Bonds and bond duration

Properties of a bond
1.
Bo and YTM are inversely related.
2.
All else equal, long term bonds are
more sensitive to interest rate changes
than short-term bonds.
3.
All else equal, low coupon bonds are
more sensitive to interest rate changes
then high coupon bonds.
Eg. 20 year 9% coupon bond
10 year 3% coupon bond
Price risk: bond prices inversely related to
the YTM of the bond.
RIRR : the return we can earn from
reinvesting our coupon payments is
positively related to the market rate of
interest (YTM).
Ex : What will be the price of a bond with10
years maturity, 8% CR and has MD of 7.32
years whose YTM has fallen to 6.45% from
7.25%.

1.
2.
3.

MD
ED
Portfolio Duration.
Advantages of duration

1.
It is more meaningful measure of the
length of a bond.
2.
It tells how much time required to
recover the initial investiment.
3.
It is a direct measure of sensitivity of
prices to the changes in YTM.
4.
It plays important role in immunization
strategies.
5.
It is used for both single and portfolio
of bonds investment strategies.
Properties of Duration
1.The duration of a zero coupon bond is the
same as its maturity.
2. For a given maturity, the bonds duration is
higher when its coupon rate is lower.
3. For a given coupon rate, a bonds duration
generally increases with maturity.

4.Other things being equal, the duration

of a coupon bond varies inversely with
its yield to maturity.
5. The duration of a level perpetuity is
(1+ yield) / yield

6. The duration of a level annuity

approximately is
1+ yield
Number of payments
=
Number of payments
yield
(1+ yield )
1

7. The duration of a coupon bond

approximately is
(1+ y )

T 1

1+ y ( 1+ y ) +T ( c y )

Where;

yis the bonds yield per payment period,

T is the number of payment periods,
and
C is the coupon rate per payment period.

Bond convexity
Properties of duration
1. All else equal, the higher the duration
(longer time to maturity or lower coupon
payment) the more error (convexity)
there will be.
2. All else equal, the bigger the change in
interest rates, the more error there will
be.
Duration and Immunisation
In addition to helping in estimate how
sensitive a bond is to interest rates,
duration can tell us an approximate.
Holding period where price risk and reinvestment rate risk offset. Holding a
bond to MD immunises us from
interest rate changes.

Eg : 10yr if held for 1 year: there is more

price risk and very less RIRR.
If held for 9 years : There more
RIRR and less price risk.
Then somewhere between 1 and 9 we
should hold the bond that is duration
years.
Eg: A 30 year bonds MD is 12 years the
YTM is 8.5% while this tells us about
price sensitivity, it also tells us that an
investor with a 12 year holding period
should expect to have the same total
proceeds if interest rates
Increase/Decrease. The extra interest
made from reinvesting the coupon
payments is almost exactly offset by the
lower selling price of the bond when
interest rates rise to 9.5% as opposed to
falling to 7.5% which is shown as follows.
Table showing the bond immunization
Year

When YTM
increases to

When YTM
increases to

9.5%
CP
1
2
3
4
5
6
7
8
9
10
11
12
12.
sale of
bond
TOTAL
CFs

70
70
70
70
70
70
70
70
70
70
70
70
788.22

7.5%
FV of at CP
9.5%
189.96 70
173.48 70
158.43 70
144.68 70
132.13 70
120.67 70
110.64 70
100.64 70
91.91 70
83.93 70
76.65 70
70.00 70
788.22 951.47

FV at
7.5%
155.09
144.27
134.21
124.84
116.13
108.03
100.43
93.48
86.96
80.89
75.25
70.00
951.47

2240.8
7

2241.1
3

PROBLEMS
1.
The following information is
available on a bond :
Face Value : Rs. 100
Coupon rate : 12 % payable annually
Years to maturity : 6
Current market price : Rs.110
What is the duration of the bond? Use
the appropriate formula for calculating
yield to maturity.

