Its all about cash flow

Kousik Guhathakurta
IIMK

Major learning outcomes:

The valuation which is the best process of
determining the fair value of a fixed financial
asset:
Single discount rate
Multiple discount rates

This process is also called pricing or valuing.

Only option-free bond valuation is presented in
this discussion

Valuation is the process of determining the fair value of a

financial asset. The process is also referred to as valuing or
pricing a financial asset.

The fundamental principle of financial asset valuation is that

its value is equal to the present value of its expected cash
flows. This principle applies regardless of the financial asset.
Thus, the valuation of a financial asset involves the following
three steps:
Step 1: Estimate the expected cash flows.
Step 2: Determine the appropriate interest rate or interest rates
that should be used to discount the cash flows.
Step 3: Calculate the present value of the expected cash flows
found in step 1 using the interest rate or interest rates determined
in step 2.

Cash flows for a bond become more complicated

when:

The issuer has the option to change the contractual due

date for the payment of the principal (callable, putable,
mortgage-backed, and asset-backed securities);
The coupon rate is reset periodically by a formula based
on come value or reference rates, prices, or exchange
rates (floating-rate securities); and
The investor has the choice to convert or exchange the
bond into common stock (convertible bonds).

Whether or not callable, putable, mortgagebacked, and asset-backed securities are

exercised early is determined by the
movement of interest rates;

If rates fall far enough, the issuer will refinance

If rates rise far enough, the borrower has an
incentive to refinance

Therefore, to properly estimate cash flows

it is necessary to incorporate into the
analysis how future changes in interest
rates and other factors might affect the
embedded options.

On-the-run Treasury yields are viewed as the

minimum interest rate an investor requires when
investing in a bond.

The risk premium or yield spread over the interest

rate on a Treasury security investors require reflects
the additional risks in a security that is not issued
by the U.S. government.

For a given discount rate, the present value of a

single cash flow received in the future is the
amount of money that must be invested today that
will generate that future value.

Interest rate and yield are used

interchangeably.

The minimum interest rate that a U.S.

investor should demand is the yield on a
Treasury security.

This is why the Treasury market is watched

closely.

For basic or traditional valuation, a single

interest rate is used to discount all cash
flows; however, the proper approach to
valuation uses multiple interest rates each
specific to a particular cash flow and time
period.

Compute the price of a 9% coupon Bond with

20,16 years to maturity and a par value of Rs
1000, if required yield is 12%,7%
Answer

20
20
16
16

yrs,
yrs,
yrs,
yrs,

12%
7%
12%
7%

774.30
1213.55
788.74
1190.69

When the price of a bond is computed using

the traditional present value approach, the
accrued interest is embodied in the price this
is referred to as the full or dirty price.

From the full price, the accrued interest must

be deducted to determine the price of the
bond, referred to as the clean price.

To compute the full price of a bond between

coupon payment dates it is necessary to determine
the fractional periods between the settlement date
and the next coupon payment date.
w periods = (days between settlement date and next coupon payment date)/days in coupon
period

Then the present value of the expected cash flow

to be received t periods from now using discount
rate I assuming the first coupon payment is w
periods from now:
Present value t = expected cash flow / (1+i)t-1+w
Acrued Interest = Coupon payment*(No of days from last coupon to settlement/ No of
coupon days)

This is called the Street method for

calculating the present value of a bond
purchased between payment dates.

Trade date/ transaction date

Settlement date
Issue date
Dated date/ interest accrue date
Coupon date

Actual /Actual (in period)

Actual(NL)/ 365
Actual /365( 366 in leap year)
Actual /360
30/360
30/365
30E/360

Purchased on July 17, coupon date: September 1

Actual/actual : 46/184
30/360: 44/180

A corporate bond with coupon rate of 10% maturing March 2012 is

purchased with a settlement date of July 17, 2006. What would be
the price of this bond if it is priced to yield 6.5%?
W=44/180= 0.24444 , n= 12, y= 3.25%
Period
Cashflow PVF
0.24444
5 0.992212545
1.24444
5 0.960980673
2.24444
5 0.930731887
3.24444
5 0.901435241
4.24444
5 0.873060766
5.24444
5 0.845579435
6.24444
5 0.818963133
7.24444
5 0.793184632
8.24444
5 0.768217562
9.24444
5 0.744036379
10.24444
5 0.720616348
11.24444
105 0.697933509
Total

