Bond Valuation

Definition of 'Bond
A debt investment in which an investor loans money to an
entity (corporate or governmental) that borrows the funds
for a defined period of time at a fixed interest rate. Bonds
are used by companies, states and foreign governments to
finance a variety of projects and activities.
Government companies and the government issue bonds
and borrow money from people or institutions. So, public is
the lender of money and government companies are the
borrowers. So, a bond can again be defined as a contract
that requires the borrower to pay interest income to the
lender.

technique for determiningthe fair value

ofa particular bond.Bond valuation
includescalculating the present value of
the bond's future interest payments, also
known as its cash flow, and the bond's
value upon maturity, also known as its
face value or par value..

Par or Face Value The amount of money that is paid to the

bondholders at maturity. For most bonds this
amount is Rs.1,000, Rs.2000, Rs. 5000 and so on.
It indicates the value of the bond. i.e. the value
stated on bond paper.

Coupon Rate The coupon rate, which is generally fixed,

determines the periodic coupon or interest
payments. It is expressed as a percentage of the
bond's face value. It also represents the interest cost
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of the bond to the issuer.

FEATURES OF BONDS
A

Sealed agreement
Repayment of principles
Specified time period
Interest payment
Call

RISK IN BONDS
Interest rate risk:- Variability in the return from
debt instruments to investors is caused by the
changes in the market interest rates. This is known
as interest rate risk.
Default risk:- The failure to pay the agreed value
of the debt instrument by the issuer in full, on time
are called so. It is due to the macro economic
factors or firm specific factors.
Marketability Risk:- Variation in returns caused by
difficulty in selling bonds quickly without having
to make a substantial price concession is known as
marketability risk.
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Callability Risk
The uncertainity created in the investors return
by the issuers ability to call the bond at any time
is known as callability risk. Debt instruments
used to carry a call option. This option provides
the issuer the right to call back the instruments
by redeeming them. Since the bond or debenture
can be called at any time there is an uncertainity
regarding the maturity period. This feature of the
bond may depress the price level of the bond.
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TIME VALUE CONCEPT

The time value of money is that the rupee received today
is more valuable than the rupee received tomorrow.
Future Value = Present Value (1+interest rate).
ie
FV = PV(1+i)n
Here the compounding technique is used.
Thus, PV= FV/(1+i)n
Here the discounting technique is used.

BOND RETURN
HOLDING PERIOD RETURN
An investor buys a bond and sells it
after holding for a period. The rate of
return in that holding period is;
HPL = Price gain or loss during the
holding period + Coupon interest rate
Price at the beginning of the holding
period
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MEASURING BOND YIELD

Current

Yield
Yield To Maturity
Yield To Call

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CURRENT YIELD
The

current Yield relates the

annual coupon interest to the
market price. It is expressed as:
Annual interest
Current Yield =
Price

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EXAMPLE
The

Current Yield of a 10 Year, 12

% coupon Bond with a Par value of
Rs.1000 and selling for Rs.950.
what is current yield.
120
Current yield = 950
= 12.63
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YIELD TO MATURITY
When

you purchase a bond, you

are not quoted a promised rate of
return. Using the information on
Bond price, maturity date, and
coupon payments, you figure out
the rate of return offered by the
bond over its life.
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Formula
C
C
C
fv
P = (1+r) + (1+r)2 + (1+r)n + (1+r)n

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YIELD TO CALL
Some

bonds carry a call feature

that entitles the issuer to call( buy
back) the bond prior to the stated
maturity date in accordance with a
call schedule for such bonds. In
such case company can fix an
yeild based on market situations
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BOND PRICING THEOREMS

THEOREM

1:
Bond prices move inversely to
interest rate changes.
When y P
When y P

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Proof:

C = Rs.20p.a., F = Rs.100, N = 1.5 years, y =

10% p.a.
Price of the bond = ?
From bond valuation model:
P =
10/(1+0.05) + 10/(1+0.05)2 + 10/
(1+0.05)3
P = Rs.113.616
Assume that interest rates rise and let y = 20% p.a.
With higher interest rates, the price of the bond
falls:
P = Rs.100.00
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THEOREM 2:
The

longest the maturity of the

bond, the more sensitive it is to
changes in interest rates.

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The price changes resulting from equal

absolute increases in YTM are not
symmetrical.
For any given maturity, a x% decrease in YTM
causes a price rise that is larger than the
price loss resulting from an equal x% increase
in YTM.

THEOREM 3:

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THEOREM 4:
The

lower a bonds coupon, the

more sensitive its price will be to
given changes in interest rates.

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