44 + 2.38 + 2.32 + + 92.86 = 100

11
Answer

c) It is 22 November 1994. A zero coupon bond matures on 21

November 1996. Calculate the fair price of this bond when the
redemption yield (or Yield to Maturity) is :
10% pa and 5% pa.
Answer
10% Yield
P = 100/(1.05)4 = 82.27
5% Yield
P = 100/(1.025)4 = 90.60

12
Bond Price between coupon payment dates
So far, the bond is valued immediately after interest payment.
Most trades are however only rarely on payment date. This will
effect the value of the bond.
When an investor purchases a bond between coupon payments,
the investor (new buyer) must compensate the seller of the bond
for the coupon interest earned from the time of the last coupon
payment to the settlement date of the bond. This amount is called
accrued interest.
NEXT Coupon
LAST Coupon Settlement Date Date
Date

So we need to calculate the clean and dirty price of the bond.

Clean Price: Just bond price without accrued interest from coupon
Dirty (Or Full) Price = Clean Price + Accrued Interests
13
Bond Price between coupon payment dates -
Example
On the 20th August 2006, a 2009 matured bond with a 2.5% coupon, US$200,000
face value, is quoted from bond dealer at clean price 104.55. The annual coupon
is paid on the 25th of June. How much US$ should the buyer pay for this?
Coupon Payment date X Coupon Payment date X

Last Coupon payment date to Settlement day (from 25th June 2006 to 20th Aug
2006) is 55 days
So, Accrued interest for 55 days has to be paid to the bond seller. The interest
for the remaining period until the next coupon payment (i.e., from 20th August
2006 to 25th June 2007) is payable to the buyer. Though the bond buyer will pay
the interest accrued till the date of purchase to the bond seller, at the next
coupon payment she will receive the total coupon.
On the 20th August 2006, the buyer will pay the bond price:
104.55% x US$200,000 = US$209,100
plus the accrued interest on 55 days: 55/360 x 2.5% x US$200,000 = US$763.89
which makes a total payment to the seller of US$209,863.89.

14
Clean and Dirty Price Calculation – Method 1
Example:
Example We buy a $100 bond with 10 years and 2 months left before
maturity which pays a 10% p.a. coupon semi annually. The current interest
rate is 8% p.a.
1. Estimate the value of the bond after the next coupon payment date (i.e. 10
years )
2. Add the coupon to be received at the time of the next coupon payment
3. Find the PV of this sum 2 months prior to this date
4. 4 months of the next interest payment is attributed to the previous owner
($5*4/6). Subtract this from 3 to get the true value
Step 4 Step 3

3.3% Coupon
2 months 10 years
X

5% Coupon

Step 2 Step 1

15
Clean and Dirty Price Calculation – Method 1

1. P0 = (C/r)[1 – 1/ (1 + r)T ] + F/(1 + r)T

= (5/4%)[1 – 1/(1.04)20] + 100/(1.04)20 = 113.59
2.    113.59 + 5 = 118.59
3.   2 months prior it is worth; 118.59/(1+0.04)2/6 = 117.052
(This is the dirty price which has reflected the holding period
of the coupon)
 4. subtract accrued interest  $3.3 (i.e. $5 * 4/6) to find
The true value or clean price = 113.719

Question: Do we expect bond price to trade at Clean or Dirty

Price?
16
 Clean and Dirty Price Calculation – Method 2
Step 3
P0
4 months 10 years
X
3.3% Coupon
5% Coupon

Step 1 Step 2

Step 1: At P0, the cashflow is 10.5 years. T=21, c=5; r=4

P0 = (C/r)[1 – 1/ (1 + r)T ] + F/(1 + r)T = (5/4%)[1 – 1/(1.04)21] + 100/(1.04)21 =
70.15+43.88 = 114.03
Step 2: Move to x position, Dirty Price = P0(1+4%)4/6 = 117.02

Step 3: Dirty Price = Clean Price + Accrued Interest

where: AIn = (5)(4/6) = 3.3

 “Clean” Price = 117.02 – 3.3 = 113.72

17
Example to calculate dirty price using Method 2
ENDESA 8.35% of August 2013

18
Clean and Dirty Price Calculation – Method 2
Valuing the ENDESA 8.350% of 2013 Bond Between Coupon Dates

Po Pn + AIn
| | | |

2/1/05 2/18/05 8/1/05 8/1/13

n = 17 actual days (17 on “30/360” basis)

 N = 181 actual days (180 on “30/360” basis)
Bond Valuation: Interest rate on 2/1/2005

