BOND VALUATION

SESSION 1
• What is a bond?
• What are its features?
• the terms related with bond valuation are

– Face value
– Coupon interest rate
– Maturity period-maturity at issue and residual maturity
– Redemption value
– Redemption Premium
– Market value
– Call option –coupon rate falls
– Put option-if the coupon rate rises
– Basis Point
 Types of Bonds
• Secured VS Unsecured Bonds
• Senior VS Subordinate Bonds
• Registered VS Unregistered Bonds
• Convertible VS Non-convertible Bonds
• Floating rate VS Fixed rate Bonds
• Zero Interest Convertible Debentures
• Detachable Equity Coupons/ Warrants-
attached to NCD
• Secured Premium notes with detachable
warrants
Suppose an investor is considering the
purchase of a 10 years, Rs.1000 par value
bond bearing a nominal rate of interest of
10%p.a. what should he be willing to pay
now to purchase the bond if the required
rate of return is
i)10%
ii)12%
iii)8%
• The bonds of P Ltd pay interest semi-annually. If
the
– par value=rs.1000
– Maturity period=10 years
– Coupon rate of interest=12%
• Compute the value of the bond if required rate of
return is
i)12%
ii) 16%
 Bond Returns
• Coupon rate
• Capital Gain or loss arising out of sale of
bond
• Cash realized on sale of bond
• Redemption of Bond
 Current Yield

• The concept of current yield

= coupon interest
current market price
 Current Yield
• The par value of a bond is Rs.1000 and
coupon rate of interest is 8%.

If it is currently selling at Rs.800, find the

current yield
 Yield to Maturity
• The rate of return earned by an investor
who purchases a bond and holds it till
maturity
• It is the discount rate at which the
purchase value of the bond is equal to the
present value of the cash flows from the
bond
• YTM is measured by comparing PV with
MV
• This is similar to the internal rate of return
• We can use simple interpolation to solve
the sum and find the value of YTM
• We can also use a simple formula to solve

• YTM~ I+ (F-P)/2
(F+ P) / 2
• Calculate the YTM of a 10 years bond,
paying 10% interest on the face value of
Rs.10000 and currently selling at
Rs.10800
 Yield to maturity

i= coupon rate
yield

6%

Current yield

100% Bond price (percent of face value)

 Realized yield
• It is the yield actually earned by the
investor
• Calculate the realized yield if the 13%
bond of face value Rs.200 is held for 1
year and sold at Rs.194.35. The purchase
price of the bond is 191.5
 Assumptions Underlying YTM
• 1. All coupon and principal payments are made
on schedule.
• 2. The bond is held to maturity.
• 3. The coupon payments are fully and
immediately reinvested at precisely the same
interest rate as the promised YTM.
• The YTM and the realized yield* will be equal if
the above conditions are fulfilled. Any violation of
the above assumptions will cause YTM to differ
from realized yield.
• An investor may hold a bond to maturity,
or decide to sell the bond before that.
• Similarly, the reinvestment rate, or the rate
at which coupon payments are reinvested
can be more or less than the promised
YTM.
• Since the reinvestment rates are different
from the YTM, the interest earned on the
coupon income will be at the reinvestment
rate and has to be separately considered.
• The total returns to an investor, as already
noted
• = Coupon interest + Interest on interest +
Capital gains (or loss) ... Eq. (6)
 Interest on Interest
• Consider a 13% bond (face value Rs.200)
redeemable after 5 years at a premium of 5%.
Let the purchase price be Rs.191.50
• Calculate
– YTM
– The interest on interest ,if
• Reinvestment rate=YTM
• Reinvestment rate=12%
– Calculate the interest on interest for different holding
period
• A fall in interest rate, reduces the return
available
 Capital Gain
• Consider a 13% bond (face value Rs.200)
redeemable after 5 years at a premium of
5%. Let the purchase price be Rs.191.50
• Calculate
– the Capital gain for different holding period if
• reinvestment rate=15%
• Reinvestment rate=12%
• Calculate the total return for different
holding period under the above cases.
 Holding Period
Reinvestment 1 2 3 4 5
rate
15 Coupon 26 52 78 104 130
% Int on int 0 3.9 12.3 25.82 45.29
CG 2.85 6.04 9.54 13.82 18.5
total 28.85 61.94 99.84 143.64 193.79
12 coupon 26 52 78 104 130
% Int on int 0 3.12 9.72 20.25 35.18
CG 21.96 20.47 19.81 19.25 18.5
total 47.96 75.59 107.53 143.5 183.68
• A fall in interest rate reduces interest on
interest, while increasing the capital gains.

• This is due to the inverse relation between

YTM and the market price
• Consider the total return and calculate the
realized yield for different holding period
under the above cases.
reinves Holding Period
tment
rate 1 2 3 4 5

