Fixed Income Securities - II

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Fixed Income Securities - II
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Mapping to Curriculum
Reading 56: Understanding Yield Spreads
Reading 58: Yield Measures, Spot Rates and Forward Rates
Reading 59: Introduction to Measurement of Interest Rate Risk
Expect around 15 questions in the exam from todays lecture
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Expect around 15 questions in the exam from todays lecture
Reading 56: Understanding Yield Spreads
Reading 58: Yield Measures, Spot Rates and Forward Rates
Reading 59: Introduction to Measurement of Interest Rate Risk
Expect around 15 questions in the exam from todays lecture
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2
Expect around 15 questions in the exam from todays lecture
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Key Concepts
Interest Rate Policy
Yield Curve Shapes
Theories Of Term Structure Of Interest Rates
LIBOR
Yield Measures
Reinvestment Risk
Bootstrapping
Nominal Spread, Zero-volatility Spread,
Option-adjusted Spread
Forward Rates
Duration, Convexity, PVBP
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Interest Rate Policy
Yield Curve Shapes
Theories Of Term Structure Of Interest Rates
LIBOR
Yield Measures
Reinvestment Risk
Bootstrapping
Nominal Spread, Zero-volatility Spread,
Option-adjusted Spread
Forward Rates
Duration, Convexity, PVBP
3
Interest Rate Policy
Yield Curve Shapes
Theories Of Term Structure Of Interest Rates
LIBOR
Yield Measures
Reinvestment Risk
Bootstrapping
Nominal Spread, Zero-volatility Spread,
Option-adjusted Spread
Forward Rates
Duration, Convexity, PVBP
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Interest Rate Policy
Yield Curve Shapes
Theories Of Term Structure Of Interest Rates
LIBOR
Yield Measures
Reinvestment Risk
Bootstrapping
Nominal Spread, Zero-volatility Spread,
Option-adjusted Spread
Forward Rates
Duration, Convexity, PVBP
3
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Agenda
Features of Debt Securities
Risks Associated with Investing in Bonds
Overview of Bond Sectors and Instruments
Understanding Yield Spreads
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Features of Debt Securities
Risks Associated with Investing in Bonds
Overview of Bond Sectors and Instruments
Understanding Yield Spreads
4
Features of Debt Securities
Risks Associated with Investing in Bonds
Overview of Bond Sectors and Instruments
Understanding Yield Spreads
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Features of Debt Securities
Risks Associated with Investing in Bonds
Overview of Bond Sectors and Instruments
Understanding Yield Spreads
4
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Key Issues In Understanding Yield Spreads
Interest Rate Policy
Yield Curve
Theories of Term structure of Interest Rates
Spot Rate
Yield Spread measures
Credit Spread
Embedded options affect on yield spread
Liquidity affect on yield spread
After-tax Yield
LIBOR
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Interest Rate Policy
Yield Curve
Theories of Term structure of Interest Rates
Spot Rate
Yield Spread measures
Credit Spread
Embedded options affect on yield spread
Liquidity affect on yield spread
After-tax Yield
LIBOR
5
Key Issues In Understanding Yield Spreads
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Interest Rate Policy
To implement the Feds monetary policy, the Fed uses the following four interest rate tools:
Discount rate: is the rate at which banks borrow from the Fed.
Open Market Operations: refers to purchase and sale of Treasury Securities in the open market.
Bank Reserve requirements: refers to the percentage of deposits the bank must keep with itself.
Pursuation: refers to the Fed asking banks to alter their lending policies.
Lowering the discount rate and/or engaging in open market operations decrease the overall interest
rates in the market.
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To implement the Feds monetary policy, the Fed uses the following four interest rate tools:
Discount rate: is the rate at which banks borrow from the Fed.
Open Market Operations: refers to purchase and sale of Treasury Securities in the open market.
Bank Reserve requirements: refers to the percentage of deposits the bank must keep with itself.
Pursuation: refers to the Fed asking banks to alter their lending policies.
Lowering the discount rate and/or engaging in open market operations decrease the overall interest
rates in the market.
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Yield Curve And Its Shapes
Yield Curve: Shows the relationship between Yield and Maturity
It can be:
Upward Sloping - Normal
Downward Sloping - Inverted
Flat
Humped
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Yield Curve: Shows the relationship between Yield and Maturity
It can be:
Upward Sloping - Normal
Downward Sloping - Inverted
Flat
Humped
Rising Declining
Imp
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Flat Humped
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Theories Of Term Structure Of Interest Rates
Pure Expectations Theory:
States that the future value of interest rates is equal to the summation of market expectations. If
short-term rates are expected to rise then the yield curve will be upward sloping
Liquidity Preference Theory:
States that investors are risk-averse and will demand a premium for securities with longer maturities
Yield curve can be normal, inverted or flat as long as yield premium for interest rate risk increases with
maturity.
Shape of Term Structure Implication According to Pure Expectations
Theory
Upward sloping (normal) Rates expected to rise
Downward sloping (inverted) Rates expected to decline
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Pure Expectations Theory:
States that the future value of interest rates is equal to the summation of market expectations. If
short-term rates are expected to rise then the yield curve will be upward sloping
Liquidity Preference Theory:
States that investors are risk-averse and will demand a premium for securities with longer maturities
Yield curve can be normal, inverted or flat as long as yield premium for interest rate risk increases with
maturity.
8
Downward sloping (inverted) Rates expected to decline
Flat Rates not expected to change
Theories Of Term Structure Of Interest Rates
Pure Expectations Theory:
States that the future value of interest rates is equal to the summation of market expectations. If
short-term rates are expected to rise then the yield curve will be upward sloping
Liquidity Preference Theory:
States that investors are risk-averse and will demand a premium for securities with longer maturities
Yield curve can be normal, inverted or flat as long as yield premium for interest rate risk increases with
maturity.
Implication According to Pure Expectations
Theory
Rates expected to rise
Rates expected to decline
Imp
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Pure Expectations Theory:
States that the future value of interest rates is equal to the summation of market expectations. If
short-term rates are expected to rise then the yield curve will be upward sloping
Liquidity Preference Theory:
States that investors are risk-averse and will demand a premium for securities with longer maturities
Yield curve can be normal, inverted or flat as long as yield premium for interest rate risk increases with
maturity.
8
Rates expected to decline
Rates not expected to change
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Theories Of Term Structure Of Interest Rates
Market Segmentation Theory:
States that most investors have set preferences regarding the length of maturities they will invest in
Example: a bank having large amount of short term liabilities will prefer to invest in short term securities.
An offshoot to above theory is that an investor can be induced to invest outside their term of
preference, if they are compensated for taking on that additional risk by moving out of their preferred
range. This is known as the Preferred Habitat Theory
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Market Segmentation Theory:
States that most investors have set preferences regarding the length of maturities they will invest in
Example: a bank having large amount of short term liabilities will prefer to invest in short term securities.
An offshoot to above theory is that an investor can be induced to invest outside their term of
preference, if they are compensated for taking on that additional risk by moving out of their preferred
range. This is known as the Preferred Habitat Theory
9
Theories Of Term Structure Of Interest Rates
Market Segmentation Theory:
States that most investors have set preferences regarding the length of maturities they will invest in
Example: a bank having large amount of short term liabilities will prefer to invest in short term securities.
An offshoot to above theory is that an investor can be induced to invest outside their term of
preference, if they are compensated for taking on that additional risk by moving out of their preferred
range. This is known as the Preferred Habitat Theory
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Market Segmentation Theory:
States that most investors have set preferences regarding the length of maturities they will invest in
Example: a bank having large amount of short term liabilities will prefer to invest in short term securities.
An offshoot to above theory is that an investor can be induced to invest outside their term of
preference, if they are compensated for taking on that additional risk by moving out of their preferred
range. This is known as the Preferred Habitat Theory
9
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Spot Rate
The discount rate of a zero coupon bond is called the spot rate for that maturity.
In the case of a treasury security, its called the treasury spot rate.
The relationship between maturity an d treasury spot rates is called the term structure of interest
rates.
This is different from the treasury yield curve.
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The discount rate of a zero coupon bond is called the spot rate for that maturity.
In the case of a treasury security, its called the treasury spot rate.
The relationship between maturity an d treasury spot rates is called the term structure of interest
rates.
This is different from the treasury yield curve.
10
The discount rate of a zero coupon bond is called the spot rate for that maturity.
In the case of a treasury security, its called the treasury spot rate.
The relationship between maturity an d treasury spot rates is called the term structure of interest
rates.
This is different from the treasury yield curve.
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The discount rate of a zero coupon bond is called the spot rate for that maturity.
In the case of a treasury security, its called the treasury spot rate.
The relationship between maturity an d treasury spot rates is called the term structure of interest
rates.
This is different from the treasury yield curve.
10
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Yield Curve
Spot rate: The rate of return earned on a zero-coupon bond, if held to maturity.
Forward rate: The yield on a zero-coupon security issued at some point in the future. Since the
securities have not been issued yet, we can never observe a forward rate, we can only estimate it. In
short, a graph of forward rates is a graph of interest rates that are expected to be paid on short-term
securities in the future. (Forward rates are typically estimated for 6-month Treasury bills.)
Yield curve: A graph that shows the yield earned on bonds of various maturities. In short, it shows
the relationship between short-term and long-term interest rates.
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Spot rate: The rate of return earned on a zero-coupon bond, if held to maturity.
Forward rate: The yield on a zero-coupon security issued at some point in the future. Since the
securities have not been issued yet, we can never observe a forward rate, we can only estimate it. In
short, a graph of forward rates is a graph of interest rates that are expected to be paid on short-term
securities in the future. (Forward rates are typically estimated for 6-month Treasury bills.)
Yield curve: A graph that shows the yield earned on bonds of various maturities. In short, it shows
the relationship between short-term and long-term interest rates.
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Spot rate: The rate of return earned on a zero-coupon bond, if held to maturity.
Forward rate: The yield on a zero-coupon security issued at some point in the future. Since the
securities have not been issued yet, we can never observe a forward rate, we can only estimate it. In
short, a graph of forward rates is a graph of interest rates that are expected to be paid on short-term
securities in the future. (Forward rates are typically estimated for 6-month Treasury bills.)
Yield curve: A graph that shows the yield earned on bonds of various maturities. In short, it shows
the relationship between short-term and long-term interest rates.
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Spot rate: The rate of return earned on a zero-coupon bond, if held to maturity.
Forward rate: The yield on a zero-coupon security issued at some point in the future. Since the
securities have not been issued yet, we can never observe a forward rate, we can only estimate it. In
short, a graph of forward rates is a graph of interest rates that are expected to be paid on short-term
securities in the future. (Forward rates are typically estimated for 6-month Treasury bills.)
Yield curve: A graph that shows the yield earned on bonds of various maturities. In short, it shows
the relationship between short-term and long-term interest rates.
11
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Yield Spread Measures
Yield Spread Measures: Yield Spread is the difference between the yield on two bonds
Absolute Yield Spread = (Yield on the subject bond - Yield on benchmark bond)
Relative Yield Spread = (Absolute Yield Spread/Yield on benchmark bond)
Yield Ratio = (Subject Bond Yield/Benchmark Bond Yield)
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Yield Spread Measures: Yield Spread is the difference between the yield on two bonds
Absolute Yield Spread = (Yield on the subject bond - Yield on benchmark bond)
Relative Yield Spread = (Absolute Yield Spread/Yield on benchmark bond)
Yield Ratio = (Subject Bond Yield/Benchmark Bond Yield)
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Credit Spread
Credit Spread: It is the spread between non - Treasury and Treasury securities that are identical in
all respects except for the credit rating
In an expanding economy, credit spreads become narrow
In a contracting economy, credit spreads widen.
This is because in a contracting economy, companies experience decline in revenues and cash flows
making it more difficult for corporate issuers to service their debt obligations. Thus, credit quality
deteriorates, and investors sell corporates and buy treasuries. Thus, widening the spreads.
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Credit Spread: It is the spread between non - Treasury and Treasury securities that are identical in
all respects except for the credit rating
In an expanding economy, credit spreads become narrow
In a contracting economy, credit spreads widen.
This is because in a contracting economy, companies experience decline in revenues and cash flows
making it more difficult for corporate issuers to service their debt obligations. Thus, credit quality
deteriorates, and investors sell corporates and buy treasuries. Thus, widening the spreads.
13
Credit Spread: It is the spread between non - Treasury and Treasury securities that are identical in
all respects except for the credit rating
In an expanding economy, credit spreads become narrow
In a contracting economy, credit spreads widen.
This is because in a contracting economy, companies experience decline in revenues and cash flows
making it more difficult for corporate issuers to service their debt obligations. Thus, credit quality
deteriorates, and investors sell corporates and buy treasuries. Thus, widening the spreads.
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Credit Spread: It is the spread between non - Treasury and Treasury securities that are identical in
all respects except for the credit rating
In an expanding economy, credit spreads become narrow
In a contracting economy, credit spreads widen.
This is because in a contracting economy, companies experience decline in revenues and cash flows
making it more difficult for corporate issuers to service their debt obligations. Thus, credit quality
deteriorates, and investors sell corporates and buy treasuries. Thus, widening the spreads.
13
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Embedded Options
Embedded Options Effect on Yield Spread:
Call Provision:
Grants the issuer the right to retire the debt, fully or partially, before the scheduled maturity date.
From an investors point of view, a non-callable bond is preferred against a Callable bond.
Investors require a higher yield on the Callable bond and the yield spread is also larger for such bonds.
Put Provision/Conversion Provision
A putable-bond is more preferred to a plain vanilla bond from the investors point of view and will have a
lower yield spread
The higher spread on an MBS is due to prepayment risk.
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Embedded Options Effect on Yield Spread:
Call Provision:
Grants the issuer the right to retire the debt, fully or partially, before the scheduled maturity date.
From an investors point of view, a non-callable bond is preferred against a Callable bond.
Investors require a higher yield on the Callable bond and the yield spread is also larger for such bonds.
Put Provision/Conversion Provision
A putable-bond is more preferred to a plain vanilla bond from the investors point of view and will have a
lower yield spread
The higher spread on an MBS is due to prepayment risk.
14
Embedded Options Effect on Yield Spread:
Call Provision:
Grants the issuer the right to retire the debt, fully or partially, before the scheduled maturity date.
From an investors point of view, a non-callable bond is preferred against a Callable bond.
Investors require a higher yield on the Callable bond and the yield spread is also larger for such bonds.
Put Provision/Conversion Provision
A putable-bond is more preferred to a plain vanilla bond from the investors point of view and will have a
lower yield spread
The higher spread on an MBS is due to prepayment risk.
Imp
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Embedded Options Effect on Yield Spread:
Call Provision:
Grants the issuer the right to retire the debt, fully or partially, before the scheduled maturity date.
From an investors point of view, a non-callable bond is preferred against a Callable bond.
Investors require a higher yield on the Callable bond and the yield spread is also larger for such bonds.
Put Provision/Conversion Provision
A putable-bond is more preferred to a plain vanilla bond from the investors point of view and will have a
lower yield spread
The higher spread on an MBS is due to prepayment risk.
14
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After-tax Yield
The difference in yield between tax-exempt securities and treasury securities is typically measured not
in terms of absolute yield spread but as a yield ratio.
One should compare the after-tax yield to arrive at an investment decision
, )
rate tax Marginal 1
yield Exempt Tax
yield equivalent Taxable
rate tax Marginal 1 * Yield Taxable Yield Tax After

