LECTURE 5

Zero Coupon Bonds and

others

Topics Covered
Horizon analysis
Fair Holding Period Return
Price of a Bond purchased
between Coupon Periods
Zero Coupon Bond STRIPS

Lecture 5

Sreejata Banerjee

Horizon Analysis
What is horizon analysis?
Forecasting the realized compound yield
over various holding periods or investment
horizons are called horizon analysis.
The forecast of total return depends on your
forecast of both the price of the bond when
you sell it at the end of the horizon and the
rate at which you are able to re-invest the
coupon income.
The sales price depends on the YTM at the
horizon date.
Lecture 5

Sreejata Banerjee

Horizon Analysis
Suppose you buy a 30 year, 7.5% (annual payment) coupon
bond for $980( when its YTM is 7.67%) and plan to hold it for
20years. Your forecast is that the bonds YTM will be 8% when
it is sold and that the reinvestment rate on the coupons will be
6%.
At the end of the investment horizon with 10 year remaining
the forecast sales price with YTM of 8% will be $966.25. The
20 coupon payments will grow with compound interest to
$2758.92. ( FV at 20 years = 36.786 *75 = 2758.92)(see the
FV table.)
Based on these forecasts your investment $980 investment
will grow in 20 years to $966.45+$2758.92 =$ $3725.37.
V0=(1+r) 20 = V 20 So annualized compound return is $980(1+r)
20 = $ 3725.37
(1+r) 20 = 3725.37/980
(1+r) = 20 3.80 = 1.069
Therefore r = 0.069 =6.9%
Lecture 5

Sreejata Banerjee

Fair Holding Period Return

When the coupon rate is lower than
the market interest rate, the coupon
payments will not provide investors
as high a return as they could earn
elsewhere in the market.
To get a fair return investors need
to earn price appreciation on their
bonds. The bonds would have to
sell below par to provide a built
in capital gain.
Lecture 5

Sreejata Banerjee

Fair Holding Period Return

Suppose a bond with Rs1000 face value was
issued some years back at 7% coupon rate
annually. If only three years are left to maturity and
current required return is 8% what will be the
market price of the bond?
It will be 70*Annuity (8%,3)+Rs1000(PV factor
8%,3) = Rs.974.4 which is less than the par value.
70*2.577+ 1000*0.794 = Rs.974.4
At what price will the bond sell after another year?
70*Annuity (8%,2) +Rs 1000*PV factor (8%2)=
Rs.982.17
Lecture 5

Sreejata Banerjee

Price of a Bond purchased between

Coupon Periods
When a bond is sold between coupon dates
to compute its price we need to know:
1.
2.

3.

How many days are there until the next

coupon bond?
How should we determine the present value of
cash flows received over the fractional
period?
How much must the buyers compensate the
seller for the coupon interest earned by the
seller for the period the bond was held by
him?
Lecture 5

Sreejata Banerjee

Price of a Bond purchased between

Coupon Periods
Day Count
For Treasury coupon securities a non-leap is
assumed to have 365 days. The number of
days between settlement and the next
coupon is the actual number of days
between the two dates, which is said to be
actual/actual days .
For corporate and municipal bonds the
convention is 30/360 days.
Lecture 5

Sreejata Banerjee

Price of a Bond purchased between

Coupon Periods
Day Count Treasury Securities (contd.)
Suppose bond is purchased on 17th July
and next coupon payment is on 1st
Sept. Then by actual number of days:July 18th to 31st is 14 days
August
31 days
Sept 1
1 day
Total
46 days
Lecture 5

Sreejata Banerjee

Price of a Bond purchased between

Coupon Periods
Compounding
The present value formula must be
modified to account for the day
counts
We need to compute the following
ratio:
W= number of days between settlement and next coupon payment
number of days in the coupon period
The number of days in a coupon period is called basis.

Lecture 5

Sreejata Banerjee

10

Price of a Bond purchased between

Coupon Periods
For a bond with a coupon payment
remaining to maturity, the price is
p= c

c ++ c

+M

(1+ i)w (1 + I )1+w (1+ i)2+w (1+ i)n-1+w (1+ i) n-1+w

Lecture 5

Sreejata Banerjee

11

Determining Interest Accrued

Accrued Interest is the fraction of the coupon
payment that the bond seller earns for
holding the bond for a period of time
between bond payments.
The bond price's inclusion of any interest
accrued since the last payment period
determines whether the bond's price is
"dirty" or "clean.
Dirty bond prices include any accrued
interest that has accumulated since the last
coupon payment while clean bond prices do
not. In newspapers, the bond prices quoted
are often clean prices.
Lecture 5

Sreejata Banerjee

12

Determining Interest Accrued

(contd.)

