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Bond
Par Value
Coupon Rate
Maturity Date
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Types of Bonds
Government Bonds Corporate Bonds Straight Bonds Zero Coupon Bonds Floating Rate Bonds Bonds with Embedded Options Convertible Bonds Callable Bonds Puttable Bonds Commodity Linked Bonds
Risks in Bonds
Interest Rate Risk Inflation Risk Default Risk Call Risk Liquidity Risk Reinvestment Risk Foreign Exchange Risk
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YIELD
Bond Valuation
P = P = P n C r [C / (1 + r)t ] + M / (1 + r)n C x PVIFA r, n + M x PVIF r, n = = = = Value (In Rupee) Number of Years Annual Coupon Payment (In Rupee) Periodic Required Return Maturity Value Time Period when the payment is received.
M = t =
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Example:
Example 1: 5 Year, 12% Coupon Bond with a Par Value of Rs. 1,000 Maturity Price @ 10% Premium Required Rate of Return = 13% Answer: 1019/Example 2: If Interest is paid semi-annually. Answer: 1017/-
Bond Yields
Current Yield Yield to Maturity (YTM) Yield to Call (YTC) Realized Yield to Maturity Holding Period Return
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1. Current Yield
CURRENT YIELD = ANNUAL INTEREST / PRICE
It reflects only the coupon Interest Rate. It doesnt consider Capital Gain or Loss. It also ignores Time Value of Money.
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earned over a given holding period as a percentage of its price at the beginning
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The term structure of interest rates, popularly called the yield curve, shows how yield to maturity (YTM) is related to maturity for bonds that are similar in all aspects, excepting maturity.
Another perspective on the term structure of interest rates is provided by the forward interest rates.
UPWARD SLOPING
DOWNWARD SLOPING
FLAT
HUMPED
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100,000
100,000
10.5
99,000
100,000
11.0
99,500
100,000
11.5
99,900
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Expectations Theory Liquidity Preference Theory Preferred Habitat Theory Market Segmentation Theory
Expectations Theory
Shape of yield curve can be explained by interest rate expectations of those who participate in the market.
Long term rate is equal to the geometric mean of current and future one-year rates expected by the market participants
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According to Modigliani and Sutch, who originally formulated the preferred habitat theory, risk aversion implies that investors will prefer to match the maturity of investment to their investor objective.
Long horizons investors Longer maturities Bonds (To Avoid Reinvestment Risk)
Short horizons investors Shorter maturities Bonds (To Avoid Price Risk)
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If there is a mismatch between demand and supply of funds in a certain maturity range,
Some lenders and borrowers may have to be induced to shift out of their preferred maturity ranges.
Of course, they will have to be compensated for this in form of a suitable risk premium which depends upon the degree of risk aversion.
Investors as well as borrowers are unwilling to shift from their preferred maturity range, come what may!!
Shape of yield curve is determined entirely by the supply and demand forces within each maturity range!!
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Maturity Premium
Future Expectations
Default Premium
Business Risk
Special Features
Call / Put Feature
Liquidity Preference
Financial Risk
Conversion Feature
Time Preference
Preferred Habitat
Collateral
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THEOREM 1
conversely if a bonds market price decreases then its yield must increase
THEOREM 2
If a bonds yield doesnt change over its life, then the size of the discount or premium will decrease as its life shortens
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THEOREM 3
If a bonds yield does not change over its life then the size of its discount or premium will decrease at an increasing rate as its life shortens
THEOREM 4
A decrease in a bonds yield will raise the bonds price by an amount that is greater in size than the corresponding fall in the bonds price that would occur if there were an equal-sized increase in the bonds yield the price-yield relationship is convex
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THEOREM 5
the percentage change in a bonds price owing to a change in its yield will be smaller if the coupon rate is higher
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