=
=
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, )
rate tax Marginal 1
yield Exempt Tax
yield equivalent Taxable
rate tax Marginal 1 * Yield Taxable Yield Tax After

=
=
The difference in yield between tax-exempt securities and treasury securities is typically measured not
in terms of absolute yield spread but as a yield ratio.
One should compare the after-tax yield to arrive at an investment decision
, )
rate tax Marginal 1
yield Exempt Tax
yield equivalent Taxable
rate tax Marginal 1 * Yield Taxable Yield Tax After

=
=
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, )
rate tax Marginal 1
yield Exempt Tax
yield equivalent Taxable
rate tax Marginal 1 * Yield Taxable Yield Tax After

=
=
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LIBOR
LIBOR: It stands for London Inter bank Offered Rate
Is the rate paid on Negotiable CDs by banks located in London
Determined by the British Bank Association (BBA)
It is quoted in many currencies:
Has become the most important reference rate over time
Is important because the fluctuations in LIBOR will impact the rate at which the funded investor (one who
borrows to make an investments) will be able to borrow funds
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LIBOR: It stands for London Inter bank Offered Rate
Is the rate paid on Negotiable CDs by banks located in London
Determined by the British Bank Association (BBA)
It is quoted in many currencies:
Has become the most important reference rate over time
Is important because the fluctuations in LIBOR will impact the rate at which the funded investor (one who
borrows to make an investments) will be able to borrow funds
16
LIBOR: It stands for London Inter bank Offered Rate
Is the rate paid on Negotiable CDs by banks located in London
Determined by the British Bank Association (BBA)
It is quoted in many currencies:
Has become the most important reference rate over time
Is important because the fluctuations in LIBOR will impact the rate at which the funded investor (one who
borrows to make an investments) will be able to borrow funds
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LIBOR: It stands for London Inter bank Offered Rate
Is the rate paid on Negotiable CDs by banks located in London
Determined by the British Bank Association (BBA)
It is quoted in many currencies:
Has become the most important reference rate over time
Is important because the fluctuations in LIBOR will impact the rate at which the funded investor (one who
borrows to make an investments) will be able to borrow funds
16
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Questions
1. The pure expectation theory can be used to explain any shape of the yield curve. This statement is
most likely
A. Incorrect; The market segmentation theory can be used to explain any shape of the yield curve
B. Incorrect; The liquidity preference theory can be used to explain any shape of the yield curve
C. Correct; The pure expectation theory explains any shape of the yield curve
2. With respect to the term structure of interest rates, the market segmentation theory holds that :
A. An increase in demand for long term borrowings could lead to an inverted yield curve
B. Expectations about the future of short term interest rates are the major determinants of the shape of the
yield curve
C. The yield curve reflects the maturity demands of financial institutions and investors
3. The tool most commonly used by Fed is:
A. Open Market Operations
B. Bank reserve requirement
C. Discount rate
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1. The pure expectation theory can be used to explain any shape of the yield curve. This statement is
most likely
A. Incorrect; The market segmentation theory can be used to explain any shape of the yield curve
B. Incorrect; The liquidity preference theory can be used to explain any shape of the yield curve
C. Correct; The pure expectation theory explains any shape of the yield curve
2. With respect to the term structure of interest rates, the market segmentation theory holds that :
A. An increase in demand for long term borrowings could lead to an inverted yield curve
B. Expectations about the future of short term interest rates are the major determinants of the shape of the
yield curve
C. The yield curve reflects the maturity demands of financial institutions and investors
3. The tool most commonly used by Fed is:
A. Open Market Operations
B. Bank reserve requirement
C. Discount rate
17
1. The pure expectation theory can be used to explain any shape of the yield curve. This statement is
most likely
A. Incorrect; The market segmentation theory can be used to explain any shape of the yield curve
B. Incorrect; The liquidity preference theory can be used to explain any shape of the yield curve
C. Correct; The pure expectation theory explains any shape of the yield curve
2. With respect to the term structure of interest rates, the market segmentation theory holds that :
A. An increase in demand for long term borrowings could lead to an inverted yield curve
B. Expectations about the future of short term interest rates are the major determinants of the shape of the
yield curve
C. The yield curve reflects the maturity demands of financial institutions and investors
3. The tool most commonly used by Fed is:
A. Open Market Operations
B. Bank reserve requirement
C. Discount rate
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1. The pure expectation theory can be used to explain any shape of the yield curve. This statement is
most likely
A. Incorrect; The market segmentation theory can be used to explain any shape of the yield curve
B. Incorrect; The liquidity preference theory can be used to explain any shape of the yield curve
C. Correct; The pure expectation theory explains any shape of the yield curve
2. With respect to the term structure of interest rates, the market segmentation theory holds that :
A. An increase in demand for long term borrowings could lead to an inverted yield curve
B. Expectations about the future of short term interest rates are the major determinants of the shape of the
yield curve
C. The yield curve reflects the maturity demands of financial institutions and investors
3. The tool most commonly used by Fed is:
A. Open Market Operations
B. Bank reserve requirement
C. Discount rate
17
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Questions (Cont...)
4. As per the Liquidity Preference Theory :
A. Investors will demand a premium for shorter maturity securities.
B. Investors will demand a premium for longer maturity securities.
C. Investors will not demand any premium.
5. As per the Preference habitat Theory :
A. Investors are will not move out of their preference habitat
B. Investors demand a premium to invest outside their preference range
C. Investors pay a premium to invest outside their preference range
6. The impact of an expanding economy on the yield spread is:
A. To increase the yield spread
B. To decrease the yield spread
C. Will not effect the yield spread
7. Which of the following will have the least Yield Spread:
A. Callable Bond
B. Putable Bond
C. A plain Fixed Coupon Bond
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4. As per the Liquidity Preference Theory :
A. Investors will demand a premium for shorter maturity securities.
B. Investors will demand a premium for longer maturity securities.
C. Investors will not demand any premium.
5. As per the Preference habitat Theory :
A. Investors are will not move out of their preference habitat
B. Investors demand a premium to invest outside their preference range
C. Investors pay a premium to invest outside their preference range
6. The impact of an expanding economy on the yield spread is:
A. To increase the yield spread
B. To decrease the yield spread
C. Will not effect the yield spread
7. Which of the following will have the least Yield Spread:
A. Callable Bond
B. Putable Bond
C. A plain Fixed Coupon Bond
18
4. As per the Liquidity Preference Theory :
A. Investors will demand a premium for shorter maturity securities.
B. Investors will demand a premium for longer maturity securities.
C. Investors will not demand any premium.
5. As per the Preference habitat Theory :
A. Investors are will not move out of their preference habitat
B. Investors demand a premium to invest outside their preference range
C. Investors pay a premium to invest outside their preference range
6. The impact of an expanding economy on the yield spread is:
A. To increase the yield spread
B. To decrease the yield spread
C. Will not effect the yield spread
7. Which of the following will have the least Yield Spread:
A. Callable Bond
B. Putable Bond
C. A plain Fixed Coupon Bond
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4. As per the Liquidity Preference Theory :
A. Investors will demand a premium for shorter maturity securities.
B. Investors will demand a premium for longer maturity securities.
C. Investors will not demand any premium.
5. As per the Preference habitat Theory :
A. Investors are will not move out of their preference habitat
B. Investors demand a premium to invest outside their preference range
C. Investors pay a premium to invest outside their preference range
6. The impact of an expanding economy on the yield spread is:
A. To increase the yield spread
B. To decrease the yield spread
C. Will not effect the yield spread
7. Which of the following will have the least Yield Spread:
A. Callable Bond
B. Putable Bond
C. A plain Fixed Coupon Bond
18
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Solutions
1. A. The market segmentation theory asserts that the supply and demand for funds within the different
maturity sectors of the yield curve determine the interest rate for that sector.
2. C. The correct answer is the yield curve reflects the maturity demands of financial institutions and
investors.
3. A. Open Market Operations
4. B. Investors will demand a premium for longer maturity securities
5. B. Investors demand a premium to invest outside their preference range
6. B. To decrease the yield spread
7. B. Puttable Bond
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1. A. The market segmentation theory asserts that the supply and demand for funds within the different
maturity sectors of the yield curve determine the interest rate for that sector.
2. C. The correct answer is the yield curve reflects the maturity demands of financial institutions and
investors.
3. A. Open Market Operations
4. B. Investors will demand a premium for longer maturity securities
5. B. Investors demand a premium to invest outside their preference range
6. B. To decrease the yield spread
7. B. Puttable Bond
19
1. A. The market segmentation theory asserts that the supply and demand for funds within the different
maturity sectors of the yield curve determine the interest rate for that sector.
2. C. The correct answer is the yield curve reflects the maturity demands of financial institutions and
investors.
3. A. Open Market Operations
4. B. Investors will demand a premium for longer maturity securities
5. B. Investors demand a premium to invest outside their preference range
6. B. To decrease the yield spread
7. B. Puttable Bond
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1. A. The market segmentation theory asserts that the supply and demand for funds within the different
maturity sectors of the yield curve determine the interest rate for that sector.
2. C. The correct answer is the yield curve reflects the maturity demands of financial institutions and
investors.
3. A. Open Market Operations
4. B. Investors will demand a premium for longer maturity securities
5. B. Investors demand a premium to invest outside their preference range
6. B. To decrease the yield spread
7. B. Puttable Bond
19
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Agenda
Introduction to the Valuation of Debt Securities
Yield Measures, Spot Rates, and Forward Rates
Introduction to Measurement of Interest Rate Risk
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Introduction to the Valuation of Debt Securities
Yield Measures, Spot Rates, and Forward Rates
Introduction to Measurement of Interest Rate Risk
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Key Issues In Yield Measures, Spot Rates, And Forward Rates
Returns from Investing in a Bond
Traditional Yield Measures
Reinvestment Income
Bond Equivalent Yield and Annual-pay Yield
Computing theoretical Treasury Spot rate
Nominal spread, Zero-volatility spread, Option-adjusted spread
Option cost in a bond
Forward Rates
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Returns from Investing in a Bond
Traditional Yield Measures
Reinvestment Income
Bond Equivalent Yield and Annual-pay Yield
Computing theoretical Treasury Spot rate
Nominal spread, Zero-volatility spread, Option-adjusted spread
Option cost in a bond
Forward Rates
21
Key Issues In Yield Measures, Spot Rates, And Forward Rates
Returns from Investing in a Bond
Traditional Yield Measures
Reinvestment Income
Bond Equivalent Yield and Annual-pay Yield
Computing theoretical Treasury Spot rate
Nominal spread, Zero-volatility spread, Option-adjusted spread
Option cost in a bond
Forward Rates
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Returns from Investing in a Bond
Traditional Yield Measures
Reinvestment Income
Bond Equivalent Yield and Annual-pay Yield
Computing theoretical Treasury Spot rate
Nominal spread, Zero-volatility spread, Option-adjusted spread
Option cost in a bond
Forward Rates
21
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Returns From Investing In A Bond
A person realizes the following returns from a coupon paying security
Interest payment made by the issuer
Reinvestment income from reinvesting the interest payments received
Recovery of the principal. includes the capital gain/loss on selling the security.
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22
A person realizes the following returns from a coupon paying security
Interest payment made by the issuer
Reinvestment income from reinvesting the interest payments received
Recovery of the principal. includes the capital gain/loss on selling the security.
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22
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Traditional Yield Measures
Traditional Yield Measures
Current Yield: the annnual interest income from the bond
Current Yield = Annual Coupon interest received
Bond Price
The current yield is simply the coupon payment (C) as a percentage of the (current) bond price (P).
Current yield = C / P
0
.
Drawbacks :
Only Considers coupon interest
Capital Gains/Losses not taken into account
No consideration for reinvestment income
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Traditional Yield Measures
Current Yield: the annnual interest income from the bond
Current Yield = Annual Coupon interest received
Bond Price
The current yield is simply the coupon payment (C) as a percentage of the (current) bond price (P).
Current yield = C / P
0
.
Drawbacks :
Only Considers coupon interest
Capital Gains/Losses not taken into account
No consideration for reinvestment income
23
Traditional Yield Measures
Current Yield: the annnual interest income from the bond
Current Yield = Annual Coupon interest received
Bond Price
The current yield is simply the coupon payment (C) as a percentage of the (current) bond price (P).
Current yield = C / P
0
.
Drawbacks :
Only Considers coupon interest
Capital Gains/Losses not taken into account
No consideration for reinvestment income
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Traditional Yield Measures
Current Yield: the annnual interest income from the bond
Current Yield = Annual Coupon interest received
Bond Price
The current yield is simply the coupon payment (C) as a percentage of the (current) bond price (P).
Current yield = C / P
0
.
Drawbacks :
Only Considers coupon interest
Capital Gains/Losses not taken into account
No consideration for reinvestment income
23
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Traditional Yield Measures
Yield to Maturity(YTM): YTM is the IRR of the bond. It is the annualised rate of return on the bond

Yield Measure Relationships:

Advantages:
Considers both coupon income and capital gain/loss if held to maturity.
Considers the timing of cashflows
Limitations
It considers the reinvestment income; the interim coupon payments are reinvested at a rate equal to
the YTM.
Bond Selling at: Relationship
Par Coupon rate = Current Yield = Yield to Maturity
Discount Coupon rate < Current Yield < Yield to Maturity
Premium Coupon rate > Current Yield > Yield to Maturity
, )
2N 2
2
YTM
1
Par C
.....
2
YTM
1
C
2
YTM
1
C

'
\

'
-
-
- -

'
\

'
-
-

'
\

'
-
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Yield to Maturity(YTM): YTM is the IRR of the bond. It is the annualised rate of return on the bond

Yield Measure Relationships:

Advantages:
Considers both coupon income and capital gain/loss if held to maturity.
Considers the timing of cashflows
Limitations
It considers the reinvestment income; the interim coupon payments are reinvested at a rate equal to
the YTM.
24
Premium Coupon rate > Current Yield > Yield to Maturity
Yield to Maturity(YTM): YTM is the IRR of the bond. It is the annualised rate of return on the bond

Yield Measure Relationships:

Advantages:
Considers both coupon income and capital gain/loss if held to maturity.
Considers the timing of cashflows
Limitations
It considers the reinvestment income; the interim coupon payments are reinvested at a rate equal to
the YTM.
Coupon rate = Current Yield = Yield to Maturity
Coupon rate < Current Yield < Yield to Maturity
Coupon rate > Current Yield > Yield to Maturity
, )
2N 2
2
YTM
1
Par C
.....
2
YTM
1
C
2
YTM
1
C

'
\

'
-
-
- -

'
\

'
-
-

'
\

'
-
Imp
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Yield to Maturity(YTM): YTM is the IRR of the bond. It is the annualised rate of return on the bond

Yield Measure Relationships:

Advantages:
Considers both coupon income and capital gain/loss if held to maturity.
Considers the timing of cashflows
Limitations
It considers the reinvestment income; the interim coupon payments are reinvested at a rate equal to
the YTM.
24
Coupon rate > Current Yield > Yield to Maturity
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Traditional Yield Measures
YTM of Annual Coupon Bond:
A 10 year, $1000 par value bond has a coupon of 7%. If it is priced at $920 what is the YTM?
PV = -920; N=10; FV=1000; PMT=70
I/Y = 8.20%
YTM for zero coupon bond:
The price of a 5-year Treasury bond is $804. Calculate the semiannual-pay YTM and annual-pay
YTM.
Semiannual-pay YTM =
Annual-pay YTM =
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YTM of Annual Coupon Bond:
A 10 year, $1000 par value bond has a coupon of 7%. If it is priced at $920 what is the YTM?
PV = -920; N=10; FV=1000; PMT=70
I/Y = 8.20%
YTM for zero coupon bond:
The price of a 5-year Treasury bond is $804. Calculate the semiannual-pay YTM and annual-pay
YTM.
Semiannual-pay YTM =
Annual-pay YTM =
25
% 41 . 4 2 * 1
804
1000
10
1
=
(
(

'
\

'
% 46 . 4 1
804
1000
5
1
=
(
(

'
\

'
YTM of Annual Coupon Bond:
A 10 year, $1000 par value bond has a coupon of 7%. If it is priced at $920 what is the YTM?
PV = -920; N=10; FV=1000; PMT=70
I/Y = 8.20%
YTM for zero coupon bond:
The price of a 5-year Treasury bond is $804. Calculate the semiannual-pay YTM and annual-pay
YTM.
Semiannual-pay YTM =
Annual-pay YTM =
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YTM of Annual Coupon Bond:
A 10 year, $1000 par value bond has a coupon of 7%. If it is priced at $920 what is the YTM?
PV = -920; N=10; FV=1000; PMT=70
I/Y = 8.20%
YTM for zero coupon bond:
The price of a 5-year Treasury bond is $804. Calculate the semiannual-pay YTM and annual-pay
YTM.
Semiannual-pay YTM =
Annual-pay YTM =
25
% 41 . 4 2 * 1
804
1000
10
1
=
(
(

'
\

'
% 46 . 4 1
804
1000
5
1
=
(
(

'
\

'
This files has expired at 30-Jun-13
Traditional Yield Measures
Bond Equivalent Yield: Doubling the semiannual yield to maturity.
Yield to Call: yield on callable bonds (bonds can be called before maturity) that are selling at a
premium. The calculation is the same as for normal bonds. The par value is substitued with the call
price and the total period is substituted with the period upto the call date
Yield to Put: yield on puttable bonds that are selling at a discount
Yield to Worst: A yield can be calculated for every possible call date and put date. The lowest of
these YTMs is called Yield to Worst.
Cash Flow Yield: used for Amortisinfg Securities. The limitation with this measure is that the actual
prepayment rates may differ from those assumed for calculation purposes.
Yield to maturity (YTM): most popular yield measure of all the above. The limitation with this
measure is that it assumes that cash flows are reinvested at the YTM and the bond is held till maturity
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Bond Equivalent Yield: Doubling the semiannual yield to maturity.
Yield to Call: yield on callable bonds (bonds can be called before maturity) that are selling at a
premium. The calculation is the same as for normal bonds. The par value is substitued with the call
price and the total period is substituted with the period upto the call date
Yield to Put: yield on puttable bonds that are selling at a discount
Yield to Worst: A yield can be calculated for every possible call date and put date. The lowest of
these YTMs is called Yield to Worst.
Cash Flow Yield: used for Amortisinfg Securities. The limitation with this measure is that the actual
prepayment rates may differ from those assumed for calculation purposes.
Yield to maturity (YTM): most popular yield measure of all the above. The limitation with this
measure is that it assumes that cash flows are reinvested at the YTM and the bond is held till maturity
26
Bond Equivalent Yield: Doubling the semiannual yield to maturity.
Yield to Call: yield on callable bonds (bonds can be called before maturity) that are selling at a
premium. The calculation is the same as for normal bonds. The par value is substitued with the call
price and the total period is substituted with the period upto the call date
Yield to Put: yield on puttable bonds that are selling at a discount
Yield to Worst: A yield can be calculated for every possible call date and put date. The lowest of
these YTMs is called Yield to Worst.
Cash Flow Yield: used for Amortisinfg Securities. The limitation with this measure is that the actual
prepayment rates may differ from those assumed for calculation purposes.
Yield to maturity (YTM): most popular yield measure of all the above. The limitation with this
measure is that it assumes that cash flows are reinvested at the YTM and the bond is held till maturity
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Bond Equivalent Yield: Doubling the semiannual yield to maturity.
Yield to Call: yield on callable bonds (bonds can be called before maturity) that are selling at a
premium. The calculation is the same as for normal bonds. The par value is substitued with the call
price and the total period is substituted with the period upto the call date
Yield to Put: yield on puttable bonds that are selling at a discount
Yield to Worst: A yield can be calculated for every possible call date and put date. The lowest of
these YTMs is called Yield to Worst.
Cash Flow Yield: used for Amortisinfg Securities. The limitation with this measure is that the actual
prepayment rates may differ from those assumed for calculation purposes.
Yield to maturity (YTM): most popular yield measure of all the above. The limitation with this
measure is that it assumes that cash flows are reinvested at the YTM and the bond is held till maturity
26
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Calculate And Compare Yield Spread
Absolute yield spread :
It is Simply the difference between yields or two bonds.
( Yield on higher yield bond - yield on lower yield bond )
Relative yield Spread :
It is the Absolute yield spread expressed as percentage of the yield on benchmark bond.
Yield Ratio : It is the ratio of yield on the subject bond to the yield on the benchmark bond
bond benchmark on the Yield
spread yield Absolute
spread yield Relative =
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Absolute yield spread :
It is Simply the difference between yields or two bonds.
( Yield on higher yield bond - yield on lower yield bond )
Relative yield Spread :
It is the Absolute yield spread expressed as percentage of the yield on benchmark bond.
Yield Ratio : It is the ratio of yield on the subject bond to the yield on the benchmark bond
27
bond benchmark on the Yield
spread yield Absolute
spread yield Relative =
yield bond benchmark
yield bond Subject
Ratio Yield =
Calculate And Compare Yield Spread
Absolute yield spread :
It is Simply the difference between yields or two bonds.
( Yield on higher yield bond - yield on lower yield bond )
Relative yield Spread :
It is the Absolute yield spread expressed as percentage of the yield on benchmark bond.
Yield Ratio : It is the ratio of yield on the subject bond to the yield on the benchmark bond
bond benchmark on the Yield
spread yield Absolute
spread yield Relative =
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Absolute yield spread :
It is Simply the difference between yields or two bonds.
( Yield on higher yield bond - yield on lower yield bond )
Relative yield Spread :
It is the Absolute yield spread expressed as percentage of the yield on benchmark bond.
Yield Ratio : It is the ratio of yield on the subject bond to the yield on the benchmark bond
27
bond benchmark on the Yield
spread yield Absolute
spread yield Relative =
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Reinvestment Income
If the reinvestment rate is less than the YTM then the actual yield realised will be less than YTM
How to calculate the Reinvestment Income earned???
20-year Treasury bond purchased at par, 7% coupon rate, how much reinvestment income should be
generated to earn a YTM of 7%?
Total Value generated in 20 years = 100(1.035)
40
= 395.9260
Reinvestment income required = 395.9260 100 40*3.50 = 155.9260
Factors Affecting:
Higher the coupon rate higher the reinvestment risk
Longer the maturity higher the reinvestment risk
If the above problem was for a 10 year bond with a coupon of 5%, the reinvestment income required
would have been $13.8616 as compared to $ 155.9260
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If the reinvestment rate is less than the YTM then the actual yield realised will be less than YTM
How to calculate the Reinvestment Income earned???
20-year Treasury bond purchased at par, 7% coupon rate, how much reinvestment income should be
generated to earn a YTM of 7%?
Total Value generated in 20 years = 100(1.035)
40
= 395.9260
Reinvestment income required = 395.9260 100 40*3.50 = 155.9260
Factors Affecting:
Higher the coupon rate higher the reinvestment risk
Longer the maturity higher the reinvestment risk
If the above problem was for a 10 year bond with a coupon of 5%, the reinvestment income required
would have been $13.8616 as compared to $ 155.9260
28
If the reinvestment rate is less than the YTM then the actual yield realised will be less than YTM
How to calculate the Reinvestment Income earned???
20-year Treasury bond purchased at par, 7% coupon rate, how much reinvestment income should be
generated to earn a YTM of 7%?
Total Value generated in 20 years = 100(1.035)
40
= 395.9260
Reinvestment income required = 395.9260 100 40*3.50 = 155.9260
Factors Affecting:
Higher the coupon rate higher the reinvestment risk
Longer the maturity higher the reinvestment risk
If the above problem was for a 10 year bond with a coupon of 5%, the reinvestment income required
would have been $13.8616 as compared to $ 155.9260
Imp
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If the reinvestment rate is less than the YTM then the actual yield realised will be less than YTM
How to calculate the Reinvestment Income earned???
20-year Treasury bond purchased at par, 7% coupon rate, how much reinvestment income should be
generated to earn a YTM of 7%?
Total Value generated in 20 years = 100(1.035)
40
= 395.9260
Reinvestment income required = 395.9260 100 40*3.50 = 155.9260
Factors Affecting:
Higher the coupon rate higher the reinvestment risk
Longer the maturity higher the reinvestment risk
If the above problem was for a 10 year bond with a coupon of 5%, the reinvestment income required
would have been $13.8616 as compared to $ 155.9260
28
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Bond Equivalent Yield And Annual-pay Yield
The following formula identifies the relationship between the two.
Bond Equivalent Yield(BEY) of an Annual-pay Bond
Yield on an annual pay basis
, ) , 1 YTM Annual 1 * 2
2
1
- = BEY
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The following formula identifies the relationship between the two.
Bond Equivalent Yield(BEY) of an Annual-pay Bond
Yield on an annual pay basis
29
(
(

