Financial Markets and Investments: Valuation of Securities

Financial Markets and Investments
Module Valuation of Securities
Session No. I
Version 1.0
Material from the published or unpublished work of others which is referred to in the Class
Notes is credited to the author in question in the text. The Class Notes prepared is of 5,050
words in length. Research ethics issues have been considered and handled appropriately
within the Globsyn Business School guidelines and procedures.
FM&I/M4SI/v1.0/081119 Valuation of Bonds | Session No. I

Table of Contents
1. Bond ........................................................................................................................... 5
1.1. Coupon ................................................................................................................. 5
1.2. Face Value ............................................................................................................ 5
1.3. Coupon Rate ......................................................................................................... 6
1.4. Periodicity of Coupon Payments ........................................................................... 6
1.5. Maturity ................................................................................................................. 6
1.6. Redemption Value ................................................................................................ 6
2. Bond Pricing .............................................................................................................. 7
3. Measurement of Bond Return .................................................................................. 9
3.1. Current Yield ......................................................................................................... 9
3.2. Spot Interest Rate ............................................................................................... 10
3.3. Yield to Maturity .................................................................................................. 11
3.4. Yield to Call ......................................................................................................... 13
4. Bond Pricing Theorem ............................................................................................ 14
5. Bond Risk ................................................................................................................ 15
5.1. Default Risk......................................................................................................... 15
5.2. Interest Rate Risk ............................................................................................... 16
6. Types of Bonds ....................................................................................................... 17
6.1. Fixed Rate and Floating Rate Bonds .................................................................. 17
6.2. Indexed Bonds .................................................................................................... 18

6.3. Zero Coupon Bonds ............................................................................................ 18
6.4. Convertible Bonds ............................................................................................... 18
7. Bond Duration ......................................................................................................... 19
References ................................................................................................................... 21
List of Figures and Tables

Figure 2.1: Formula of Bond Pricing ........................................................................................... 7
Figure 3.1: Formula of Yield to Maturity ....................................................................................11
Figure 1.2: Simple formula of YTM ............................................................................................13
Figure 5.1: Impact of Changes in Market Interest Rate .............................................................17
Figure 7.1: Formula of Bond Duration .......................................................................................19
Figure 7.2: Formula of Bond Duration .......................................................................................19
Table 7.1: Solution of Bond Duration.........................................................................................20

1. Bond
Bond is a kind of debt instrument. It is generally a long term security. The nature of income
generated from this instrument is fixed. Debenture is also a debt instrument. However, debt
instrument issued by the Government or the public sector organization is termed as bond.
Otherwise, bond instrument is alike with debenture. There are two types of bonds found in the
capital market. One is called government bond and another type of bond is known as corporate
bond. Government bond is a way of collecting money from the investors by issuing such bonds
in the market. It is sort of borrowing instrument of the Government. Issue of bond made by the
companies to the public face the incident of debt obligation. Default risk may arise if any issuing
company fails to meet the debt obligation. However, bond works as a borrowing instrument in
collecting the required money from the public. These collected amount is used by the firm for its
business. While issuing a bond two things are specified clearly. These are cash flow streams
and time horizon. Cash flow streams consist of both interest and principal amount. Time horizon
denotes bond’s maturity. This sort of specification makes a bond valuation easier than the
valuation of shares. However, some complexity still exists in the bond valuation due to the
presence of two categories of bonds. These are callable bonds and convertible bonds. When a
bond is called up for redemption earlier than its maturity is called callable bond. Convertible
bond carries the word conversion which means bond can change its shape and converted into
other instrument (Wall Street Mojo, 2019). Likewise, bond can be converted into share fully or
partly at a later period of time. There are certain other important factors associated with bond.
These factors are laid down below.
1.1. Coupon
Coupon is a kind of interest payment given to the bondholder which remains effective from the
date of issue and lasts until such bond matures. Suppose a bond is issued worth Rs.. 1000 with
5% coupon rate, then Rs. 50 to be paid annually to the bond holder by way of coupon. It means
annual interest payment is equivalent with coupon amount and the bond holder will receive the
maturity amount at the end of the term (Wall Street Mojo, 2019).
1.2. Face Value

Face Value, also known as par value, is a value which is stated on the face of the bond
instrument. The principal sum borrowed is repaid at the end of the bond period. In respect of
issue price of the bond the notable factor is that in most cases dissimilarity arises between the
face value and the subscription price. When a bond is oversubscribed the excess amount above

the face value is referred to as premium. When the subscription amount is paid below the face
value such shortfall is termed as discount.
1.3. Coupon Rate

