Financial Institutions and Markets

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Indian Financial System

n

The economic development of a nation is reflected by the progress of the various economic units, broadly classified into corporate sector, government and household sector. While performing their activities these units will be placed in a surplus/deficit/balanced budgetary situations. There are areas or people with surplus funds and there are those with a deficit. A financial system or financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit. A Financial System is a composition of various institutions, markets, regulations and laws, practices, money manager, analysts, transactions and claims and liabilities.

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Financial System; The word "system", in the term "financial system", implies a set of complex and closely connected or interlined institutions, agents, practices, markets, transactions, claims, and liabilities in the economy. The financial system is concerned about money, credit and finance-the three terms are intimately related yet are somewhat different from each other. Indian financial system consists of financial market, financial instruments and financial intermediation. These are briefly discussed below

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Financial Institutions
n

Includes institutions and mechanisms which

q q q

Affect generation of savings by the community Mobilisation of savings Effective distribution of savings

Institutions are banks, insurance companies, mutual funds- promote/mobilise savings Individual investors, industrial and trading companies- borrowers

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Financial market
n

These assets represent a claim to the payment of a sum of money sometime in the future and/or periodic payment in the form of interest or dividend. Classification
q q q

Money market (Short term instrument) Organized (Banks) Unorganized (money lenders, chit funds, etc.) Capital markets (Long term instrument) Primary Issues Market Stock Market Bond Market

q q q q

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Financial markets facilitate:

n n n

The raising of capital The transfer of risk International trade

They are used to match those who want capital to those who have it. Typically a borrower issues a receipt to the lender promising to pay back the capital. These receipts are securities which may be freely bought or sold. In return for lending money to the borrower, the lender will expect some compensation in the form of interest or dividends. Financial markets could mean:
n

Organizations that facilitate the trade in financial products. i.e. Stock exchanges facilitate the trade in stocks, bonds and warrants. The coming together of buyers and sellers to trade financial products. i.e. stocks and shares are traded between buyers and sellers in a number of ways including: the use of stock exchanges; directly between buyers and sellers etc.

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Financial Markets
n n n

OTC Auction Market Organized Market

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Types of Financial markets

n

Capital markets
n

Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof. Bond markets, which provide financing through the issuance of Bonds, and enable the subsequent trading thereof.

n n

Commodity markets Money markets

q

which provide short term debt financing and investment. which provide instruments for the management of financial risk.
n n n n

Derivatives markets
q

Futures Forward Options Swaps

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Insurance markets
q

which facilitate the redistribution of various risks.

Foreign exchange markets

q
n

which facilitate the trading of foreign exchange.

Credit market

where banks, FIs and NBFCs purvey short, medium and long-term loans to corporate and individuals.

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Purpose of Financial Markets

Purpose: n To facilitate the transfer of funds between borrowers and lenders n Trade TIME & RISK
n

Price discovery: Trading on secondary markets provides public information on asset prices (market price = last traded price of an asset) Lower search costs: Since all trading parties converge to the same location, matching is made easier Provides liquidity: investors can sell assets prior to maturity on secondary markets to satisfy their time preference for consumption and diversification needs.

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FM Participants
Firms - Net Borrowers Households (Individuals/Consumers)- Net Savers Financial Institutions -Borrowers and Savers Government (Federal/State/Local)

n n n n

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Money Market
Main Function

To channelize savings into short term productive investments like working capital .

Instruments in Money Market

Call money market Treasury bills market Markets for commercial paper Certificate of deposits Bills of Exchange Money market mutual funds Promissory Note

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Primary Markets
When companies need financial resources for its expansion, they borrow money from investors through issue of securities. Securities issued a)Preference Shares b)Equity Shares c)Debentures

Secondary Markets
The place where such securities are traded by these investors is known as the secondary market. Securities like Preference Shares and Debentures cannot be traded in the secondary market.

Equity shares is issued by the under Equity shares are tradable through a writers and merchant bankers on private broker or a brokerage house. behalf of the company. People who apply for these securities Securities that are traded are traded are: by the retail investors,FIs,MFs etc a)High networth individual b)Retail investors c)Employees d)Financial Institutions e)Mutual Fund Houses f)Banks One time activity by the company. 5/3/12 Helps in mobilising the funds for the investors in the short run.