'
\

'
- = 1
2
BEY
1
2
YTM
Bond Equivalent Yield And Annual-pay Yield
The following formula identifies the relationship between the two.
Bond Equivalent Yield(BEY) of an Annual-pay Bond
Yield on an annual pay basis
, ) , 1 YTM Annual 1 * 2
2
1
- = BEY
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The following formula identifies the relationship between the two.
Bond Equivalent Yield(BEY) of an Annual-pay Bond
Yield on an annual pay basis
29
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Computing Theoretical Treasury Spot Rate
Bootstrapping: It is the method of calculating the spot rates using the prices of coupon bonds. One
spot rate is used to calculate the spot rate for the next period. The two consecutive spot rates are
used for calculating the next spot rate
Spot Rate Curve:
Theoretical Spot Rate Curve
(Term Structure of interest rates)
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30
0%
1%
2%
3%
4%
5%
6%
7%
0 0.5 1 1.5 2 2.5
Theoretical Spot Rate Curve
(Term Structure of interest rates)
Computing Theoretical Treasury Spot Rate
Bootstrapping: It is the method of calculating the spot rates using the prices of coupon bonds. One
spot rate is used to calculate the spot rate for the next period. The two consecutive spot rates are
used for calculating the next spot rate
Spot Rate Curve:
Theoretical Spot Rate Curve
(Term Structure of interest rates)
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30
3
Theoretical Spot Rate Curve
(Term Structure of interest rates)
Rate
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Bootstrapping
Yield Curve
Yields are bond-specific; given a bond's market price and
coupons, the yield
is the rate that all cash flows are discounted at to make present
and
future values the same.
Spot Curve
The spot curve diagrams what pure discount rate the market
applies to any
Summarizing the curves
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31
Spot Curve
The spot curve diagrams what pure discount rate the market
applies to any
cash flow at each maturity point. It is not bond specific.
Also called the zero curve.
Forward
Curve
This is a plot of what the market charges to borrow money for a
6 month
period starting at certain future dates.
Note that forward curves could be made for any borrowing term
(i.e. 1 year forwards, 3 month forwards, etc.)
Yields are bond-specific; given a bond's market price and
coupons, the yield
is the rate that all cash flows are discounted at to make present
and
The spot curve diagrams what pure discount rate the market
applies to any
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The spot curve diagrams what pure discount rate the market
applies to any
cash flow at each maturity point. It is not bond specific.
This is a plot of what the market charges to borrow money for a
6 month
period starting at certain future dates.
Note that forward curves could be made for any borrowing term
(i.e. 1 year forwards, 3 month forwards, etc.)
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Bootstrapping Example:
Consider 3 treasury securities with their maturities and market rates given in the table below:
Using the method of bootstrapping, find the theoretical Treasury spot rates.
Solution:
The bond with six months left to maturity has a semiannual discount rate of 0.03/2 = 0.015 or 3.0% on an
annual bond equivalent yield (BEY) basis.
Since the bond will only make a single payment of 101.50 in six months, the market rate is the spot rate
for cash flows to be received six months from now.
Maturity Market Rate
6 months 3%
12 months 4%
18 months 5%
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Consider 3 treasury securities with their maturities and market rates given in the table below:
Using the method of bootstrapping, find the theoretical Treasury spot rates.
Solution:
The bond with six months left to maturity has a semiannual discount rate of 0.03/2 = 0.015 or 3.0% on an
annual bond equivalent yield (BEY) basis.
Since the bond will only make a single payment of 101.50 in six months, the market rate is the spot rate
for cash flows to be received six months from now.
32
Consider 3 treasury securities with their maturities and market rates given in the table below:
Using the method of bootstrapping, find the theoretical Treasury spot rates.
Solution:
The bond with six months left to maturity has a semiannual discount rate of 0.03/2 = 0.015 or 3.0% on an
annual bond equivalent yield (BEY) basis.
Since the bond will only make a single payment of 101.50 in six months, the market rate is the spot rate
for cash flows to be received six months from now.
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Consider 3 treasury securities with their maturities and market rates given in the table below:
Using the method of bootstrapping, find the theoretical Treasury spot rates.
Solution:
The bond with six months left to maturity has a semiannual discount rate of 0.03/2 = 0.015 or 3.0% on an
annual bond equivalent yield (BEY) basis.
Since the bond will only make a single payment of 101.50 in six months, the market rate is the spot rate
for cash flows to be received six months from now.
32
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Solution
100
)
2
1 (
102
015 . 1
2
2
1
=
-
-
S
100
)
2
1 (
5 . 102
) 02 . 1 (
5 . 2
015 . 1
5 . 2
3
5 . 1
2
=
-
- -
S
The one-year bond will make two payments, one in six months of 2 and one in one year of 102. We
can solve for the one-year spot rate in the equation:
where S
1.0
is the annualized 1-year spot rate. Solving we get: S
1.0
= 4.01 %.
Using the 6-month and 1-year spot rates, we can use the same approach to find the 18-month spot
rate from the equation
where S
1.0
is the annualized 18-month spot rate. Solving we get: S
1.5
= 5.03%.
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33
100
)
2
1 (
5 . 102
) 02 . 1 (
5 . 2
015 . 1
5 . 2
3
5 . 1
2
=
-
- -
S
The one-year bond will make two payments, one in six months of 2 and one in one year of 102. We
can solve for the one-year spot rate in the equation:
where S
1.0
is the annualized 1-year spot rate. Solving we get: S
1.0
= 4.01 %.
Using the 6-month and 1-year spot rates, we can use the same approach to find the 18-month spot
rate from the equation
where S
1.0
is the annualized 18-month spot rate. Solving we get: S
1.5
= 5.03%.
The one-year bond will make two payments, one in six months of 2 and one in one year of 102. We
can solve for the one-year spot rate in the equation:
where S
1.0
is the annualized 1-year spot rate. Solving we get: S
1.0
= 4.01 %.
Using the 6-month and 1-year spot rates, we can use the same approach to find the 18-month spot
rate from the equation
where S
1.0
is the annualized 18-month spot rate. Solving we get: S
1.5
= 5.03%.
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33
The one-year bond will make two payments, one in six months of 2 and one in one year of 102. We
can solve for the one-year spot rate in the equation:
where S
1.0
is the annualized 1-year spot rate. Solving we get: S
1.0
= 4.01 %.
Using the 6-month and 1-year spot rates, we can use the same approach to find the 18-month spot
rate from the equation
where S
1.0
is the annualized 18-month spot rate. Solving we get: S
1.5
= 5.03%.
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Nominal Spread, Zero-volatility Spread,
Option-adjusted Spread
Nominal Spread: is the YTM of a bond minus the YTM of a Treasury security of similar maturity
Zero-Volatility Spread: is the constant spread that is to be added to the spot rate yield at EACH
POINT on the Treasury curve where a cash flow is received that will make the price of a security
equal to the present value of its cash flows. Each cash flow of the security is discounted at the
appropriate Treasury spot rate plus the Z-spread. It is also known as "static spread"
PV of Bond(for a two year annual pay security)
Z-spread Vs Nominal:
A nominal spread uses one point on the Treasury yield curve to determine the spread at a single point that
will equal the present value of the security's cash flows to its price
Option Adjusted Spread: is the spread without the affect of the option for a bond with embedded
options.
Treasury Bond
YTM YTM Spread Nominal =
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Nominal Spread: is the YTM of a bond minus the YTM of a Treasury security of similar maturity
Zero-Volatility Spread: is the constant spread that is to be added to the spot rate yield at EACH
POINT on the Treasury curve where a cash flow is received that will make the price of a security
equal to the present value of its cash flows. Each cash flow of the security is discounted at the
appropriate Treasury spot rate plus the Z-spread. It is also known as "static spread"
PV of Bond(for a two year annual pay security)
Z-spread Vs Nominal:
A nominal spread uses one point on the Treasury yield curve to determine the spread at a single point that
will equal the present value of the security's cash flows to its price
Option Adjusted Spread: is the spread without the affect of the option for a bond with embedded
options.
34
, ) , )
(

- -
-
(

- -
=
2 1
2 1
Coupon
ZS rate Spot 1yr 1
Coupon
Price
ZS rate Spot yr
Cost Option Spread - Z Spread Adjusted Option =
Nominal Spread, Zero-volatility Spread,
Option-adjusted Spread
Nominal Spread: is the YTM of a bond minus the YTM of a Treasury security of similar maturity
Zero-Volatility Spread: is the constant spread that is to be added to the spot rate yield at EACH
POINT on the Treasury curve where a cash flow is received that will make the price of a security
equal to the present value of its cash flows. Each cash flow of the security is discounted at the
appropriate Treasury spot rate plus the Z-spread. It is also known as "static spread"
PV of Bond(for a two year annual pay security)
Z-spread Vs Nominal:
A nominal spread uses one point on the Treasury yield curve to determine the spread at a single point that
will equal the present value of the security's cash flows to its price
Option Adjusted Spread: is the spread without the affect of the option for a bond with embedded
options.
Treasury Bond
YTM YTM Spread Nominal =
Imp
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Nominal Spread: is the YTM of a bond minus the YTM of a Treasury security of similar maturity
Zero-Volatility Spread: is the constant spread that is to be added to the spot rate yield at EACH
POINT on the Treasury curve where a cash flow is received that will make the price of a security
equal to the present value of its cash flows. Each cash flow of the security is discounted at the
appropriate Treasury spot rate plus the Z-spread. It is also known as "static spread"
PV of Bond(for a two year annual pay security)
Z-spread Vs Nominal:
A nominal spread uses one point on the Treasury yield curve to determine the spread at a single point that
will equal the present value of the security's cash flows to its price
Option Adjusted Spread: is the spread without the affect of the option for a bond with embedded
options.
34
, ) , )
(