The rate of interest payable by the issuer to the investor of the bond is known as the Coupon
Rate. Several factors become effective in determining the coupon rate of the bond. The current
economic conditions, risk, quality of the issuer are the three predominant factors which make a
great impact in determining the coupon rate of the bond. This rate helps to show what cash flow
the bond will produce.
1.4. Periodicity of Coupon Payments

The coupon rate can be applicable on annual basis. It means coupon interest is accrued
annually. However, an issuer may decide to make the payment on regular basis. Such regular
basis of payment can be any even intervals of time. The periodicity of payment becomes a
determinant of the bond value. Coupon payment done by quarterly mode should be more than
coupon payment made on annual basis as timing of cash flow is injected into the mode of
calculation of the stream of cash flows. More contraction over the timing of cash flow yields
better return as coupon rate is compounded within a small margin of time. Compounding once
in a year and compounding twice in a year the latter produces better result as the money is
compounded twice in a year comparing to the money which is compounded once in a year
(Analyst Notes, 2019).
1.5. Maturity
The borrowed sum which is obtained through bond carries a fixed duration. Such duration is
predetermined and when such duration is over the subscriber gets the predetermined amount.
The duration from the date of issue until the bond is redeemed is termed as maturity period of
the bond. It can be any years like three years; five years etc.
1.6. Redemption Value

The borrowed sum is refunded at the end of the period. The money so refund after the maturity
is called redemption value. Generally, bonds are redeemed at par value represented by words
‘redeemable at par’. However, bond is also redeemed at premium or discount to the face value.
In this connection, it should be kept in mind that discount on coupon does not similar with
discounting rate. Discount on coupon arises when a bond is transacted below its face value. On
the other hand, discounting rate is used in finding the present value of the stream of cash flows.
Suppose a bond will be matured after three years. If we want to know the present value of the

matured bond, we have to apply the discounting rate to know the present value of the bond
(SEC, 2019).
2. Bond Pricing
Bond is an investment. Any invested money derives the value from the cash flows over the
period of time. Therefore, the expected future value of the bond is required to be recognized. In
such recognition it is required to apply the discounting rate to know the exact value of the future
cash flows. The value of a bond is equal to the present value of its expected cash flows. The
cash flow of bond is the summation of two different types of items. One is interest payment and
another is principal amount.
The formula of the present value of bond is given below:
Figure 2.1: Formula of Bond Pricing
(Wall Street Mojo, 2019)
Where,
P0 = Present value of the bond
It = Annual interest payments
MV = Maturity value of the bond
n = Number of years to maturity
k = Appropriate discount rate
The measurement of appropriate discount rate can be assessed by considering the rate which
is prevailed in the market. Moreover, if the investor would choose any other investment option
he may avail the rate of return which is currently prevailed in the market. This appropriate
discount rate is used in the present value model (Wall Street Mojo, 2019).

Example 1:
What is the price of a 6% annual coupon bond with a Rs. 1000 face value, which matures in 3
years? Assume a required return of 5.6%.
60 60 1060
PV = + +
(1.056)¹ (1.056)² (1.056)³
PV = Rs. 1010.77
Example 2:
What is the price of the bond if the required rate of return is 6% of the previous example?
60 60 1060
PV = + +
(1.06)¹ (1.06)² (1.06)³
PV = Rs. 1000
Example 3:
What is the price of the bond if the required rate of return is 15% instead of 5.6% given in
Example 1.
60 60 1060
PV = + +
(1.15)¹ (1.15)² (1.15)³
PV = Rs. 794.51
Example 4:
What is the price of the bond if the hurdle rate is 5.6% and the coupons are paid semiannually?
Here two aspects should be taken into consideration. The interest payment is made
semiannually i.e. Rs. 30. The interest rate should be considered half of the current interest rate.
30 30 30 30 30 1030
PV = + + + +
(1.028)¹ (1.028)² (1.028)³ (1.028)⁴ (1.028)⁵ (1.028)⁶
PV = Rs. 1010.91
On the above example the notable factor lies on the nature of duration of the interest payment.
Generally, the interest is paid on annual basis. However, the duration of such payment can be
made semiannually, quarterly or monthly even on daily basis. In such a case ‘time’ should be
taken according to the mode of interest payment. Rate of interest also to be considered as per

requirement. Suppose any payment is made on quarterly basis. Therefore, ‘Time’ should be
considered in the following manner:
Time × 4 [ To make it equal with 1 year per quarter is multiplied by 4]
Rate of interest should be: Rate / 4
Interest amount should be divided by 4 in order to avail the interest amount equal with quarterly
payment.
3. Measurement of Bond Return

