Professional Documents
Culture Documents
=
1
1 1
1
1
[ 6-1]
Where:
I = interest (or coupon ) payments
k
b
= the bond discount rate (or market rate)
n = the term to maturity
F = Face (or par) value of the bond
CHAPTER 6 Bond Valuation and Interest Rates 6 - 19
Bond Valuation: Example
What is the market price of a ten-year, $1,000 bond with a
5% coupon, if the bonds yield-to-maturity is 6%?
( )
( )
( )
( )
10
10
1 1
1
1 1.06
1, 000
50
0.06
1.06
$926.40
n
b
n
b
b
k
F
B I
k
k
(
+
= + (
+
(
(
= + (
(
=
Calculator Approach:
1,000 FV
50 PMT
10 N
I/Y 6
CPT PV 926.40
CHAPTER 6 Bond Valuation and Interest Rates 6 - 20
Factors Affecting Bond Prices
Bond Price-Yield Curve
Market Yield (%)
FIGURE 6-2
Price
($)
When interest rates increase, bond prices fall
CHAPTER 6 Bond Valuation and Interest Rates 6 - 21
The relationship between the coupon rate and the bonds
yield-to-maturity (YTM) determines if the bond will sell at a
premium, at a discount, or at par
If Then Bond Sells at a:
Coupon < YTM Market < Face Discount
Coupon = YTM Market = Face Par
Coupon > YTM Market > Face Premium
Factors Affecting Bond Prices
CHAPTER 6 Bond Valuation and Interest Rates 6 - 22
Bond Valuation: Semi-Annual Coupons
So far, we have assumed that all bonds have annual
pay coupons. While this is true for many
Eurobonds, it is not true for most domestic bond
issues, which have coupons that are paid semi-
annually
To adjust for semi-annual coupons, we must make
three changes:
Size of the coupon payment (divide by 2)
Number of periods (multiply by 2)
Yield-to-maturity (divide by 2)
CHAPTER 6 Bond Valuation and Interest Rates 6 - 23
Bond Valuation: Semi-Annual Coupons
For example, suppose you want to value a five-year,
$10,000 Government of Canada bond with a 4% coupon,
paid twice a year, given a YTM of 6%.
2
2
2 5
2 5
1 1
2
2
1
2
2
.06
1 1
400 10, 000
2
0.06
2
.06
1
2
2
$9,146.98
n
b
n
b
b
x
x
k
I F
B
k
k
(
| |
+
(
|
\ .
(
= +
(
| |
+
(
|
(
\ .
(
| |
+
(
|
\ .
(
= +
(
| |
+
(
|
\ .
=
Calculator Approach:
10,000 FV
400 2 = PMT
5 x 2 = N
6 2 = I/Y
CPT PV 926.40
CHAPTER 6 Bond Valuation and Interest Rates 6 - 24
Factors Affecting Bond Prices
There are three factors that affect the price volatility
of a bond
Yield to maturity
Time to maturity
Size of coupon
CHAPTER 6 Bond Valuation and Interest Rates 6 - 25
Factors Affecting Bond Prices
Yield to maturity
Bond prices go down when the YTM goes up
Bond prices go up when the YTM goes down
Look at the graph on the next slide. It shows how
the price of a 25 year, 10% coupon bond changes
as the bonds YTM varies from 1% to 30%
Note that the graph is not linear instead it is said
to be convex to the origin
CHAPTER 6 Bond Valuation and Interest Rates 6 - 26
Factors Affecting Bond Prices
Price and Yield: 25 Year Bond, 10% Coupon
Price/Yield Relationship
0
50
100
150
200
250
300
350
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
Percent YTM
P
r
i
c
e
p
e
r
$
1
0
0
o
f
F
a
c
e
V
a
l
u
e
CHAPTER 6 Bond Valuation and Interest Rates 6 - 27
The convexity of the price/YTM graph reveals two
important insights:
The price rise due to a fall in YTM is greater than the
price decline due to a rise in YTM, given an identical
change in the YTM
For a given change in YTM, bond prices will change
more when interest rates are low than when they are
high
Factors Affecting Bond Prices
Bond Convexity
CHAPTER 6 Bond Valuation and Interest Rates 6 - 28
Factors Affecting Bond Prices
Time to maturity
Long bonds have greater price volatility than short