The Indian Capital Market

n

Market for long-term capital. Demand comes from the industrial, service sector and government Supply comes from individuals, corporates, banks, financial institutions, etc. Can be classified into:
q q

Gilt-edged market Industrial securities market (new issues and stock market)
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Major Reforms in Indian Capital Market

n n

n n

Setting up of SEBI Introduction of free pricing in the primary capital market and abolition of capital control Standardization of disclosures in public issue Permission to FIIs to operate in the Indian capital market. Modernization of trading infrastructure on-line screen based electronic trading system Shift from account period settlement to (14 days) to rolling settlement (T+2) Safety and Integrity Measures margining system, intra-day trading limit, exposure limit and setting up of trade/settlement guarantee fund Clearing of transactions through the clearing house

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n n n n n

Dematerialization of securities Two depositories in the country Reconstitution of Governing Boards of Stock Exchanges Introduction of trading in equity derivative products Indian corporate allowed to access International capital markets through q American Depository Receipts q Global Depository Receipts q Foreign Currency Convertible Bonds q External Commercial Borrowings

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Bond (Debt) Market

Session 2

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What is a Bond?
You've just loaned your neighbour $1,000 so that he can renovate his home. He's promised to pay you 6% interest each year for the next 5 years, and then hell give you back your money. A bond works much the same way you give a company $1,000 and they pay you a fixed rate of interest for a specified period of time, after which they return your principal. Governments (federal, provincial and municipal) and corporations use bonds to raise the capital they need to expand. 5/3/12

You could also decide to sell that bond to someone else for $1,100. In that case youd earn a capital gain of $100 (plus whatever interest payments you had received in the meantime).

Now, why would someone pay you $1,100 for a bond that only cost you $1,000?

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Selling bonds
Your $1,000 bond pays 6% interest. Since you bought that bond, however, interest rates have gone down. Similar companies are now only offering a 5% interest rate on their bonds. Your original rate looks pretty good to another investor. So you can sell that 6% bond at a higher cost than you paid for it, which is called selling for a premium.

However, if interest rates have gone up, and similar companies are now offering 8%, you may have to sell your bond for less which is known as selling at a discount.

Interest rates and bond prices, then, are like a seesaw when interest rates go down, bond prices go up 5/3/12 (and vice versa).

Bond Issuers
n n n n

Government Bonds Municipal Bonds Corporate Bonds International Bonds

q q q

Eurobond Foreign bonds Global Bonds

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Corporate Bonds
n

Corporate bonds are debt securities issued by private and public corporations. Companies issue corporate bonds to raise money for a variety of purposes, such as building a new plant, purchasing equipment, or growing the business. When one buys a corporate bond, one lends money to the "issuer," the company that issued the bond. In exchange, the company promises to return the money, also known as "principal," on a specified maturity date. Until that date, the company usually pays you a stated rate of interest, generally semiannually.

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Wholesale Debt Market

n n

The Wholesale Debt Market segment deals in fixed income securities and is fast gaining ground in an environment that has largely focused on equities. The Wholesale Debt Market (WDM) segment of the Exchange commenced operations on June 30, 1994. This provided the first formal screen-based trading facility for the debt market in the country. This segment provides trading facilities for a variety of debt instruments including Government Securities, Treasury Bills and Bonds issued by Public Sector Undertakings/ Corporates/ Banks like Floating Rate Bonds, Zero Coupon Bonds, Commercial Papers, Certificate of Deposits, Corporate Debentures, State Government loans, SLR and Non-SLR Bonds issued by Financial Institutions, Units of Mutual Funds and Securitized debt by banks, financial institutions, corporate bodies, trusts and others. Large investors and a high average trade value characterize this segment. Till recently, the market was purely an informal market with most of the trades directly negotiated and struck between various participants. The commencement of this segment by NSE has brought about transparency and efficiency to the debt market. 5/3/12

Retail Debt Market

n

With a view to encouraging wider participation of all classes of investors across the country (including retail investors) in government securities, the Government, RBI and SEBI have introduced trading in government securities for retail investors. Trading in this retail debt market segment (RDM) on NSE has been introduced w.e.f. January 16, 2003. Trading shall take place in the existing Capital Market segment of the Exchange. In the first phase, all outstanding and newly issued central government securities would be traded in the retail segment. Other securities like state government securities, T-Bills etc. would be added in subsequent phases.

