Chapter 6 - Bond Valuation and Interest Rates

Prepared by
Ken Hartviksen and Robert Ironside

INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth W. Sean Cleary

Chapter 6 Bond Valuation and Interest
Rates
CHAPTER 6
Bond Valuation and Interest
Rates
CHAPTER 6 Bond Valuation and Interest Rates 6 - 3
Lecture Agenda
Learning Objectives
Important Terms
Basic Structure of Bonds
Valuing Bonds
Bond Yields
Interest Rate Determinants
Other Types of Bonds/Debt Instruments
Summary and Conclusions
Concept Review Questions
Appendix Bond Duration
Learning Objectives
The basic features of different types of bonds
How to value bonds given an appropriate discount rate
How to determine the discount rate or yield given the market
value of a bond
How market interest rates or yields affect bond investors
How bond prices change over time
The factors (both domestic and global) that affect interest rates
Important Chapter Terms
Balloon payment
Bills
Bond indenture
Bullet payment
Call prices
Callable bonds
Canada Savings Bonds
Collateral trust bonds
Coupons
Current yield
Debentures
Debt ratings
Default free

Default risk
Discount (premium)
Duration
Equipment trust certificates
Expectations theory
Extendible bonds
Face value
Floating rate bonds
Interest payments
Interest rate parity (IRP) theory
Interest rate risk
Issue-specific premiums
Liquidity preference theory
Maturity value
Important Chapter Terms
Mortgage bonds
Nominal interest rates
Notes
Paper
Par value
Protective covenants
Purchase fund provisions
Real return bonds
Retractable bonds
Risk-free rate
Sinking fund provisions
Spread
Term structure of interest
rates
Term to maturity
Yield curve
Yield to maturity
Zero coupon bond
The Basic Structure of Bonds
Bond Valuation and Interest Rates
What is a Bond?
In its broadest sense, a bond is any debt instrument
that promises a fixed income stream to the holder
Fixed income securities are often classified
according to maturity, as follows:
Less than one year Bills or Paper
1 year < Maturity < 7 years Notes
< 7 years Bonds
A typical bond has the following characteristics:
A fixed face or par value, paid to the holder of the
bond, at maturity
A fixed coupon, which specifies the interest payable
over the life of the bond
Coupons are usually paid either annually or semi-annually
A fixed maturity date
Note:
The coupon rate, the maturity date, par value are all
set (fixed) at the time the bond was originally sold to
the market
The coupon rate will reflect the required rates of
interest at the time of bond issue.
After issue, interest rates, and required rates of return
will change. Because everything is fixed except the
required rate of return and the bond price, as rates
change, so too will bond prices!
Bonds may be either:
Bearer bonds
Registered bonds
Bond indenture - the contract between the issuer of
the bond and the investors who hold it
The market price of a bond is equal to the present
value of the payments promised by the bond

(See the basic pattern of cash flows from a traditional bond on the next slide)
Cash Flow Pattern for a Traditional Coupon-Paying Bond

0 1 2 3 n

I I I I I
F

6-1 FIGURE
I = interest payments, and F = principal repayment
Cash Flow Pattern of a Bond
The Purchase Price or Market Price of a bond is simply the present
value of the cash inflows, discounted at the bonds yield-to-maturity
0 2
3
4 n 1
Coupon Coupon Coupon Coupon Coupon +
Face Value
Purchase
Price
Cash Inflows
to the Investor
Cash Outflows
to the Investor
Bond Features and Provisions
Bond Indenture
The bond indenture is the contract between the
issuer and the holder. It specifies:
Details regarding payment terms
Collateral
Positive & negative covenants
Par or face value (usually increments of $1,000)
Bond pricing usually shown as the price per $100 of
par value, which is equal to the percentage of the
bonds face value
More Bond Terminology
Term-to-maturity the time remaining to the bonds
maturity date
Coupon rate the annual percentage interest paid
on the bonds face value. To calculate the dollar
value of the annual coupon, multiply the coupon rate
times the face value.
If the coupon is paid twice a year, divide the annual
coupon by two
Example: A $1000 bond with an 8% coupon rate will
have an $80 coupon if paid annually or a $40 coupon
if paid semi-annually.

