HON VALtATtON HON VALtATtON

Dr. Rana Singh

Associate Professor
www.ranasingh.org
2
CONTENTS
ntroduction
Bond Returns
coupon rate
current yield
spot interest rate
yield to maturity
yield to call
Bond Prices
Bond Pricing Theorems
Bond Risks
Bond Duration
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NTRODUCTON
Bonds are Long-term fixed income securities.
Debentures are aIso Iong-term fixed income
securities. Both of these are debt securities.
The two major categories of bonds are
4;ernment b4nds & c4rp4rate b4nds.
There are the two main features of bonds such
as callability and c4n;ertibility.
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BOND RETURNS
COUPON RATE:-
t is the nominaI rate of interest fixed and
printed on the bond certificate. t is caIcuIated on
the face vaIue of the bond. t is the rate at which
interest is payabIe by the issuing company to the
bondhoIder.
5
BOND RETURNS (CONT..)
CURRENT YELD:-
The current market price of a bond in the secondary
market may differ from its face vaIue.
The current yieId reIates the annuaI interest
receivabIe on a bond to its current market price. t can
be expressed as foIIows:-
Where

n
= AnnuaI nterest
P
o
= Current market price
current yieldI
n
/P
o
100
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BOND RETURNS (CONT..)
SPOT NTEREST RATE:-
Zero coupon bond is a speciaI type of bond which does
not pay annuaI interests.
The return on this bond is in the form of a disc4unt 4n
issue 41 the b4nd.
This type of bond is aIso caIIed pure disc4unt b4nd 4r
deep disc4unt b4nd.
Spot interest rate is the annuaI rate of return on a bond
that has onIy one cash infIow to the investor.
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BOND RETURNS (CONT..)
YELD TO MATURTY (YTM):-
This is the most wideIy used measure of return
on bonds.
t may be defined as the compounded rate of
return an investor is expected to receive from a
bond purchased at the current market price
and heId to maturity.
t is reaIIy the internaI rate of return earned from
hoIding a bond tiII maturity.
YTM depends upon the cash outfIow for
purchasing the bond, that is, the cost or
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BOND RETURNS (CONT..)
Current market price of the bond as weII as the
cash infIows from the bond, nameIy the future
interest payments and the terminaI principaI
repayment.
YTM is the discount rate that makes the present
vaIue of cash infIows from the bond equaI to
the cash outfIow for purchasing the bond.
The reIation between the cash outfIow, the cash
infIow and the YTM of a bond can be expressed
as:
MP = Ct TV
(1 + YTM)
t
(1 + YTM)
n
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BOND RETURNS (CONT..)
Where :-
MP = Current market price of the bond
Ct = Cash infIow from the bond throughout
the hoIding period.
TV = TerminaI cash infIow received at the
end of the hoIding period.
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BOND PRCNG THEOREMS
The reIation between bond prices and changes in
the market interest rates have been stated by Burton G.
MaIkieI in the form of five generaI principIes. These are
known as Bond pricing theorems.
The five principIes are:-
Bond prices wiII move inverseIy to market interest
changes.
Bond price variabiIity is directIy reIated to the term to
maturity; which means, for a given change in the IeveI
of market interest rates, change in bond prices are
greater for Ionger-term maturities.
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BOND PRCNG THEOREMS(CONT...)
A bond's sensitivity to changes in market
interest rate increases at a diminishing rate as
the time remaining untiI its maturity increases.
The price changes resuIting from equaI
absoIute increases in market interest rates are
not symmetricaI, i.e. for any given maturity, a
decrease in market interest rate causes a price
rise that is Iarger than the price decIine that
resuIts from an equaI increase in market
interest rate.
12
BOND PRCNG THEOREMS (CONT...)
Bond price voIatiIity is reIated to the coupon
rate, which impIies that the percentage change
in a bond's price due to a change in the market
interest rate wiII be smaIIer if its coupon rate is
higher.
13
BOND RSKS
Two types of risk are associated with
investment in bonds, nameIy de1ault risk and
interest rate risk.
DEFAULT RSK:-
DefauIt risk refers to the possibiIity
that a company may faiI to pay the interest or
principaI on the stipuIated dates. Poor financiaI
performance of the company Ieads to such
defauIts.
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BOND RSKS (CONT...)
NTEREST RATE RSK:-
The risk that an investment's vaIue wiII
change due to a change in the absoIute IeveI of
interest rates. Such changes usuaIIy affect
securities inverseIy and can be reduced by
diversifying or hedging.
nterest rate risk affects the vaIue
of bonds more directIy than stocks, and it is a
major risk to aII bondhoIders. As interest rates
rise, bond prices faII and vice versa.
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BOND DURATON
Duration is the weighted average measure of a
bond's Iife. The various time periods in which
the bond generates cash fIows are weighted
according to the reIative size of the present
vaIue of those fIows.
The formuIa for computing duration d is:-
(t) (C
t
)
d= (1 + k)
t
C
t
(1 + k)
t
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BOND DURATON (CONT...)
Where :-
C
t
= AnnuaI cash fIow incIuding interest &
repayment of principaI.
n = HoIding period.
k = Discount rate which is the market
interest rate.
t = The time period of each cash fIow.