- -
-
(

- -
=
2 1
2 1
Coupon
ZS rate Spot 1yr 1
Coupon
Price
ZS rate Spot yr
Cost Option Spread - Z Spread Adjusted Option =
This files has expired at 30-Jun-13
Option Cost In A Bond
Option Cost in % = Z-spread Option Adjusted Spread(OAS)
In case of a callble bond the OAS < Z-spread as one needs to be compensated for the call feature
In case of putable options the OAS > Z-spread
Spread
Measure
Benchmark Reflects Compensation for
Nominal Treasury Yield
Curve
Credit Risk, Liquidity Risk,
Option Risk
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35
Treasury Yield
Curve
Credit Risk, Liquidity Risk,
Option Risk
Zero-Volatility Treasury Spot
Rate Curve
Credit Risk, Liquidity Risk,
Option Risk
Option-
Adjusted
Treasury Spot
Rate Curve
Credit Risk, Liquidity Risk
Option Cost in % = Z-spread Option Adjusted Spread(OAS)
In case of a callble bond the OAS < Z-spread as one needs to be compensated for the call feature
In case of putable options the OAS > Z-spread
Reflects Compensation for
Credit Risk, Liquidity Risk,
Option Risk
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35
Credit Risk, Liquidity Risk,
Option Risk
Credit Risk, Liquidity Risk,
Option Risk
Credit Risk, Liquidity Risk
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Forward Rates
Forward Rates: rates of interest implied by the current zero rates for a period of time in the future
For example, 6-Month Forward in 6 Months is equivalent to borrowing or lending the Notional
Amount for 6 month after 6 months from today
The same is represented as:
S
1
=
1
f
0
= Current Spot rate
1
f
1
= is the rate for a 1-year loan to be made one year from now
1
f
2
= is the rate for a 1-year loan to be made two years from now
Relating the above terminology:
Neev Knowledge Management Pristine
Forward Rates: rates of interest implied by the current zero rates for a period of time in the future
For example, 6-Month Forward in 6 Months is equivalent to borrowing or lending the Notional
Amount for 6 month after 6 months from today
The same is represented as:
S
1
=
1
f
0
= Current Spot rate
1
f
1
= is the rate for a 1-year loan to be made one year from now
1
f
2
= is the rate for a 1-year loan to be made two years from now
Relating the above terminology:
36
, ) , ), ), )
2 1 1 1 0 1
3
3
1 1 1 1 f f f S - - - = -
Forward Rates: rates of interest implied by the current zero rates for a period of time in the future
For example, 6-Month Forward in 6 Months is equivalent to borrowing or lending the Notional
Amount for 6 month after 6 months from today
The same is represented as:
S
1
=
1
f
0
= Current Spot rate
1
f
1
= is the rate for a 1-year loan to be made one year from now
1
f
2
= is the rate for a 1-year loan to be made two years from now
Relating the above terminology:
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Forward Rates: rates of interest implied by the current zero rates for a period of time in the future
For example, 6-Month Forward in 6 Months is equivalent to borrowing or lending the Notional
Amount for 6 month after 6 months from today
The same is represented as:
S
1
=
1
f
0
= Current Spot rate
1
f
1
= is the rate for a 1-year loan to be made one year from now
1
f
2
= is the rate for a 1-year loan to be made two years from now
Relating the above terminology:
36
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Forward Rates
For example: if we have the zero rates for year 4 and year 5 then the forward rate for the period of
time between year 4 and year 5 would be known as the forward rate for that time period of 1 year.
The 5-year spot rate is 10.50% and the 4-year spot rate is 11.25%. What is the one year forward rate
four years from no?
7.02%
7.55%
8.35%
Solution: (1+z
5
)
5
= (1+z
4
)
4
*(1+f
1
) = (1.105)
5
= (1.1125)
4
*(1+f
1
)
(1+f
1
) = 1.0755
f
1
= 7.55%
Year 4
F
4,5
F
4
= 4%
Neev Knowledge Management Pristine
For example: if we have the zero rates for year 4 and year 5 then the forward rate for the period of
time between year 4 and year 5 would be known as the forward rate for that time period of 1 year.
The 5-year spot rate is 10.50% and the 4-year spot rate is 11.25%. What is the one year forward rate
four years from no?
7.02%
7.55%
8.35%
Solution: (1+z
5
)
5
= (1+z
4
)
4
*(1+f
1
) = (1.105)
5
= (1.1125)
4
*(1+f
1
)
(1+f
1
) = 1.0755
f
1
= 7.55%
37
For example: if we have the zero rates for year 4 and year 5 then the forward rate for the period of
time between year 4 and year 5 would be known as the forward rate for that time period of 1 year.
The 5-year spot rate is 10.50% and the 4-year spot rate is 11.25%. What is the one year forward rate
four years from no?
7.02%
7.55%
8.35%
Solution: (1+z
5
)
5
= (1+z
4
)
4
*(1+f
1
) = (1.105)
5
= (1.1125)
4
*(1+f
1
)
(1+f
1
) = 1.0755
f
1
= 7.55%
Year 5
F
5
= 5%
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For example: if we have the zero rates for year 4 and year 5 then the forward rate for the period of
time between year 4 and year 5 would be known as the forward rate for that time period of 1 year.
The 5-year spot rate is 10.50% and the 4-year spot rate is 11.25%. What is the one year forward rate
four years from no?
7.02%
7.55%
8.35%
Solution: (1+z
5
)
5
= (1+z
4
)
4
*(1+f
1
) = (1.105)
5
= (1.1125)
4
*(1+f
1
)
(1+f
1
) = 1.0755
f
1
= 7.55%
37
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Questions
1. Karen invests in an 8% 5-year semi-annual callable bond on 5
th
January 2010. The Z-spread for the
callable bond is 150bps. The option cost is 56 bps. The OAS is closest to
A. 100 bps
B. 94 bps
C. 206 bps
2. Reinvestment income is least effected by:
A. The time to maturity.
B. The size of the debt issue.
C. The Coupon rate.
3. The z-spread of a callable bond is 340 basis points. The OAS of the bond is most likely to be:
A. Greater than 340 basis points
B. Lesser than 340 basis points
C. Equal to 340 basis points
Neev Knowledge Management Pristine
1. Karen invests in an 8% 5-year semi-annual callable bond on 5
th
January 2010. The Z-spread for the
callable bond is 150bps. The option cost is 56 bps. The OAS is closest to
A. 100 bps
B. 94 bps
C. 206 bps
2. Reinvestment income is least effected by:
A. The time to maturity.
B. The size of the debt issue.
C. The Coupon rate.
3. The z-spread of a callable bond is 340 basis points. The OAS of the bond is most likely to be:
A. Greater than 340 basis points
B. Lesser than 340 basis points
C. Equal to 340 basis points
38
1. Karen invests in an 8% 5-year semi-annual callable bond on 5
th
January 2010. The Z-spread for the
callable bond is 150bps. The option cost is 56 bps. The OAS is closest to
A. 100 bps
B. 94 bps
C. 206 bps
2. Reinvestment income is least effected by:
A. The time to maturity.
B. The size of the debt issue.
C. The Coupon rate.
3. The z-spread of a callable bond is 340 basis points. The OAS of the bond is most likely to be:
A. Greater than 340 basis points
B. Lesser than 340 basis points
C. Equal to 340 basis points
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1. Karen invests in an 8% 5-year semi-annual callable bond on 5
th
January 2010. The Z-spread for the
callable bond is 150bps. The option cost is 56 bps. The OAS is closest to
A. 100 bps
B. 94 bps
C. 206 bps
2. Reinvestment income is least effected by:
A. The time to maturity.
B. The size of the debt issue.
C. The Coupon rate.
3. The z-spread of a callable bond is 340 basis points. The OAS of the bond is most likely to be:
A. Greater than 340 basis points
B. Lesser than 340 basis points
C. Equal to 340 basis points
38
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Questions (Cont....)
4. For a 7% 3-year semi-annual option-free bond. The Treasury spot rates are given below. The bond is
at par. Calculate the no-arbitrage price for the bond. If the market price is $104.5 the BEY is closest
to
Maturity (months) Yield
6 5.2%
12 5.5%
18 5.8%
24 6.0%
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39
24 6.0%
30 6.2%
36 6.5%
5. The yield on a Bond Equivalent basis of an annual-pay 8.50% coupon bond prices at par is:
A. 4.16%
B. 8.33%
C. 6.43%
6. The annual-pay yield to maturity of a 8.50% coupon semi-annual pay bond is:
A. 17.72%
B. 8.68%
C. 13.43%
4. For a 7% 3-year semi-annual option-free bond. The Treasury spot rates are given below. The bond is
at par. Calculate the no-arbitrage price for the bond. If the market price is $104.5 the BEY is closest
to
No-Arbitrage
Price
BEY
A 102.34 5.45%
B 101.48 5.36%
C 104.50 5.25%
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39
C 104.50 5.25%
5. The yield on a Bond Equivalent basis of an annual-pay 8.50% coupon bond prices at par is:
A. 4.16%
B. 8.33%
C. 6.43%
6. The annual-pay yield to maturity of a 8.50% coupon semi-annual pay bond is:
A. 17.72%
B. 8.68%
C. 13.43%
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Solutions
1. B. OAS = Z-spread option cost = 150 -56 = 94 bps
2. B. The size of the debt issue
3. B. Lesser than 340 basis points
4. B. No-arbitrage price is calculated by discounting all the cash flows by the spot rates
The bond equivalent yield can be calculated by using the CF function
Input 6 cash flows for coupon payment and one principal payment cash flow. CF0 = 104.5 CPT IRR.
IRR = 2.68% BEY = 2* IRR = 5.36%
5. B. 8.33%
6. B. 8.68%
Mo n t h s Y i e l d P V F a c t o r C a s h F l o w P V o f C F
6 5 . 2 0 % 0 . 9 7 4 7 3 . 5 3 . 4 1 1 3
1 2 5 . 5 0 % 0 . 9 4 7 2 3 . 5 3 . 3 1 5 2
1 8 5 . 8 0 % 0 . 9 1 7 8 3 . 5 3 . 2 1 2 3
2 4 6 . 0 0 % 0 . 8 8 8 5 3 . 5 3 . 1 0 9 7
3 0 6 . 2 0 % 0 . 8 5 8 4 3 . 5 3 . 0 0 4 5
3 6 6 . 5 0 % 0 . 8 2 5 4 1 0 3 . 5 8 5 . 4 2 8 0
1 0 1 . 4 8 0 9 8 0 9
Neev Knowledge Management Pristine
1. B. OAS = Z-spread option cost = 150 -56 = 94 bps
2. B. The size of the debt issue
3. B. Lesser than 340 basis points
4. B. No-arbitrage price is calculated by discounting all the cash flows by the spot rates
The bond equivalent yield can be calculated by using the CF function
Input 6 cash flows for coupon payment and one principal payment cash flow. CF0 = 104.5 CPT IRR.
IRR = 2.68% BEY = 2* IRR = 5.36%
5. B. 8.33%
6. B. 8.68%
40
Mo n t h s Y i e l d P V F a c t o r C a s h F l o w P V o f C F
6 5 . 2 0 % 0 . 9 7 4 7 3 . 5 3 . 4 1 1 3
1 2 5 . 5 0 % 0 . 9 4 7 2 3 . 5 3 . 3 1 5 2
1 8 5 . 8 0 % 0 . 9 1 7 8 3 . 5 3 . 2 1 2 3
2 4 6 . 0 0 % 0 . 8 8 8 5 3 . 5 3 . 1 0 9 7
3 0 6 . 2 0 % 0 . 8 5 8 4 3 . 5 3 . 0 0 4 5
3 6 6 . 5 0 % 0 . 8 2 5 4 1 0 3 . 5 8 5 . 4 2 8 0
1 0 1 . 4 8 0 9 8 0 9
1. B. OAS = Z-spread option cost = 150 -56 = 94 bps
2. B. The size of the debt issue
3. B. Lesser than 340 basis points
4. B. No-arbitrage price is calculated by discounting all the cash flows by the spot rates
The bond equivalent yield can be calculated by using the CF function
Input 6 cash flows for coupon payment and one principal payment cash flow. CF0 = 104.5 CPT IRR.
IRR = 2.68% BEY = 2* IRR = 5.36%
5. B. 8.33%
6. B. 8.68%
Mo n t h s Y i e l d P V F a c t o r C a s h F l o w P V o f C F
6 5 . 2 0 % 0 . 9 7 4 7 3 . 5 3 . 4 1 1 3
1 2 5 . 5 0 % 0 . 9 4 7 2 3 . 5 3 . 3 1 5 2
1 8 5 . 8 0 % 0 . 9 1 7 8 3 . 5 3 . 2 1 2 3
2 4 6 . 0 0 % 0 . 8 8 8 5 3 . 5 3 . 1 0 9 7
3 0 6 . 2 0 % 0 . 8 5 8 4 3 . 5 3 . 0 0 4 5
3 6 6 . 5 0 % 0 . 8 2 5 4 1 0 3 . 5 8 5 . 4 2 8 0
1 0 1 . 4 8 0 9 8 0 9
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1. B. OAS = Z-spread option cost = 150 -56 = 94 bps
2. B. The size of the debt issue
3. B. Lesser than 340 basis points
4. B. No-arbitrage price is calculated by discounting all the cash flows by the spot rates
The bond equivalent yield can be calculated by using the CF function
Input 6 cash flows for coupon payment and one principal payment cash flow. CF0 = 104.5 CPT IRR.
IRR = 2.68% BEY = 2* IRR = 5.36%
5. B. 8.33%
6. B. 8.68%
40
Mo n t h s Y i e l d P V F a c t o r C a s h F l o w P V o f C F
6 5 . 2 0 % 0 . 9 7 4 7 3 . 5 3 . 4 1 1 3
1 2 5 . 5 0 % 0 . 9 4 7 2 3 . 5 3 . 3 1 5 2
1 8 5 . 8 0 % 0 . 9 1 7 8 3 . 5 3 . 2 1 2 3
2 4 6 . 0 0 % 0 . 8 8 8 5 3 . 5 3 . 1 0 9 7
3 0 6 . 2 0 % 0 . 8 5 8 4 3 . 5 3 . 0 0 4 5
3 6 6 . 5 0 % 0 . 8 2 5 4 1 0 3 . 5 8 5 . 4 2 8 0
1 0 1 . 4 8 0 9 8 0 9
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Agenda
Introduction to the Valuation of Debt Securities
Yield Measures, Spot Rates, and Forward Rates
Introduction to Measurement of Interest Rate Risk
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41
Introduction to the Valuation of Debt Securities
Yield Measures, Spot Rates, and Forward Rates
Introduction to Measurement of Interest Rate Risk
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41
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Key Issues In Introduction To The Measurement Of Interest
Rate Risk
Measuring Interest Rate Risk
Price Volatility
Convexity
Effective Duration
Alternative definitions of Duration
Duration of a portfolio
Convexity measure of a bond
Modified and Effective Convexity
Price Value of a Basis Point(PVBP)
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Measuring Interest Rate Risk
Price Volatility
Convexity
Effective Duration
Alternative definitions of Duration
Duration of a portfolio
Convexity measure of a bond
Modified and Effective Convexity
Price Value of a Basis Point(PVBP)
42
Key Issues In Introduction To The Measurement Of Interest
Rate Risk
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42
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Measuring Interest Rate Risk
Interest rate risk can be measured by two methods:
Full Valuation Method:
This is referred to as scenario analysis.
Under this method the normal pricing techniques are used to value a bond or a bond with embedded
options
When the interest rates change the entire portfolio is re-evaluated by the same method
The two values are compared to arrive at the impact of change in interest rate
Calculation gets complicated when there are a large number of bonds in the portfolio.
Duration/Convexity Method:
This gives an approximate result of the sensitivity of the bond.
It is much simpler compared to the full valuation method.
Neev Knowledge Management Pristine
Interest rate risk can be measured by two methods:
Full Valuation Method:
This is referred to as scenario analysis.
Under this method the normal pricing techniques are used to value a bond or a bond with embedded
options
When the interest rates change the entire portfolio is re-evaluated by the same method
The two values are compared to arrive at the impact of change in interest rate
Calculation gets complicated when there are a large number of bonds in the portfolio.
Duration/Convexity Method:
This gives an approximate result of the sensitivity of the bond.
It is much simpler compared to the full valuation method.
43
Interest rate risk can be measured by two methods:
Full Valuation Method:
This is referred to as scenario analysis.
Under this method the normal pricing techniques are used to value a bond or a bond with embedded
options
When the interest rates change the entire portfolio is re-evaluated by the same method
The two values are compared to arrive at the impact of change in interest rate
Calculation gets complicated when there are a large number of bonds in the portfolio.
Duration/Convexity Method:
This gives an approximate result of the sensitivity of the bond.
It is much simpler compared to the full valuation method.
www.edupristine.com
Interest rate risk can be measured by two methods:
Full Valuation Method:
This is referred to as scenario analysis.
Under this method the normal pricing techniques are used to value a bond or a bond with embedded
options
When the interest rates change the entire portfolio is re-evaluated by the same method
The two values are compared to arrive at the impact of change in interest rate
Calculation gets complicated when there are a large number of bonds in the portfolio.
Duration/Convexity Method:
This gives an approximate result of the sensitivity of the bond.
It is much simpler compared to the full valuation method.
43
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Disadvantages Of A Callable Bond
From the investors perspective the disadvantages of an embedded call option is:
Cash flow pattern is not known with certainity
Investor exposed to reinvestment risk
Price appreciation potential will be decreased relative to an otherwise comparable option-free bond.
Negative convexity
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44
From the investors perspective the disadvantages of an embedded call option is:
Cash flow pattern is not known with certainity
Investor exposed to reinvestment risk
Price appreciation potential will be decreased relative to an otherwise comparable option-free bond.
Negative convexity
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44
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Price Volatility And Convexity
We have already seen that the price-yield curve is a negatively sloped and is a curve. This is referred
to as convex.
Properties concerning the price volatility of an option free bond:
Percentage price change per change in interest rates is not the same for all bonds
For either small increases or decreases in yield, percentage change in price for given bond is roughly
the same.
For a given large change in yield, the percentage price increase is greater than the percentage price
decrease.
Price
Neev Knowledge Management Pristine
We have already seen that the price-yield curve is a negatively sloped and is a curve. This is referred
to as convex.
Properties concerning the price volatility of an option free bond:
Percentage price change per change in interest rates is not the same for all bonds
For either small increases or decreases in yield, percentage change in price for given bond is roughly
the same.
For a given large change in yield, the percentage price increase is greater than the percentage price
decrease.
45
We have already seen that the price-yield curve is a negatively sloped and is a curve. This is referred
to as convex.
Properties concerning the price volatility of an option free bond:
Percentage price change per change in interest rates is not the same for all bonds
For either small increases or decreases in yield, percentage change in price for given bond is roughly
the same.
For a given large change in yield, the percentage price increase is greater than the percentage price
decrease.
YTM
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We have already seen that the price-yield curve is a negatively sloped and is a curve. This is referred
to as convex.
Properties concerning the price volatility of an option free bond:
Percentage price change per change in interest rates is not the same for all bonds
For either small increases or decreases in yield, percentage change in price for given bond is roughly
the same.
For a given large change in yield, the percentage price increase is greater than the percentage price
decrease.
45
YTM
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Price Volatility And Convexity
The curve of a Callable bond exhibits Negative Convexity. This is because the increase in the price
of a security as a result of fall in the yield is capped at the call price. See the below graph:
P
r
i
c
e
Option-free bond
C
a
l
l
a
b
l
e

b
o
n
d
Value of call
Neev Knowledge Management Pristine
46
Coupon
C
a
l
l
a
b
l
e

