S2: Bond Pricing Background Reading 1

The Pricing and Analysis of Commonwealth Government Securities

Objectives: study the pricing of Commonwealth government securities (CGS)

Learning Outcomes:
- understand the time line of cash flows when and how much?
- identify and compute the inputs required to price a bond
transaction/trade/valuation date (VD)
coupon rate (C)
maturity month / year
yield to maturity (YTM)
- understand the cash flow entitlements when investors do not hold the bond to maturity
- understand the two sources of return from bond investments



S2: Bond Pricing Background Reading 2
CGSs Source Data

A sample of CGS data extracted from the Australian Financial Review (AFR) on Tue, 09/02/10
Wholesale Market - Indicative mid-rates of selected Commonwealth Government Securities.
Coupon Maturity Yield % p.a. 8/2
Fixed Coupon Bonds:
...
5.25% Mar 2019 5.410
4.50% Apr 2020 5.480
5.75% May 2021 5.530

- Each row shows a separate CGS series traded in the secondary market.
- A CGS is described by its (i) coupon rate, and (ii) maturity month and year.
- The Treasury sets the coupon rate when the bond is first issued. This rate remains fixed over the life of the
bond and is the annual amount of coupon interest expressed as a percentage of the bonds face value (FV)
of $100.
- The Treasury also sets the maturity date (MD) when the bond is first issued. For the purpose of bond pricing,
the maturity date falls on the 15
th
of the maturity month and determines the timing of the bonds cash flows.
- The govt pays (i) coupon interests semi-annually on the 15
th
of every coupon payment month until the bond
matures and (ii) the FV on the maturity date.
- If the 15
th
of a coupon payment or the maturity month falls on a public holiday or weekend, the
Commonwealth will pay the promised amount on the following working day.
- The market sets the yield to maturity, an annualised discount rate used to compute the price of a bond.

Concept Question (CQ) 2-1: Explain the difference in coupon rates across the CGSs.
CQ 2-2: For the 5.75% May 2021 CGS, (i) When does it mature? (ii) Identify the two coupon payment dates in
2015 for the purpose of bond pricing? (iii) What is the amount of each coupon interest?
S2: Bond Pricing Background Reading 3
CGSs Pricing Conventions

- The market sets the YTM to three decimals with a minimum tick size of half a basis point.
- The market reports the settlement price to three decimals per $100 face value, e.g., $100.123 (from
100.12251233...)
- The settlement amount is rounded to the nearest cent, e.g., $1001.23, 100,122.51, ....
- The minimum trade sizes in the primary and secondary markets are per $100,000 and $1,000 face value,
respectively.
- At the time of writing (of the textbook), settlement in the primary market is based on T+2, i.e., the successful
bidder pays the contract value and acquire ownership of the bond 2 working days after the tender. I use this
convention for all computations. For example, if the tender is announced, or a trade occurs, on Mon, 25 July,
then the settlement date is Wed, 27 July when money and ownership change hand. (Note that the settlement
convention has since been changed to T+3. For the sake of this subject, I will continue using T+2.)
- A bond is ex-interest if there are 7 days or less from settlement to the next coupon payment date (NCPD).
Thus the 5.75% May 2021 CGS is ex-interest when the settlement date falls on the 8
th
(and up to the 15
th
) of
May or Nov.
- A bond is cum-interest if it is settled outside of the ex-interest period. Thus the 5.75% May 2021 CGS is
cum-interest from June through Oct, from Dec through April, when the settlement date falls between the
1st

and the
7th
, or between the 1
6th
to the end of May and Nov.
- For ex-(cum-)interest bonds, the coupon interest on the NCPD is excluded (included) from the price.