Several techniques are present in valuing the return of bond. It is desirable to understand the
meaning of each such techniques.
3.1. Current Yield

Generally, the face value of a bond differs with the market price. For example, face value of a
bond is Rs. 100 however, its market rate can be Rs. 95 or Rs. 105 depending on the current
financial position of the market. Although face value remains unchanged.
The current yield relates the annual interest receivable on a bond to its current market price. It is
shown below:
Iₙ
Current yield = P₀
× 100
Where,
Iₙ = Annual Interest
P₀ = Current market price
Example:
If a bond of face value Rs. 2000 and a coupon rate of 12% is currently selling for Rs. 1600. The
current yield of the bond is:
Iₙ
Current yield = × 100
P₀
240
Current yield = 1600
× 100
Current yield = 15%

When the market price is lower than the face value current yield is more than the coupon rate
and vice versa. Sometimes bonds are purchased from the secondary market by a bond holder
and sold it before maturity. Current yield measures the annual return of such bond. It is
assumed that price remains same during the time of purchase and sale. Current yield is not
useful for the time period that starts from date of issue of bond and ends at its maturity time. It
means current yield does not consider annual interest received from the bond and the capital
gain or loss arises for selling the bond in the market (Finance formulas, 2019).
3.2. Spot Interest Rate

It is a type of bond which is issued in a discounted manner and the amount shown at the
certificate is the face value of the bond. It means no annual interest is paid during the bond
period. For example, a two year bond whose face value is Rs. 1000 may be issued at a discount
price of Rs.. 797.19. The bond holder, after the maturity, will receive Rs. 1000. This type of bond
is also called pure discount bond or deep discount bond.
Problem:
Consider a zero coupon bond whose face value is Rs.. 1000 is purchased at Rs. 519.37. Find
out the spot rate. Bond will be matured after 5 years.
Solution:
Face value
Discounted Amount =
(1+k)5
1000
Or, 519.37 =
(1+k)5
1000
Or, (1 + k)5 =
519.37
5
Or, 1+K = √1.9254
5
Using the mathematical calculator √1.9254 comes 1.14
Or, 1+k = 1.14
Or, k = 1.14-1
Or, k = .14
Or, k = 14%
Therefore, spot rate is 14%

3.3. Yield to Maturity

In respect of bond, yield to maturity is a certain discount rate which equalizes outflow of money
with inflow of cash that includes future interest payments and terminal principal repayment. The
discount rate is treated as an internal rate of return. This measurement is useful to make a
connectivity between the current market price of the bond and the future interest payments plus
principal repayment. Since the bond is purchased on current price therefore, this discount rate
measures the interest amount that will be generated throughout the bond period. The discount
rate to be considered upon the expected interest amount that will be earned throughout the
bond period (Money Chimp, 2018). The relationship between outflow of cash and inflow of cash
can be expressed in the following manner:
Figure 3.1: Formula of Yield to Maturity
(CFI, 2019)
Where,
MP = Current market price of the bond
Ct = Cash inflow from the bond throughout the holding period.
TV = Terminal cash flow during the time of maturity
However, this formula demands to catch up the process of trial and error and practice until the
outflow amount is equal with the expected maturity value of the bond.
Example:
A face value of Rs. 1000 and a coupon rate is 15%. The current market price of the bond is Rs.
900. Bond will mature after 5 years and the bond is repaid at par. Find out YTM.
Ct 𝑇𝑉
MP = +
(1+𝑌𝑇𝑀)𝑡 (1+𝑌𝑇𝑀)𝑛
Here MP = Rs. 900; Ct = Rs. 150; TV = Rs. 1000
150 1000
Or 900 = +
(1+𝑌𝑇𝑀)5 (1+𝑌𝑇𝑀)5