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Bonds Terminology
n

Issuer q Government, municipality, corporation, federal agency or other entity known as the issuer. Par Value q It is the value stated on the face of the bond. q It represents the amount the firm borrows and promises to repay at the time of the maturity. q It is also known as the principal, face value, or par value. q It is important to remember that bonds are not always sold at par value. In the secondary market, a bond's price fluctuates with interest rates. If interest rates are higher than the coupon rate on a bond, the bond will have to be sold below par value (at a "discount"). If interest rates have fallen, the price will be higher.

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Maturity q It is also called term-to-maturity. At the time of maturity, the issuer is no longer obligated to make interest payments. q Maturities range significantly, from 1 year to 40+ years for some corporate bonds. q Short-term notes: maturities of up to 5 years; q Intermediate term or Medium-term: maturities of five to 12 years; q Long-term bonds: maturities of 12 or more years.

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Coupon
q q

q q

The coupon rate is the interest rate that is paid out to the bond holder. The name derives from the old system of payment, in which bond holders would need to send in coupons in order to receive payment. The coupon is set when the bond is issued and is usually expressed as an annual percentage of the par value of the bond. Coupon payment can be annually, semi annually, quarterly or monthly. There are some bonds that do not pay out any coupons; these are called zero-coupon bonds .

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Yield to Maturity
q

The rate of return anticipated on a bond if it is held until the maturity date. YTM is considered a longterm bond yield expressed as an annual rate. The calculation of YTM takes into account the current market price, par value, coupon interest rate and time to maturity. It is also assumed that all coupons are reinvested at the same rate. Sometimes this is simply referred to as "yield" for short.

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CREDIT RATINGS
n

Each of the agencies assigns its ratings based on an in-depth analysis of the issuer's financial condition and management, economic and debt characteristics, and the specific revenue sources securing the bond.

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Types of Bonds
I. Classification on the basis of Variability of Coupon n Zero Coupon Bonds
q

Zero Coupon Bonds are issued at a discount to their face value and at the time of maturity, the principal/face value is repaid to the holders. No interest (coupon) is paid to the holders and hence, there are no cash inflows in zero coupon bonds. The difference between issue price (discounted price) and redeemable price (face value) itself acts as interest to holders. The issue price of Zero Coupon Bonds is inversely related to their maturity period, i.e. longer the maturity period lesser would be the issue price and viceversa. These types of bonds are also known as Deep Discount Bonds.

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Floating Rate Bonds

q q q

Reference rate + quoted margin (LIBOR + Q. margin) Floors Caps

Fixed
q

Stays same until maturity; ie: buy a Rs 1000 bond with 8% fixed interest rate and you will receive Rs 80 every year until maturity and at maturity you will receive the Rs 1000 back.

Payable at Maturity
q

Receive no payments until maturity and at that time you receive principal plus the total interest earned compounded semi-annually at the initial interest rate.

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II. Classification on the Basis of Variability of Maturity

n

Callable Bonds q The issuer of a callable bond has the right (but not the obligation) to change the tenor of a bond (call option). The issuer may redeem a bond fully or partly before the actual maturity date. These options are present in the bond from the time of original bond issue and are known as embedded options. q This embedded option helps issuer to reduce the costs when interest rates are falling, and when the interest rates are rising it is helpful for the holders.

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Puttable Bonds q The holder of a puttable bond has the right (but not an obligation) to seek redemption (sell) from the issuer at any time before the maturity date. q In riding interest rate scenario, the bond holder may sell a bond with low coupon rate and switch over to a bond that offers higher coupon rate. Consequently, the issuer will have to resell these bonds at lower prices to investors. q Therefore, an increase in the interest rates poses additional risk to the issuer of bonds with put option (which are redeemed at par) as he will have to lower the re-issue price of the bond to attract investors.

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Convertible Bonds q The holder of a convertible bond has the option to convert the bond into equity (in the same value as of the bond) of the issuing firm (borrowing firm) on pre-specified terms. q This results in an automatic redemption of the bond before the maturity date. The conversion ratio (number of equity of shares in lieu of a convertible bond) and the conversion price (determined at the time of conversion) are pre-specified at the time of bonds issue. q Convertible bonds may be fully or partly convertible. For the part of the convertible bond which is redeemed, the investor receives equity shares and the non-converted part remains as a bond.