CQ 2-4: For the 4.5% Apr 2020 CGS, (i) define the cum- and ex-interest periods in 2010. (ii) Is the bond cum-
or ex-interest if the settlement date falls on (a) Mon, 10/05/2010, (b) Wed, 28/07/2010?
S2: Bond Pricing Background Reading 4
Pricing of CGSs (i) when settlement falls on a coupon payment date

Lets refer to the 5.75% May 2021 CGS. Assume that the YTM is 5.530% on Thu, 11/11/10 and the settlement
date (SD) falls on Mon, 15/11/10, which is also a coupon payment date. Compute the settlement price on
11/11/10.

The closest coupon payment date relative to the SD is 15/11/10. This means 15/11/10 is the next coupon
payment date (NCPD). Since there are 0 days between the SD and the NCPD, the bond is ex-interest and no
coupon interest should be placed on the timeline of promised cash flows on 15/11/10 shown below:

$2.875 $2.875 $2.875 . $2.875 $2.875 $2.875 + $100

15/11/10 15/05/11 15/11/11 15/05/12 . 15/05/20 15/11/20 15/05/21

SD = NCPD = 15/11/10

How many 6-month periods (t) are there between the SD / NCPD and the maturity date (MD)?
t =
What is the discount rate (r)?
r =
How much are you willing to pay for the promised cash flows? In other words, what is the settlement price (P
0
)?
P
0
= 2.875 PVA(r%, t) + 100 PVF(r%, t)
=
( )
( )
t
t
r
r
r
+
+
+

1
1
100
1 1
875 . 2
= $101.735
In summary, the settlement price is computed on 11/11/10 given the yield observed or agreed between the two
parties to the trade. The parties will then exchange ownership and money on the settlement date on 15/11/10.
S2: Bond Pricing Background Reading 5
Pricing of CGSs (ii) when settlement is within 7 days before a coupon payment date
Lets use the 5.75% May 2021 CGS again, but now we assume that the YTM is 5.530% on Mon, 08/11/10 and
the settlement date falls on Wed, 10/11/10. Compute the settlement price on 08/11/10.

Now the bond has 5 days from the SD on 10/11/10 to the NCPD on 15/11/10. Thus the bond is ex-interest with
respect to the NCPD on 15/11/10 and has the following timeline of promised cash flows:

$2.875 $2.875 $2.875 . $2.875 $2.875 $2.875 + $100

15/05/10 15/11/10 15/05/11 15/11/11 15/05/12 . 15/05/20 15/11/20 15/05/21

next coupon payment date
settlement date on 10/11/10
previous coupon payment date

We have just computed and know that the present value of the cash flows that are beyond the NCPD on the
NCPD 15/11/10. Lets call the amount P for the time being.
P =
( )
( )
21
21
02765 . 0 1
1
100
02765 . 0
02765 . 0 1 1
875 . 2
+
+
+

= 101.735
How much are you willing to pay for the amount 5 days earlier on 10/11/10?
P
0
=
( )
( )
( )
( ) 184
5
21
21
02765 . 0 1
02765 . 0 1
1
100
02765 . 0
02765 . 0 1 1
875 . 2
1
'
+
+
+
+

=
+

f
r
P
= $101.659

In summary, the settlement price is computed on 08/11/10 using the yield observed or agreed between the two
parties to the trade. The parties will then exchange ownership and money on the settlement date on 10/11/10.
S2: Bond Pricing Background Reading 6
Pricing of CGSs (iii) when settlement is outside of the ex-interest period
Lets use the 5.75% May 2021 CGS again, but now we assume that the YTM is 5.530% on Mon, 26/07/10 and
the settlement date falls on Wed, 28/07/10. Compute the settlement price on 26/07/10.