However, because many of the bonds

traded in the secondary markets are
often traded in between coupon payment
dates, the bond seller must be
compensated for the portion of the
coupon payment he or she earns for
holding the bond since the last payment.
The amount of the coupon payment that
the buyer should receive is the coupon
payment minus accrued interest. The
following example will make this concept
more clear
Lecture 5

Sreejata Banerjee

13

Determining Interest Accrued

(contd.)

Illustration On March 1, 2003,

Francesca is selling a corporate
bond with a face value of $1,000
and a 7% coupon paid semiannually. The next coupon payment
after March 1, 2003, is expected on
June 30, 2003. What is the interest
accrued on the bond?
Lecture 5

Sreejata Banerjee

14

Determining Interest Accrued

(contd.)
Step 1 Determine the Semi-Annual Coupon
Payment: Because the coupon payments are semiannual, divide the coupon rate in half, which gives
a rate of 3.5% (7% / 2). Each semi-annual coupon
payment will then be $35 ($1,000 X 0.035).
Step 2. Determine the Number of Days Remaining in
the Coupon Period: Because it is a corporate bond,
we will use the 30/360 day-count convention.
Time Period = Days Counted
March 1-30 = 30 days
April 1-30 = 30 days
May 1-30 = 30 days
June 1-30 = 30 days
Total Days = 120 days

Lecture 5

Sreejata Banerjee

15

Determining Interest Accrued

(contd.)

Step 3 Calculate the Accrued Interest:

Accrued interest is the fraction of
the coupon payment that the
original holder (in this case
Francesca) has earned. It is
calculated by the following formula:

Lecture 5

Sreejata Banerjee

16

Determining Interest Accrued

(contd.)

Lecture 5

Sreejata Banerjee

17

Determining Interest Accrued

(contd.)

In this example, the interest

accrued by Francesca is $11.67. If
the buyer only paid her the clean
price, she would not receive the
$11.67 to which she is entitled for
holding the bond for those 60 days
of the 180-day coupon period.

Lecture 5

Sreejata Banerjee

18

Bond Price in between Coupon

Payments
Cash Flow per $100 of
Par

Period

Present value of $1 at
3.25%

PV of cash value

0.24444

$5.00

$0.99221

$4.961060

1.24444

$5.00

0.96098

4.804902

2.24444

$5.00

0.930731

4.653658

3.24444

$5.00

0.901435

4.507175

4.24444

$5.00

0.87306

4.365303

5.24444

$5.00

0.845579

4.227896

6.24444

$5.00

0.818963

4.094815

7.24444

$5.00

0.793184

3.965922

8.24444

$5.00

0.768217

3.841087

9.24444

$5.00

0.744036

3.720181

10.24444

$5.00

0.720616

3.603081

11.24444

$105.00

0.697933

73.28300

Total

Lecture 5

Sreejata Banerjee

$120.028080

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Bond Price in between Coupon

Payments
What is the accrued interest in this case?
The number of days from date of settlement to next
coupon date is
136( 180- 44)
The accrued interest that the seller is entitled to receive is
the full price of the bond minus the accrued interest per
$100 par value

AI = $5

[ 136/180] = $ 3.777778

The full or dirty price included the accrued interest the

clean or flat price is the full price without the accrued
interest. We must note that in a full price the next
coupon payment is a discounted value but in
calculation of accrued interest, it is an undiscounted
value
Lecture 5

Sreejata Banerjee

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Repayment Schemes

Pure Discount or Zero-Coupon Bonds

Pay no coupons prior to maturity.
Pay the bonds face value at maturity.
Coupon Bonds
Pay a stated coupon at periodic intervals prior to
maturity.
Pay the bonds face value at maturity.
Floating-Rate Bonds
Pay a variable coupon, reset periodically to a reference
rate.
Pay the bonds face value at maturity.
Perpetual Bonds (Consols)
No maturity date.
Pay a stated coupon at periodic intervals.
Annuity or Self-Amortizing Bonds
Pay a regular fixed amount each payment period.
Principal repaid over time rather than at maturity.

Lecture 5

Sreejata Banerjee

21

Annuities (contd)
Separating interest and principal
components:
2N

P0
t 1

1 ( R / 2)

Par

1 ( R / 2)

2N

where C coupon payment

Lecture 5

Sreejata Banerjee

22

Annuities (contd)
Example
A bond currently sells for $870, pays $70 per year
(Paid semiannually), and has a par value of $1,000.
The bond has a term to maturity of ten years.
What is the yield to maturity?

Lecture 5

Sreejata Banerjee

23

Annuities (contd)
Example (contd)
Solution: Using a financial calculator and the following input
provides the solution:
N
PV
PMT
FV
CPT I

= 20
= $870
= $35
= $1,000
= 4.50

This bonds yield to maturity is 4.50% x 2 = 9.00%.

