Chapter 10

Chapter 10
Bond Valuation
1 Beninga et al. (2012) & Nguyen (BFN3174)
Learning Outcomes
What is a bond?
Features of a bond
Valuation of a bond
Bond duration
The use of bond duration
Terms structure of interest rates

Whats a Bond?
Bond Terminology
Face value
Coupon rate
Maturity date
Payments:
Annual
Semiannual
Quarterly
Covenants
Boilerplate

Corporate Bonds
Structurallylooks like government bonds
Issue date
Maturity date
Interest paymentsmost often semiannually
Computing the Yield to Maturity (YTM)
YTM is essentially
just the effective
annual interest rate
(EAIR)

Reminder: EAIR is
the IRR properly
calculated

When the XYZ bond
was issued, it had a
YTM =7%
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A B C
Market price of bond 1,000.00
Date
Bond cash
flow
15-Dec-09 -1,000.00
15-Dec-10 70.00
15-Dec-11 70.00
15-Dec-12 70.00
15-Dec-13 70.00
15-Dec-14 70.00
15-Dec-15 70.00
15-Dec-16 1,070.00
YTM of bond 7.00% <-- =IRR(B5:B12)
XYZ Bond: YIELD TO MATURITY
Complications in Computing Bond YTM
Uneven spacing of bond payments
Solution: Use Excel XIRR function
Semiannual payments of interest
Solution: XIRR again!
Accrued interest
Solution: Just understand whats going on
Complication Factor 1: Uneven Spacing of
Bond Payments
Example:
XYZ bond issued on 15 Dec 2009
What if you buy the XYZ bond on 15 May 2010
for $1,050?
Complication Factor 2: What if XYZ Bond has
Semiannual Payments?
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A B C
Market price of bond 1000.00
Date
ABC bond
cash flow
15-Dec-09 -1,000.00 <-- =-B2
15-J un-10 35.00
15-Dec-10 35.00
15-J un-11 35.00
15-Dec-11 35.00
15-J un-12 35.00
15-Dec-12 35.00
15-J un-13 35.00
15-Dec-13 35.00
15-J un-14 35.00
15-Dec-14 35.00
15-J un-15 35.00
15-Dec-15 35.00
15-J un-16 35.00
15-Dec-16 1,035.00
Semiannual IRR 3.50% <-- =IRR(B5:B19)
Annualized IRR
This is the YTM! 7.12% <-- =(1+B21)^2-1
YTM using
XIRR 7.12% <-- =XIRR(B5:B19,A5:A19)
YTM WITH SEMIANNUAL COUPON PAYMENTS
Semiannual payments:
Bond pays 7%
annually, 3.5% every
half year

Use IRR wisely or
XIRR to compute the
YTM of the bond.
Complication Factor 3: Accrued Interest
ProblemIn US the actual price paid for
bond:
Quoted bond price
Accrued interest (unpaid interest from
last interest date until sale date)
Accrued Interest: Example
15 Dec 2009
last
coupon
date
3 Apr 2010
bond
purchase
date
15 Dec 2011
next
coupon
date
Days
15-Dec-09
3-Apr-10 109 <-- =A19-A18
15-Dec-10 365 <-- =A20-A18
COMPUTING THE
ACCRUED INTEREST
109 days
365 days
$70 Coupon
for this period
109
*70 20.90
365
Accrued interest = =
Buy XYZ bond on 3 April 2010.
Last coupon date 15 Dec 2009
Next coupon date 15 Dec 2011

See accrued interest computation
to left.
YTM with Accrued Interest
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A B C D E
Bond purchase date 3-Apr-10
Previous coupon date 15-Dec-09 Number of days since last coupon 109 <-- =B2-B3
Next coupon date 15-Dec-10 Number of days between coupons 365 <-- =B4-B3
Coupon payment over the period 70.00
Quoted bond price 1050.00
Accrued interest 20.90 <-- =B5*D3/D4
Actual bond price paid 1070.90 <-- =B7+B8
Year
Bond
cash flow
3-Apr-10 -1,070.90
15-Dec-10 70.00
15-Dec-11 70.00
15-Dec-12 70.00
15-Dec-13 70.00
15-Dec-14 70.00
15-Dec-15 70.00
15-Dec-16 1,070.00
YTM of bond, using XIRR 6.06% <-- =XIRR(B12:B19,A12:A19)
YTM of bond, using Yield 6.06% <-- =YIELD(A12,A19,7%,105,100,1,3)
ACCRUED INTEREST AND YTM COMPUTATIONS
Note: Actual price paid
for bond is:

Quoted price +Accrued
interest =$1,050 +
20.90
US Treasury Bills
Short-term securities issued by US
government
Typical maturity: Less than a year
Bills are discounted: No explicit interest
Treasury bill issued
on 2 Nov 2010 with
maturity on
2 October 2011

Suppose price at
issue = 99. Then
YTM = 1.10%
Date Cash flow
2-Nov-10 -99
2-Oct-11 100
YTM 1.10% <-- =XIRR(B3:B4,A3:A4)
TREASURY BILL
COMPUTATION
US Treasury Bills (cont.)
Zero-coupon Bonds
Have only terminal payment (no coupons)
Treasury strips:
Each payment (coupon or return of
principal) of a Treasury security is traded
separately

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A B C D E F G H I J K L
Current date 12-J un-09
Maturity Price
Days till
maturity
Annual
yield
15-Aug-09 100.02 64 <-- =A5-$B$2 -0.1140% <-- =(100/B5)^(365/C5)-1
15-Nov-09 100.08 156 <-- =A6-$B$2 -0.1869%
15-Feb-10 99.86 248 0.2064%
15-Aug-11 98.26 794 0.8102%
15-May-12 96.72 1068 1.1463%
15-Aug-12 95.69 1160 1.3959%
15-Aug-12 94.87 1160 1.6709% <-- =(100/B11)^(365/C11)-1
15-Feb-13 94.38 1344 1.5832%
15-Feb-13 93.77 1344 1.7623%
15-Aug-13 92.95 1525 1.7652%
15-Nov-13 92.27 1617 1.8326%
15-Nov-13 91.02 1617 2.1466%
15-Feb-14 90.65 1709 2.1187%
15-Feb-14 90.85 1709 2.0706%
15-May-14 89.73 1798 2.2242%
15-Aug-14 88.53 1890 2.3807%
15-Nov-15 83.55 2347 2.8345%
15-Feb-16 82.13 2439 2.9900%
15-Nov-16 78.69 2713 3.2768%
15-May-17 76.28 2894 3.4739%
15-Feb-18 72.80 3170 3.7229%
15-Aug-18 71.27 3351 3.7580%
15-Nov-18 70.28 3443 3.8096%
15-Aug-19 67.09 3716 3.9983%
15-Feb-20 64.90 3900 4.1291%
15-May-20 63.91 3990 4.1805%
15-Aug-20 62.83 4082 4.2431%
15-Aug-20 62.87 4082 4.2372%
PRICES AND YIELDS OF U.S. TREASURY STRIPS
-1%
0%
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TREASURY STRIP YIELD CURVE
Zero-coupon Bonds (cont.)
Duration
Beninga et al. (2012) & Nguyen (BFN3174) 17
Duration of a bond measures the sensitivity of the price of a bond
to changes in the interest rate at which the bond is discounted.
D: duration of the bond
Ct: coupon payment at time t
r : interest rate
N: the number of payments made throughout the bonds life.
P: price of the bond.
Duration Example 1
Given the following information of two bonds:
Bond A has just been issued. Its face value is
$1,000, it bears the current market interest rate
of 7 percent, and it will mature in 10 years.
Coupon payment = 1000 * 7% = 70

Duration Example 1
Bond B was issued five years ago, when interest
rates were higher. This bond has $1,000 face value
and bears a 13 percent coupon rate. When issued,
this bond had a 15-year maturity. Since the current
market rate of interest rate is 7 percent, Bond Bs
market price is given by:
Annual Coupon payment = 1000 * 13% = $130
Remaining life of Bond B = 15 5 = 10 years.

Duration Example 1
Duration Example 1

Duration Example 1

The Use of Duration
Recall the formula for a bonds price:

The derivative of its price with respect to the current
interest rate is as follows:

Duration Example 1


Duration of a Portfolio
The duration of a portfolio is the
weighted average duration of the
assets in the portfolio.
Duration of a Portfolio
Term Structure of Interest Rate


Beninga et al. (2012) & Nguyen (BFN3174)
31



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