bonds
The longer the bond, the longer the period for which the
cash flows are fixed
Size of coupon
Low coupon bonds have greater price volatility
than high coupon bonds
High coupons act like a stabilizing device, since a greater
proportion of the bonds total cash flows occur closer to
today & are therefore less affected by a change in YTM
CHAPTER 6 Bond Valuation and Interest Rates 6 - 29
Interest Rate Risk & Duration
The sensitivity of bond prices to changes in interest
rates is a measure of the bonds interest rate risk
A bonds interest rate risk is affected by:
Yield to maturity
Term to maturity
Size of coupon
These three factors are all captured in one number
called duration
CHAPTER 6 Bond Valuation and Interest Rates 6 - 30
Duration
Duration is a measure of interest rate risk
The higher the duration, the more sensitive the bond
is to changes in interest rates
A bonds duration will be higher if its:
YTM is lower
Term to maturity is longer
Coupon is lower
CHAPTER 6 Bond Valuation and Interest Rates 6 - 31
Bond Quotations
Issuer Coupon Maturity Price Yield
Canada 5.500 2009-Jun-01 103.79 4.16
CHAPTER 6 Bond Valuation and Interest Rates 6 - 32
Cash Versus Quoted Prices
The quoted price is the price reported by the media
The cash price is the price paid by an investor
The cash price includes both the quoted price plus
any interest that has accrued since the last coupon
payment date
CHAPTER 6 Bond Valuation and Interest Rates 6 - 33
Cash Versus Quoted Price: Example
Assume you want to purchase a $1,000 bond with a 5%
coupon, paid semi-annually. Today is July 15
th
. The last
coupon was paid June 30
th
. If the quoted price is $902,
how much is the cash price?
Solution: The cash price is equal to:
Quoted price of $902
Plus 15 days of interest
( )( )
15
902 1, 000 0.05
365
902 2.05
$904.05
Cash price=Quoted Price+Accrued Interest
| |
= +
|
\ .
= +
=
CHAPTER 6 Bond Valuation and Interest Rates 6 - 34
Bond Yields
Yield-to-maturity (YTM) the discount rate used to
evaluate bonds
The yield earned by a bond investor who:
Purchases the bond at the current market price
Held the bond to maturity
Reinvested all of the coupons at the YTM
Is the bonds Internal Rate of Return (IRR)
CHAPTER 6 Bond Valuation and Interest Rates 6 - 35
Bond Yield to Maturity
The yield to maturity is that discount rate that causes the sum
of the present value of promised cash flows to equal the
current bond price.
YTM) (
F
YTM
YTM) (
I B
n
n
+
+
(
(
(
(
=
1
1 1
1
1
[ 6-2]
CHAPTER 6 Bond Valuation and Interest Rates 6 - 36
Solving for YTM
To solve for YTM, solve for YTM in the following formula:
Problem: cant solve for YTM algebraically; therefore, must
either use a financial calculator, spreadsheet, trial and
error, or approximation formula.
( )
( )
1 1
1
n
n
YTM
F
B I
YTM
YTM
(
+
= +
(
+
(
CHAPTER 6 Bond Valuation and Interest Rates 6 - 37
Solving for YTM
Example: What is the YTM on a 10 year, 5% coupon bond
(annual pay coupons) that is selling for $980?
( )
( )
( )
( )
10
10
1 1
1
1 1
1, 000
980 50
1
5.26%
n
n
YTM
F
B I
YTM
YTM
YTM
YTM
YTM
YTM
(
+
= + (
+
(
(
+
= + (
+
(
=
Financial Calculator
1,000 FV
980 +/- PV
50 PMT
10 N
I/Y 5.26%
CHAPTER 6 Bond Valuation and Interest Rates 6 - 38
Solving for YTM: Semi-annual Coupons
When solving for YTM with a semi-annual pay
coupon, the yield obtained must be multiplied by two
to obtain the annual YTM
Example: What is the YTM for a 20 year, $1,000
bond with a 6% coupon, paid semi-annually, given a
current market price of $1,030?