b
o
n
d
The curve of a Callable bond exhibits Negative Convexity. This is because the increase in the price
of a security as a result of fall in the yield is capped at the call price. See the below graph:
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46
Yield
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Price Volatility And Convexity
The curve of a Puttable bond exhibits Positive Convexity. This is because the decrease in the price
of a security as a result of increase in the yield is limited to the put price. See the below graph:
P
r
i
c
e
Putable Bond
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47
Coupon
Value of Put
Yield
The curve of a Puttable bond exhibits Positive Convexity. This is because the decrease in the price
of a security as a result of increase in the yield is limited to the put price. See the below graph:
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47
Value of Put
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Effective Duration
Duration is the measure of how long on an average the holder of the bond has to wait before he receives his
payments on the bond. A coupon paying bonds duration would be lower than n as the holder gets some of
his payments in the form of coupons before n years
In simple words, duration of a bond is sensitivity of bond price to change in its interest rate
Effective duration is calculated as:
Percentage change in Bond Price = -Effective Duration * Change in yield in percent. (y)
Example: Consider a bond trading at 96.54 with duration of 4.5 years. In this case
B = - 96.54* 4.5 y
B = -434.43 y
If there is 10 basis points increase ( + y) in the yield then the bond price would change by:
B = -434.43 * ( 0.001) = -.43443
Hence, B = 96.54- .43443 = 96.10
decimals) in yield in (Change * Price) (Initial * 2
rises) yield when price Bond falls yield when price (Bond
Duration Effective =
Neev Knowledge Management Pristine
Duration is the measure of how long on an average the holder of the bond has to wait before he receives his
payments on the bond. A coupon paying bonds duration would be lower than n as the holder gets some of
his payments in the form of coupons before n years
In simple words, duration of a bond is sensitivity of bond price to change in its interest rate
Effective duration is calculated as:
Percentage change in Bond Price = -Effective Duration * Change in yield in percent. (y)
Example: Consider a bond trading at 96.54 with duration of 4.5 years. In this case
B = - 96.54* 4.5 y
B = -434.43 y
If there is 10 basis points increase ( + y) in the yield then the bond price would change by:
B = -434.43 * ( 0.001) = -.43443
Hence, B = 96.54- .43443 = 96.10
48
Duration is the measure of how long on an average the holder of the bond has to wait before he receives his
payments on the bond. A coupon paying bonds duration would be lower than n as the holder gets some of
his payments in the form of coupons before n years
In simple words, duration of a bond is sensitivity of bond price to change in its interest rate
Effective duration is calculated as:
Percentage change in Bond Price = -Effective Duration * Change in yield in percent. (y)
Example: Consider a bond trading at 96.54 with duration of 4.5 years. In this case
B = - 96.54* 4.5 y
B = -434.43 y
If there is 10 basis points increase ( + y) in the yield then the bond price would change by:
B = -434.43 * ( 0.001) = -.43443
Hence, B = 96.54- .43443 = 96.10
decimals) in yield in (Change * Price) (Initial * 2
rises) yield when price Bond falls yield when price (Bond
Duration Effective =
Imp
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Duration is the measure of how long on an average the holder of the bond has to wait before he receives his
payments on the bond. A coupon paying bonds duration would be lower than n as the holder gets some of
his payments in the form of coupons before n years
In simple words, duration of a bond is sensitivity of bond price to change in its interest rate
Effective duration is calculated as:
Percentage change in Bond Price = -Effective Duration * Change in yield in percent. (y)
Example: Consider a bond trading at 96.54 with duration of 4.5 years. In this case
B = - 96.54* 4.5 y
B = -434.43 y
If there is 10 basis points increase ( + y) in the yield then the bond price would change by:
B = -434.43 * ( 0.001) = -.43443
Hence, B = 96.54- .43443 = 96.10
48
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Percentage Change In Price Using Duration
Approximate percentage price change = - Duration * y * 100
For example, you hold a bond that has a duration of 7.8 years. The interest rates fell by 25 bps.
Calculate the approximate percentage price change.
Answer: Approximate percentage price change = - Duration * y * 100
= -7.8 *(- .0025) * 100
= 1.95%
For large changes in yield, convexity should also be used. Percentage change in price becomes
inaccurate with only taking duration into account.
Neev Knowledge Management Pristine
Approximate percentage price change = - Duration * y * 100
For example, you hold a bond that has a duration of 7.8 years. The interest rates fell by 25 bps.
Calculate the approximate percentage price change.
Answer: Approximate percentage price change = - Duration * y * 100
= -7.8 *(- .0025) * 100
= 1.95%
For large changes in yield, convexity should also be used. Percentage change in price becomes
inaccurate with only taking duration into account.
49
Percentage Change In Price Using Duration
Approximate percentage price change = - Duration * y * 100
For example, you hold a bond that has a duration of 7.8 years. The interest rates fell by 25 bps.
Calculate the approximate percentage price change.
Answer: Approximate percentage price change = - Duration * y * 100
= -7.8 *(- .0025) * 100
= 1.95%
For large changes in yield, convexity should also be used. Percentage change in price becomes
inaccurate with only taking duration into account.
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Approximate percentage price change = - Duration * y * 100
For example, you hold a bond that has a duration of 7.8 years. The interest rates fell by 25 bps.
Calculate the approximate percentage price change.
Answer: Approximate percentage price change = - Duration * y * 100
= -7.8 *(- .0025) * 100
= 1.95%
For large changes in yield, convexity should also be used. Percentage change in price becomes
inaccurate with only taking duration into account.
49
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Alternative Definitions Of Duration
Macaulay Duration: is the weighted average of the times when the payments are made. And the
weights are a ratio of the coupon paid at time t to the present bond price
Macaulay duration is also used to measure how sensitive a bond or a bond portfolio's price is to
changes in interest rates.
where:
t = Respective time period
C= Periodic Coupon payments ; y =Periodic yield : n = Total number of periods
M = maturity Value
Calculating Macaulay Duration:
Note that this is 3.77 six-month periods, which is about 1.89 years
Price Bond Current
y) (1
M * n
y) (1
C * t
Duration Macaulay
n
1 t
n t
=
-
-
-
=
Neev Knowledge Management Pristine
Macaulay Duration: is the weighted average of the times when the payments are made. And the
weights are a ratio of the coupon paid at time t to the present bond price
Macaulay duration is also used to measure how sensitive a bond or a bond portfolio's price is to
changes in interest rates.
where:
t = Respective time period
C= Periodic Coupon payments ; y =Periodic yield : n = Total number of periods
M = maturity Value
Calculating Macaulay Duration:
Note that this is 3.77 six-month periods, which is about 1.89 years
50
, )
, )
, )
, )
, )
, )
, )
, )
77 . 3
54 . 964
76 . 3636
54 . 964
4
05 . 1
1040
3
05 . 1
40
2
05 . 1
40
1
05 . 1
40
4 3 2
= =
- - -
= D
0 1
40 -964.54
Macaulay Duration: is the weighted average of the times when the payments are made. And the
weights are a ratio of the coupon paid at time t to the present bond price
Macaulay duration is also used to measure how sensitive a bond or a bond portfolio's price is to
changes in interest rates.
where:
t = Respective time period
C= Periodic Coupon payments ; y =Periodic yield : n = Total number of periods
M = maturity Value
Calculating Macaulay Duration:
Note that this is 3.77 six-month periods, which is about 1.89 years
1,000
Price Bond Current
y) (1
M * n
y) (1
C * t
Duration Macaulay
n
1 t
n t
=
-
-
-
=
www.edupristine.com
Macaulay Duration: is the weighted average of the times when the payments are made. And the
weights are a ratio of the coupon paid at time t to the present bond price
Macaulay duration is also used to measure how sensitive a bond or a bond portfolio's price is to
changes in interest rates.
where:
t = Respective time period
C= Periodic Coupon payments ; y =Periodic yield : n = Total number of periods
M = maturity Value
Calculating Macaulay Duration:
Note that this is 3.77 six-month periods, which is about 1.89 years
50
, )
, )
, )
, )
, )
, )
, )
, )
77 . 3
54 . 964
76 . 3636
54 . 964
4
05 . 1
1040
3
05 . 1
40
2
05 . 1
40
1
05 . 1
40
4 3 2
= =
- - -
= D
1 2 3 4
40
1,000
40 40 40
This files has expired at 30-Jun-13
Change In Bond Price With Change In Discount Rate
Modified Duration
The modified duration is equal to the percentage change in price for a given change in yield.
Example:
The current price of a bond is 98.75. Its modified duration is 5.2 years. The YTM of the bond is
7.5%. What would the price be if the yield became 8%?
Solution:
V = -98.75 * 5.2 * 0.005
= -2.57
The new price of the bond is 96.18
y ModD V V
y
V
/ /
/
/
. .
V
1
- ModD
Neev Knowledge Management Pristine
Modified Duration
The modified duration is equal to the percentage change in price for a given change in yield.
Example:
The current price of a bond is 98.75. Its modified duration is 5.2 years. The YTM of the bond is
7.5%. What would the price be if the yield became 8%?
Solution:
V = -98.75 * 5.2 * 0.005
= -2.57
The new price of the bond is 96.18
51
Change In Bond Price With Change In Discount Rate
Modified Duration
The modified duration is equal to the percentage change in price for a given change in yield.
Example:
The current price of a bond is 98.75. Its modified duration is 5.2 years. The YTM of the bond is
7.5%. What would the price be if the yield became 8%?
Solution:
V = -98.75 * 5.2 * 0.005
= -2.57
The new price of the bond is 96.18
www.edupristine.com
Modified Duration
The modified duration is equal to the percentage change in price for a given change in yield.
Example:
The current price of a bond is 98.75. Its modified duration is 5.2 years. The YTM of the bond is
7.5%. What would the price be if the yield became 8%?
Solution:
V = -98.75 * 5.2 * 0.005
= -2.57
The new price of the bond is 96.18
51
This files has expired at 30-Jun-13
Alternative Definitions Of Duration
Modified Duration: is derived from Macaulay Duration. It is better than Macaulay Duration as it
takes into account the current YTM.
Effective Duration calculations explicitly take into account the a bonds option provisions such as
embedded options. The other methods of calculation ignore the option provision
In summary duration is,
The first derivative of the price-yield function
The slope of the price-yield curve.
A weighted average of the time till the cash flows willl be received.(Macaulay Duration)
The approximate percentage change in price for a 1% change in yield.(Effective Duration)
)
year per payments interest of no
YTM
(1
Duration Macaulay
Duration Modified
-
=
Neev Knowledge Management Pristine
Modified Duration: is derived from Macaulay Duration. It is better than Macaulay Duration as it
takes into account the current YTM.
Effective Duration calculations explicitly take into account the a bonds option provisions such as
embedded options. The other methods of calculation ignore the option provision
In summary duration is,
The first derivative of the price-yield function
The slope of the price-yield curve.
A weighted average of the time till the cash flows willl be received.(Macaulay Duration)
The approximate percentage change in price for a 1% change in yield.(Effective Duration)
52
Modified Duration: is derived from Macaulay Duration. It is better than Macaulay Duration as it
takes into account the current YTM.
Effective Duration calculations explicitly take into account the a bonds option provisions such as
embedded options. The other methods of calculation ignore the option provision
In summary duration is,
The first derivative of the price-yield function
The slope of the price-yield curve.
A weighted average of the time till the cash flows willl be received.(Macaulay Duration)
The approximate percentage change in price for a 1% change in yield.(Effective Duration)
)
year per payments interest of no
YTM
(1
Duration Macaulay
Duration Modified
-
=
www.edupristine.com
Modified Duration: is derived from Macaulay Duration. It is better than Macaulay Duration as it
takes into account the current YTM.
Effective Duration calculations explicitly take into account the a bonds option provisions such as
embedded options. The other methods of calculation ignore the option provision
In summary duration is,
The first derivative of the price-yield function
The slope of the price-yield curve.
A weighted average of the time till the cash flows willl be received.(Macaulay Duration)
The approximate percentage change in price for a 1% change in yield.(Effective Duration)
52
This files has expired at 30-Jun-13
Duration Of A Portfolio
Duration of a portfolio is the weighted average of the duration of the individual securities in the
portfolio.
Portfolio Duration =
The problem with the above equation is that it holds good only for a parallel shift in the yield curve.
This is because securities with different maturities may have different changes in yield.
N N 2 2 1 1
D W ......... D W D W - - -
Neev Knowledge Management Pristine
Duration of a portfolio is the weighted average of the duration of the individual securities in the
portfolio.
Portfolio Duration =
The problem with the above equation is that it holds good only for a parallel shift in the yield curve.
This is because securities with different maturities may have different changes in yield.
53
Duration of a portfolio is the weighted average of the duration of the individual securities in the
portfolio.
Portfolio Duration =
The problem with the above equation is that it holds good only for a parallel shift in the yield curve.
This is because securities with different maturities may have different changes in yield.
N N 2 2 1 1
D W ......... D W D W - - -
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Duration of a portfolio is the weighted average of the duration of the individual securities in the
portfolio.
Portfolio Duration =
The problem with the above equation is that it holds good only for a parallel shift in the yield curve.
This is because securities with different maturities may have different changes in yield.
53
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Convexity Measure Of A Bond
Convexity is the measure of the curvature of a price-yield cuve.
Duration is an appropriate measure for small changes in the yield. For larger changes in yield
convexity should also be used.
Percentage Change in Price = Duration Effect + Convexity Effect
=[(-Duration * y) + (Convexity * y
2
) ] * 100
Note: In this formula all the values are used as numbers. E.g. 1% must be written as 0.01.
This is also the reason to multiply it by 100
B
o
n
d
P
r
i
c
e
(
$
)
P
Actual Price Yield
Curve
Curvature effect not
incorporated by Duration
Neev Knowledge Management Pristine
Convexity is the measure of the curvature of a price-yield cuve.
Duration is an appropriate measure for small changes in the yield. For larger changes in yield
convexity should also be used.
Percentage Change in Price = Duration Effect + Convexity Effect
=[(-Duration * y) + (Convexity * y
2
) ] * 100
Note: In this formula all the values are used as numbers. E.g. 1% must be written as 0.01.
This is also the reason to multiply it by 100
54
Y
2
decimals) in yield in (Change * Price) (Initial * 2
Price) Bond Initial * 2 - rises yield when price Bond falls yield when price (Bond
Convexity
-
=
Convexity is the measure of the curvature of a price-yield cuve.
Duration is an appropriate measure for small changes in the yield. For larger changes in yield
convexity should also be used.
Percentage Change in Price = Duration Effect + Convexity Effect
=[(-Duration * y) + (Convexity * y
2
) ] * 100
Note: In this formula all the values are used as numbers. E.g. 1% must be written as 0.01.
This is also the reason to multiply it by 100
Price based on Duration.
Actual Price Yield
Curve
Curvature effect not
incorporated by Duration
www.edupristine.com
Convexity is the measure of the curvature of a price-yield cuve.
Duration is an appropriate measure for small changes in the yield. For larger changes in yield
convexity should also be used.
Percentage Change in Price = Duration Effect + Convexity Effect
=[(-Duration * y) + (Convexity * y
2
) ] * 100
Note: In this formula all the values are used as numbers. E.g. 1% must be written as 0.01.
This is also the reason to multiply it by 100
54
Price based on Duration.
2
decimals) in yield in (Change * Price) (Initial * 2
Price) Bond Initial * 2 - rises yield when price Bond falls yield when price (Bond
Convexity
-
=
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Price Value Of A Basis Point (PVBP)
This is a measure of interest rate risk.
This is also known as the dollar value of an 01 (DV01)
PVBP It is the absolute value of the change in the price of a bond for a 1 basis point change in
yield.
The PVBP is the same for both increase and decrease (because change in yield is small)
The PVBP is a special case of dollar duration.
point basis 1 by changes yield when Price - Price Initial PVBP =
Neev Knowledge Management Pristine
This is a measure of interest rate risk.
This is also known as the dollar value of an 01 (DV01)
PVBP It is the absolute value of the change in the price of a bond for a 1 basis point change in
yield.
The PVBP is the same for both increase and decrease (because change in yield is small)
The PVBP is a special case of dollar duration.
55
Value Bond * 0.01% * Duration PVBP =
This is a measure of interest rate risk.
This is also known as the dollar value of an 01 (DV01)
PVBP It is the absolute value of the change in the price of a bond for a 1 basis point change in
yield.
The PVBP is the same for both increase and decrease (because change in yield is small)
The PVBP is a special case of dollar duration.
point basis 1 by changes yield when Price - Price Initial PVBP =
www.edupristine.com
This is a measure of interest rate risk.
This is also known as the dollar value of an 01 (DV01)
PVBP It is the absolute value of the change in the price of a bond for a 1 basis point change in
yield.
The PVBP is the same for both increase and decrease (because change in yield is small)
The PVBP is a special case of dollar duration.
55
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Yield Volatility
Price Yield Relationship
As seen in the graph, the when the yield level is high, a change in interest rates does not produce a
large change in price.
However, when yields are low, changes in interest rates produces a large change in price.
Interest Rate Risk can be decomposed into:
Duration risk
Yield Volatility
Yield volatility explains why junk bonds have higher interest rate risk than treasuries. Yield Volatility is
given by the standard deviation of yield changes
Neev Knowledge Management Pristine
Price Yield Relationship
As seen in the graph, the when the yield level is high, a change in interest rates does not produce a
large change in price.
However, when yields are low, changes in interest rates produces a large change in price.
Interest Rate Risk can be decomposed into:
Duration risk
Yield Volatility
Yield volatility explains why junk bonds have higher interest rate risk than treasuries. Yield Volatility is
given by the standard deviation of yield changes
56
Price Yield Relationship
As seen in the graph, the when the yield level is high, a change in interest rates does not produce a
large change in price.
However, when yields are low, changes in interest rates produces a large change in price.
Interest Rate Risk can be decomposed into:
Duration risk
Yield Volatility
Yield volatility explains why junk bonds have higher interest rate risk than treasuries. Yield Volatility is
given by the standard deviation of yield changes
www.edupristine.com
Price Yield Relationship
As seen in the graph, the when the yield level is high, a change in interest rates does not produce a
large change in price.
However, when yields are low, changes in interest rates produces a large change in price.
Interest Rate Risk can be decomposed into:
Duration risk
Yield Volatility
Yield volatility explains why junk bonds have higher interest rate risk than treasuries. Yield Volatility is
given by the standard deviation of yield changes
56
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Questions
1. A 5 year bond paying 8% annual pay coupon is currently trading for $1023.56 and having YTM of 7.42%,
calculate the effective duration of the bond given 25 basis point in YTM.
Given : V- = 1033.88, V+ = $1013.29
A. 5.03%
B. 4.02%
C. 4.56%
2. Calculate the duration of the portfolio of two bonds A and B having weights of 60% and 40% respectively.
Duration of bond A is 7.9 and duration of bond B is 6.7.
A. 7.64
B. 7.42
C. 7.24
3. A bond has a convexity of 63.80. The convexity effect if the yield decreases by 80 basis points is:
A. 0.41%
B. 0.35%
C. 0.54%
4. A bond has a duration of 9.75 and a convexity of 105.80. What is the change in the price of the bond for a
100 basis fall in the yield:
A. 10.25%
B. 9.75%
C. 10.80%
Neev Knowledge Management Pristine
1. A 5 year bond paying 8% annual pay coupon is currently trading for $1023.56 and having YTM of 7.42%,
calculate the effective duration of the bond given 25 basis point in YTM.
Given : V- = 1033.88, V+ = $1013.29
A. 5.03%
B. 4.02%
C. 4.56%
2. Calculate the duration of the portfolio of two bonds A and B having weights of 60% and 40% respectively.
Duration of bond A is 7.9 and duration of bond B is 6.7.
A. 7.64
B. 7.42
C. 7.24
3. A bond has a convexity of 63.80. The convexity effect if the yield decreases by 80 basis points is:
A. 0.41%
B. 0.35%
C. 0.54%
4. A bond has a duration of 9.75 and a convexity of 105.80. What is the change in the price of the bond for a
