Bond Valuation

A bond is a......... ....... security that obligates the issuer to make specified interest and principal payments to the holder on specified dates. Bonds are sometimes called fixed income securities

Issuers Government state as well as central govt.s Corporates

The bond terminology Par value: Face amount; paid at maturity 1. Coupon interest rate: 2. Multiply by par value to get interest in rupee terms. Generally fixed. Maturity: Years until bond must be repaid as 3. time elapses this declines. Issue date: Date when bond was issued. 4. Stated interest rate.

Basis point defined A basis point (bp) is 1% of 0.01 or 0.0001. The difference between a rate of 5.00% and 5.01% is one basis point

Basic Valuation premise The (market) value of any investment asset is simply the present value of expected cash flows

... A ZCB's value In the case of a zero coupon bond the value of the bond is given as V = FV/(1+ k)n where FV is the price at which the bond will be redeemed k is the required rate of return n is the number of years to maturity

Bond Valuation contd.... CM C P (1 k ) (1 k ) 2 (1 k ) 3 C C .... (1 k ) n Where: P = bond price at time zero C = coupon payment M = maturity amount k = appropriate required return (discount rate) n = life of the bond

Inflation and returns The relationship between real and nominal returns is described by the Fisher Effect. Let: R = the nominal return r = the real return h = the inflation rate According to the Fisher Effect: 1 + R = (1 + r) x (1 + h) For example, the real return is 4.76%; the nominal return is 10%, and the inflation rate is (1 + R) = 1.10 (1 + r) x (1 + h) = 1.10 and h = 5%

Bond Valuation contd.... Assume a company's bonds have a Rs.1,000 face value The promised annual coupon is Rs.100 The bonds mature in 10 years The market's required return on similar bonds is 10%

Bond Valuation contd.... 1. Calculate the present value of the face value = Rs.1,000 x [1/1.1010 ] = Rs.1,000 x 0.3855 = Rs.385.50 2. Calculate the present value of the coupon payments = Rs.100 x [1 - (1/1.1010)]/.10 = Rs.100 x 6.1446 = Rs. 614.46 3. The value of each bond = Rs. 1,000 (barring rounding off errors)

Let's go a little deeper Suppose you purchase the G Sec described earlier and immediately thereafter expected inflation rose by 3%, causing k = 13%?

PV of annuity PV of principal Bond value

543.315 295.85 839.165

When the interest rate goes up, the bond price will always go down.

Contd... What would happen if inflation fell, and k declined to 7%? PV of annuity PV of principal Bond value 702.4 508.0 1210.4 prices will always go up. When interest rates go down, bond

Prices and Coupon Rates Price

Yield

Contd... Bond prices are inversely related to interest rates (or yields). A bond sells at par only if its coupon rate equals the required return (Coupon rate = required return). A bond sells at a premium if its coupon is above the required return. A bond sells at a discount if its coupon is below the required return.

Price Converges to Par at Maturity It is also important to note that a bond's price will approach par value as it approaches the maturity date, regardless of the interest rate and regardless of the coupon rate.

Pulled to par Bond price

Premium bond Par value Discount bond Maturity

Current Yield Coupon Interest Current yield = Current market Price Face Value = Rs.1000 Interest rate = 8% Market Price = 800 Current yield = 80/800 = 0.10 or 10%

YTM We have seen how to value a bond can we reverse the dynamics?? i.e., lets find out return on a bond given its price CM C P (1 y) (1 y) (1 y) 2 3 C C .... (1 y) n

This is the same equation we saw earlier when we solved for price. In this case, we know the market price but are solving for return.

YTM The yield to maturity measures the compound annual return to an investor and considers all bond cash flows. In other words it is the single rate that when used to discount a bond's Cash flows produces the bond's market price

YTM: an approximation

C = coupon P = current price

C (M P)/n 0.4M 0.6P M = maturity value n = no. of years

This formula was suggested by Gabriel A Hawawini and Ashok Vora, in an article published in the Journal of Finance.

Example Face Value = Rs.1000 Coupon interest = 9% Maturity = 8 years Current Market Price = 800/1200

After doing trial and error method, YTM is 13.02% 90 (1000 800)/8 0.4(1000) 0.6(800) = 115/880 = 13.07

Type of Bond

Coupon rate

Current yield

YTM

Premium Bond (bonds selling above par value) Discount Bonds

9 9

7.5 11.25

6 13

The Reinvestment Rate Assumption It is important to note that the computation of the YTM implicitly assumes that interest rates are reinvested at the YTM. In other words, if the bond pays a Rs. 100 coupon and the YTM is 8%, the calculation assumes that all of the Rs. 100 coupons are invested at that rate. If market interest rates fall, however, the investor may be forced to reinvest at something less than 8%, resulting a realized YTM which is less than promised. Of course, if rates rise, coupons may be reinvested at a higher rate resulting in a higher realized YTM.

