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Objectives
Identify the characteristics of bonds
government and corporate bonds
Develop a framework for valuing bonds
Determine the price sensitivity of bonds to
interest rate changes
Develop the analysis of interest rates and
portfolio management of bonds
Bonds
Bonds are financial instruments that are issued by bodies such as Governments and corporations
to raise funds by promising to pay interest and to repay the amount borrowed at some point in the
future
The future cash flows promised to the investors in conventional bonds are contractually defined
as
Periodic interest payments
Repayment of principal
The value of a bond will be given by the present value of cash flows that can be anticipated by
the holder of the bond
The rate of return required by investors on a bond, used to calculate the present value of the
anticipated net cash flows, will depend on the returns offered by bonds of similar risk and
duration to understand the benchmark requires an analysis of interest rates
Bond Characteristics
Face or par value
The amount the issue pays the bondholder at expiration of the
bond. (UK Government bonds: 100, US Government bonds:
$1,000.)
Valuation of a Bond
The value of a bond will be given by the present value
of cash flows that can be anticipated by the holder of
the bond
The rate of return required by investors on a bond will
depend on return offered by bonds of similar risk and
duration.
Interest Payment Interest Payment
Interest Payment Principal
P0
2
1 r
1 r
1 r n
r B
r B
r BB
P0 C C 2 C
1 r 1 r
1 r n
Bisthefaceorparvalueofabond
rcisthecouponrateofinterestandiscontractuallydefined
ristheprevailinginterestrate,theratethatinvestorscan
expecttoearnonsimilarriskinvestments.
5
100
P0= f (y)
rc=y
Required yield
6
......
7
100
(1 0.09)
(1 0.09) 2
(1 0.09) 3
(1 0.09)12
(1 0.09)12
100.00
85.67
P = f (r)
0.07
0.09
Interest rate
Required rate of return
Required yield
10
Time
Maturitydate
Bondissellingatadiscountasthecouponrateisbelowtheprevailinginterestrate.
Thepriceofabondmustequalitsnominalorfacevalueatthematuritydateandits
marketvaluewillincreaseyearbyyeartoeliminatethediscountbythatdate.
/ P0
where
I = rcB= interest payment
P1 = expected price at the end of period one
P0 = purchase price
P0 =85.6785
P1 =86.3896
HPR = [ I + ( P1 P0 )]
/P
85.6785 = 0.09
12
Capital depreciation
Annual return (t 1)
rc B Pt 1 Pt
Pt
Pt
where Pt Pt 1
Time
Annual return (t 1)
Capital appreciation
Below Par
rc B Pt 1 Pt
Pt
Pt
where Pt 1 Pt
13
Thecouponrateis7percentandtherequiredrateofreturn
is9percentthereforetheappropriatediscountrate.
14
Years
15
B
r
B
c
P
y
)
(1
y
)(1
T
0
t
t
1
Yield to Maturity
16
.
3
5
1
0
9
5
y
)
(1
y
)(
2
0
T
t
t
1
A bond offers a coupon rate of interest of 7 per cent, with interest being paid
on a semi-annual basis. If the bond is trading at 95.00 and has ten years to
run to maturity determine its yield to maturity. (Use Excel)
y = 3.8635%
17
Yield Measures
Calculation of yield
Red yield
2.80
Interest due
7 Jun / Dec
21
Bn
Time
23
32.1973
Maturity date
(10)
Time
24
100
32.1973
y rs10
1/ n
10
1
10
1 0.12
100
1 0.12
32.1973
25
Maturity
26
27
28
88.1727
29
30
31
32
33
97.3636
1 1.100 1 0.10
P 95.6028
7
107
1.1000 (1 rs 2 ) 2
rs 3 3 (1 rs 2 ) 2 1 3
105
1 0.092
2
89.3501 5 / 1.1 5 /(1.095)
35
Forward rates
The forward rate of interest is the short term (one
period) rate of interest for year n that will make an
investor indifferent between
investing in a zero for n-1 years and re-investing the
proceeds at maturity in a one year investment and
investing in a n year zero
36
n
(W
1h
rersfn
)fsnn1is(1
rthensffnp
)ro
(w
rt1a
1
)dersfo
itm
n
p
e
slfrpeiodn.
r
o
d
Forward Rates from Observed Spot Rates
38
f4
= .1351 or 13.51%
39
1(1+rs1)
0
1(1+rs1)(1+r2,s1)
1
1(1+rs2)2
0
P
Price-yield curve
y
Yield
44
Price
Longer maturity bond
Required Yield
Duration
A measure of the effective maturity of a bond takes into account the
timing of all the cash flows promised by a bond
It is defined as the weighted average of the time until each payment
is received, with the weights being given by the present value of the
cash flow of each period in relation to the price of the bond
Duration is shorter than maturity for all bonds except zero coupon
bonds, where the duration is equal to maturity of the bond.
46
Yield
47
PH
PL
Price-yield curve
yL
yH
Yield
48
C
ia
P
r
c
e
(C
)
1
y
w
F
shF
low
fpriodt
t
tD
tt
T
tt1
w
t
49
50
B
r c B + r c B + .... + r c B +
(1 + y )
(1 + y )2
(1 + y )n (1 + y )n
51
Macaulays Duration
dP
1
(1) r c B
(2) r c B
(n) r c B
(n)B
=
+
+ .... +
+
2
n
d (1 y )
(1 y ) (1 + y ) (1 + y )
(1 + y ) (1 + y )n
dP / P
=
d (1 y ) /(1 y )
(1) r c B
(2) r c B
(n) r c B
(n)B
+
+
....
