Definitions
Yield Curve
Bond Valuation
The term structure
C1 C2 C3 C4 C5 Ct R
0 1 2 3 4 5 t
As the cash flows on a fixed coupon paying bond are fixed in time, the
market price (present value) of such an instrument varies according to the
interest rate environment.
Types of Bonds
The interest payment on bonds is referred to as `coupon’ and is fixed on the face
value of the bond at the time of issue. Coupon payments are semi-annual usually
(though you should assume one annual payment unless otherwise stated in this
course.)
The most common type of bonds pay fixed interest and such bonds are called
straights or vanillas.coupon
Some bonds do not pay any interest at all , and such bonds are called zero coupon
bonds. Zero coupon bonds sell at a deep discount to their par values because all the
benefit from holding the bond is realised at maturity.
Some Bonds link their coupons to market interest rates and such bonds are called
floating rate notes
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Some bonds link their interest payment to the retail price index and such bonds are
called index linked bonds. The return on Index linked bonds is closer to `real interest
rates.’
Bonds which allow the holder to exercise an option to convert into equity are called
convertible bonds.
Bonds redeemable at the option of the issuer are `callable’ while bonds redeemable at
the option of the holder are `puttable.’
Strips are securities which result from breaking down a security into various
constituents which are sold off seperately. The usual way in which this is done is to
sell off each future coupon payment and the redemption amount for its present value.
Risks
The holder of a bond has default risk; ie the risk that the issuer will not honour
payments on the bond. It is also called the credit risk.
The two main credit rating agencies are Moody’s and Standard and Poor’s.
The annexure is a typical extract.
`non-investment grade’: < Ba , Moody’s or < BB S&P Bonds with lower credit
ratings have a higher default risk and risk premium.
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Definitions of various yields terms
The Spot rate refers to the yield (IRR) of a `pure discount’ or zero coupon bond
of that maturity.
R
0 1 2 3 4 5 6
P 6 year zero
P = R / (1+ st) t
ie st = t √ ( R/P) - 1
where
st = spot yield (rate) for period `t’
P = the Market Value of the Bond
R = the redemption amount on the bond (amount at maturity)
The yield curve is a plot of the spot yields of zero coupon bonds of different
maturity.
In general, a Bond makes regular payments of interest (coupon) to the holder over a
period of time.
R
C1 C2 C3 C4 C5 Ct
0 1 2 3 4 5 t
The Market price of a bond is the present value of various payments made by the
bond and is arrived at by discounting the various payments on the bond by the
related spot rate.
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Redemption yield (also called the `yield to maturity’ or `ytm’ or the `gry’
gross redemption yield) of a bond is the IRR on the bond.
The Current Yield or Flat yield of a bond is simply its interest payment divided by
its market price.
CY = Ct / P
The Forward Rate of interest for the period t+1 is the one period
Investment rate between the end of period `t’ and end of period `t+1’.
Note alternatively that that the one period forward rate on a bond can be calculated
from the spot yield of two adjacent periods:
( 1 + S t) t
ie t-1 Ft = ---------------- - 1
( 1 + S t -1) t-1
Yield curves
The spot yield curve plots the spot yields (or zero coupon yields) against term to
maturity. The spot yield curve is also called the Term structure of interest rates.
The ytm curve is a plot of the ytms of bonds of the same maturity over time. It is
usually obtained by regression. ( You will notice in the tutorial how bonds of the same
maturity but different coupons have slightly different ytms based on their cash flows.)
Finally, the forward yield curve plots one period forward rates against term to
maturity.
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Valuing Bonds.
Q A company has issued bonds redeemable at the end of three years from now,
with a coupon of 6.0 % payable annually and redeemable at par. (The par value of a
bond is £ 100 unless mentioned otherwise.). The one year, two year and three year
spot rates are 6%, 8% and 10% respectively.
Answer:
(i) The market value of the bond is the present value of all its payments:
Total £ 90.44
Locate the two rates between which the NPV changes sign and interpolate.
If you have an irredeemable bond with a 6.0% coupon, and the ytm is 9.823% what
will be its value?
The term structure of interest rates shows the relationship between short term
and long term spot rates.
(1+ S 2 ) 2 = ( 1+ S1 )( 1+ 1 F 2 ) ;
In general:
This implies that if a contract is made to roll over one period investments, it is the
same as if an investment had been made for the entire period: ie there are no excess
profits to be made by following either strategy: ` perfect substitutability’. The theory
also states that forward rates are the best indicators of expected future
spot rates.
The Liquidity preference hypothesis states that investors have a preference for
liquidity and therefore they will prefer short term investments as compared to longer
term investments. Therefore they are prepared to accept lower rates of interest for the
short term. Conversely, borrowers have to pay a premium for longer term investors.
Here then a premium term, depending upon the maturity, has to be incorporated to
equate the `t’ period spot yield with the yield constructed from one period forward
rates.
Ie
where `Tn’ is a premium term which increases with the term to maturity.
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The Market Segmentation or preferred habitat theory states that the market is
segmented by different participants who have a preference for different maturities:
banks at the short end and pension funds at the long end. Supply and demand
conditions thus determine the shape of the term structure. This theory explains a
`hump’ noticed often in the yield curve, as there is often not much 09demand for n
medium term maturities.
The effects of inflation could also be kept in mind. A rising yield curve thus implies
higher expectations of inflation in the future (also called the Fisher effect).
Empirical evidence favours the former two theories: the expectations hypothesis
remains the basis of determining what interest rates could be expected to be
while liquidity premiums have been noticed from time to time.
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