On February 1, 2005: P0 = 17
4.175 100
 t
+ 17
= 118.3007
t =1  .0561315   .0561315 
1   1  
 2   2 
On February 18, 2005: Pn + AIn = (118.3007)(1 + 0.0561315/2)(17/180) = 118.6103
(Dirty Price which carries the accrued coupon)

where: AIn = (4.175)(17/180) = 0.3943

 “Clean” Price = 118.6103 - 0.3943 = 118.2160

19
Example: ENDESA 8.350% Bond of August ’13

20
Measuring Bond Yield – Current Yield

21
Measuring Bond Yield - Yield to Maturity

Yield to Maturity
It is the discount rate that equates the present value of the bond’s future
cash flows till maturity with the current market price of the bond. Just
after the coupon payment, we have :
 C C CF 
P 1
 2
 ......  n
 (1  YTM) (1  YTM) (1  YTM) 
YTM assumes that the bond is held to maturity, and that all cash flows
are received as scheduled through final maturity, and are
immediately reinvested at the same YTM rate.

Note: YTM should not be confused with the total return on

the bond investment.

22
Measuring Bond Yield - Yield to Maturity
So given the bond price at 99.876, we can find out the YTM as following:

8 8 8  100
99.876   2

1  YTM (1  YTM) (1  YTM) 3
Solve for YTM! We get YTM = 8.05%
Note: The YTM is found by iteratively trying different interest rates (through excel) or
though financial calculator. See (‘bond_valuation_and_yield_calculation.xls’) and
(‘Excel functions for Bond - menu.xls’)

Investors earn the YTM if the bond is held to maturity and all
coupons are reinvested at YTM

23
Limitation of YTM
• YTM is better than Current Yield because it considers
the coupon, capital gain/loss, and reinvestment
income. It is also based on the time value of money
concepts.
- However, it assumes that the coupon payments from a
bond can be reinvested at an interest rate equal to the yield
to maturity.
• This assumption can be highly misleading because of
reinvestment risk
- We have seen that a term structure of interest rates exists,
which can result in different yields at different points in time.

24
 Limitation of YTM – Illustration of reinvestment
assumption
• Example: Suppose an investor has a 15-year 8% p.a. semi-
annual coupon bond purchased at par ($100).
- The YTM is 8%p.a.
> Translated into total future dollars this is:
• $100 x (1.04)30 = $324.34 – (compound interest reinvestment)
• $324.34 can be broken down to $100 of principal
return and $224.34 of total dollar return

> Without reinvestment income, the dollar return would be:

• $120 of coupon income and $0 capital gain (because
the bond is purchased at par)
(30 x 4%)

25
Limitation of YTM – Illustration of reinvestment
assumption
• The difference between the 2 case is $224.34 - $120 = $104.34
- This shortfall is made up if the coupon payments are reinvested at a yield
of 8% (the interest rate at the time the bond was purchased)
- For this bond, the reinvestment income is 46.5% ($104.34/224.34) of the
total dollar return needed to produce a yield of 8%

• The investor will only realize the YTM of 8% if:

- The coupon payments can be reinvested at the YTM of 8% (this is
reinvestment risk)
- The bond is held to maturity (if the bond is not held to maturity, the
investor faces the risk of selling for less than the purchase price which is
known as interest rate risk)
- These are large and questionable assumptions

26
Measuring Bond Yield - Yield to Call (YTC)

Bond Price when

c
Ct CP
P  called – can be at a
t 1 (1  YTC) t (1  YTC) 2c premium to PAR
value
27
Measuring Bond Yield - Yield to Call (YTC)

• Yield based on the deferred call period

• Substitute number of periods until first call date for and call
price for face value
Bond Price when
c
Ct CP
P t
 2c
called – can be at
a premium to
t 1 (1  YTC) (1  YTC)
PAR value

28
Measuring Bond Yield - Yield to Call (YTC)

Yield to Call (YTC) - Example

For a bond with 3 years left the YTM was estimated as:
80 80 1080
998.76   2

1  YTM (1  YTM) (1  YTM) 3
YTM = 8.05
If however the bond was callable after 2 years then the Yield
to call is:
80 1080
998.76  
1  YTC (1  YTC) 2
YTC = 8.07%

29
Measuring Bond Yield - RCY
D. Realized Compound Yield (RCY) or Horizon Yield
It is different from the YTM which is the ‘promised’ yield rather than the
actual yield.
Note: Coupon are assumed to reinvest at the going market interest rate at
the time of their receipt and held till maturity.
Estimation
If we know the Total Return (TR), the purchase price and the holding
period (n), the RCY can be estimated.
TR = Purchase Price * (1+ RCY)n
1/n
 TR 
RCY    1.0 Where n = the number of periods

 Purchase Price 
interest is paid

Final
Initial

Bond maturity
Investment Horizon (n years)