CHAPTER 6 Bond Valuation and Interest Rates 6 - 39
Solving for YTM: Semi-annual Coupons
( )
( )
( )
( )
40
40
1 1
1
1 1
1, 000
1, 030 30
1
2.87 2 5.74%
n
n
YTM
F
B I
YTM
YTM
YTM
YTM
YTM
YTM x
(
+
= + (
+
(
(
+
= + (
+
(
= =
Financial Calculator
1,000 FV
1,030 +/- PV
30 PMT
40 N
I/Y 2.87 x 2
= 5.746%
CHAPTER 6 Bond Valuation and Interest Rates 6 - 40
The Approximation Formula
Where
F = Face Value = Par Value = $1,000
B = Bond Price
I = the semi annual coupon interest
N = number of semi-annual periods left to maturity
1 YTM) annual - semi (1 YTM
YTM annual - semi 2 YTM
2
n
B - F
Maturity to Yield annual - Semi
2
+ =
=
+
+
=
B F
I
CHAPTER 6 Bond Valuation and Interest Rates 6 - 41
Example
Find the yield-to-maturity of a 5 year 6% coupon
bond that is currently priced at $850. (Always
assume the coupon interest is paid semi-annually.)
Therefore there is coupon interest of $30 paid
semi-annually
There are 10 semi-annual periods left until maturity
CHAPTER 6 Bond Valuation and Interest Rates 6 - 42
Solution
The actual answer is 9.87%...so of course, the
approximation approach only gives us an approximate
answerbut that is just fine for tests and exams.
% 97 . 9 1 ) 0486 . 1 ( 1 YTM) annual - semi (1 YTM
9.3% 0.09273 2 0.0486 YTM annual - semi 2 YTM
0486 . 0
925 $
30 $ 15 $
2
850 , 1 $
30 $
10
850 $ 000 , 1 $
2
n
B - F
Maturity to Yield annual - Semi
2 2
= = + =
= = = =
=
+
=
+
=
+
+
=
B F
I
CHAPTER 6 Bond Valuation and Interest Rates 6 - 43
The Logic of the Equation
Approximation Formula for YTM
The numerator simply represents the average semi-annual
returns on the investment; it is made up of two components:
The first component is the average capital gain (if it is a discount
bond) or capital loss (if it is a premium priced bond) per semi-
annual period.
The second component is the semi-annual coupon interest
received.
The denominator represents the average price of the bond.
Therefore the formula is basically, average semi-annual return
on average investment.
Of course, we annualize the semi-annual return so that we
can compare this return to other returns on other investments
for comparison purposes.
CHAPTER 6 Bond Valuation and Interest Rates 6 - 44
Yield to Call
If a bond has a call feature, the issuer can call the
bond prior to its stated maturity
To calculate the yield to call, replace the maturity
date with the first call date
CHAPTER 6 Bond Valuation and Interest Rates 6 - 45
Yield to Call
The yield to call is that discount rate that causes the present
value of all promised cash flows including the call price (CP)
to equal the current bond price.
YTC) (
CP
YTC
YTC) (
I B
n
n
+
+
(
(
(
(
=
1
1 1
1
1
[ 6-3]
CHAPTER 6 Bond Valuation and Interest Rates 6 - 46
Solving for YTC: Semi-Annual Coupons
Financial Calculator
1,050 FV
1,030 +/- PV
30 PMT
10 N
I/Y 3.081 x 2
= 6.16%
YTC on a 20-year 6 percent bond that is callable in five years at a call price of
$1,050. The bond pays semi-annual coupons and is selling for $1,030.
% 16 . 6 2 % 081 . 3
% 081 . 3
1
050 , 1 $ 1
1
1
30 $ 030 , 1 $
1
1 1
1
1
10
10
= =
=
+
+
(
(
(
(
=
+
+
(
(
(
(
=
YTC
annually semi YTC
YTC) ( YTC
YTC) (
YTC) (
CP
YTC
YTC) (
I B
n
n
CHAPTER 6 Bond Valuation and Interest Rates 6 - 47
Current Yield
The current yield is the yield on the bonds current market
price provided by the annual coupon
It is not a true measure of the return to the bondholder because it
does not consider potential capital gain or capital losses based
on the relationship between the purchase price of the bond and
its par value.