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III. Classification on the basis of Amortizing Bonds Principal Repayment

q q

Amortizing Bonds are those types of bonds in which the borrower (issuer) repays the principal along with the coupon over the life of the bond. The amortizing schedule (repayment of principal) is prepared in such a manner that whole of the principle is repaid by the maturity date of the bond and the last payment is done on the maturity date. For example - auto loans, home loans, consumer loans, etc.

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Debt Instruments
Type Central Government Securities Typical Features Medium long term bonds issued by RBI on behalf of GOI. Coupon payment are semi annually Medium long term bonds issued by RBI on behalf of state govt. Coupon payment are semi annually Medium long term bonds issued by govt agencies and guaranteed by central or state govt. Coupon payment are semi annually Medium long term bonds issued by PSU. 51% govt equity stake Short - Medium term bonds issued by private companies. Coupon payment are semi annually State Government Securities

Government Guaranteed Bonds

PSU Corporate

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Risk Associated with Investing in Bonds

n

Interest Rate Risk

n

n n

The price of the bond will change in the opposite direction from the change in interest rate. As interest rate rises the bond price decreases and vice versa. If an investor has to sell a bond prior to the maturity date, it means the realisation of capital loss. This risk depends on the type of the bond; callable puttable etc????

Reinvestment Income or Reinvestment Risk

n

The additional income from such reinvestment called interest on interest, depends on the prevailing interest rate levels at the time of reinvestment.

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Call Risk
n

The issuer usually retains this right in order to have flexibility to refinance the bond in the future is market interest rate drops below the coupon rate Disadvantage for investors for callable bond: cash flow pattern not known with certainty, interest rate drop, capital appreciation will reduce. If the issuer of a bond will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of the amount borrowed. Yield = market yield + risk associated with credit risk

Credit Risk
n

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Inflation Risk
n n

Purchasing power risk arises because of the variation in the value of cash flow from the security due to inflation. Eg: ??? Risk associated with the currency value for non-rupee denominated bonds. Eg: US treasury bond

Exchange Rate Risk

n

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Liquidity Risk
n n n

Its depends on the size of the spread between bid and ask price quoted. Wider the spread is risky. For investors keeping till maturity, this is uminportant. Market to market should be calculated portfolio value. Value of bond will increase when expected interest rate volatility increases. Natural uncertainty. Avoid securities in which knowledge is less.

Volatility Risk
n

Risk Risk
n n

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Time value of money

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Time value of Money

n

Present value of money

q q

One time Annuity One time Annuity

Future value of money

q q

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Question
n

Suppose an instrument promises to pay Rs 5,000,000 seven years from now with no interim cash flows. Assuming rate of interest is 10%. What is the present value of this investment? Rs 2,565,791

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Present value of an Ordinary Annuity

n

When the same amount of rupees is received each year or paid each year is referred to as an annuity. When the first payment is received one period from now is called as an ordinary annuity. PV = 1- 1 A (1+r)n
r

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Question
n

Suppose that an investor expects to receive Rs 100 at the end of each year for the next eight year. Interest rate 9%. Calculate PV of the receivable amount. PV = 1- 1 100 (1.09)8
0.09

100 [5.534811] = Rs 533.48

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Bond Pricing
n

Reason
q q

Indicate the yield received Should the bond be purchased

Priced at Premium, Discount, or at Par

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Calculating Bond Price

n

Sum of the present values of all expected coupon payments plus the present value of the par value at maturity.