2.
An insurance company has an
obligation to pay Rs. 215,900 after 10
years. The market interest rate is 8% ,
so the present value of the bligation is
Rs. 100,000. The insurance companys
manager wants to fund the obligation

with a mix of six year zero coupon

bonds and perpetuities paying annual
coupons. In what proportion should he
buy these debt instruments?
3. A Rs. 100,000 par five year maturity
bond with a 9 percent coupon rate
(paid annually) currently sells at a
yield to maturity of 8 percent. A
portfolio manager wants to forecast
the total return on the bond over the
coming two years, as his horizon is two
years. He believes that two years from
now, three- year maturity bond will sell
at a yield of 7 percent and the coupon
income can be reinvested in short
-term securities over the next two
years at a rate of 6 percent. What is
the expected annualized rate of return
over the two year period?
3. Consider a company having payment
liabilities of Rs. 1 million, Rs. 2 million
and Rs. 1 million over the next 1, 2

and 3 years respectively. If the yield is

expected to remain at 10 % and we
have only 10% perpetuity and 1 year
zero coupon bonds available, how the
treasury manager would immunize his
liability using these bonds.

4. The following bonds are considered

for investment by a pf manager. His
aim is to immunize the liability due in
6 years.All bonds have face value of
Rs.1000.
Bond

Maturity in Coupon % Duration in

years
years
A
10
8
7.35
B
8
9
6.15
C
5
7
4.30
If the pf manager wishes to invest 50%
in A, what is the percentage of total
amount that can be invested in the
other two bonds to immunize the pf.

CAPM
1.
The market portfolio is assumed to
be composed of four securities. Their
covariances with the market and their
proportions are shown below
Security
Covariance with
market
Proportion
A

242

0.20

360

0.30

155

0.20

210

0.30

Given this data, calculate the market

portfolios deviation.

2.
Based on the risk and return
relationships of the CAPM, supply
values for the seven missing data in
the following table.
Security Expected Beta

Standard

no

return %
A
B
C
D
E

_______
19.0
15.0
7.0
16.6

0.8
1.5
_____
0
_____

Deviation
%
______
______
12
8
15

ma
ris
81
36
0
___
___

3.
You are given the following
information on two securities, the
market portfolio and the risk free rate :
Expected
Return
Security
1
Security
2
Market
Portfolio
Risk Free
Rate

15.5 %

Correlation Stand
with market Devia
portfolio
0.90
20.0%

9.2

0.80

9.0

12.0

1.00

12.0

5.0

0.00

0.0

a. Draw the SML

b. What are the betas of two

securities?
c.Plot the two securities on the
SML.

FINANCIAL MANAGEMENT
1.
Calculate the cost of debt ( kd )in
the following cases :
Case (a)
A Ltd issued 12 %
Debentures of Rs. 100 each at par.
Brokerage2 % of issue price.Corporate
tax rate 30 %.

Case (b)B Ltd issued 12 % Debentures

of Rs. 100 each at 5 % discount and
redeemable after 5 years at 5 %
premium. Brokerage 2%. Corporate tax
rate 30 %.
Case (c ) C Ltd issued Rs. 100 lakhs,
12 % Debentures of Rs. 100 each at
par and redeemable at par in five
equal annual installments beginning
with the end of year 1. Floatation cost
10 %, Corporate tax rate 30 %.
Case (d)
D Ltd issued Rs. 100
lakhs, 12 % Debentures of Rs. 100
each at par and redeemable at par in
five equated annual installments
beginning with the end of year 1.
Floatation cost 10 %, Corporate tax
rate 30 %.
Case (e) E Ltd took 12 % Term Loan
ofRs.100 lakhs from a Bank. Corporate
tax rate 30 %, Brokerage 2%.