Or, 900 = 150×PVIFA (5y, interest) + 1000×PVF (5y, interest)
PVIFA = present value annuity factor
PVF = Present value factor.
From PVIFA and PVF chart we have to find out the interest rate factor. The interest payment is
lower than the face value. It indicates that the market interest rate should be more than the
coupon rate. Accordingly, a user has to search in the PVIFA table.
Let us take the interest rate as 20%.
150×PVIFA (5y, 20%) + 1000×PVF (5y, 20%)
Using PFIVA and PVF table we get the following data
=150×2.9906 + 1000×.4019
= Rs. 850.49
Hence this amount is not equal with Rs. 900
If we consider the interest rate 18%, we will get the following result:
150×PVIFA (5y, 18%) + 1000×PVF (5y, 18%)
=150×3.1272 + 1000×0.4371
= Rs. 906.18
This value is closer to Rs. 900 but little bit higher. In drawing the outcome equal with Rs. 900 it
is required to make an interpolation
906.18−900
Hence YTM = 18+[ ] × (20-18)
906.18−850.49
= 18 + 0.22
= 18.22 percent
Using the formula of such takes lots of time so in order to avoid this formula an alternative
simple formula is used which gives an approximate estimate of YTM.

This formula is given below:

Figure 1.2: Simple formula of YTM
(CFI, 2019)
Where C = Amount of annual interest
FV = Maturity value at the end of the holding period
PV = Cost of current market price of the bond
t = holding period till maturity
Using this formula, the result of the previous example can be shown:
FV−PV
C+ t
YTM = FV+PV
2
150+(1000−900)/5
=
(1000+900)/2
150+20
=
950
= 0.1789
= 17.89%
3.4. Yield to Call

Most of the times the long term bonds say fifteen years’ bond can be withdrawn before its
maturity date. Therefore, it is required to see what should be the value of such withdrawal prior
to the original date of maturity. Moreover, it is also required to check whether the yield of the
prior period is more than the yield of the maturity or not. If the yield drawn on the prior period is
more than yield on maturity, then it is considered as an advantage for the bondholder for making
such deal of bond withdrawal. Checking the yield on the prior period related to withdrawal of
bond can be measured through yield to call. Yield to call is a rate which equalizes present value

of inflow money to the bond’s current market price or the cost of purchase of the bond.
Comparison is required to be made between yield to call rate on the date of redemption and
yield to maturity. On the basis of such comparison the bond holder should decide whether he
will go for such redemption or holding the bond till its maturity (Money Chimp, 2018).
4. Bond Pricing Theorem

A bond is issued with fixed rate of interest. This fixed rate of interest is called coupon rate. This
rate is fixed till the end of maturity and it is used to determine the amount of interest of the bond.
It means such interest rate or coupon rate is applicable on the face value of the bond in
determining the amount of interest. When a bond is issued the coupon rate and market rate
becomes similar. However, later, the market rate gets changed according to the movement of
the market considering various factors present in the market that affects the price. The market
rate may go upward or it may decline depending upon the condition of the market. When the
market rate is more than the coupon rate and during this time if any investor wants to sell the
bond in the market definitely he will suffer a loss as the current yield is greater than the coupon
rate. As for example suppose a face value of a bond is Rs. 1000 and the coupon rate is 12%.
However, currently the price of the bond is Rs. 800. Its current yield is:
120
Current Yield = × 100
800
= 15%
It means when current yield gets increased the price of debt instrument declines. It means there
exists an inverse relationship between market rate of debt instrument and the movement of
price of such debt instrument. Due to the increase in market rate when the price of bond
declines it does not attract the investors to buy such bond from the market. On the other hand,
when the market interest rate falls it brings better price for the bond. The difference between the
market price and the face value is called premium. When an investor sees that there is an
opportunity to avail premium by selling the bond in the market he can proceed with such sale
and earn the premium amount. The notable fact is that if the duration of bond is for longer
period such longer term of investment may bring sensitivity into the prices of the bond. It is so
because the market meets various changes during this period. Sometimes, the condition of the
market remains good and sometimes bad. These volatile conditions affect the market price of
the bond and accordingly the market rate gets changed. It is generally found that longer
duration welcomes interest rate risk. The long term bond is more prone to interest rate changes