15% 15 15 15 15 15

12% 25 18.54 16 15 14.4

• In an environment of falling interest rate ,
the investor realized a lower yield as term
to maturity approaches
• He benefits by shortening his holding
period and realizing capital gain
• interest on interest and capital gains are
balanced at a holding period of 4 years.
 Accrued interest
• In the middle of July,2001, the 12.75%
bonds were issued by Exec ltd. maturing
in year 2003. the coupon dates for this
bond are in the middle of April and
October and the bond matures in the
middle of April 2003. if the YTM is 10.17%,
calculate the Present value
 Riskiness of Bond
• Default risk
• Interest rate risk
 Determining the Interest Rate
• Loan able Fund Theory
– There are the suppliers of fund and seekers of
fund
– Supply of fund is directly related to the
change in interest rate
– Demand of funds is inversely related to the
interest rate
– Equilibrium is reached when demand=supply
 Determining the Interest Rate
• Liquidity Preference Theory
– Spenders keep a portion of their fund idle
which has an opportunity cost of capital
– The opportunity cost increases as interest
rate increases
– As opportunity cost increases , demand for
cash balance decreases
– The demand for cash balance also depends
on the growth rate of the economy
 Determining the Interest Rate
• DM=f (Y, i)
• DM=M
• f (Y, i)=M
• i=f ( M, Y)
• If suppliers feel that inflation would go up,
they would demand higher rate of interest
• Hence, i=f ( M, Y, P)
Forecasting Interest rate Trends
Term Structure of Interest Rates
• The difference in yield observed for bonds
which are similar in all respect except in
the term to maturity is known as the term
structure of interest rates
 Yield Curves
• The yield is plotted for the securities
issued by the government and serves as a
benchmark for all other fixed income
securities issued by other organizations
• Interest rate levels are categorized as
short term, medium term and long term
 Positive yield curve
• A yield curve may be positive for a variety of reasons. First of all,
the concept of risk plays an important role in the tendency of yield
to be higher as a bond’s length to maturity increases. Quite simply,
the more time that remains until a bond matures, the greater the risk
of an unfavorable event that could lower the bond’s market value —
whether an increase in interest rates on newly issued bonds or
default on the part of the issuer. The extra yield that investors want
to earn to tie their money up in longer-term bonds is known as the
risk premium.
When investors expect higher inflation, that can also have a
significant impact on creating a positive yield curve. In periods of
economic growth, the market anticipates that inflation will increase,
making it more likely that the Fed will tighten the money supply by
raising short-term interest rates. As investors shift their money from
long-term into short-term securities to take advantage of the higher
rates, the market prices of long-term bonds are driven lower and
their yields higher.
 Negative yield curve
• Although risk premiums and investors’ conventional preference for the liquidity of
short-term bonds has tended to keep the yield curve positive, situations do occur
where short-term yields exceed long-term yields. In these cases, the yield curve is
described as negative or inverted — sloping downward from the left as maturities
increase.
Negative yield curves may emerge when the market anticipates a deteriorating
economic situation accompanied by falling interest rates. Investors who expect an
economic slowdown tend to lock in long-term bond investments at their current rates,
reducing the yield, and avoid short-term bonds in the expectation that short-term
rates will fall. This reduced demand increases the short-term yield. Additionally, since
a slowing economy often results in a decrease in inflation, existing long-term bonds
become more attractive.
Another possible explanation for an inverted curve may be that while the Federal
Reserve’s Open Market Committee can exert pressure on short-term rates, it has no
direct control over long-term rates. If a rise in long-term rates doesn’t follow an
increase in short-term ones, the normal curve will be reversed.
 Flat yield curves

• In certain cases, there is little or no

difference between the yields on short-
term and long-term bonds — a situation
known as a flat yield curve. A flat yield
curve may reflect widespread uncertainty
about the future of interest rates and the
economy as a whole. Or an extended
period when the curve is flat may be the
result of shifts in investor attitudes.
 Causes for the Term Structure
• The pure expectations hypothesis
• The liquidity premium hypothesis
 Pure Expectation hypothesis
• An investor will opt for one year security
now only when he is certain that the
interest rate after 1 year is greater than the
interest rate on 2 years security
• An upward sloping yield curve indicates
that investors expect the interest rates to
rise
• Downward curve indicates the opposite
• The spot rate on 1year, 2 year and 3 year
Central Government Securities on 1.1.08
were 8.5%, 9% and 10.5% respectively.
Find the forward rates f2 and f3embodied
in the prevailing term structure?
• Assume that 4 year bond are currently
yielding 7% and 3 year bonds are yielding
6%. What is the forward yield for 1 year
bond starting 3 years from now?
 Liquidity Premium Theory
• The investors are not indifferent to risk and they
charge higher rates than the expected future
rates, if the maturity of the instrument increases
• The price of bonds with longer maturity are more
sensitive to interest rate changes than the bonds
with shorter maturity.
• The liquidity premium charged is actually the risk
premium
• Future rates include liquidity premium, and do
not reflect only the expectations of investors
 Market segmentation theory
• Financial instruments of different terms are not
substitutable.
• As a result, the supply and demand in the markets for
short-term and long-term instruments is determined
independently.
• Prospective investors would have to decide in advance
whether they need short-term or long-term instruments.
• Due to the fact that investors prefer their portfolio to be
liquid, they will prefer short-term instruments to long-term
instruments.
• Therefore, the market for short-term instruments will
receive a higher demand. Higher demand for the
instrument implies higher prices and lower yield.
• This explains the fact that short-term yields are usually
lower than long-term yields.
• Preferred habitat theory
• The Preferred Habitat Theory states that in addition to interest rate
expectations, investors have distinct investment horizons and
require a meaningful premium to buy bonds with maturities outside
their "preferred" maturity, or habitat. Proponents of this theory
believe that short-term investors are more prevalent in the fixed-
income market and therefore, longer-term rates tend to be higher
than short-term rates, for the most part, but short-term rates can be
higher than long-term rates occasionally. This theory represents a
middle ground between the Market Segmentation Theory and the
Market Expectations Theory. Moreover, it seems to explain both the
persistence of the normal yield curve shape and the tendency of the
yield curve to shift up and down while retaining its shape.