B
interest Annual
CY = [ 6-4]
CHAPTER 6 Bond Valuation and Interest Rates 6 - 48
Current Yield
Example
The current yield is the yield on the bonds current market
price provided by the annual coupon
Example: If a bond has a 5.5% annual pay coupon and the
current market price of the bond is $1,050, the current yield is:
55
1, 050
5.24%
Annual Coupon
Current Yield =
Current Market Price
=
=
CHAPTER 6 Bond Valuation and Interest Rates 6 - 49
Interest Rate Determinants
Interest is the price of money
Basis points 1/100 of 1%
Interest rates go:
Up when the demand for loanable funds rises
Down when the demand for loanable funds falls
CHAPTER 6 Bond Valuation and Interest Rates 6 - 50
Risk-free Interest Rate
Usually use the yield on short federal government
treasury bills as a proxy for the risk-free rate (RF)
The risk-free rate is comprised of two components:
Real rate compensation for deferring consumption
Expected inflation compensation for the expected
loss in purchasing power
(See Figure 6-3 to see rates of inflation and yields on long Canada bonds since 1961)
CHAPTER 6 Bond Valuation and Interest Rates 6 - 51
Inflation and Yields over Time
FIGURE 6-3
CHAPTER 6 Bond Valuation and Interest Rates 6 - 52
Fisher Equation
If we call the risk-free rate the nominal rate, then the
relationship between the real rate, the nominal rate and
expected inflation is usually referred to as the Fisher
Equation (after Irving Fisher)
inflation Expected rate Real RF + = [ 6-5]
CHAPTER 6 Bond Valuation and Interest Rates 6 - 53
Fisher Equation
When inflation is low, can safely use the approximation
formula:
When inflation is high, use the exact form of the Fisher
Equation:
Nominal Real
R = R +Expected Inflation
( ) ( )( )
1 1 1
Nominal Real
R = R Expected Inflation + + +
CHAPTER 6 Bond Valuation and Interest Rates 6 - 54
Fisher Equation
Example
If the real rate is 3% and the nominal rate is 5.5%, what is
the approximate expected future inflation rate?
5.5 3
2.5%
Nominal Real
R = R +Expected Inflation
Expected Inflation
Expected Inflation
= +
=
CHAPTER 6 Bond Valuation and Interest Rates 6 - 55
Global Influences on Interest Rates
Canadian domestic interest rates are heavily
influenced by global interest rates
Interest rate parity (IRP) theory states that FX
forward rates will be established that equalize the
yield an investor can earn, whether investing
domestically or in a foreign jurisdiction
A country with high inflation and high interest rates
will have a depreciating currency
CHAPTER 6 Bond Valuation and Interest Rates 6 - 56
Term Structure of Interest Rates
Is that set of rates (YTM) for a given risk-class of
debt securities (for example, Government of Canada
Bonds) at a given point in time.
When plotted on a graph, the line is called a Yield
Curve
CHAPTER 6 Bond Valuation and Interest Rates 6 - 57
Term Structure of Interest Rates
The Yield Curve is the graph created by putting term
to maturity on the X axis, YTM on the Y axis and
then plotting the yield at each maturity.
The four typical shapes of yield curves:
Upward sloping (the most common shape)
Downward sloping
Flat
Humped
(See Figure 6-4 for Yield curves that existed at various times in Canada)
CHAPTER 6 Bond Valuation and Interest Rates 6 - 58
Historical Yield Curves
1990, 1994, 1998, 2004
P
e
r
c
e
n
t
Term Left to Maturity
16
14
12
10
8
6
4
2
0
1 mth 3 mths 6 mths 1 yr 2yrs 5 yrs 7 yrs 10 yrs 30 yrs
FIGURE 6-4
1990 1994 1998 2004
CHAPTER 6 Bond Valuation and Interest Rates 6 - 59
Theories of the Term Structure
Three theories are used to explain the shape of the
term structure
Liquidity preference theory
Investors must be paid a liquidity premium to hold less
liquid, long-term debt
Expectations theory
The long rate is the average of expected future short interest
rates
Market segmentation theory
Distinct markets exist for securities of different maturities
CHAPTER 6 Bond Valuation and Interest Rates 6 - 60
Term Structure of Interest Rates
Risk Premiums
More risky bonds (i.e.. BBB rated Corporate Bonds) will have
their own yield curve and it will plot at higher YTM at every
term to maturity because of the default risk that BBBs carry
The difference between the YTM on a 10-year BBB corporate
bond and a 10-year Government of Canada bond is called a
yield spread and represents a default-risk premium investors
demand for investing in more risky securities.
Spreads will increase when pessimism increases in the
economy
Spreads will narrow during times of economic expansion
(confidence)
CHAPTER 6 Bond Valuation and Interest Rates 6 - 61
Yield Curves for Different Risk Classes
Risk Premiums (Yield Spreads)
P
e
r
c
e
n
t
Term Left to Maturity
16
14
12
10
8
6
4
2
0
1 mth 3 mths 6 mths 1 yr 2yrs 5 yrs 7 yrs 10 yrs 30 yrs
BBB Corporates Government of Canada Bonds
Yield
Spread
CHAPTER 6 Bond Valuation and Interest Rates 6 - 62
Risk Premiums
The YTM on a corporate bond is comprised of:
The maturity yield differential is explained by the term
structure
Spread is the additional yield due to default risk
Spread al differenti yield Maturity - / RF k
b
+ + = =YTM
[ 6-6]
CHAPTER 6 Bond Valuation and Interest Rates 6 - 63
Debt Ratings
All publicly traded bonds are assigned a risk rating
by a rating agency, such as Dominion Bond Rating
Service (DBRS), Standard & Poors (S&P), Moodys,
Fitch, etc.
