333FF2 - Bond Pricing & Bond Pricing Theorems 1

333FF2 Bond Pricing & Bond Pricing Theorems
BOND PRICING THEOREMS
1. Bond prices move inversely to

interest rate changes.
2. The longest the maturity of the
bond, the more sensitive it is to
changes in interest rates.
3. The price changes resulting
from equal absolute increases in
YTM are not symmetrical.
INTERNATIONAL FINANCIAL INVESTMENT
4. The lower a bonds coupon, the

more sensitive its price will be to
given changes in interest rates.
These 4 principles were first derived and

proven from the basic bond valuation
equation in:
Burton G. Malkiel, Expectations, Bond
Prices and the Term Structure of Interest
Rates, Quarterly Journal of Economics,
1962 (p. 197-218)
THEOREM 1: Bond prices move

inversely to interest rate changes.
When y P
When y P
Proof:
C = 20p.a., F = 100, N = 1.5 years,
y = 10% p.a.
Price of the bond = ?
From bond valuation model:

P = 10/(1+0.05) + 10/(1+0.05)2 +
110/(1+0.05)3
P = 113.616
Assume that interest rates rise and let y
= 20% p.a.
With higher interest rates, the price of
the bond falls:
P = 100.00
THEOREM 2: The longest the

maturity of the bond, the more
sensitive it is to changes in interest
rates.
Proof:
Original annual YTM 10% for all bonds
Bond A
Bond B
Bond C
Term to maturity
3 yrs
6 yrs
9 yrs
Annual Coupon
10
10
10
Current price
100
100
100
Assume that interest rates fall by 2%,

so that YTM becomes 8%.
Term to maturity
Current price
Price sensitivity
(in )
Bond A
Bond B
Bond C
3 yrs
6 yrs
9 yrs
105.24
109.38
112.66
+ 5.24
+ 9.38
+ 12.66
A 2% fall in YTM causes a higher price

increase (+ 12.66) for the 9 year bond.
Assume that interest rates increase

by 2%, so that YTM becomes 12%.
Bond A
Bond B
Bond C
3 yrs
6 yrs
9 yrs
Current price
95.08
91.62
89.17
Price sensitivity
(in )
- 4.92
- 8.38
- 10.83
Term to maturity
A 2% increase in YTM causes a higher

price fall (- 12.66) for the 9 year bond.
THEOREM 3: The price changes

resulting from equal absolute
increases
in
YTM
are
not
symmetrical.
Proof:
Bond A
Bond B
Bond C
Price changes (in )

YTM falls by 2% + 5.24
+ 9.38
+ 12.66
YTM rises by 2% - 4.92
- 8.38
- 10.83
For any given maturity, a x%

decrease in YTM causes a price rise
that is larger than the price loss
resulting from an equal x% increase
in YTM.
10
THEOREM 4: The lower a bonds

coupon, the more sensitive its price
will be to given changes in interest
rates.
Proof:
Assume annual YTM 10% for all
bonds.
Bond A Bond B Bond C
Term to
maturity
Annual
Coupon
ZCB
3 years
30
15
Current 150.76 112.69 87.31

price
74.62
11
Assume that interest rates increase by

2%, so that YTM becomes 12%.
Bond A Bond B Bond C Z C B

Term to
maturity
Annual
Coupon
Current
price
3 years
30
15
144.26 107.38 82.79 70.50
12
The change in the price of the bond as a

percentage of the initial price is:
Annual
Coupon
% Change
in Price
Bond A
Bond B
Bond C
Zero
Coupon
Bond
30
15
- 4.31%
- 4.71%
- 5.18% - 5.52%
Notice that zero coupon bonds are the

most sensitive to changes in interest
rates.
ADDITIONAL FACTORS
AFFECTING BOND VALUE
1.Taxation
2.Marketability
3.Call and Put Option provisions
13
1. TAXATION
There is no Capital Gains Tax (CGT) on
most UK bonds.
Most investors pay tax on interest
income (coupon payments).
For the latter reason, investors in high
tax brackets prefer low coupon bonds.
For purely taxation purposes and for
maintaining market share, high coupon
bonds usually offer higher YTM to
compensate investors for tax losses.
14
2. MARKETABILITY
(or LIQUIDITY)
Marketability or liquidity of a bond
depends on the ability to be bought or
sold
without
significant
price
concessions.
In general, the larger the size of a bond
issue, the greater its marketability.
15
Institutional investors usually require

bond liquidity; liquid bonds tend to
trade at a premium.
The more marketable a bond is, the
lower its yield.
Credit ratings provide a good indication
of a bonds marketability.
16
3. CALL AND
PROVISIONS
PUT
OPTION
Bonds often are issued with an option

provision.
Callable bonds (i.e. bonds with a call
option provision) give issuer the right to
redeem bond prior to maturity at a
specified price.
17
Putable bonds (i.e. bonds with a put

option provision) give investor the right
to force issuer to redeem the bond prior
to maturity at a specified price.
Option provisions are exercised when
market interest rates and coupon rates
differ.
18
Call provisions are more valuable when

interest rates fall or become more
volatile.
Callable bonds are redeemed when
market interest rates drop below coupon
rates.
This is because the bond price
increases. In this case, the issuer, in
order to avoid paying the appreciation
in the bonds value, exercises the call
option.
19
Callable bonds restrict investors capital

gains. Therefore, callable bonds are
expected to offer high yields.
Low coupon bonds with call option
provisions attached are unlikely to be
called.
Callable bonds are more advantageous
to issuing companies.
Callable bonds are usually subject to
low credit ratings.
20
Summary
The 4 bond pricing theorems have as
follows:
1. Bond prices move inversely to
interest rate changes.
2. The longest the maturity of the
bond, the more sensitive it is to
changes in interest rates.
3. The price changes resulting from
equal absolute increases in YTM
are not symmetrical.
21
4. The lower a bonds coupon, the

more sensitive its price will be to
given changes in interest rates.
Additional factors affecting bond
value are taxation, marketability and
option provisions.
There is no Capital Gains Tax (CGT)
on most UK bonds. Most investors pay
tax on interest income (coupon
payments).
Marketability or liquidity of a bond
depends on the ability to be bought or
sold
without
significant
price
concessions.
22
The more marketable a bond is, the

lower its yield.
Institutional investors usually require
bond liquidity; liquid bonds tend to
trade at a premium.
Option provisions are exercised when
market interest rates and coupon rates
differ.
Callable bonds are more advantageous
to issuing companies
23

333FF2 - Bond Pricing & Bond Pricing Theorems 1

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333FF2 Bond Pricing & Bond Pricing Theorems

BOND PRICING THEOREMS

1. Bond prices move inversely to

INTERNATIONAL FINANCIAL INVESTMENT