C = coupon payment, ordinary annuity n = number of payments i = interest rate, or required yield M = value at maturity, or par value

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Eg: Calculate the price of a bond with a par value of $1,000 to be paid in 10 years, coupon rate of 10%, and required yield of 12%.....? Coupon payments are made semi-annually to bond holders and that the next coupon payment is expected in 6 months
n n n n

Determine the Number of Coupon Payments Determine the Value of Each Coupon Payment Determine the Semi-Annual Yield Plug the Amounts Into the Formula

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Bond price is less than its par value i.e, extra incentive to invest in the bonds

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Price Yield Relationship

n

n n n

When yield increases, investor would not buy the issue because it offers a below market yield; the resulting lack of demand would cause the price to fall. When yield decreases ?????? This is how bond price falls below its par value. When bond sells below its par value, it is said to be selling at a discount

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Coupon rate is less than the required yield Price is less than the par ( Discount Bond) n Coupon rate is equal to the required yield Price is equal to the par n Coupon rate is more than the required yield Price is more than the par ( premium Bond)
n
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A fundamental property of a bond is that its price changes in the opposite direction from the change in the required yield As the required yield increases, the present value of cash flow decreases; hence the price decreases. As the required yield decreases, the present value of cash flow increases; hence the price

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Session 3
Yield YTM Duration

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Question 1
n

Calculate the Bond price for a 20 year 10% coupon bond with a par value of Rs 1000. Lets suppose the yield on this bond is 11%. The cash flows for this bond are as follows:
q q

40 semi anually coupon payment of Rs 50 Rs 1000 to be received 40 six month period from now.

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Solution
50 11 (1.055)4 0.055 1000

(1.055)40

Rs 50 1- 0.117463 + Rs 100 0.055 8.51332

= Rs 802.31 + 117.46 = Rs 919.77

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Question 2
n

Calculate the Bond price for a 20 year 10% coupon bond with a par value of Rs 1000. Lets suppose the yield on this bond is 6.8%. The cash flows for this bond are as follows:
q q

40 semi anually coupon payment of Rs 50 Rs 1000 to be received 40 six month period from now.

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Solution
50 10.034 1 1000 (1.034)40

(1.034)40

= Rs 1084.51 + 262.53 = Rs 1,347.04

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Calculate the Bond price for a 20 year 10% coupon bond with a par value of Rs 1000. Lets suppose the yield on this bond is 10%. The cash flows for this bond are as follows:
q

40 semi anually coupon payment of Rs 50 q Rs 1000 to be received 40 six month period from now. Ans Rs 1000

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Assignment 1
n

Find out different factor that affect risk free rate?

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Pricing Zero-Coupon Bonds

n n

No coupon payment until maturity. Because of this, the present value of annuity formula is unnecessary. Calculate the price of a zero-coupon bond that is maturing in 5 years, has a par value of $1,000 and required yield of 6%....?
q q

Determine the Number of Periods Determine the Yield

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Determining Interest Accrued

n

Accrued interest is the fraction of coupon payment that the bond seller earns for holding the bond for a period of time between bond payments
q

The amount that the buyer pays the seller is the agreed upon the price plus accrued interest. This is referred as a Dirty bond prices The price of a bond without accrued interest is called the Clean bond prices

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Accrued Interest
q

Interest accrues linearly during coupon period

Last Coupon Date

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Settlement Date

Next Coupon Date

Eg: On March 1, 2010, X is selling a corporate bond with a face value of $1,000 and 7% coupon paid semiannually. The next coupon payment after March 1, 2010, is expected on June 30, 2010. What is the interest accrued on the bond?

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Yield
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Bond Basics
n

Two basic yield measures for a bond are its coupon rate and its current yield.

Annual coupon Coupon rate = Par value

Annual coupon Current yield = Bond price
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6710-67

Yield
n

Yield is the return you actually earn on the bond--based on the price you paid and the interest payment you receive Two Types of Yields:
q

Current Yield: annual return on the dollar amount paid for the bond and is derived by dividing the bond's interest payment by its purchase price Yield To Maturity: total return you will receive by holding the bond until it matures or is called.

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Yield
n

From the time a bond is originally issued until the day it matures, its price in the marketplace will fluctuate according to changes in market conditions or credit quality. The constant fluctuation in price is true of individual bonds-and true of the entire bond marketwith every change in the level of interest rates typically having an immediate, and predictable, effect on the prices of bonds.

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Yield
1.

Current yield: Annual coupon receipts/ Market price of the bond It does not consider:
n n

n.

Time value of money Complete series of future cash flow

n.

It compares a pre-specified coupon with the current market price, it is called as current yield.