Reinvestment rate... A 3-year 10% bond trades at Rs. 951.9634 implying a YTM of 12%. -951.9634 7.44 @12% for 1year 112 @12% for 2 years 125.44 1.4049 1 11.99% ~ 12% 1337.44 Return realized 13 951.9634 100 100 1100 133

If reinvestment rate = 10%

-951.9634

100

100 @10% for 1year

1100 1331 110

@10% for 2 years 121 1.3981 1 11.81% 1331 Return realized 13 951.9634

Malkiel's theorems Bond prices move inversely with interest rates 1. For a given bond the absolute rupee price increase caused by a 2. fall in yields will exceed the price decrease caused by an increase in yields of the same magnitude Bonds with longer maturity experience greater percentage 3. change for a given change in interest rates The price sensitivity of bonds increases with maturity but it 4. increases at a decreasing rate (maturity effect) Bonds with lower coupon rates experience more % changes for 5. a given change in interest rates (coupon effect)

Four bonds priced initially to yield 9% 1) 9% coupon, 5 years to maturity, initial price = 100 2) 9% coupon, 20 years to maturity, initial price = 100 3) 5% coupon, 5 years to maturity, initial price = 84.1746 4) 5 % coupon, 20 years to maturity initial price = 63.1968

Bond price volatility

Percentage price change for bonds with differe nt Change in yield from 9% to : 6.00 5 8.00 6 8.99 0 9.01 0 10.00 4 12.00 (-300.00) -11.04 -22.57 -11.89 -25.0 9 Note : The initial yield is 9% and the first two columns indicate the illusatrat ive new yields (1%) and the change in yield (bp), Columns (1) -(4) show the percentage change in bond price for different coupons and maturities (100.00) -3.86 -8.58 -4.13 -9.6 (1.00) -0.04 -0.09 -0.04 -0.1 (-1.00) 0.04 0.09 0.04 0.1 (-100.00) 4.06 9.90 4.35 11.2 Change (bp) (-300.00) coupon and maturity 1 2 3 4 9%, 5 year 9%, 20 year 5%, 5 year 5%, 20 year 12.80 34.67 13.73 39.9

Price change (volatility) is greater the lower the coupon rate Price change is greater the longer the term to maturity

Implications of Malkiel's theorems A bond buyer in order to receive the maximum price impact of an expected change in interest rates should purchase low coupon long maturity bonds If an increase in interest rates is expected an investor contemplating their purchase should consider those bonds with large coupons or short maturities or both

From Malkiel's theorems to ... Consider two bonds A 9.5% 8 yr bond and B 11% 9 yr bond Which one is more interest rate sensitive? To address such questions Malkiel's theorems may not be sufficient.

Duration Duration Combines the effects of differences in coupon rates and differences in maturity

Macaulay's duration n t.c n.M (1 y)t (1 y)n Duration t 1 P Where t = number of periods in the future C = cash flow to be delivered in t periods n= term-to-maturity & y = yield to maturity.

Duration Weighted sum of the number of periods in the future of each cash flow, (weighted by respective fraction of the PV of the bond as a whole). For a zero coupon bond, duration equals maturity since 100% of its present value is generated by the payment of the face value, at maturity.

Computation of duration

Duration contd.. Duration is shorter than maturity for all bonds except zero coupon bonds Duration of a zero-coupon bond is equal to its maturity

Understanding duration

What is the use of Duration? No Use

Trading Strategies Using Duration Longest-duration security provides the maximum price variation If you expect a decline in interest rates, increase the average duration of your bond portfolio to experience maximum price volatility If you expect an increase in interest rates, reduce the average duration to minimize your price decline Note that the duration of your portfolio is the market-valueweighted average of the duration of the individual bonds in the portfolio

Modified duration dp 1 1 Mac Dur 1 y dy p

Modified duration MD can be interpreted as the approximate percentage change in price for a 100bp change in yield

Modified duration (MD) DMacualey MD 1 y Direct measure of price sensitivity to interest rate changes Can be used to estimate percentage price volatility of a bond

dp MD dy P

Example Modified duration of the earlier bond:

4.1698 MD 1.10 If yields increase to 10.10%, how does the bond price change? The percentage price change of this bond is given by: = 3.7907 X 0.1 =0.37907 3.7907

What is the predicted change in rupee terms?

dp 1 . MD dy p dp MD * P * dy 3.7907 *100 * 0.1% 0.379079 New predicted price: 100 0.37909 = 99.62091 Actual dollar price (using PV equation):99.6219 Reasonable approximation!

finding the predicted price change Step 1: Find Macaulay duration of bond.

Step 2: Find modified duration of bond.

Step 3: Recall that when interest rates change, the change in a bond's price can be related to the change in yield according to the rule: dp MD dy P

Duration and Convexity Price

Pricing Error from convexity

Duration Yield

Convexity

The convexity is the measure of the curvature and is the second derivative of price with respect to yield (d2P/di2) divided by price Convexity is the percentage change in dP/dy for a given change in yield d 2P 2 dy Convexity measure P

Convexity

t t CF 2 n 1 y t 1 Convexity P(1 y ) 2 t

Convexity Adjustment

dP MD dy dy

1 convexity measure (dy) 2 2