10/16/2012

UNIT IV Bond Valuation

Bond

Par Value

Coupon Rate

Maturity Date

10/16/2012

Types of Bonds
Government Bonds Corporate Bonds Straight Bonds Zero Coupon Bonds Floating Rate Bonds Bonds with Embedded Options Convertible Bonds Callable Bonds Puttable Bonds Commodity Linked Bonds

Risks in Bonds
Interest Rate Risk Inflation Risk Default Risk Call Risk Liquidity Risk Reinvestment Risk Foreign Exchange Risk

10/16/2012

Price Yield Relationship

PRICE

YIELD

Bond Valuation
P = P = P n C r [C / (1 + r)t ] + M / (1 + r)n C x PVIFA r, n + M x PVIF r, n = = = = Value (In Rupee) Number of Years Annual Coupon Payment (In Rupee) Periodic Required Return Maturity Value Time Period when the payment is received.

M = t =

10/16/2012

Example:
Example 1: 5 Year, 12% Coupon Bond with a Par Value of Rs. 1,000 Maturity Price @ 10% Premium Required Rate of Return = 13% Answer: 1019/Example 2: If Interest is paid semi-annually. Answer: 1017/-

Bond Yields
Current Yield Yield to Maturity (YTM) Yield to Call (YTC) Realized Yield to Maturity Holding Period Return

10/16/2012

1. Current Yield
CURRENT YIELD = ANNUAL INTEREST / PRICE

It reflects only the coupon Interest Rate. It doesnt consider Capital Gain or Loss. It also ignores Time Value of Money.

An Incomplete and Simplistic Measure of Yield

2. Yield to Maturity (YTM)

Rate of Return offered by the BOND over its Life YTM refers to the Discounting Rate which makes the present value of the cash flows receivable from owning the bond to the price of the bond. Formula: Approximation: YTM = C+(MP)/n 0.4 M + 0.6 P Trial and Error: YTM = R1 + [R2 R1] PV at R1 P PV at R1 PV at R2

10/16/2012

3. Yield to Call (YTC)

Applicable to Callable Bonds Similar to YTM except the Duration M = n = Call Price Number of Years until the assured call date

4. Realized Yield to Maturity

Year 0 1 2 3 4 5 INV (850) INT 150 150 150 150 150 Re- INV Period 4 3 2 1 0 Compound Factor 1.81 1.56 1.35 1.16 1.00 FV 271.5 234.0 202.5 174.0 150.0 ACF 0 0 0 0 1032 + MATURITY PRICE

10/16/2012

5. Holding Period Return

Holding Period Return is the income Current Return (Interest) Capital Return (Change in Price)

earned over a given holding period as a percentage of its price at the beginning

YIELD CURVE OR TERM STRUCTURE OF INTEREST RATES

10/16/2012

Yield Curve / Term Structure of Interest Rates

The term structure of interest rates, popularly called the yield curve, shows how yield to maturity (YTM) is related to maturity for bonds that are similar in all aspects, excepting maturity.

Another perspective on the term structure of interest rates is provided by the forward interest rates.

Types of Yield Curve

UPWARD SLOPING

DOWNWARD SLOPING

FLAT

HUMPED

10/16/2012

Calculate Forward Rates

FACE VALUE INTEREST RATE MATURITY (YEARS) 1 CURRENT PRICE 91,000

100,000

100,000

10.5

99,000

100,000

11.0

99,500

100,000

11.5

99,900

10/16/2012

Explaining Term Structure

Expectations Theory Liquidity Preference Theory Preferred Habitat Theory Market Segmentation Theory

Expectations Theory
Shape of yield curve can be explained by interest rate expectations of those who participate in the market.

Long term rate is equal to the geometric mean of current and future one-year rates expected by the market participants

10

10/16/2012

Liquidity Preference Theory

According to this theory, there is UNCERTAINTY about the one-year period return from a bond whose maturity is greater than one period. This uncertainty regarding one-period return increases with the maturity of the bond. J. R. Hicks argued that investors (being risk averse) require an inducement to hold long term bonds. Thus, forward rates should incorporate interest rate expectations as well as a risk premium.

Preferred Habitat Theory

According to Modigliani and Sutch, who originally formulated the preferred habitat theory, risk aversion implies that investors will prefer to match the maturity of investment to their investor objective.

Long horizons investors Longer maturities Bonds (To Avoid Reinvestment Risk)

Short horizons investors Shorter maturities Bonds (To Avoid Price Risk)

11

10/16/2012

Preferred Habitat Theory (2)

According to this theory,

If there is a mismatch between demand and supply of funds in a certain maturity range,

Some lenders and borrowers may have to be induced to shift out of their preferred maturity ranges.

Of course, they will have to be compensated for this in form of a suitable risk premium which depends upon the degree of risk aversion.

Market Segmentation Theory

Extreme form of the preferred habitat theory It states

Investors as well as borrowers are unwilling to shift from their preferred maturity range, come what may!!

Hence according to this theory,

Shape of yield curve is determined entirely by the supply and demand forces within each maturity range!!

12

10/16/2012

Determinants of Interest Rates

Shortterm Risk Free Rate
Inflation Rate

Maturity Premium
Future Expectations

Default Premium
Business Risk

Special Features
Call / Put Feature

Real Growth Rate

Liquidity Preference

Financial Risk

Conversion Feature

Time Preference

Preferred Habitat

Collateral

Others (Ex. Floating, 0-Coupon)

BOND PRICING THEOREMS

5 BOND PRICING THEOREMS

for a typical bond making periodic coupon payments and a terminal principal payment

13

10/16/2012

BOND PRICING THEOREMS

5 BOND PRICING THEOREMS

THEOREM 1

If a bonds market price increases then its yield must decrease

conversely if a bonds market price decreases then its yield must increase

BOND PRICING THEOREMS

5 BOND PRICING THEOREMS

THEOREM 2

If a bonds yield doesnt change over its life, then the size of the discount or premium will decrease as its life shortens

14

10/16/2012

BOND PRICING THEOREMS

5 BOND PRICING THEOREMS

THEOREM 3

If a bonds yield does not change over its life then the size of its discount or premium will decrease at an increasing rate as its life shortens

BOND PRICING THEOREMS

5 BOND PRICING THEOREMS

THEOREM 4
A decrease in a bonds yield will raise the bonds price by an amount that is greater in size than the corresponding fall in the bonds price that would occur if there were an equal-sized increase in the bonds yield the price-yield relationship is convex

15

10/16/2012

BOND PRICING THEOREMS

5 BOND PRICING THEOREMS

THEOREM 5
the percentage change in a bonds price owing to a change in its yield will be smaller if the coupon rate is higher

BOND THEOREMS IN BRIEF

Bond price move inversely to changes in interest rates. Longer maturity makes a bond price more sensitive to interest rates. Price sensitivity increases with maturity at a decreasing rate. Lower coupon rates increase price sensitivity. A price increase caused by a yield decrease exceeds a price decrease caused by a similar yield increase.

16