PVofCF
4.96106272
4.80490336
4.65365943
4.50717621
4.36530383
4.22789717
4.09481566
3.96592316
3.84108781
3.7201819
3.60308174
73.2830184
120.03

As a bond gets closer to maturity, its value

changes:

Value decreases over time for bonds selling at a

premium.
Value increases over time for bonds selling at a
discount.
Value is unchanged if a bond is selling at par.

At maturity at bond is worth par value so

there is a pull to par value over time.

Exhibit 2 shows the time effect on a bonds

price based on the years remaining until
maturity.

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

16

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

17

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

18

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

19

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

20

Change in Yield due to change in credit quality

Change in Maturity as it moves (time path)
Change in yield due to change in comparable
bonds
Suppose , a money manager buys 20 yr , 9% bond
at 774.30 to yield 12%. Holding period -4 yrs;
yield on comparable 16 yr bonds at the time 8%
Total change in Price = 1089.37-744.30 = 315.07
Change due to time path=788.74-744.30= 14.44
Change due to fall in yield = 300.63

There are several ways that we can describe

the rate of return on a bond:

Coupon rate
Current yield
Yield to maturity
Modified yield to maturity
Yield to call
Realized Yield

The coupon rate of a bond is the stated

rate of interest that the bond will pay
The coupon rate does not normally
change during the life of the bond,
instead the price of the bond changes as
the coupon rate becomes more or less
attractive relative to other interest rates
The coupon rate determines the dollar
amount of the annual interest payment:
Annual Pmt Coupon Rate Face Value

The current yield is a measure of the current

income from owning the bond
It is calculated as:
Annual Pmt
CY
Face Value

The yield to maturity is the average annual

rate of return that a bondholder will earn
under the following assumptions:
The bond is held to maturity
The interest payments are reinvested at the YTM

The yield to maturity is the same as the

bonds internal rate of return (IRR)

The assumptions behind the calculation of the YTM

are often not met in practice
This is particularly true of the reinvestment
assumption
To more accurately calculate the yield, we can
change the assumed reinvestment rate to the
actual rate at which we expect to reinvest
The resulting yield measure is referred to as the
modified YTM, and is the same as the MIRR for the
bond

Most corporate bonds, and many older government

bonds, have provisions which allow them to be
called if interest rates should drop during the life
of the bond
Normally, if a bond is called, the bondholder is
paid a premium over the face value (known as the
call premium)
The YTC is calculated exactly the same as YTM,
except:
The call premium is added to the face value, and
The first call date is used instead of the maturity date

The realized yield is an ex-post measure of

the bonds returns
The realized yield is simply the average
annual rate of return that was actually earned
on the investment
If you know the future selling price,
reinvestment rate, and the holding period,
you can calculate an ex-ante realized yield
which can be used in place of the YTM (this
might be called the expected yield)

As an example of the calculation of the bond return

measures, consider the following:
You are considering the purchase of a 2-year bond
(semiannual interest payments) with a coupon rate of 8%
and a current price of Rs 964.54. The bond is callable in
one year at a premium of 3% over the face value. Assume
that interest payments will be reinvested at 9% per year,
and that the most recent interest payment occurred
immediately before you purchase the bond. Calculate the
various return measures.

Now, assume that the bond has matured (it was not
called). You purchased the bond for Rs 964.54 and
reinvested your interest payments at 9%. What was your
realized yield?