Now the bond has 110 days from the SD on 28/07/10 to the NCPD on 15/11/10. Thus the bond is cum-interest
with respect to the NCPD on 15/11/10 and comes with the following time line of promised cash flows:

Interest on the NCPD is now included
cash flows beyond the next coupon payment date

P
0
$2.875 $2.875 $2.875 $2.875 . $2.875 $2.875 $2.875 + $100

15/05/10 15/11/10 15/05/11 15/11/11 15/05/12 . 15/05/20 15/11/20 15/05/21

next coupon payment date (NCPD)
settlement date on 28/07/10
previous coupon payment date (PCPD)

Similarly, we first compute P, the present value of the cash flows beyond the NCPD on the NCPD 15/11/10:
P =
( )
( )
21
21
02765 . 0 1
1
100
02765 . 0
02765 . 0 1 1
875 . 2
+
+
+

= 101.735
In this case, we also include the interest on the NCPD before discounting the sum back by 110 days?
P
0
=
( )
( )
( )
( ) 184
110
21
21
02765 . 0 1
02765 . 0 1
1
100
02765 . 0
02765 . 0 1 1
875 . 2 875 . 2
1
'
+
+
+
+
+
=
+
+

f
r
P CPP
= $102.918

In summary, the settlement price is computed on 26/07/10 using the yield observed or agreed between the two
parties to the trade. The parties will then exchange ownership and money on the settlement date on 28/07/10.
S2: Bond Pricing Background Reading 7
YTM and its Components

In the context of bond pricing, YTM is the annualised discount rate that equates the present value of the cash
flows of a bond to its price on the assumption that the bond is held to maturity.

In the context of return, YTM observed at any point in time represents the return required by the market at that
point in time. In equilibrium, YTM should also represent the average return expected by the investors over the
life of the bond.

From the time line of cash flows, YTM has 2 components:
- current yield: the annual amount of coupon interest expressed as a percentage of the settlement price; and
- capital gain/loss, the difference between the face value and the settlement price.

Consider the 5.75% May 2021 CGS. On Mon, 26/07/2010, given a YTM of 5.530% and the settlement price of
$102.918, the current yield is
5.75/102.918 = 5.5587% > YTM or 5.530%.

An investor who planned to hold the bond to maturity would expect a capital loss of
100-102.918 = -$2.918.

If a bond is not held to maturity, the capital gain/loss component is defined as the difference between the selling
price and the purchasing price.
S2: Bond Pricing Background Reading 8
The Relationship between Bond Price and YTM (for private study)

Consider the 5.75% May 2021 CGS. On Thu, 11/11/10, the bond has exactly 21 periods remaining to maturity.
A hypothetical series of YTM ranging from 2% to 18% is used to generate a corresponding bond price series.

YTM P
0



2.0% 135.36
4.0% 114.88
5.75% 100.00
6.0% 98.07
8.0% 84.22
10.0% 72.76
12.0% 63.24
14.0% 55.30
16.0% 48.66
18.0% 43.09


- Other things being equal, the price of a bond varies inversely (but not linearly) with the level of YTM.
- Bonds are less (price) sensitive to changes in YTM at higher levels of interest rates.
- When the bond is paying
i) a higher amount of interest than the market rate, i.e., C > YTM, it commands a premium.
ii) the same rate of interest as the market, i.e., C = YTM, it is at par.
iii) less interest than the market rate, i.e., C < YTM, it is priced at a discount.
S2: Bond Pricing Background Reading 9
Tracking the Passage of Bond Price over Time
Holding YTM constant at 5.530%, we observe the following price path for the 5.75% May 2021 CGS:
Valuation Date Settlement Date Cum / Ex Interest Settlement Price Price Change
Tue, 02/11/2010 04/11/10 Cum 104.439 0.015
Wed, 03/11/2010 05/11/10 Cum 104.455 0.015
Thu, 04/11/2010 08/11/10 Ex 101.629 -2.826
Fri, 05/11/2010 09/11/10 Ex 101.664 0.015
Mon, 08/11/2010 10/11/10 Ex 101.659 0.015
Tue, 09/11/2010 11/11/10 Ex 101.674 0.015

How can we explain the abrupt fall in price when the bond becomes ex-interest despite a zero change in YTM?