Security & Protective Provisions
Mortgage bonds secured by real assets
Debentures either unsecured or secured with a
floating charge over the firms assets
Collateral trust bonds secured by a pledge of
financial assets, such as common stock, other
bonds or treasury bills
Equipment trust certificates secured by a pledge
of equipment, such as railway rolling stock
Covenants
Positive covenants things the firm agrees to do
Supply periodic financial statements
Maintain certain ratios

Negative covenants things the firm agrees not to
do
Restrictions on the amount of debt the firm can take on
Prevents the firm from acquiring or disposing of assets
More Bond Features More Bond Features
Call feature allows the issuer to redeem or pay off
the bond prior to maturity, usually at a premium
Retractable bonds allows the holder to sell the
bonds back to the issuer before maturity
Extendible bonds allows the holder to extend the
maturity of the bond
Sinking funds funds set aside by the issuer to
ensure the firm is able to redeem the bond at
maturity
Convertible bonds can be converted into common
stock at a pre-determined conversion price
Bond Valuation
Annual Coupon Payments
Bond Valuation
The value of a bond is a function of:
The bonds par (face) value
Term to maturity
Coupon rate
Investors required rate of return (discount rate is also
known as the bonds yield to maturity)
Bond Value
General Formula

) k (
F
k
) k (
I B
n
b b
n
b
+
+
(
(
(
(
=
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
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
Bond Valuation
Semi-Annual Coupon Payments
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 the annual coupon payment
by 2 to get the cash flow paid each 6 months )
Number of periods (multiply number of years to maturity by 2 to
get number of semi-annual periods)
Yield-to-maturity (divide by 2 to get the semi-annual yield)
Once you solve for the semi-annual yield, you will want to
convert it back to an annualized rate of return (YTM).
Bond Valuation: Semi-Annual Coupons
For example, suppose you want to value a 5 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
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
We will look at each of these in turn.
Inverse Relationship Between Bond
Prices and Yields to Maturity
When interest rates (required rate of return on the
bond) increase, bond prices fall.

(See Figure 6 2 on the next slide)
Bond Price-Yield Curve
Market Yield (%)
6 - 2 FIGURE
Price ($)
Bond Convexity
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
Coupon Rate Relationship to Yield-to-
Maturity
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
Inverse Relationship Between Yields and Prices
Yield to maturity (investors required return)
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
Price & 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
As interest rates
increase, bond prices
fall, but fall at a
decreasing rate
Other Factors Affecting Bond Prices
Term to Maturity and Size of Coupon
Term to maturity - long bonds have greater price
volatility than short bonds

Size of coupon low coupon bonds have greater
price volatility than high coupon bonds

Time to Maturity
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
More distant cash flows are affected more in the
discounting process (remember the exponential nature of
compoundingand that discounting is the inverse of
compounding)
The most distant cash flow from a bond investment is the
most important (it is the face value of the bond) and this
cash flow is affected the greatest in the discounting
process.

Size of the Coupon Rate
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
The greatest price volatility is found with stripped bonds
(no coupon payments)

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
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

(See the Appendix to this slide set for a complete discussion of duration)
Bond Quotations
Bond Prices
Discount and Premium Priced Bonds
Bonds trading at prices > par - premium priced
Bonds trading at prices < par discount priced
Bond Quotations
Issuer Coupon Maturity Price Yield
Canada 5.500 2009-Jun-01 103.79 4.16
The issuer of the bond. The coupon rate in percent.
The bonds maturity date.
It takes on meaning on the
bond reporting page
because there will be a
current date. The
difference between the two
dates is the number of
years to maturity.
The bonds price is in
dollars assuming a par
value of $100. Since this
bond price is greater than
$100, it is called a
premium priced bond.
The bond equivalent yield
to maturity (BEY)
expressed in percent on
an annualized basis.
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
Cash Versus Quoted Price: Example
Assume that 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?
Cash Versus Quoted 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
| |
= +
|
\ .
= +
=
Bond Yields
Bond Yields
The Yield to Maturity = Investors Required Rate of Return
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
Holds the bond to maturity
Reinvests all of the coupons at the YTM for the remaining
term to maturity (the reinvestment rate assumption)
Is the bonds Internal Rate of Return (IRR)
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]
Solving for YTM
To solve for YTM, solve for YTM in the following formula:

There is a Problem:
You cant solve for YTM algebraically; therefore, must either
use a financial calculator, Excel, trial & error or approximation
formula.
( )
( )
1 1
1
n
n
YTM
F
B I
YTM
YTM
(
+
= +
(
+
(

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%
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?
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
(
+
= + (
+
(