100 basis fall in the yield:
A. 10.25%
B. 9.75%
C. 10.80%
57
1. A 5 year bond paying 8% annual pay coupon is currently trading for $1023.56 and having YTM of 7.42%,
calculate the effective duration of the bond given 25 basis point in YTM.
Given : V- = 1033.88, V+ = $1013.29
A. 5.03%
B. 4.02%
C. 4.56%
2. Calculate the duration of the portfolio of two bonds A and B having weights of 60% and 40% respectively.
Duration of bond A is 7.9 and duration of bond B is 6.7.
A. 7.64
B. 7.42
C. 7.24
3. A bond has a convexity of 63.80. The convexity effect if the yield decreases by 80 basis points is:
A. 0.41%
B. 0.35%
C. 0.54%
4. A bond has a duration of 9.75 and a convexity of 105.80. What is the change in the price of the bond for a
100 basis fall in the yield:
A. 10.25%
B. 9.75%
C. 10.80%
www.edupristine.com
1. A 5 year bond paying 8% annual pay coupon is currently trading for $1023.56 and having YTM of 7.42%,
calculate the effective duration of the bond given 25 basis point in YTM.
Given : V- = 1033.88, V+ = $1013.29
A. 5.03%
B. 4.02%
C. 4.56%
2. Calculate the duration of the portfolio of two bonds A and B having weights of 60% and 40% respectively.
Duration of bond A is 7.9 and duration of bond B is 6.7.
A. 7.64
B. 7.42
C. 7.24
3. A bond has a convexity of 63.80. The convexity effect if the yield decreases by 80 basis points is:
A. 0.41%
B. 0.35%
C. 0.54%
4. A bond has a duration of 9.75 and a convexity of 105.80. What is the change in the price of the bond for a
100 basis fall in the yield:
A. 10.25%
B. 9.75%
C. 10.80%
57
This files has expired at 30-Jun-13
Questions (Cont...)
5. The most accurate measure for arriving at the effect of duration is?
A. Duration Approach
B. Full valuation approach
C. PVBP
6. A bond manager has collected the following information regarding a portfolio of fixed income
investments which have a par value of $10mn. The current market price is $11.25mn. If the duration
is 5.2 the most likely estimate of the price change for the bond issue for a 25 bps change is
A. 1.3% of $10mn
B. 1.3% of $11.25mn
C. 2.1% of $11.25mn
7. A portfolio manager notices the following in his portfolio has a portfolio duration of 4.35. How much
will be the change in the portfolio if the interest rate declines by 25 bps
A. $ 28,280
B. $ 14,250
C. $ 27,100
Neev Knowledge Management Pristine
5. The most accurate measure for arriving at the effect of duration is?
A. Duration Approach
B. Full valuation approach
C. PVBP
6. A bond manager has collected the following information regarding a portfolio of fixed income
investments which have a par value of $10mn. The current market price is $11.25mn. If the duration
is 5.2 the most likely estimate of the price change for the bond issue for a 25 bps change is
A. 1.3% of $10mn
B. 1.3% of $11.25mn
C. 2.1% of $11.25mn
7. A portfolio manager notices the following in his portfolio has a portfolio duration of 4.35. How much
will be the change in the portfolio if the interest rate declines by 25 bps
A. $ 28,280
B. $ 14,250
C. $ 27,100
58
Issue
A
B
C
5. The most accurate measure for arriving at the effect of duration is?
A. Duration Approach
B. Full valuation approach
C. PVBP
6. A bond manager has collected the following information regarding a portfolio of fixed income
investments which have a par value of $10mn. The current market price is $11.25mn. If the duration
is 5.2 the most likely estimate of the price change for the bond issue for a 25 bps change is
A. 1.3% of $10mn
B. 1.3% of $11.25mn
C. 2.1% of $11.25mn
7. A portfolio manager notices the following in his portfolio has a portfolio duration of 4.35. How much
will be the change in the portfolio if the interest rate declines by 25 bps
A. $ 28,280
B. $ 14,250
C. $ 27,100
www.edupristine.com
5. The most accurate measure for arriving at the effect of duration is?
A. Duration Approach
B. Full valuation approach
C. PVBP
6. A bond manager has collected the following information regarding a portfolio of fixed income
investments which have a par value of $10mn. The current market price is $11.25mn. If the duration
is 5.2 the most likely estimate of the price change for the bond issue for a 25 bps change is
A. 1.3% of $10mn
B. 1.3% of $11.25mn
C. 2.1% of $11.25mn
7. A portfolio manager notices the following in his portfolio has a portfolio duration of 4.35. How much
will be the change in the portfolio if the interest rate declines by 25 bps
A. $ 28,280
B. $ 14,250
C. $ 27,100
58
Maturity Market Value
2 $8.5mn
5 $4.6mn
10 $12.9mn
This files has expired at 30-Jun-13
Solutions
1. B. V = $1023.56, V- = 1033.88, V+ = $1013.29, Change in yield is = 25 bps = 0.0025
So effective duration is = ($1033.88 - $1013.29)/2 * $1023.88 *0.0025 = 4.02
2. B. The portfolio duration is =0.6 * 7.9 + 0.4 *6.7 = 7.42
3. A. 0.41%
4. C. 10.80%
5. B. Full valuation approach
6. B. The estimated change = 5.2*0.25 = 1.3%. (The par value of $10mn is given to confuse the
candidate. Par value never changes. Current value of $11.25mn is more important)
7. A. 26mn * 4.35 * (0.25)% = $ 28,280
Neev Knowledge Management Pristine
1. B. V = $1023.56, V- = 1033.88, V+ = $1013.29, Change in yield is = 25 bps = 0.0025
So effective duration is = ($1033.88 - $1013.29)/2 * $1023.88 *0.0025 = 4.02
2. B. The portfolio duration is =0.6 * 7.9 + 0.4 *6.7 = 7.42
3. A. 0.41%
4. C. 10.80%
5. B. Full valuation approach
6. B. The estimated change = 5.2*0.25 = 1.3%. (The par value of $10mn is given to confuse the
candidate. Par value never changes. Current value of $11.25mn is more important)
7. A. 26mn * 4.35 * (0.25)% = $ 28,280
59
1. B. V = $1023.56, V- = 1033.88, V+ = $1013.29, Change in yield is = 25 bps = 0.0025
So effective duration is = ($1033.88 - $1013.29)/2 * $1023.88 *0.0025 = 4.02
2. B. The portfolio duration is =0.6 * 7.9 + 0.4 *6.7 = 7.42
3. A. 0.41%
4. C. 10.80%
5. B. Full valuation approach
6. B. The estimated change = 5.2*0.25 = 1.3%. (The par value of $10mn is given to confuse the
candidate. Par value never changes. Current value of $11.25mn is more important)
7. A. 26mn * 4.35 * (0.25)% = $ 28,280
www.edupristine.com
1. B. V = $1023.56, V- = 1033.88, V+ = $1013.29, Change in yield is = 25 bps = 0.0025
So effective duration is = ($1033.88 - $1013.29)/2 * $1023.88 *0.0025 = 4.02
2. B. The portfolio duration is =0.6 * 7.9 + 0.4 *6.7 = 7.42
3. A. 0.41%
4. C. 10.80%
5. B. Full valuation approach
6. B. The estimated change = 5.2*0.25 = 1.3%. (The par value of $10mn is given to confuse the
candidate. Par value never changes. Current value of $11.25mn is more important)
7. A. 26mn * 4.35 * (0.25)% = $ 28,280
59
This files has expired at 30-Jun-13
Extra-Quiz Questions
1. What is least likely to be true regarding Macaulay and modified duration
A. Both are calculated from the bonds expected cash flows with no adjustments for embedded options on
cash flows
B. For bonds with no options, modified duration is similar to effective duration
C. Macaulay duration takes into consideration embedded options in the bond
2. A fixed income analyst makes the following two statements:
Statement 1: YTM assumes that coupon payments are
reinvested at the rate equal to the cash flow yield.
Statement 2: The bond is assumed to be held
till maturity.
3. Consider the following two statements:
Statement 1: The static spread is the spread
over the Treasury spot rate that makes the PV
of all the cash flows from a non-Treasury security
equal to its price.
Statement 2: The Z-spread ignores the interest rate
volatility and assumes it to be zero.
Neev Knowledge Management Pristine
1. What is least likely to be true regarding Macaulay and modified duration
A. Both are calculated from the bonds expected cash flows with no adjustments for embedded options on
cash flows
B. For bonds with no options, modified duration is similar to effective duration
C. Macaulay duration takes into consideration embedded options in the bond
2. A fixed income analyst makes the following two statements:
Statement 1: YTM assumes that coupon payments are
reinvested at the rate equal to the cash flow yield.
Statement 2: The bond is assumed to be held
till maturity.
3. Consider the following two statements:
Statement 1: The static spread is the spread
over the Treasury spot rate that makes the PV
of all the cash flows from a non-Treasury security
equal to its price.
Statement 2: The Z-spread ignores the interest rate
volatility and assumes it to be zero.
60
1. What is least likely to be true regarding Macaulay and modified duration
A. Both are calculated from the bonds expected cash flows with no adjustments for embedded options on
cash flows
B. For bonds with no options, modified duration is similar to effective duration
C. Macaulay duration takes into consideration embedded options in the bond
2. A fixed income analyst makes the following two statements:
Statement 1: YTM assumes that coupon payments are
reinvested at the rate equal to the cash flow yield.
Statement 2: The bond is assumed to be held
till maturity.
3. Consider the following two statements:
Statement 1: The static spread is the spread
over the Treasury spot rate that makes the PV
of all the cash flows from a non-Treasury security
equal to its price.
Statement 2: The Z-spread ignores the interest rate
volatility and assumes it to be zero.
Statement 1 Statement 2
A Correct Correct
B Correct Incorrect
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1. What is least likely to be true regarding Macaulay and modified duration
A. Both are calculated from the bonds expected cash flows with no adjustments for embedded options on
cash flows
B. For bonds with no options, modified duration is similar to effective duration
C. Macaulay duration takes into consideration embedded options in the bond
2. A fixed income analyst makes the following two statements:
Statement 1: YTM assumes that coupon payments are
reinvested at the rate equal to the cash flow yield.
Statement 2: The bond is assumed to be held
till maturity.
3. Consider the following two statements:
Statement 1: The static spread is the spread
over the Treasury spot rate that makes the PV
of all the cash flows from a non-Treasury security
equal to its price.
Statement 2: The Z-spread ignores the interest rate
volatility and assumes it to be zero.
60
B Correct Incorrect
C Incorrect Correct
Statement 1 Statement 2
A Correct Correct
B Correct Incorrect
C Incorrect Correct
This files has expired at 30-Jun-13
Extra-Quiz Questions
4. Sally states that there are a number of yield measures that are used traditionally in the bond market. The
least likely yield measure that is used
A. Yield to call
B. Yield to worst
C. Yield to settlement
5. Duration is not a good measure for large changes in yield. Duration also assumes that the yield curve will
shift in a parallel fashion. The statements are most likely
A. Both statements are correct.
B. Only one statement is correct.
C. Both the statements are incorrect.
6. An 8% coupon bond is valued at 104.35. When the yield increases by 20 bps the price of the bond declines
to 103.44. The PVBP for the bond is closest to
A. $0.0455
B. $0.0512
C. $0.0519
Neev Knowledge Management Pristine
4. Sally states that there are a number of yield measures that are used traditionally in the bond market. The
least likely yield measure that is used
A. Yield to call
B. Yield to worst
C. Yield to settlement
5. Duration is not a good measure for large changes in yield. Duration also assumes that the yield curve will
shift in a parallel fashion. The statements are most likely
A. Both statements are correct.
B. Only one statement is correct.
C. Both the statements are incorrect.
6. An 8% coupon bond is valued at 104.35. When the yield increases by 20 bps the price of the bond declines
to 103.44. The PVBP for the bond is closest to
A. $0.0455
B. $0.0512
C. $0.0519
61
4. Sally states that there are a number of yield measures that are used traditionally in the bond market. The
least likely yield measure that is used
A. Yield to call
B. Yield to worst
C. Yield to settlement
5. Duration is not a good measure for large changes in yield. Duration also assumes that the yield curve will
shift in a parallel fashion. The statements are most likely
A. Both statements are correct.
B. Only one statement is correct.
C. Both the statements are incorrect.
6. An 8% coupon bond is valued at 104.35. When the yield increases by 20 bps the price of the bond declines
to 103.44. The PVBP for the bond is closest to
A. $0.0455
B. $0.0512
C. $0.0519
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4. Sally states that there are a number of yield measures that are used traditionally in the bond market. The
least likely yield measure that is used
A. Yield to call
B. Yield to worst
C. Yield to settlement
5. Duration is not a good measure for large changes in yield. Duration also assumes that the yield curve will
shift in a parallel fashion. The statements are most likely
A. Both statements are correct.
B. Only one statement is correct.
C. Both the statements are incorrect.
6. An 8% coupon bond is valued at 104.35. When the yield increases by 20 bps the price of the bond declines
to 103.44. The PVBP for the bond is closest to
A. $0.0455
B. $0.0512
C. $0.0519
61
This files has expired at 30-Jun-13
Extra-Quiz Questions
7. Which of the following 10-year fixed-coupon bonds has the least price volatility? All else equal, the bond with
a coupon rate of:
A. 6.50%
B. 5.00%
C. 8.00%
8. Carl manages the following portfolio
The value for the portfolio duration is
closest to
A. 5.833
B. 4.351
C. 4.555
Coupon
8%
11%
Neev Knowledge Management Pristine
7. Which of the following 10-year fixed-coupon bonds has the least price volatility? All else equal, the bond with
a coupon rate of:
A. 6.50%
B. 5.00%
C. 8.00%
8. Carl manages the following portfolio
The value for the portfolio duration is
closest to
A. 5.833
B. 4.351
C. 4.555
62
8%
11%
9.75%
10.25%
7. Which of the following 10-year fixed-coupon bonds has the least price volatility? All else equal, the bond with
a coupon rate of:
A. 6.50%
B. 5.00%
C. 8.00%
8. Carl manages the following portfolio
The value for the portfolio duration is
closest to
A. 5.833
B. 4.351
C. 4.555
Coupon Maturity Par Value
Market
Value
Duration
5 years $ 5 mn $ 4 mn 4.87
7 years $ 10 mn $ 11.4 mn 5.72
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7. Which of the following 10-year fixed-coupon bonds has the least price volatility? All else equal, the bond with
a coupon rate of:
A. 6.50%
B. 5.00%
C. 8.00%
8. Carl manages the following portfolio
The value for the portfolio duration is
closest to
A. 5.833
B. 4.351
C. 4.555
62
5 years $ 5 mn $ 4 mn 4.87
7 years $ 10 mn $ 11.4 mn 5.72
10 years $ 15 mn
$ 14.5
mn
8.50
10.25% 5 years $ 20 mn
$ 21.2
mn
4.25
This files has expired at 30-Jun-13
Solutions
1. C.
2. A.
3. A.
The Z-spread is also known as the static spread and it is the spreads that should be added on top of
spot rates to calculate the PV of cash flows of a bond. It also assumes the volatility of interest rates is
zero hence it is also known as the zero-volatility OAS.
4. C.
Yield to settlement is not a traditional measure of yield. The yield measures that are generally used are
a) yield to maturity b) yield to call c) yield to put d) yield to worst e)current yield f) cash flow yield.
5. A.
As the duration measure is not useful for measuring changes in price when there are large changes in
yield. The duration also assumes that yields change is parallel across the entire yield curve.
6. A.
The PVBP = 104.35 103.44 / 20 = 0.0455
Neev Knowledge Management Pristine
1. C.
2. A.
3. A.
The Z-spread is also known as the static spread and it is the spreads that should be added on top of
spot rates to calculate the PV of cash flows of a bond. It also assumes the volatility of interest rates is
zero hence it is also known as the zero-volatility OAS.
4. C.
Yield to settlement is not a traditional measure of yield. The yield measures that are generally used are
a) yield to maturity b) yield to call c) yield to put d) yield to worst e)current yield f) cash flow yield.
5. A.
As the duration measure is not useful for measuring changes in price when there are large changes in
yield. The duration also assumes that yields change is parallel across the entire yield curve.
6. A.
The PVBP = 104.35 103.44 / 20 = 0.0455
63
1. C.
2. A.
3. A.
The Z-spread is also known as the static spread and it is the spreads that should be added on top of
spot rates to calculate the PV of cash flows of a bond. It also assumes the volatility of interest rates is
zero hence it is also known as the zero-volatility OAS.
4. C.
Yield to settlement is not a traditional measure of yield. The yield measures that are generally used are
a) yield to maturity b) yield to call c) yield to put d) yield to worst e)current yield f) cash flow yield.
5. A.
As the duration measure is not useful for measuring changes in price when there are large changes in
yield. The duration also assumes that yields change is parallel across the entire yield curve.
6. A.
The PVBP = 104.35 103.44 / 20 = 0.0455
www.edupristine.com
1. C.
2. A.
3. A.
The Z-spread is also known as the static spread and it is the spreads that should be added on top of
spot rates to calculate the PV of cash flows of a bond. It also assumes the volatility of interest rates is
zero hence it is also known as the zero-volatility OAS.
4. C.
Yield to settlement is not a traditional measure of yield. The yield measures that are generally used are
a) yield to maturity b) yield to call c) yield to put d) yield to worst e)current yield f) cash flow yield.
5. A.
As the duration measure is not useful for measuring changes in price when there are large changes in
yield. The duration also assumes that yields change is parallel across the entire yield curve.
6. A.
The PVBP = 104.35 103.44 / 20 = 0.0455
63
This files has expired at 30-Jun-13
Solutions
7. C.
If bonds are identical except for the coupon rate, the one with the lowest coupon will exhibit the most price
volatility. This is because a bonds price is determined by discounting the cash flows. A lower-coupon
bond pays more of its cash flows later (more of the cash flow is comprised of principal at maturity) than a
higher-coupon bond does. Longer-term cash flows are discounted more heavily in the present value
calculation. Another way to think about this: The relationship between the coupon rate and price volatility
(all else equal) is inverse a greater coupon results in less price volatility. Examination tip: If you get
confused on the examination, remember that a zero-coupon bond has the highest interest rate risk
because it delivers all its cash flows at maturity. Since a zero-coupon bond has a 0.00% coupon, a low
coupon equates to high price volatility.
8. A.
Neev Knowledge Management Pristine
7. C.
If bonds are identical except for the coupon rate, the one with the lowest coupon will exhibit the most price
volatility. This is because a bonds price is determined by discounting the cash flows. A lower-coupon
bond pays more of its cash flows later (more of the cash flow is comprised of principal at maturity) than a
higher-coupon bond does. Longer-term cash flows are discounted more heavily in the present value
calculation. Another way to think about this: The relationship between the coupon rate and price volatility
(all else equal) is inverse a greater coupon results in less price volatility. Examination tip: If you get
confused on the examination, remember that a zero-coupon bond has the highest interest rate risk
because it delivers all its cash flows at maturity. Since a zero-coupon bond has a 0.00% coupon, a low
coupon equates to high price volatility.
8. A.
64
Issue Market Value
MV % of Portfolio
Value
A $ 4 mn
7.83%
B $ 11.4 mn
22.31%
C $ 14.5 mn
28.38%
D $ 21.2 mn
41.49%
Total $ 51.1 mn
100%
7. C.
If bonds are identical except for the coupon rate, the one with the lowest coupon will exhibit the most price
volatility. This is because a bonds price is determined by discounting the cash flows. A lower-coupon
bond pays more of its cash flows later (more of the cash flow is comprised of principal at maturity) than a
higher-coupon bond does. Longer-term cash flows are discounted more heavily in the present value
calculation. Another way to think about this: The relationship between the coupon rate and price volatility
(all else equal) is inverse a greater coupon results in less price volatility. Examination tip: If you get
confused on the examination, remember that a zero-coupon bond has the highest interest rate risk
because it delivers all its cash flows at maturity. Since a zero-coupon bond has a 0.00% coupon, a low
coupon equates to high price volatility.
8. A.
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7. C.
If bonds are identical except for the coupon rate, the one with the lowest coupon will exhibit the most price
volatility. This is because a bonds price is determined by discounting the cash flows. A lower-coupon
bond pays more of its cash flows later (more of the cash flow is comprised of principal at maturity) than a
higher-coupon bond does. Longer-term cash flows are discounted more heavily in the present value
calculation. Another way to think about this: The relationship between the coupon rate and price volatility
(all else equal) is inverse a greater coupon results in less price volatility. Examination tip: If you get
confused on the examination, remember that a zero-coupon bond has the highest interest rate risk
because it delivers all its cash flows at maturity. Since a zero-coupon bond has a 0.00% coupon, a low
coupon equates to high price volatility.
8. A.
64
Duration
MV% * Duration
4.87
0.3813
5.72
1.2761
8.50
2.4123
4.25
1.7633
5.8330
This files has expired at 30-Jun-13
Five Minute Recap
N 3 2
YTM) (1
PAR C
......
YTM) (1
C
YTM) (1
C
YTM) (1
C
bond a of Value
-
-
-
-
-
-
-
-
=
Bond Selling at: Relationship
Par Coupon rate = Current Yield = Yield to Maturity
Discount Coupon rate < Current Yield < Yield to Maturity
Premium Coupon rate > Current Yield > Yield to Maturity
Neev Knowledge Management Pristine
65
bond benchmark on the Yield
spread yield Absolute
spread yield Relative =
yield bond benchmark
yield bond Subject
Ratio Yield =
Bond Benchmark on Yield - Bond on Yield Spread Yield Absolute =
N 3 2
YTM) (1
PAR C
......
YTM) (1
C
YTM) (1
C
YTM) (1
C
bond a of Value
-
-
-
-
-
-
-
-
=
Coupon rate = Current Yield = Yield to Maturity
Coupon rate < Current Yield < Yield to Maturity
Coupon rate > Current Yield > Yield to Maturity
, ) , 1 YTM Annual 1 * 2
2
1
- = BEY
(
(