When the bond is cum interest prior to Thu, 4/11/2010,
( )
f
r
CPP P
P
+
+
'
=
1
0
. However, when it becomes ex interest
on Thur, 4/11/2010,
( )
f
r
P
P
+
'
=
1
0
. Since the 2 equations refer to the same P and the values for f differ only
marginally, the abrupt price fall is due mainly to the
- market convention of an ex-interest period during which
- the coupon interest on the NCPD is excluded from the price of the bond.

CQ 2-7: Do you think that bonds are overpriced in the cum interest period? In other words, are investors better
off buying bonds during the ex interest period? $CPP (who will get it?)
cum-int:SD = 16/05/10 - 07/11/10 ex-int: SD = 08/11/10 - 15/11/10
15/05/10 08/11/10 15/11/10
PCPD cut-off NCPD
S2: Bond Pricing Background Reading 10
Computing the Capital / Quoted Price of a CGS

While we pay/receive the settlement price P
0
for buying/selling a bond, the market quotes a different price known
as the capital price, P
adj
, to reflect the theoretical interest entitlement over the fractional period from settlement to
the NCPD.
( )
f
r
CPP P
P
+
+
'
=
1
0
, ( ) f CPP P P
adj
= 1
0
if the bond is cum interest, and
( )
f
r
P
P
+
'
=
1
0
, f CPP P P
adj
+ =
0
if the bond is ex interest.

(1-f) f
P
0
$2.875 $2.875 $2.875 $2.875 . $2.875 $2.875 $2.875 + $100

15/05/10 15/11/10 15/05/11 15/11/11 15/05/12 . 15/05/20 15/11/20 15/05/21

To illustrate, lets continue with the 5.75% May 2021 CGS. On
- Mon, 26/7/2010, P
adj
= $102.918 2.875(1 - 110/184) = $101.762
As there are only 110 days or f six-month periods from settlement to the NCPD, P
0
should in theory include only
a portion of coupon interest (CPP * f) rather than the entire amount (CPP * 1). Hence, we need to remove
CPP*(1-f) from P
0
to reflect the excessive interests accrued from the PCPD to settlement.

- Mon, 8/11/2010, P
adj
= $101.659 + 2.875(5/184) = $101.737
As there are 5 days or f 6-month periods from settlement to the NCPD, P
0
should in theory include a portion of
coupon interest (CPP * f) rather than nothing (CPP * 0). Hence, we need to add (CPP * f) to P
0
to reflect the
omitted interests accrued from settlement to the NCPD.

S2: Bond Pricing Background Reading 11
Rationale for the Market Practice of Accrued Interest Adjustment

Lets compare the passage of settlement and quoted prices over time on the assumption that the YTM of 5.75%
May 2021 CGS is held constant at 5.530%:

Valuation Date
Settlement
Date
Cum / Ex
Interest
Settlement
Price
Settlement
Price Change
Quoted Price
Quoted Price
Change
Tue, 02/11/2010 04/11/10 Cum 104.439 0.015 101.736 0.000
Wed, 03/11/2010 05/11/10 Cum 104.455 0.015 101.736 0.000
Thu, 04/11/2010 08/11/10 Ex 101.629 -2.826 101.739 0.003
Fri, 05/11/2010 09/11/10 Ex 101.664 0.015 101.738 -0.001
Mon, 08/11/2010 10/11/10 Ex 101.659 0.015 101.737 -0.001
Tue, 09/11/2010 11/11/10 Ex 101.674 0.015 101.737 -0.001


By holding YTM constant, the daily changes in the quoted price are due entirely to the change in the time
remaining to maturity and no abrupt fluctuation is observed.

This market practice of quoting the adjusted price is in place to
- ensure that any change in the price of a bond is driven by the change in yields and times to maturity rather
than the market convention of having an ex-interest period and
- avoid any confusion on the value of a bond when it becomes ex-interest.