2.
Calculate the Cost of Preference
Share (k p) in the following cases. :
Case (a) P Ltd issued Preference
Shares of Rs.100 each at
par.Brokerage2 % of issue price.
Corporate tax rate 30 %, Dividend tax
rate 20%
Case (b) Q Ltd issued Preference
Shares of Rs.100 each at 5 % discount
and redeemable after 5 years at 5 %
premium. Brokerage 2%. Corporate tax
rate 30 %, Dividend tax rate 20%
Case ( c ) R Ltd issued Rs. 100 lakhs,
12 % Preference Shares of Rs. 100
each at par and redeemable at par in
five equal annual installments
beginning with the end of year 1.
Floatation cost 10 %, Corporate tax
rate 30 %, Dividend tax rate 20%
Case (d) S Ltd issued Rs. 100 lakhs,
12 % Preference Shares of Rs. 100
each at par and redeemable at par in

five equated annual installments

beginning with the end of year 1.
Floatation cost 10 %, Corporate tax
rate 30 %, Dividend tax rate 20%.
3.
The Equity dividend per share
(DPS) over the last five years are
given below :
Year
1
2
3
DPS
2
2.4
2.88
(Rs.)
Calculate the growth rate.

4
3.46

4.
Tulsian (1) Ltd has the following
Capital Structure as per its Balance
Sheet as at 31st March, 2009 :
Rs. In
lakhs
Equity Share Capital (fully paid shares
of Rs .10 each)
8
18 % Preference Share Capital (fully
paid shares of Rs .100 each)
6
Retained Earnings
2

5
4.15

12.5 % Debentures (fully paid of Rs .

100 each)
16
12% Term Loan
8
___
40
___
Additional Information :
(a) Currently Quoted Prices in the
stock exchange :
Equity Shares @ Rs. 64.25,
Preference Shares @ Rs.90 ,
Debentures @ Rs. 95.
(b) For the last year, the Company
had paid equity dividend of Rs. 8 per
share which is expected to grow @
5% p.a forever.
(c) The Corporate Tax Rate is 30%
Calculate Weighted Average Cost of
capital using (a) Book Value Weights
(b) Market Value Weights.

5.
Show the effect of financial
leverage on EPS by considering the
following two financial plans if EBIT is
(a) Rs. 2,00,000 (b) Rs.1,00,000.
Total Funds Required - Rs.
10,00,000
Financial Plan A
- 100 %
Equity Shares of Rs. 10 each
Financial Plan B - 50 %
Equity Shares of Rs. 10 each,
and
50% 15% Debt
Tax Rate
- 40%
6.
Tulsian (6) Ltd. provides you the
following information :
Operating Leverage2, Combined
Leverage 5, Profit / Volume Ratio 40%,
Tax Rate 40%, Earnings After Tax Rs.
7.20 lakhs.
(a) Calculate the percentage drop in
Sales to make EBIT Zero.
(b) Calculate the percentage drop in
EBIT to make EPS Zero.
(c) Calculate the percentage drop in
Sales to make EPS Zero.

(d) At what Sales level, the EBIT will be

Zero?
(e) At what Sales level, the EBT will be
Zero?
(f) At what Sales level , the EPS will be
Zero?
7.
Determine the working capital
requirements from the following
particulars :
Annual Budget for
Raw Materials
Supplies and
Components
Manpower Expenses
Factory Expenses
(including depreciation
Rs.10 lakhs)
Administration
Expenses
Sales

Amount (Rs. In lakh)

720
240
480
130

180
2380

You are given the following additional

information :

I. Stock Levels Planned : Raw

Materials, 30 days; supplies
and components, 90 days
II. 50 % of the sales is for cash; for
the remaining 20 days credit is
normal.
III. Finished goods are held in stock
for a period of 7 days before
they are released for sale and
are valued at factory cost.
IV. Goods remain in process for 5
days. Materials and
components are supplied in the
beginning and expenses are
incurred evenly.
V. The company enjoys 30 days
credit facilities on 20 % of the
purchases.
VI. Cash and bank balances had
been planned to be kept at the
rate of half months budgeted
expenses ( Assume 360 days in
an year)
8.
Suppose you are the financial
director of Tulsian Ltd. The company

proposes to produce 6,00,000 units of

its product in the next year
commencing on on 1st April 20X8. The
estimated cost of the product is as
follows :
Item
Raw Material

Cost per Unit (Rs)

10.00