'
\

'
- = 1
2
BEY
1
2
YTM
P
r
i
c
e
Option-free
bond
Callable
bond
Value of
call
www.edupristine.com
65
Bond Benchmark on Yield - Bond on Yield Spread Yield Absolute =
Yield Coup
on
P
r
i
c
e
Coupon
Putable
Bond
Value
of Put
Yield
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Five Minute Recap
Spread
Measure
Benchmark Reflects Compensation for
Nominal Treasury Yield
Curve
Credit Risk, Liquidity Risk,
Option Risk
Zero-Volatility Treasury Spot
Rate Curve
Credit Risk, Liquidity Risk,
Option Risk
Option-
Adjusted
Treasury Spot
Rate Curve
Credit Risk, Liquidity Risk
Neev Knowledge Management Pristine
66
Treasury Bond
YTM YTM Spread Nominal =
, ) , )
(

- -
-
(

- -
=
2 1
2 1
Coupon
ZS rate Spot 1yr 1
Coupon
Price
ZS rate Spot yr
Cost Option Spread - Z Spread Adjusted Option =
decimals) in yield in (Change * Price) (Initial * 2
rises) yield when price Bond falls yield when price (Bond
Duration Effective =
2
decimals) in yield in (Change * Price) (Initial * 2
Price) Bond Initial * 2 - rises yield when price Bond falls yield when price (Bond
Convexity
-
=
y ModD V V
y
V
/ /
/
/
. .
V
1
- ModD
)
year per payments interest of no
YTM
(1
Duration Macaulay
Duration Modified
-
=
Value Bond * 0.01% * Duration PVBP =
Theories Of Term Structure Of Interest Rates
Pure Expectations Theory
Liquidity Preference Theory
Market Segmentation Theory
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66
, ) , ), ), )
2 1 1 1 0 1
3
3
1 1 1 1 f f f S - - - = -
decimals) in yield in (Change * Price) (Initial * 2
rises) yield when price Bond falls yield when price (Bond
Duration Effective =
2
decimals) in yield in (Change * Price) (Initial * 2
Price) Bond Initial * 2 - rises yield when price Bond falls yield when price (Bond
Convexity
-
=
Theories Of Term Structure Of Interest Rates
Pure Expectations Theory
Liquidity Preference Theory
Market Segmentation Theory
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