30
Measuring Bond Yield - RCY

Example
Total Return = 110.03
Purchase price of Bond = 85.90
The bond is sold after 3 periods

110.03 = 85.9*(1+ RCY)3

 110.03/85.9 = (1+ RCY)3
(110.03/85.9)1/3 = 1 + RCY
 (110.03/85.9)1/3 - 1 = RCY
 RCY = 8.602%

31
Measuring Bond Yield - RCY
More detailed example
$100 is invested in a bond bought at face value with 10%pa coupon and
which has a 3 year life. The bond pays compound interest of 5%pa semi-
annually. What is the RCY assuming the bond is held to maturity?
1/n
Work out the Total Return (TR)  TR 
RCY    1.0
 TR= Total Future Dollar Value  Purchase Price 
= Coupons re-invested + proceeds of bond sale/redemption
(1) Coupon re-invested (compounded semi-annually) =
C + C(1+r)1 + C(1+r)2 + … + C(1+r)T-1 (assuming the first coupon received in Year 1)
= (C/r)[(1+r)T – 1]
= (5/2.5%)[(1.025)6 -1] (Future Value Annuity Formula)

= 31.94;
(2) proceeds of bond sale/redemption = 100 (why?)

32
Measuring Bond Yield - RCY

Therefore, TR = 31.94 + 100 = 131.94

 Then work out the RCY
RCY = (131.94/100)1/6 - 1 = 0.047 semi-annually or 9.4% pa

This is easy if interest is simple to compound. However

this is not always the case. See next example.

33
Measuring Bond Yield – RCY (More Example)

You buy a bond with a par value of $100 with an annual

coupon of 8% for $85.90. This reaches maturity in 7 years.
Interest rates rise to 14% soon after you buy the bond and you
decide to sell it after 3 years
What is the Realized Compound Yield (RCY)?

Recalling: RCY = (Total Return/Bond Purchase Price)1/n – 1

Need to work out:

(1) Total Return and (2) Bond Price at Purchase

34
Measuring Bond Yield – RCY (More Example)

35
Measuring Bond Yield

Selling price of the bond after 3 years

Calculating value of the bond when it is sold
C 1  F
P 1   
r  1  r T  1  r T
P = 82.51

So now,
TR = Sum of all coupons reinvested + Selling price of the
bond after 3 years
 TR = 27.52 + 82.51 = 110.03

36
Measuring Bond Yield

2. The Realized Compound Yield (RCY) over the 3 year

period is :
We know the initial purchase price of bond = $85.90
RCY = (TR/ initial purchase price)1/n - 1
RCY = (110.03/85.90)1/3 -1 = 8.602%

37
Reinvestment risk

(So far we have assumed the reinvestment rate to be the

same, what if they are not?)
- This is risk associated with the fact that interest on re-
invested coupons can be higher or lower than the
original rate
- When YTM is calculated it assumes that interest is
reinvested at the same rate. As this may not be so the
Realized Compound Yield may differ from the YTM.

38
Factors Affecting Reinvestment Risk

The two factors affecting reinvestment risk are:

1. For a given YTM and a given non-zero coupon rate,
the longer the maturity, the more the bond’s total dollar
return depends on reinvestment income to realize the
YTM at the time of purchase. That is, the greater the
reinvestment risk.

The implication is that the YTM for a long-term, high coupon

bond may have a large amount of the total dollar return as
reinvestment income (which is more risky).

39
 Factors Affecting Reinvestment Risk
The two factors affecting reinvestment risk are:
2. For a coupon bond, for a given YTM and maturity, the
higher the coupon rate, the more dependent the bond’s
total dollar return will be on the reinvestment of the
coupon payments in order to produce the YTM at the
time of the purchase.
– The implication is that bonds selling at a premium will be more
dependent on reinvestment income than bonds selling at par. This is
because the reinvestment income has to make up the capital loss due
to amortizing the price premium when holding the bond to maturity.
– Conversely, a bond selling at a discount will be less dependent on
reinvestment income.