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Example
n

The current yield for a 15 years 7% coupon bond with a par value of Rs 1000, selling for Rs 769.40 = 9.10%

Current yield = Rs 70 Rs769.40

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Yield to Maturity
n

Given a pre-specified set of cash flows and a price, the YTM of a bond is that rate which equates the discounted value of the future cash flows to the present price of the bond.

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YTM
n

n n

Yield to maturity (YTM) is the interest rate (i) that equates the present value of cash flow payments received from a debt instrument with its value today. It is the most accurate measure of interest rates. The yield to maturity is the annual return annual rate (discounted) earned over a bond kept until maturity. The yield to maturity is the discount rate estimated mathematically that equals the cash flow of payment of interest and principal received with the purchasing price of the bond. This term is also referred to as internal rate of return or as the expected rate of return of the bond and it is the yield in which most bond investors are interested in.

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n n n

The yield-to-maturity depends on two assumptions: The bonds are held to maturity The interest payments received are reinvested at the same rate as the yield-to-maturity In reality matching the yield-to-maturity rate from the interest received is difficult because interest rates are changing constantly. The interest received is usually reinvested at different rates from the stated yield-tomaturity rate.

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The yield is the interest rate that will make the present value of cash flow equals to the bond price. YTM is calculated same way as IRR, the cash flows are those that the investor would realized by holding the bond till maturity. To compute the YTM requires a trial and error method

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Yield of Bond
Eg: You hold a bond whose par value is $100 but has a current yield of 5.21% because the bond is priced at $95.92. The bond matures in 30 months and pays a semi-annual coupon of 5%.

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Example
n

Calculate the YTM for a 15 years 7% coupon bond with a par value of Rs 1000. Lets suppose the bond price is Rs 769.42. The cash flows for this bond are as follows:
q q

30 semi anually coupon payment of Rs 35 Rs 1000 to be received 30 six month period from now.

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769.42 = Rs 35 1- 1 (1+y)30 y

1000 1 (1+y)30

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Trial and error method

PV of 30 payments PV of Rs 1000 30 PV of cash flows of Rs 35 periods from now 570.11 553.71 538.04 532.04 508.68 267 248.53 231.38 215.45 200.64 837.11 802.24 769.42 738.49 709.32

Annual Interest rate 9% 9.5% 10% 11.5 % 11 %

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Question?
n

The following three bonds, each of which has a par value of Rs 1000 and pays coupon semi-annually
Coupon rate (%) Number of years to maturity Price (Rs)

Bond

A B C

7 8 9

5 7 4

884.20 948.90 967.70

Calculate the Yield to maturity for three bonds

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YTC, YTP, Bond Price Volatility & Duration

Session 3 Click to edit Master subtitle style

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Yield to Call (YTC)

n

Yield to call (YTC) is the interest rate that investors would receive if they held the bond until the call date. The period until the first call is referred to as the call protection period. Yield to call is the rate that would make the bond's present value equal to the full price of the bond. Essentially, its calculation requires two simple modifications to the yield-to-maturity formula:

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YTC
n

When the bond may be called and at what price are specified at the time the bond is issued. The price at which bond may be called is referred to as the call price.

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Example
n

n n n n

Consider an 18 years 11% coupon bond payable semi annually with a maturity value of Rs 1000 selling at Rs 1169. suppose that the first call date is 8 years from now and that the call price is Rs 1055. Call price = 1055 N = 8*2 = 16 m C = 1000*11%/2 = 55 Bond price = 1169

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Solution
1169 = Rs 55 1- 1 (1+y)16 + y 1055 1 (1+y)16

8.54% is the yield to first call

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Yield to Put (YTP)

n n

n n

This mean that the bond holder can force the issuer to buy the issue at a specified price Yield to put (YTP) is the interest rate that investors would receive if they held the bond until its put date To calculate yield to put, the same modified equation for yield to call is used except the bond put price replaces the bond call value and the time until put date replaces the time until call date M = put price n = number of periods until assumed put date.