S2: Bond Pricing Background Reading 12
The Cash Flows to Bond Traders who DO NOT Hold the Bond to Maturity (if time permits)

Assume that the YTM of the 5.75% May 2021 CGS remains unchanged at 5.530%.
Valuation Date Settlement Date Cum / Ex Interest Settlement Price Quoted Price
Mon, 26/07/2010 28/07/2010 Cum $102.918 $101.762

Wed, 03/11/2010 05/11/2010 Cum 104.455 101.736
Thu, 04/11/2010 08/11/2010 Ex 101.629 101.739

Suppose that a trade was executed on Mon, 26/07/2010 at a YTM of 5.530%, the investor who
purchased the bond would transfer the settlement price amounting to $102.918 plus any
brokerage to the broker two working days later on Wed, 28/07/2010.

If the investor subsequently sold the bond on Wed, 03/11/2010, the investor would receive the
settlement price amounting to $104.455 less any brokerage from the broker two working days later
on Fri, 05/11/2010, i.e.,
Pay 102.918 get 104.455
cum-int ex-int
15/05/10 08/11/10 15/11/10
PCPD cut-off NCPD
28/07/10 05/11/10

CQ 2-8: If the investor sold the bond a day later on Thu, 04/11/2010 at the same YTM of 5.530% instead, what
/ how much / when would s/he get?

cum-int ex-int
15/05/10 08/11/10 15/11/10
PCPD cut-off NCPD
28/07/10 08/11/10
S2: Bond Pricing Background Reading 13
Whats next?
- Study this lecture and the prescribed reading.
- Redo all the worked examples and learn all the market terminologies and conventions in bond pricing.
- Attempt the adaptive tutorial to compute the price a bond when the corresponding settlement date
i) falls on a coupon payment date
ii) is no more than 7 days before a coupon payment date
iii) is more than 7 days before a coupon payment date
- On the day of your first tutorial in week 2, look up the YTM of the 4.5% Apr 2020 CGS from the Reserve Bank
web site or the Australian Financial Review. Price the 4.5% Apr 2020 CGS on the basis of T+2.
- Attempt the tutorial questions to extend and apply knowledge in bond pricing, e.g.,
i) That the longer is the time to maturity, the more sensitive is the value of the bond to interest rate changes
ii) That the lower is the coupon rate, the more sensitive is the value of the bond to interest rate changes
iii) That the lower is the level of interest rates, the more sensitive is the value of the bond to interest rate
changes
- Dont forget to bring the answers to the tutorial for discussion and correction.
S2: Bond Pricing Background Reading 14
Supplement for Private Study - Present Value Concept
If you were to receive $1 at regular intervals (of the same length) over the next t periods with the
first payment being received at the end of the first period and you demand a return of r% per
period, the present value of this $1 annuity is defined as:
$1 $1 $1 . $1 $1 $1

0 1 2 3 . t-2 t-1 t

( ) ( ) ( ) ( ) ( ) ( ) ( )

=

+
=
+
+
+
+
+
+ +
+
+
+
+
+
t
n
n t t t
r r r r r r r 1
1 2 3 2 1
1
1 $
1
1 $
1
1 $
1
1 $
...
1
1 $
1
1 $
1
1 $
.

This equation is known as the present value annuity factor (PVA), which may be simplified to:
( )
( )
(

+
=

r
r
t r PVA
t
1 1
1 $ , . Thus an annuity of $z is simply $z PVA(r, t). This formula
applies if and only if t is a whole number.

On the other hand, if you were to receive a single lump sum payment of $1 after t periods and you
demand a return of r% per period, the present value of this $1 lump sum is also known as the
present value factor (PVF) and is defined as:

$1

0 1 2 3 . t-2 t-1 t

( )
( )
t
r
t r PVF
+
=
1
1 $
, . Similarly a lump sum of $z at the end of t periods is $z PVF(r, t).