Lecture 5

Sreejata Banerjee

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Zero Coupon Bonds

A zero coupon bond has a specific
maturity date when it returns the
bond principal
A zero coupon bond pays no
periodic income
The only cash inflow is the par value
at maturity
Lecture 5

Sreejata Banerjee

25

Zero Coupon Bonds and Treasury

STRIPS
A zero coupon bond carries no coupons and provides
all its return in the form of a price appreciation. The
ZCB provides only one cash flow to their owners, on
the maturity date.
US Treasury Bill are examples of short term ZCB. If the
bill has a face value of $10,000,the Treasury sells it for
an amount less than that and agreeing to re-pay
$10,000 at maturity.
Longer term ZCB are commonly created from coupon
bearing notes and bonds with the US Treasury. A bond
dealer who purchases a Treasury CB may ask the
Treasury to breakdown the cash flows or be paid by
the bond into a series of independent securities.
Lecture 5

Sreejata Banerjee

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Zero Coupon Bonds and Treasury

STRIPS
For example, a 10 year coupon bond
would be stripped of its 20 semi-annual
coupons. Each coupon payment will be
treated as a stand-alone zero coupon
bond. The maturities of these bonds
would be from 6 months to 10 years.
The final payment of face value would be
treated as another zero coupon bond.
Lecture 5

Sreejata Banerjee

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Zero Coupon Bonds and Treasury

STRIPS
Each of these payments are treated as independent
security and is assigned a CUSIP number (by the
committee of Uniform Securities Identification
Procedures)
The Treasury program under which coupon stripping
is performed is called STRIPS (Separate Trading
of Registered Interest and Principal Securities).
These ZCB s are called Treasury strips.
As time passes each of these zero coupon bonds
price should approach the par value.

Lecture 5

Sreejata Banerjee

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Zero Coupon Bonds and Treasury

STRIPS
Consider a 30 year ZCB and suppose the market
rate of interest is 10% per year. The price of the
bond will be $1000(1/(1.10)30) = 1000(1/17.4494)
= 1000(0.57309)= $ 57.31.
Next year with only 29years until maturity, if the yield
is still 10%, the price will be $1000(1.10) 29
= 1000*(1/(15.86304)
= 1000*(0.06304)= $63.04
What will be the price of the same bond in 25
years?
$1000(1.1)25 = 92.30
Lecture 5

Sreejata Banerjee

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Valuation: Zero Coupon Bonds

B
F
R
m
i
T
N

= Market price of the Bond of bond

= Face value
= Annual percentage rate
= compounding period (annual m = 1, semiannual m = 2,)
= Effective periodic interest rate; i=R/m
= Maturity (in years)
= Number of compounding periods; N = T*m

Two cash flows to purchaser of bond:

-B at time 0
F at time T
What is the price of a bond?
Use present value formula:

Lecture 5

Sreejata Banerjee

F
1 i N

30

APR
'Annual Percentage Rate - APR'
The annual rate that is charged for borrowing (or
made by investing), expressed as a single
percentage number that represents the actual
yearly cost of funds over the term of a loan. This
includes any fees or additional costs associated
with the transaction.
Loans or credit agreements can vary in terms of
interest-rate structure, transaction fees, late
penalties and other factors. A standardized
computation such as the APR provides borrowers
with a bottom-line number they can easily compare
to rates charged by other potential lenders.
Lecture 5

Sreejata Banerjee

31

APR contd.
Credit card companies are allowed to advertise
interest rates on a monthly basis (e.g. 2% per
month), but are also required to clearly state
the APR to customers before any agreement is
signed. For example, a credit card company
might charge 1% a month, but the APR is 1% x
12 months = 12%. This differs from annual
percentage yield, which also takes compound
interest into account.

Lecture 5

Sreejata Banerjee

32

Valuing Zero Coupon Bonds:

An Example
What is the value of a 20 year, U.S.
Treasury strip with face value of
$1,000. The APR is R=8% with annual
compounding?

33

Valuing Zero Coupon Bonds:

An Example
What is the value of a 20 year, U.S.
Treasury strip with face value of
$1,000. The APR is R=8% with annual
compounding?
Answer is $214.5

34

Zero Coupon Bonds

For a zero-coupon bond (annual
and semiannual compounding):
Par
P0
(1 R )t
Par
P0
(1 R / 2) 2t
Lecture 5

Sreejata Banerjee

35

Price of a Zero Coupon Bond

Pricing of a zero coupon bond is similar to
that of other bonds except in this case there is
only one cash payment at the time of maturity.

Illustration
The price of a zero coupon bond that matures in
10 years with a maturity value of $ 1000, when
required yield rate is 8.6% is
$1000[1/(1.043)20 =$ 430.83
Note for computation the required yield has been divided
by 2 i.e., 4.3% the number of coupon payments is
considered to be semi-annual
Lecture 5

Sreejata Banerjee

36