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Example of YTP
n

n n n

Consider an 18 years 11% coupon bond payable semi annually issue selling Rs 1169. assume that issue is putable at par (Rs 1000) in five years. Put price = 1000 N = 5*2 = 10 m C = 1000*11%/2 = 55

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Solution
1169 = Rs 55 1- 1 (1+y)10 + y 1000 1 (1+y)10

6.94% 7% is the yield to put

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Bond price volatility

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Volatility of Bond Prices in the Secondary Market

n n n n

Maturity Yield Credit rating Current interest rate

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Price Yield Relationship for Six Hypothetical Bonds

n n n n n n

9% coupon bond with 5 years to maturity 9% coupon bond with 25 years to maturity 6% coupon bond with 5 years to maturity 6% coupon bond with 25 years to maturity 0% coupon bond with 5 years to maturity 0% coupon bond with 25 years to maturity

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Price Volatility Characteristics of Option- Free Bonds (Properties)

n

Although the prices of all the option free bonds move in the opposite direction from the change in yield required, the percentage price change is not the same for all bonds. For very small changes in the yield required, the percentage price change for a given bonf is roughly the same, whether the yield required increases or decreases

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For large changes in the required yield, the percentage price change is not the same for an increase in the required yield as it is for a decrease in the required yield For a given change in basis point, the percentage price increase is greater than the percentage price decrease. (Long position: Potential capital gain is more than the capital loss, Short position: )

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Bond Price Volatility Duration & Convexity

Session 4 Click to edit Master subtitle style

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Characteristics of a Bond that Affect its Price Volatility

n

There are two characteristics of an option free bonds that determine its price volatility: Coupon and Term to Maturity

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Long maturities in portfolio:

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Investors who wants to increase a portfolios price volatility because they expect interest rate to fall, all other factors being constant, should hold for long maturity

Short maturities in portfolio:

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Effects of Yield to Maturity

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Price change for a 100 Basis point change in yield for a 9% 25 yrs bond trading at different yield level
Percent decline (%) 10.30 9.70 9.13 8.58 8.08 7.61 7.16 6.75 123.46 110.74 100 90.87 83.87 76.37 70.55 65.50 110.74 100 90.87 83.87 76.37 70.55 65.50 61.08 12.72 10.74 9.13 7.80 6.71 5.81 5.05 4.42

Yield level (%) Initial price (Rs) New price (Rs) Price decline (Rs) 7% 8 9 10 11 12 13 14 5/3/12

Measures of Bond Price Volatility

Three measures: n Price value of a basis point n Yield value of a price change n Duration

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Price value of a basis point

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Price Value of a Basis Point refers to the change in the price of a bond if the yield changes by 1 basis point (0.01%) If the price of Security A falls by 20 paise when the yield rises by 0.01% and the price of Security B falls by 25 paise for the same rise in the yield

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Yield value of a price change

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Yield Value of a Price change refers to the change in the yield of a security for a specified change in the price of the security. The smaller the yield value, the price volatility would be greater since even a small change in the yield would change the price considerably.

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DURATION
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In CAPM, Beta is a measure of a shares sensitivity to changes in an index. An analogous measure is calculated for bonds: it is called Duration. Duration is a measure of the sensitivity of the price of a bond to a change in interest rates. The duration measure allows us to evaluate the relative exposure to interest rate risk, of bonds with differing patterns of coupon payments. Duration is a measure of how quickly the (present) value of a bond is returned.

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Duration
It is a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. n Formula: Duration = Weighted Average of PV ofCash Flows Present Value of Cash Flows n The answer will give a measure of the average life of the bond in a present value sense. n A bonds with a low duration gets most of its value from cash flows occurring early.
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Macaulays Duration
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Macaulays definition: a weighted average term to maturity where all cash flows are in terms of their present value. Macaulays duration measure takes into account both interim and final coupon payments, weighting earlier cash flows as being more important than latter ones. This is done by calculating the present value of each cash-flow payment. As a result earlier coupon payments have higher present value than later coupon payments.

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Computation of Macaulays D=[1 * C1/(1+y) + duration 2 * C2/(1+y)2 + ... + N * CN/(1+y)N + N * F/(1+y)N ] / P

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D = Macaulays duration Ci = Cash-flow in period i N = Number of semi-annual time periods F = Redemption value y = YTM per period (prior to changes in interest rates) P = current price of the bond
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The answer will give a measure of the average life of the bond in a present value sense. A bonds with a low duration gets most of its value from cash flows occurring early.