40
Summary
Bond Valuation Principle
- Value of financial securities = PV of expected future
cash flows
Various way to measure yield
- Most commonly used
- Promised compound rate of return received from a
bond purchased at the current market price and
held to maturity
- Equates the present value of the expected future
cash flows to the initial investment
- Similar to internal rate of return

41
Summary
• The current or running yield considers only the coupon
interest payments.
• Yield to maturity (YTM) takes into account of:
- the periodic coupon interest payments made by the
issuer
- any capital gain (or capital loss—negative dollar return)
when the bond matures, is called, or is sold
- interest income generated from reinvestment of the
periodic cash flows
Summary
• Investor realizes the yield to maturity only if the bond is
held to maturity and the coupon payments can be
reinvested at the computed yield to maturity.
• Reinvestment risk is the risk that future reinvestment
rates will be less than the yield to maturity at the time the
bond is purchased.
• There are two characteristics of a bond that determine the
importance of the interest-on- interest component and
therefore the degree of reinvestment risk: maturity and
coupon.
Summary
• The total return is a measure of yield that incorporates an
explicit assumption about the reinvestment rate.
• The yield-to-call measure is subject to the same problems
as the yield to maturity because it assumes that the:
- bond will be held until the first call date
- coupon interest payments will be reinvested at the yield
to call
• Realised Compound Yield or Horizon Return analysis
refers to when a total return is calculated over an investment
horizon.  An often-cited objection to the total return measure
is that it requires the portfolio manager to formulate
assumptions about reinvestment rates and future yields as
well as to think in terms of an investment horizon.
Question
Consider the following “Spot” or zero-coupon curve:

Maturity “Spot” or Zero

Coupon Rate
1 S1 = 4%
2 S2 = 4.5%
3 S3 = 4.75%
4 S4 = 4.9%
5 S5 = 5%

S1 S2 S3 S4 S5
0 1 2 3 4 5

45
Question
1. What is the price of a 5-year bond with a $100 face value,
which delivers a 5% annual coupon rate?
 5 5 5 5 105 
P     
 (1  4%) (1  4.5%) 2 (1  4.75%)3 (1  4.9%) 4 (1  5%)5 
 
 $100.136

5 5 105
100.136    ... 
1  YTM (1  YTM) 2 (1  YTM)5

The YTM = 4.9686% - this represents the combined return rate of all the spot
rates. That’s why it is also the Internal Rate of Return (IRR)

46
Question
2. Suppose that the spot interest rate curve increases
instantaneously and uniformly by 0.5%. What is the new
price?
Maturity Spot Interest Rate
1 4.5%
2 5%
3 5.25%
4 5.4%
5 5.5%

 5 5 5 5 5 
P     
 (1  4.5%) (1  5%) 2 (1  5.25%)3 (1  5.4%) 4 (1  5.5%)5 
 
 $97.99

47
Question
3. From Q1, suppose now that the Spot Interest Rate curve
remains stable over time. You hold the bond until maturity.
What is the realised compound yield (RCY) of your
investment?
Maturity Spot Interest Rate
1 4%
2 4.5%
3 4.75%
4 4.9%
5 5%
1/n
 Total Return 
RCY     1.0
 Purchase Price of bond 
48
Question
Total Return = Sum of all Coupons reinvested + proceeds
of bond sale/redemption
Normally, Sum of all Coupons reinvested 

C + C(1+r)1 + C(1+r)2 + … + C(1+r)4 = C/r((1+r)T – 1)

Why this is not suitable here?
Notice “r”! Is it the same across different years?
It has a TERM STRUCTURE. So,
C + C(1+r1)1 + C(1+r2)2 + … + C(1+r4)4
C C C C C
r1 r2 r3 r4 r5
0 1 2 3 4 5

49
Question
After 1 year, C(1+r4)4 = 5 × (1 + 4.9%)4 = $6.0544
After 2 years, C(1+r3)3 = 5 × (1 + 4.75%)3 = $5.7469
After 3 years, C(1+r2)2 = 5 × (1 + 4.5%)2 = $5.4601
After 4 years, C(1+r1)1 = 5 × (1 + 4%)1 = $5.2
After 5 years, C = 5 (and face value redemption = $100)
The Total Return (TR) for bondholder to hold the bond till
maturity (five years later) is:
C + C(1+r1)1 + C(1+r2)2 + … + C(1+r4)4 + Bond Price @
maturity
TR = 6.0544 + 5.7469 + 5.4601 + 5.2 + 5 + 100 =
$127.4614
50
Question
From question 1, we know the bond was valued at $100.136
1/n
 Total Return 
RCY     1.0
 Purchase Price of bond 

Total Return = $127.4614 (see previous page)

RCY = ($127.4614/$100.136)1/5 – 1 = 4.944%

51
Question
Recalling question 1, Yield to maturity (YTM) is calculated
as:
5 5 5  100
100.136   2
 ... 
1  YTM (1  YTM) (1  YTM) 5

YTM = 4.9686%; RCY = 4.944%

Why is the RCY different from the YTM?
The RCY (4.944%) is different from YTM of this bond (4.9686%) because
the curve is not flat at a 4.9686%.

When YTM is calculated it assumes that interest is reinvested

at the same rate. As this may not be so the RCY may differ
from the YTM.

52