(
+
= + (
+
(

= =
1,000 FV
1,030 +/- PV
30 PMT
40 N
I/Y 2.87 x 2
= 5.746%
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?
Using the Approximation Formula to
Solve for Yield to Maturity
The Approximation Formula
This formula gives you a quick estimate of the yield
to maturity
It is an estimate because it is based on a linear
approximation (again you will remember the
exponential nature of compound interest)
Should you be concerned with the error inherent in
the approximated YTM?
NO
Remember a YTM is an ex ante calculation as a
forecast, it is based on assumptions which may or
may not hold in this case, therefore as a forecast or
estimate, the approximation approach should be fine.
The Approximation Formula
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
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
Example with Solution
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.)
% 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
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.
The Logic of the Equation
Approximation Formula for YTM
The numerator simply represents the average semi-annual returns
on the investmentit 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.
Yield To Call
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, simply replace the
maturity date with the first call date
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]
Solving for YTC: Semi-annual Coupons
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
Current Yield
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]
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
=
=
Short-Term Interest Rates
Interest Rate Determinants
Interest is the price of money
Interest rate changes are often measured in 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
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)
Inflation and Yields over Time
6 - 3 FIGURE
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]
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 + + +
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
= +
=
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
Term Structure of Interest Rates
(Long-term 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

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 and persistent shape historically
when short-term interest rates and inflation are low)
Downward sloping (occurs at peaks in the short-term interest rate
cycle, when inflation is expected to decrease in the future)
Flat (occurs when rates are transitioning)
Humped (occurs when rates are transitioning or perhaps market
participants are attracted in large numbers to particular maturity
segment of the market)

(See Figure 6-4 for Yield curves that existed at various times in Canada)
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
6 - 4 FIGURE
1990 1994 1998 2004
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
Risk Premiums

More risky bonds (ie. 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)
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
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]
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)

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

Other Types of Bonds/Debt
Instruments

Treasury Bills
Short-term obligations of government with an initial term to
maturity of one year or less
Issued at a discount & 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)
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
=
| |
+
|
\ .
=
| |
+
|
\ .
=
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
| |
=
|
\ .
| |
=
|
\ .
=
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
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
=
+
=
=
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.
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 plus accrued interest (after the first three
months after issue)
There is no secondary market for CSBs (they are non-
negotiable meaning that they cannot be traded in a market
between investors.
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
Concept Review Questions
Concept Review Question 1
Bonds and Mortgages
In what ways are bonds different from mortgages?

Appendix A Bond Duration
Duration
An alternative measure of bond price sensitivity is the bonds duration.
Duration measures the life of the bond on a present value basis.
Duration can also be thought of as the average time to receipt of the
bonds cash flows.
The longer the bonds duration, the greater is its sensitivity to interest
rate changes.
Duration Rules-of-Thumb
Duration of zero-coupon bond (strip bond) = the term left until maturity.
Duration of a consol bond (ie. a perpetual bond) = 1 + (1/k)
where: k = required yield to maturity
Duration of an FRN (floating rate note) = 1/2 year

Other Duration Rules-of-Thumb
Duration and Maturity
Duration increases with maturity of a fixed-income asset, but at a decreasing
rate.

Duration and Yield
Duration decreases as yield increases.

Duration and Coupon Interest
The higher the coupon or promised interest payment on the security, the lower
its duration.
Economic Meaning of Duration
duration is a direct measure of the interest rate sensitivity or
elasticity of an asset or liability. (ie. what impact will a change in
YTM have on the price of the particular fixed-income security?)

interest rate sensitivity is equal to:

dP = - D [ dk/(1+k)]
P
Where: P = Price of bond
C = Coupon (annual)
k = YTM
N = Number of periods
F = Face value of bond
Interest Rate Elasticity
the percent change in the bonds price caused by a
given change in interest rates (change in YTM)

(The following slide illustrates how bond price sensitivity can be graphed against
changing discount rates)
Price Elasticity of Stripped Bonds
$0
$5,000
$10,000
$15,000
$20,000
0.0% 5.0% 10.0% 15.0% 20.0%
30 year stripped bond price given different YTM.
Price Sensitivity of a Stripped Bond
Take our previous example where a $20,000 30-year stripped bond has a
required rate of return of 12%:

P
0
= $20,000(PVIF
n=30, k = 12%
)
= $20,000 (.0334)
= $668.00
Assume now that interest rates fall by 16.7% from 12% to 10%. What is
the percentage change in price of the bond?