than the short term bonds, the long term bond carries greater exposure to interest rate risk.
Burton G. Malkeil discovered the relationship between bond prices and market interest rate. His
discovery is known as Bond pricing theorems (Wall Street Mojo, 2019). There exist five
principles behind the discovery of bond pricing theorem. These are:
 Bond prices will move inversely to market interest changes.
 The variability of bond price is directly proportionate to the term to maturity. If any market
interest is changed it causes greater changes in bond prices for longer-term maturity.
 A bond’s sensitivity to changes in market interest rate increases at a diminishing rate as
the time remaining until its maturity increases.
 For any given maturity, a decrease in market interest rate causes a price rise that is
larger than the price decline that results from an equal increase in market interest rate.
 The volatility of bond price is connected with the coupon rate. Percentage change in a
bond’s price due to change in the market interest rate will be smaller if its coupon rate is
higher.
The relationship exists between market interest rate; fixed rate bonds and fixed rate bond yield.
This relationship is shown below.
5. Bond Risk
Bond is a debt instrument the value of which can be safely retrieved along with interest after its
maturity. Therefore, apparently it looks like a risk free instrument. However, in the economic
world no investment is actually risk free as there are several factors present in the market that
influence the price of the invested assets. In the bond market risk like default risk and interest
rate risk plays a significant role which may lead to bring variation in returns. The actual returns
realized from a bond may vary from the expected returns. Two types of risks are described
below.
5.1. Default Risk

When a company fails to disburse the stipulated money at the right time it can be said that such
types of failure occurs due to the presence of default risk in the operational process of the firm.
Poor financial performance may lead to create such situation and the investors get suffered by
collecting the expected sum of money from the investment. Loss arises and such loss reduces
the return from the bond. Degree of risk associated with a bond is measured through credit
rating. It is a sort of security mechanism which shows the default risk involved with the bond.

The process of such rating involves a qualitative analysis of the company’s business and
management and a quantitative analysis of the company’s financial performance (Finance
Train, 2019).
5.2. Interest Rate Risk

Market interest rate causes interest rate risk. Market interest rate sometimes moves up or
moves down depending upon the economic factors present in the market. Movement of price of
a security follows the ups and downs of the market. Interest amount of a bond can be reinvested
by the bond holder annually or semi-annually or any other mode of payment. Such investment is
made under the prevailing rate of interest in the market. When the market moves up the
reinvested amount will earn better return. The principal amount or the face value of the bond
can suffer a loss when it gets released after a certain holding period. It is so because there
exists an inverse relationship between market interest rate and bond price. When the market
interest rate increases the face value of the bond decreases in comparison with the prevailing
market price of the bond. Accordingly, after the release a bond holder may suffer loss due to the
increased market interest rate. Now it is required to check the difference between the gain on
return on the reinvested amount and the loss arises on the face value after releasing the bond.
If the gain on reinvestment is less than the loss on sale, the investor will suffer a net loss on
account of the rise in market interest rate. However, when the market interest rate goes down
and the interest amount generated from the bond on annual basis or any other basis is
reinvested at such decline rate then such reinvested amount will face loss. Such loss is required
to be compared with the net gain of the face value of the bond when a bondholder releases his
holding and sell it off in the market. If it is found that the difference between the net gain of the
bond is greater than net loss of the reinvested sum a bond holder will be benefited for such
declined market interest rate (Rajesh, 2014).
Thus, an investor is able to understand the variations in his returns due to changes in the
market interest rate during the holding period. Such variation in the return is held due to the
presence of interest rate risk factor in the market. Here the interest rate risk can be classified
into two factors. One is the reinvestment of annual interest and the capital gain or loss on sale
of bond at the end of the holding period. Rise in market interest rate causes gain in the
reinvested amount and decline in the face value of the bond price. Downfall in market interest
rate causes decline in the reinvested amount and gain in the face value of the bond price.
Therefore, two components are present in the interest rate risk. One is reinvestment risk and
price risk. These risks are derived from the interest rate risk and acts in an opposite direction.

Reinvestment risk is proportionate with the interest rate risk. Conversely, price risk is inversely
proportionate with interest rate risk. For any bond there is a holding period at which these two
effects balance each other in an appropriate manner. Anything lost from the reinvestment effect
can be compensated by the gains happens in the price effect. When these two factors play the
balancing role within the holding period of the bond then it can be said that holding period
actually does not carry, as such, interest rate risk. This particular holding period where there is
no existence of interest rate risk is called Bond duration. An investor therefore, eliminate interest
rate risk of a bond by holding the bond for its duration.
Figure 5.1: Impact of Changes in Market Interest Rate
(SEC, 2019)
6. Types of Bonds
Bonds can be classified into various categories. Such classification is made on the basis of the
nature of the issuer. Bonds are classified into government bonds and capital bonds. There are
many types of corporate bonds found in the corporate bond category. However, no such
variants are found in the category of Government bond.
6.1. Fixed Rate and Floating Rate Bonds