Bonds are categorized as
Investment grade top four rating categories (AAA,
AA, A & BBB)
Junk or high yield everything below investment
grade (BB, B, CCC, CC, D, Suspended)
CHAPTER 6 Bond Valuation and Interest Rates 6 - 64
Why Do Bonds Have Different Yields?
Default risk the higher the default risk, the higher
the required YTM
Liquidity the less liquid the bond, the higher the
required YTM
Call features increase required YTM
Extendible feature reduce required YTM
Retractable feature reduce required YTM
CHAPTER 6 Bond Valuation and Interest Rates 6 - 65
Treasury Bills
Treasury bills are short-term obligations of government with
an initial term to maturity of one year or less
Issued at a discount and mature at face value
The difference between the issue price and the face value is
treated as interest income
To calculate the price of a T-bill, use the following formula
1
T Bill
F
P
n
BEY
B
=
| |
+
|
\ .
Where:
P = market price of the T Bill
F = face value of the T Bill
BEY = the bond equivalent yield
n = the number of days until maturity
B = the annual basis (365 days in Canada)
CHAPTER 6 Bond Valuation and Interest Rates 6 - 66
Treasury Bills: Example
What is the price of a $1,000,000 Canadian T bill with 80
days to maturity and a BEY of 4.5%?
1
1, 000, 000
80
1 .045
365
$990, 233.32
T Bill
F
P
n
BEY
B
=
| |
+
|
\ .
=
| |
+
|
\ .
=
CHAPTER 6 Bond Valuation and Interest Rates 6 - 67
Solving for Yield on a T Bill
To solve for the yield on a T bill, rearrange the previous
formula and solve for BEY.
Example: What is the yield on a $100,000 T bill with 180 days
to maturity and a market price of $98,200?
100, 000 98, 200 365
98, 200 180
3.72%
F P B
BEY
P n
| |
=
|
\ .
| |
=
|
\ .
=
CHAPTER 6 Bond Valuation and Interest Rates 6 - 68
Zero Coupon Bonds
A zero coupon bond is a bond issued at a discount
that matures at par or face value
A zero coupon bond has no reinvestment rate risk,
since there are no coupons to be reinvested
To calculate the price of a zero coupon bond, solve
for the PV of the face amount
CHAPTER 6 Bond Valuation and Interest Rates 6 - 69
Zero Coupon Bonds
Example: What is the market price of a $50,000 zero
coupon bond with 25 years to maturity that is currently
yielding 6%?
( )
( )
25
F
1
50, 000
1.06
$11, 649.93
n
b
B
k
=
+
=
=
CHAPTER 6 Bond Valuation and Interest Rates 6 - 70
Floating Rate & Real Return Bonds
Floating rate bonds have a coupon that floats with
some reference rate, such as the yield on T bills
Because the coupon floats, the market price will
typically be close to the bonds face value
Real return bonds are issued by the Government of
Canada to protect investors against unexpected
inflation
Each period, the face value of the bond is grossed up
by the inflation rate. The coupon is then paid on the
grossed up face value.
CHAPTER 6 Bond Valuation and Interest Rates 6 - 71
Canada Savings Bonds
A Canada Savings Bond (CSB) is a special type of
bond issued by the Government of Canada
It is issued in two forms:
Regular interest interest is paid annually
Compound interest interest compounds over the life
of the bond
CSBs are redeemable at any chartered bank in
Canada at their face value
There is no secondary market for CSBs
CHAPTER 6 Bond Valuation and Interest Rates 6 - 72
Summary and Conclusions
In this chapter you have learned:
About the nature of bonds as an investment
How to value a bond using discounted cash flow
concepts
About the determinants of interest rates and theories
used to explain the term structure of interest rates
CHAPTER 6 Bond Valuation and Interest Rates 6 - 73
Copyright
Copyright 2007 John Wiley & Sons Canada, Ltd. All rights reserved.
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