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Valuation
Value of bonds/debentures
= PV of expected future cash flows
Types:
Coupon and Zero Coupon
Key Features of a Coupon Bond
Par value or Face value: Rs 1,000 or Rs 100 (usually)
Issue Price is generally equal to the par value, but may be
lower or higher
Market Price: Price of the bond in the market.
Answer: 950.26
VALUE OF A BOND WITH SEMI-ANNUAL INTEREST
2n
P = t= 1 Ct / 2
+
M
(1+r/2)t (1+r/2)2n
where:
P = market price of the bond
Ct = annual coupon payment
n = number of years to maturity
M = Maturity value of the bond
r = annual return required by the bondholder
ILLUSTRATION
As an illustration, consider an 8 year, 12 percent coupon bond with a
par value of Rs. 100 on which interest is payable semi-annually. The
required return on this bond is 14 percent.
Value of the bond is:
16
P= 6
(1.07)t
+
100
(1.07)16
t=1
= Rs. 90.55
Answer: 921.37
PRICE-YIELD RELATIONSHIP
Coupon is 14%
Coupon Rate, Required Yield, & Price
if semi annual
What is the price of a zero coupon bond with a 1,000 face
value, 10-year maturity, and semiannual compounding when
the market interest rate is 12 percent?
1000/ (1.06) 20
=311.8
649.93
Computing Bond Yields
Yield to Maturity
Yield to Maturity
Approximation method
Reinvesting of coupons at YTM
Year CF FV
1 60 87.69316
2 60 79.75577
3 60 72.53682
4 60 65.97127
5 1060 1060
Total FV 1365.957
PV 850
Yield
[(1365.957/850)^(1/5)]-1 9.95%
Approximation method
M-P
C
Annual Yield to Maturity n
MP
2
M = Maturity Value
P = Bond Price
C = the annual coupon interest (in Rupees)
n = number of years
M-P
[C/2]
Semi - annual Yield to Maturity 2n
MP
2
For annualisation:
Long term bonds receive much of their cash flows into the
future, and because of time value of money, these cash
flows are heavily discounted.
Assume two, 8% coupon bonds, one with a maturity of 2 year, other
with 10 years. Calculate price with YTM of 7%. FV is Rs 100.
Maturity Maturity
2 years 10 years
YTM Price % change YTM Price % change
If 7% 101.81 7% 107.02
The lower the bonds coupon rate, the greater the proportion
of the bonds cash flow investors will receive at maturity.
Consider two 20 year bonds, one with a
coupon rate of 3% and the other with 8%
Coupon 3% Coupon 8%
YTM Price % change YTM Price % change
If 7% 57.62 7% 110.59
If 10% 40.40 -29.9% 10% 82.97 -24.98%
Bond Theorem Applications
Trading Strategies
Inflation risk
Higher than expected inflation reduces the cash proceeds in
real terms for lender
Reinvestment risk
Interest payments may have to be reinvested at a lower
interest rate
Foreign exchange risk
If bonds are denominated in a foreign currency
Term Structure of Interest Rates
Upward Sloping
Flat
Downward Sloping
Maturity
The Structure of Interest Rates
(1 Nominal RR)
1
(1 Rate of Inflation)
The Structure of Interest Rates
The Real Rate of Interest
The real rate of interest varies with business cycle.
Highest rates seen at end of a period of business
expansion.
Lowest rates at bottom of a recession.
The Structure of Interest Rates
http://blogs.wsj.com/indiarealtime/2015/08/24/raghuram-rajans-common-
man-theory-on-inflation/
The Structure of Interest Rates
6.80%
6.70%
6.60%
6.50%
6.40%
6.30%
6.20%
6.10%
91 day 364 day 10 year
Source:
https://rbi.org.in/scripts/BS_PressReleaseDisplay.aspx
http://www.tradingeconomics.com/india/government-bond-yield