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Example - Macaulay Duration

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A 10% coupon bond with a par value of Rs 100 on 1.1.2010. Coupons are paid semiannually; 1 January and 1 July. The bond will be redeemed at par on 1.7.2011. What is the bond's duration?

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n n

Semi-annual coupon payments = Rs 5 Semi-annual cash-flows: 1.1.10 (100) 1.7.10 5 1.1.11 5 1.7.11 105

y = 5% n Since Par value = market value YTM = Ci ) Duration: D = [1 * 5/(1+0.05) + 2 * 5/(1+0.05)2 + 3 * 105/(1+0.05)3] 100

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Click icon to add table

Peroid 1 2 3 Total Duration

PV of CF 4.76 4.535 90.7

Duration Cal 4.76 9.07 272.11 285.94 2.86 1.43

D = 2.8594 semi-annual periods (i.e. 1.43 years),

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Example
Five Year Bond Par Value = Rs. 10,000 , Coupon rate = 8%, YTM = 10%, Maturity = 5 Years
Time 1 2 3 4 5 Cash Flow 800 800 800 800 10800 PV Multiplier 0.909091 0.826446 0.751315 0.683013 0.620921 PV 727.27 661.16 601.05 546.41 6,705.95 9,241.84 Weighted PV 727.27 1,322.31 1,803.16 2,185.64 33,529.75 39,568.14

Duration = 39,568.14 / 9,241.84 = 4.2814 Yrs

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For each of the two basic types of bonds the duration is the following: Zero-Coupon Bond Vanilla Bond

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Duration of a Zero Coupon Bond

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Duration of a Vanilla or Straight Bond

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Modified Duration
Accounts for changing interest rates. n Indicates the percentage change in the price of a bond for a given change in yield. n Modified duration formula shows how a bond's duration changes in relation to interest rate movements. Formula: Modified Duration = Macaulay Duration 1 + Yield to Maturity
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Example
Eg: Currently a bond is selling at $1,000 or par, which translates to a yield to maturity of 7.5% semi annually. Calculated Macaulay duration is 4.26 Modified Duration = 1 + 0.0375 4.26 = 4.10

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PROPERTIES OF DURATION
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The duration measure, being the first derivative of the price function, depends on the following factors: Time to maturity Coupon payments and frequency of coupon payments in a year, and Yield to maturity.

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Question?
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Calculate the Bond duration and Modified bond for the bond with the face value of Rs 1000 for 5 years coupon rate is 10% semi annually. YTM is 10%

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Period 0 1 2 3 4 5 6 7 8 9 10 5/3/12

Cash Flow ($1,000.00) 50.00 50.00 50.00 50.00 50.00 50.00 50.00 50.00 50.00 1,050.00

PV Cash Flow 47.62 45.35 43.19 41.14 39.18 37.31 35.53 33.84 32.23 644.61

Duration Calc 47.62 90.70 129.58 164.54 195.88 223.86 248.74 270.74 290.07 6,446.09

Total 8107.82

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Duration is 4.05 (8107.82/ 1000/2) Modified duration is 3.86 (4.05 /1.05)

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Question 1
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Calculate the Bond duration and Modified bond for the bond with the face value of Rs 1000 for 5 years coupon rate is 10% semi annually. YTM is 8%. First calculate Bond Price Bond duration is 4.22 Modified Duration 4.06

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Question 2
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Calculate the Bond duration and Modified bond for the bond with the face value of Rs 1000 for 5 years coupon rate is 10% semi annually. YTM is 12% Bond duration is 4.01 Modified Duration 3.78

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Types of Yield Curves

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Three Main Patterns

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Normal Yield Curve: This is the yield curve shape that forms during normal market conditions. Investors expect higher yields for fixed income instruments with long-term maturities that occur farther into the future. As general current interest rates increase, the price of a bond will decrease and its yield will increase.

Yield

Maturity

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2.

Flat Yield Curve: A flat yield curve usually occurs when the market is making a transition that emits different but simultaneous indications of what interest rates will do. When the yield curve is flat, investors can maximize their risk/return tradeoff by choosing fixed-income securities with the least risk, or highest credit quality.

Yield

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3.

Inverted Yield Curve: The inverted yield curve indicates that the market currently expects interest rates to decline as time moves farther into the future, which in turn means the market expects yields of long-term bonds to decline.

Yield

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