P
0
= $20,000(PVIF
n=30, k = 10%
)
= $20,000 (.0573)
= $1,146.00

Percentage change in price = ($1,146 - $668) / $668
=71.6%
This stripped bond had a 71.6% increase in price with a 2% decrease
(200 bp) decrease in required rate of return.
Duration and Coupon Rates
A bonds duration is affected by the size of the coupon rate offered by
the bond.
The duration of a zero coupon bond is equal to the bonds term to
maturity. Therefore, the longest durations are found in stripped bonds
or zero coupon bonds. These are bonds with the greatest interest rate
elasticity.
The higher the coupon rate, the shorter the bonds duration. Hence the
greater the coupon rate, the shorter the duration, and the lower the
interest rate elasticity of the bond price.
Duration
The numerator of the duration formula represents the present value of future
payments, weighted by the time interval until the payments occur. The longer
the intervals until payments are made, the larger will be the numerator, and the
larger will be the duration. The denominator represents the discounted future
cash flows resulting from the bond, which is the bonds present value.
maturity to yield s bond the k
provided are payments the which at time the t
bond the by generated payment principal or coupon the C where
k
C
k
t C
DUR
t
n
t
t
t
n
t
t
t
'
:
) 1 (
) 1 (
) (
1
1
=
=
=
+
+
=
=
=
Duration Example
A Formula-based Duration Calculation for a Three Year, 7% Coupon Bond
As an example, the duration of a bond with $1,000 par value and a 7 percent
coupon rate, three years remaining to maturity, and a 9 percent yield to maturity
is:
years
DUR
80 . 2

) 09 . 1 (
1070 $
) 09 . 1 (
70 $
) 09 . 1 (
70 $
) 09 . 1 (
) 3 ( 1070 $
) 09 . 1 (
) 2 ( 70 $
) 09 . 1 (
70 $
3 2 1
3 2 1
=
+ +
+ +
=
Duration Example
A Formula-based Duration Calculation for a Zero Coupon Bond
As an example, the duration of a zero-coupon bond with $1,000 par value and
three years remaining to maturity, and a 9 percent yield to maturity is:
0 . 3

) 09 . 1 (
1000 $
) 09 . 1 (
) 3 ( 1000 $
3
3
years
DUR
=
=
Example of a Duration Calculation
Using a Spreadsheet Model
Example
Assume a 10% coupon bond with three years left to maturity and a required return of 8%.
Coupon Rate = 10.00%
Required Return = 8.00%
Time Cashflow PVIF Present Value Weight
Time
Weighted
CFs
0
0.5 50 0.96225 $48.11 4.55% 0.022767679
1 50 0.925926 $46.30 4.38% 0.043816419
1.5 50 0.890973 $44.55 4.22% 0.063243554
2 50 0.857339 $42.87 4.06% 0.081141517
2.5 50 0.824975 $41.25 3.90% 0.097598077
3 1050 0.793832 $833.52 78.89% 2.36662759
Bond Price = $1,056.60 100.00% 2.675194837 =Duration
Duration of a Portfolio
Bond portfolio mangers commonly attempt to immunize their portfolio,
or insulate their portfolio from the effects of interest rate movements.
This is a common challenge when the investment portfolio is dedicated
to funding a future liability.
Insurance Company Example

A life insurance company knows that they need $100 million 30 years from now cover
actuarially-determined claims against a group of life insurance policies just no sold to
a group of 30 year olds.

The insurance company has invested the premiums into 30-year government bonds.
Therefore there is no default risk to worry about. The company expects that if the
realized rate of return on this bond portfolio equals the yield-to-maturity of the bond
portfolio, there wont be a problem growing that portfolio to $100 million. The problem
is, that the coupon interest payments must be reinvested and there is a chance that
rates will fall over the life of the portfolio.

If this happens the portfolios terminal value will be less than the liability the insurance
company needs to finance. This shortfall in investment returns will have to be borne
at the expense of the Insurance companys shareholders.

Duration of a Portfolio ...
Interest Rate Risk
The life insurance company example illustrates a key risk in fixed-
income portfolio management - interest rate risk.
The portfolio manager, before-the-fact calculates the bond portfolios
yield-to-maturity. This is an ex ante calculation.
As such, a nave assumption assumption is made that the coupon
interest received each year is reinvested at the yield-to-maturity for the
remaining years until the bond matures.
Over time, however, interest rates will vary and reinvestment
opportunities will vary from that which was forecast.
Immunization
The insurance company will want to IMMUNIZE their portfolio from this
reinvestment risk.
The simplest way to do this is to convert the entire bond portfolio to
zero-coupon/stripped bonds. Then the ex ante yield-to-maturity will
equal ex post (realized) rate of return. (ie. the ex ante YTM is locked in
since there are no intermediate cash flows the require reinvestment).
If the bond portfolio manager matches the duration of the bond portfolio
with the expected time when they will require the $100 m, then interest
rate risk will be largely eliminated.
Copyright
Copyright 2007 John Wiley & Sons
Canada, Ltd. All rights reserved.
Reproduction or translation of this work
beyond that permitted by Access
Copyright (the Canadian copyright
licensing agency) is unlawful. Requests
for further information should be
addressed to the Permissions
Department, John Wiley & Sons Canada,
Ltd. The purchaser may make back-up
copies for his or her own use only and
not for distribution or resale. The author
and the publisher assume no
responsibility for errors, omissions, or
damages caused by the use of these files
or programs or from the use of the
information contained herein.

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