+
+
(1 + y ) (1 + y )2
(1 + y )n (1 + y )n
P
dP/P
NCF/(1 y)t
t x
Macaulay's Duration
d(1 y)/(1 y)
P
The proportionate change in the price in relation to a very small proportionate
change in the yield factor
52
MacD ()
t 1
t (r C B)
nB
t
(1 y) (1 y)t
P
53
Calculating Duration
A three year bond offering a coupon of 15 per cent has
a yield of 15 per cent and is selling at par.
54
Weight (t )
PV(C t )
Price
0.756
0.130
0.113
55
Calculating Duration
D = 1 x (15/1.15)/100+ 2 x 15/1.152)/100 + 3 x 115/1.153)/100
= 1 x 0.1304 + 2 x 0.1134 + 3 x 0.7561 = 2.626
2.268
3
2
1
0.226
0.130
0.130
0.756
0.113
56
Modified Duration
The proportionate change in the price in relation to the proportionate
change in the yield factor
dP/P
NCF/(1 y)t
Macaulay's Duration
t x
d(1 y)/(1 y)
P
Modified Duration
Macaulay's Duration/(1 y)
Using Duration
Assume required yield increased from 10 to 10.5 per cent
dP/P
NCF/(1 y)t
Macaulay's Duration
t x
d(1 y)/(1 y)
P
821.08
6.2812
130.72
Macaulay's Duration
Estimated Change in price
x y x P
1 y
6.2812
58
59
Using Duration
Determining Duration
dP/P
NCF/(1 y)t
t x
d(1 y)/(1 y)
P
821.0819
6.2812
130.72
Macaulay's Duration
Estimated Change in price
x y x P
1 y
6.2812
60
P0=130.72
P1=127.07
Est.P1=126.99
Price-yield curve
y0
y1
Yield
61
Assessing Duration
Modified duration provides a reasonable basis for
estimating the proportionate change in price for small
changes in the required yield
When there are more significant changes in the
required yield, modified duration fails to provide an
adequate basis to estimate the price change.
Duration will overestimate the price change when the
required yield increases, thereby underestimating the
new price.
When the required yield falls, duration will
underestimate the price change and thereby
underestimate the new price.
62
Portfolio Duration
63
Convexity (a)
The first steps in deriving the convexity of a bond is to
determine the second derivative of the price of a bonds with
respect to its yield:
B
r
r
r
cB
cB
cB
P=
+
+ .... +
+
1
2
n
n
(1 + y ) (1 + y )
(1 + y ) (1 + y )
dP
(-1) r c B (-2) r c B
(-n) r c B
(-n)B
=
+
+ .... +
+
2
3
n+1
d (1 y ) (1 + y ) (1 + y )
(1 + y )
(1 + y )n+1
65
Convexity (b)
The second derivative is given by
(1) (2)r c B (-2)(3) r c B
d 2P
(-n) (n 1) r c B (-n) (n 1)B
=
+
+ .... +
+
3
4
n +2
d(1 y) 2
(1 + y )
(1 + y )
(1 + y )
(1 + y )n + 2
1
(1 y) 2
(1 y) 2
2rc B
6rc B
n (n 1)rc B n (n 1)B
(1 y) (1 y) 2
n 2
(1 y)
(1 y) n 2
t (t 1) NCFt
t 1
1
(1 y) t
1
t(t 1)NCF t
(1 y)t 2
t1
66
Convexity (c)
Convexity is given by 1/2 the second derivative divided
by the price of a bond
1
1
2 (1 y ) 2
1
t (t 1) NCFt
/P
t
(1 y )
t 1
1 n
1
t (t 1) NCFt
/P
t 2
2 t 1
(1 y )
67
68
Calculating Convexity
Second Derivative:
Convexity is given by
1
x( Second Derivative) / Price
2
1
x 2281.7465 / 115 .9708
2
9.8376
LIABILITY ARISES
BONDS MATURE
3..n ..m
Invest
Receive interest
and reinvest
UNCERTAIN SUM
LIABILITY ARISES
Long Duration
Bonds Mature
..n ..m
Invest
Receive interest
and reinvest. Also reinvest
the proceeds from the sale
of maturing bonds
72
Long Duration
Bonds Mature
LIABILITY ARISES
..n ..m
+
73
Long Duration
Bonds Mature
LIABILITY ARISES
..n ..m
74
Immunisation Illustration
A pension fund has a liability of 10 million
to meet 4 years from now
The yield curve is flat and the interest rate
is 6 per cent
There are two zero bonds available for
investment, one matures after two years
and the other after 8 years
Construct an immunised portfolio
1
7.921 m
(1.06)4
Weights
2 x (1 - w) 8w 4
6w 2
w 1/3
Invest one third in the 8 year zero and two thirds in the 2 year zero
ie 2.64 m and 5.281 m respectively
V4 2.64 m (1.06)8
1
5.281 x (1.06)2 (1.06)2 10 m
4
(1.06)
If the interest changes to 5.5 per cent the payoff from the 2 year zero
remains the same, but this will only earn 5.5 per cent for the subsequent
two years invested in the 8 year zero. However, with a lower interest rate the
the original 8 year zeros will be worth more after 4 years.
V4 2.64 m (1.06)8
1
5.281 x (1.06)2 (1.055 )2 10 m
4
(1.055 )