A fixed rate bond is a certain kind of bond that carries a predetermined rate of interest
throughout its duration. The interest rate is called coupon rate and interest rate is payable at
specified dates before bond maturity. Since the coupon rate is fixed it creates interest rate risk.
The market is sensitive and the market rate is volatile. It changes according to the existing
conditions of the market. When market interest rate moves up the interest holder will be
benefitted subject to reinvestment. However, when a bond is sold a loss may arise as market
price of a bond exceeds the face value of the bond. The difference of such gain or loss should
be calculated to check the net gain or loss of the bond. In case of floating rate bond it is

observed that coupon rate is linked with some benchmark. This rate acts as variable rate which
is equal to a money market reference rate. LIBOR is a common benchmark used wherein the
coupon payment is based on the most recent LIBOR rate. The LIBOR rate is used to hedge the
risk which arises due to changing interest rate in the market (Monica J Busch, 2019).
6.2. Indexed Bonds

This kind of bond is issued with such a coupon payment which is linked with index. Bonds are
issued for a long period of time. The coupon rate of these bonds are generally not so high in
comparison with other investment options. On the other hand, an investor also considers
inflation factor when he calculates the returns from the bond. Therefore, uncertainty occurs in
receiving the amount of the bond whenever it is required to sell it in the market due to the
fluctuation of inflation in the market. The index bond facilitates the investor to get over this
concern as issue of index-linked bonds assures subscribers of some real return over inflation
(Pimco, 2018).
6.3. Zero Coupon Bonds

When a bond is issued having no option to pay coupon to the bond holder then such type of
bond is termed as zero coupon bond. When such bond gets matured the investors will be given
the face value of the bond. The question arises how the investors get benefitted by purchasing
such bond when there is no option of earnings? Fact is that this type of bond is issued at a
discounted price (Monica J Busch, 2019). For example, suppose the face value of a bond is Rs.
100000 and it is issued for 25 years at Rs. 10000. It means the investor has to pay Rs. 10000
only now to avail the face value after 25 years.
6.4. Convertible Bonds

Convertible bonds are converted into shares of the issuing company’s stock at the discretion of
the bondholder. The price of such bond depends on the price movement of stocks. When the
price of the stock increases the price of the bond also increases. The rising price of the
underlying stock increases the value of the convertible security. The face value of stock is
divided among certain number of conversion option in order to get effective conversion price
(Rajesh, 2014). Suppose the stock value is Rs. 1000 and the conversion option is 25 it means if
the bond is converted into shares the bondholder will receive 25 shares. The conversion price
would be Rs. 40. This is set as a standard. Suppose earnings from the convertible bond is Rs.
50 and the market price of share rise to Rs. 60. In such a situation if conversion happens the

gain should be (Rs..60 – Rs.50) Rs. 10 per conversion of shares. Number of conversion option
is 25 so the gain will be 25 multiplied by Rs. 10 that is Rs. 250.
7. Bond Duration
Duration is the weighted average measure of a bond’s life. The various time periods in which
the bond generates cash flows are weighted according to the relative size of the present value
of those flows. The formula for computing duration d is:
Figure 7.1: Formula of Bond Duration
The equation consists of setting out the series of cash flows, discounting them and multiplying
each discounted cash flow by the time period in which it occurs. The sum of these cash flows is
then divided by the price of the bond obtained using the present value. The general formula of
bond duration is shown below:
Figure 7.2: Formula of Bond Duration
Where,
Ct = Annual cash flow including interest and repayment of principal
n = Holding period
k = Market interest rate
t = The time period of each cash flow
Maturity of bond does not same with bond’s duration. The emphasis of duration of bond is that it
neutralizes reinvestment risk and price risk of a bond. Reinvestment risk and price risk are the

components of interest rate risk. The impact of reinvestment risk and price risk would offset
each other exactly to reduce the interest risk to zero but it moves on the opposite direction.
Problem:
A bond with 12% coupon rate issued three years ago is redeemable after 5 years from now at a
premium of 5%. The market interest rate is 14%. Find out the duration of the bond.
Table 7.1: Solution of Bond Duration
Year Cash Flow (Rs.) PV @14% Present Value PV multiplied by Years
1 12 0.8772 10.5264 10.5264
2 12 0.7695 9.2340 18.468
3 12 0.675 8.1000 24.3
4 12 0.5921 7.1052 28.4208
5 12 0.5194 6.2328 31.164
6 105 0.5194 54.5370 272.685
Total 95.7354 385.5642
(Kevin, 2009)
Total of PV multiplied by years

Duration =
Total present value
385.5642
=
95.7354
= 4.03 years
The bond duration is 4.03 years where as maturity time is 5 years. If the bondholder follows the
time duration and withdraws the invested money at 4.03 years he can evade the risk of interest
rate as reinvestment risk and price risk would offset each other.