Timeline
if not called

Timeline
if called

-964.54

40

40

40

1,000
40

-964.54

40

1,030
40

The yields for the example bond are:

Current yield = 8.294%
YTM = 5% per period, or 10% per year
Modified YTM = 4.971% per period, or 9.943% per
year
YTC = 7.42% per period, or 14.84% per year
Realized Yield:
if called = 7.363% per period, or 14.725% per year
if not called = 4.971% per period, or 9.943% per year

YTM/YTC
The bond is held to maturity/call date
All coupon interest payments are re-invested at the
YTM/YTC
Re-investment risk
Bond
Coupon(%)
A
5
B
6
C
11
D
8

Maturity(yrs)
3
20
15
5

YTM(%)
9.0
8.6
9.2
8.0

Step 1

1 r n 1

Coupon interest plus interest on interest c

r

c= semi- annual coupon interest

r = semi-annual reinvestment rate
N= number of periods to maturity

Step2
Totalfutureamount
Pr iceofbond

1/ n

Step 3
(1+ semiannual total return)2 1
Example

7-year, 9% bond selling at par with RR 5%

RR 9%
20 yr, 7% bond selling at 816, RR 6%
RR 11%

If sold prior to maturity, expected price is to be

computed at the end of the target period.
Investor with 5 yr horizon considering 7 yr, 9% par bond.
Expected RR: 9.4%; Expected YTM after 5yrs: 11.2%
Investor with 3 yr horizon considering 20 yr, 8% $828.40
bond. Expected RR: 6%; Expected YTM after 5yrs: 7%

Consider a Portfolio manager who has the

following options
Buy a bond A, a 20-yr, 9% non-callable bond selling
at 109.896 per 100 of par. YTM is 8%. Assume that
his horizon is 3 yrs. He believes that the RR can
vary between 3% and 6.5% and yield at horizon can
vary from 5% to 12%
Holds bond B a 14-yr, 7.25% non-callable bond
selling at 94.553 per 100 of par. YTM is 7.9%.
Wants to Swap B with A

The traditional valuation methodology is to

discount every cash flow of a security by
the same interest rate (or discount rate),
thereby incorrectly viewing each security as
the same package of cash flows.

The arbitrage-free approach values a bond

as a package of cash flows, with each cash
flow viewed as a zero-coupon bond and
each cash flow discounted at its own
unique discount rate.

Traditional approach This is also called the

relative price approach.

A benchmark or similar investments discount

rate is used to value the bonds cash flows (i.e.
10-year Treasury bond).

The flaw is that it views each security as the same

package of cash flows and discounts all of them
by the same interest rate.

It will provide a close approximation, but not

necessarily the most accurate.

Arbitrage-free pricing approach Assumes

that no arbitrage profits are possible in the
pricing of the bond.

Each of the bonds cash flow (coupons and

principal) is priced separately and is discounted
at the same rate as the corresponding zerocoupon government bond.

Since each bonds cash flow is known with

certainty, the bond price today must be equal to
the sum of each of its cash flows discounted at
the corresponding or arbitrage is possible.

Arbitrage is the simultaneous buying and

selling of an asset at two different prices in
two different markets.

The arbitrageur buys low in one market and sells

for a higher price in another.
The fundamental principle of finance is the law of
one price.

If arbitrage is possible, it will be immediately

exploited by arbitrageurs.
If a synthetic asset can be created to replicate anther
asset, the two assets must be priced identically or
else arbitrage is possible.

The Treasury zero-coupon rates are called Treasury

spot rates.

The Treasury spot rates are used to discount the

cash flows in the arbitrage-free valuation approach.

To value a security with credit risk, it is necessary

to determine a term structure of credit rates.

Adding a credit spread for an issuer to the Treasury

spot rate curve gives the benchmark spot rate curve
used to value that issuers security.

Valuation models seek to provide the fair value of a

bond and accommodate securities with embedded
options.

By viewing a bond as a package of zerocoupon bonds (Exhibit 4), it is possible to

value the bond and the package of zerocoupon bonds.

If they are priced differently, arbitrage profits

would be possible.

To implement the arbitrage-free approach,

it is necessary to determine the interest rate
that each zero-coupon for each maturity.

The Treasury spot rate is used to discount a

default-free cash flow with the same maturity.
The value of a bond based on spot rates if called
the arbitrage-free value.