References
Analyst Notes, 2019. Yield measures for Fixed rate bonds. [Online]
Available at: http://analystnotes.com/cfa-study-notes-yield-measures-for-fixed-rate-bonds.html
[Accessed 8 11 2019].
CFI, 2019. Yield to Maturity. [Online]
Available at: https://corporatefinanceinstitute.com/resources/knowledge/finance/yield-to-
maturity-ytm/
[Accessed 7 11 2019].
Finance formulas, 2019. Current Yield. [Online]
Available at: https://financeformulas.net/Current-Yield.html
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Financial Markets and Investments

Module Valuation of Securities

FM&I/M4SI/v1.0/081119 Valuation of Bonds | Session No. I

1.1. Coupon ................................................................................................................. 5

1.2. Face Value ............................................................................................................ 5

1.3. Coupon Rate ......................................................................................................... 6

1.4. Periodicity of Coupon Payments ........................................................................... 6

1.5. Maturity ................................................................................................................. 6

1.6. Redemption Value ................................................................................................ 6

2. Bond Pricing .............................................................................................................. 7

3. Measurement of Bond Return .................................................................................. 9

3.1. Current Yield ......................................................................................................... 9

3.2. Spot Interest Rate ............................................................................................... 10

3.3. Yield to Maturity .................................................................................................. 11

3.4. Yield to Call ......................................................................................................... 13

4. Bond Pricing Theorem ............................................................................................ 14

5. Bond Risk ................................................................................................................ 15

5.1. Default Risk......................................................................................................... 15

5.2. Interest Rate Risk ............................................................................................... 16

6. Types of Bonds ....................................................................................................... 17

6.1. Fixed Rate and Floating Rate Bonds .................................................................. 17

6.2. Indexed Bonds .................................................................................................... 18

FM&I/M4SI/v1.0/081119 Valuation of Bonds | Session No. I

6.3. Zero Coupon Bonds ............................................................................................ 18

6.4. Convertible Bonds ............................................................................................... 18

7. Bond Duration ......................................................................................................... 19

List of Figures and Tables

Figure 3.1: Formula of Yield to Maturity ....................................................................................11

Figure 1.2: Simple formula of YTM ............................................................................................13

Figure 5.1: Impact of Changes in Market Interest Rate .............................................................17

Figure 7.1: Formula of Bond Duration .......................................................................................19

Figure 7.2: Formula of Bond Duration .......................................................................................19

Table 7.1: Solution of Bond Duration.........................................................................................20

FM&I/M4SI/v1.0/081119 Valuation of Bonds | Session No. I

1.2. Face Value

FM&I/M4SI/v1.0/081119 Valuation of Bonds | Session No. I

1.3. Coupon Rate

1.4. Periodicity of Coupon Payments

1.6. Redemption Value

FM&I/M4SI/v1.0/081119 Valuation of Bonds | Session No. I

The formula of the present value of bond is given below:

Figure 2.1: Formula of Bond Pricing

(Wall Street Mojo, 2019)

P0 = Present value of the bond

It = Annual interest payments

MV = Maturity value of the bond

n = Number of years to maturity

k = Appropriate discount rate

FM&I/M4SI/v1.0/081119 Valuation of Bonds | Session No. I

FM&I/M4SI/v1.0/081119 Valuation of Bonds | Session No. I

Time × 4 [ To make it equal with 1 year per quarter is multiplied by 4]

Rate of interest should be: Rate / 4

3. Measurement of Bond Return

3.1. Current Yield

P₀ = Current market price

Current yield = 15%

FM&I/M4SI/v1.0/081119 Valuation of Bonds | Session No. I

3.2. Spot Interest Rate

FM&I/M4SI/v1.0/081119 Valuation of Bonds | Session No. I

3.3. Yield to Maturity

Figure 3.1: Formula of Yield to Maturity

Ct = Cash inflow from the bond throughout the holding period.