Yield to Call

Many bonds, especially those issued by corporations, are callable. This means that the issuer of the bond can redeem the bond prior to maturity by paying the call price, which is greater than the face value of the bond, to the bondholder. Often, callable bonds cannot be called until 5 or 10 years after they were issued. When this is the case, the bonds are said to be call protected. The date when the bonds can be called is refered to as the call date. The yield to call is the rate of return that an investor would earn if he bought a callable bond at its current market price and held it until the call date given that the bond was called on the call date. It represents the discount rate which equates the discounted value of a bond's future cash flows to its current market price given that the bond is called on the call date. This is illustrated by the following equation:

where

B0 = the bond price, C = the annual coupon payment, CP = the call price, YTC = the yield to call on the bond, and CD = the number of years remaining until the call date.

Like the yield to maturity, the yield to call usually cannot be solved for directly. It generally must be determined using trial and error or an iterative technique. Fortunately, financial calculators make the task of solving for the yield to maturity quite simple. Yield to Call Example Find the yield to call on a semiannual coupon bond with a face value of $1000, a 10% coupon rate, 15 years remaining until maturity given that the bond price is $1175 and it can be called 5 years from now at a call price of $1100. Solution:

Top of Form

Bottom of Form

Calculating Current Yield A simple yield calculation that is often used to calculate the yield on both bonds and the dividend yield for stocks is the current yield. The current yield calculates the percentage return that the annual coupon payment provides the investor. In other words, this yield calculates what percentage the actual dollar coupon payment is of the price the investor pays for the bond. The multiplication by 100 in the formulas below converts the decimal into a percentage, allowing us to see the percentage return:

So, if you purchased a bond with a par value of $100 for $95.92 and it paid a coupon rate of 5%, this is how you'd calculate its current yield:

Notice how this calculation does not include any capital gains or losses the investor would make if the bond were bought at a discount or premium. Because the comparison of the bond price to its par value is a factor that affects the actual current yield, the above formula would give a slightly inaccurate answer - unless of course the investor pays par value for the bond. To correct this, investors can modify the current yield formula by adding the result of the current yield to the gain or loss the price gives the investor: [(Par Value Bond Price)/Years to Maturity]. The modified current yield formula then takes into account the discount or premium at which the investor bought the bond. This is the full calculation:

Let's re-calculate the yield of the bond in our first example, which matures in 30 months and has a coupon payment of $5:

The adjusted current yield of 6.84% is higher than the current yield of 5.21% because the bond's discounted price ($95.92 instead of $100) gives the investor more of a gain on the investment. One thing to note, however, is whether you buy the bond between coupon payments. If you do, remember to use the dirty price in place of the market price in the above equation. The dirty price is what you will actually pay for the bond, but usually the figure quoted in U.S. markets is the clean price. Now we must also account for other factors such as the coupon payment for a zero-coupon bond, which has only one coupon payment. For such a bond, the yield calculation would be as follows:

n = years left until maturity If we were considering a zero-coupon bond that has a future value of $1,000 that matures in two years and can be currently purchased for $925, we would calculate its current yield with the following formula:

Calculating Yield to Maturity The current yield calculation we learned above shows us the return the annual coupon payment gives the investor, but this percentage does not take into account the time value of money or, more specifically, the present value of the coupon payments the investor will receive in the future. For this reason, when investors and analysts refer to yield, they are most often referring to the yield to maturity (YTM), which is the interest rate by which the present values of all the future cash flows are equal to the bond's price. An easy way to think of YTM is to consider it the resulting interest rate the investor receives if he or she invests all of his or her cash flows (coupons payments) at a constant interest rate until the bond matures. YTM is the return the investor will receive from his or her entire investment. It is the return that an investor gains by receiving the present values of the coupon payments,

the par value and capital gains in relation to the price that is paid. The yield to maturity, however, is an interest rate that must be calculated through trial and error. Such a method of valuation is complicated and can be time consuming, so investors (whether professional or private) will typically use a financial calculator or program that is quickly able to run through the process of trial and error. If you don't have such a program, you can use an approximation method that does not require any serious mathematics. To demonstrate this method, we first need to review the relationship between a bond's price and its yield. In general, as a bond's price increases, yield decreases. This relationship is measured using the price value of a basis point (PVBP). By taking into account factors such as the bond's coupon rate and credit rating, the PVBP measures the degree to which a bond's price will change when there is a 0.01% change in interest rates. The charted relationship between bond price and required yield appears as a negative curve:

This is due to the fact that a bond's price will be higher when it pays a coupon that is higher than prevailing interest rates. As market interest rates increase, bond prices decrease. The second concept we need to review is the basic price-yield properties of bonds: Premium bond: Coupon rate is greater than market interest rates. Discount bond: Coupon rate is less than market interest rates. Thirdly, remember to think of YTM as the yield a bondholder receives if he or she reinvested all coupons received at a constant interest rate, which is the interest rate that we are solving for. If we were to add the present values of all future cash flows, we would end up with the market value or purchase price of the bond. The calculation can be presented as:

OR

Example 1: You hold a bond whose par value is $100 but has a current yield of 5.21% because the bond is priced at $95.92. The bond matures in 30 months and pays a semi-annual coupon of 5%. 1. Determine the Cash Flows: Every six months you would receive a coupon payment of $2.50 (0.025*100). In total, you would receive five payments of $2.50, plus the future value of $100. 2. Plug the Known Amounts into the YTM Formula:

Remember that we are trying to find the semi-annual interest rate, as the bond pays the coupon semi-annually. 3. Guess and Check: Now for the tough part: solving for i, or the interest rate. Rather than pick random numbers, we can start by considering the relationship between bond price and yield. When a bond is priced at par, the interest rate is equal to the coupon rate. If the bond is priced above par (at a premium), the coupon rate is greater than the interest rate. In our case, the bond is priced at a discount from par, so the annual interest rate we are seeking (like the current yield) must be greater than the coupon rate of 5%. Now that we know this, we can calculate a number of bond prices by plugging various annual interest rates that are higher than 5% into the above formula. Here is a table of the bond prices that result from a few different interest rates:

Because our bond price is $95.92, our list shows that the interest rate we are solving for is between 6%, which gives a price of $95, and 7%, which gives a price of $98. Now that we have found a range between which the interest rate lies, we can make another table showing the prices that result from a series of interest rates that go up in increments of 0.1% instead of 1.0%. Below we see the bond prices that result from various interest rates that are between 6.0% and 7.0%:

We see then that the present value of our bond (the price) is equal to $95.92 when we have an interest rate of 6.8%. If at this point we did not find that 6.8% gives us the exact price that we are paying for the bond, we would have to make another table that shows the interest rates in 0.01% increments. You can see why investors prefer to use special programs to narrow down the interest rates - the calculations required to find YTM can be quite numerous!

Bond duration
In finance, the duration of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows are received. Duration also measures the price sensitivity to yield, the percentage change in price for a parallel shift in yields. [1] [2] The dual characterization of duration, as both the weighted average time until repayment and as the percentage change in price, often causes confusion. Strictly speaking, Macaulay duration is the name given to the weighted average time until cash flows are received, and is measured in years. Modified duration is the name given to the price sensitivity and is the percentage change in price for a unit change in yield. When yields are continuously-compounded Macaulay duration and modified duration will be numerically equal. When yields are periodically-compounded

Macaulay and modified duration will differ slightly, and in this case there is a simple relation between the two. Modified duration is used more than Macaulay duration. Macaulay duration and modified duration are both termed "duration" and have the same (or close to the same) numerical value, but it is important to keep in mind the conceptual distinctions between them. Macaulay duration is a time measure with units in years, and really makes sense only for an instrument with fixed cash flows. For a standard bond the Macaulay duration will be between 0 and the maturity of the bond. It is equal to the maturity if and only if the bond is a zero-coupon bond. Modified duration, on the other hand, is a derivative or price sensitivity and measures the percentage rate of change of price with respect to yield. (Price sensitivity with respect to yields can also be measured in absolute (dollar) terms, and the absolute sensitivity is often referred to as dollar duration, DV01, PV01, or delta ( or ) risk.) The concept of modified duration can be applied to interest-rate sensitive instruments with non-fixed cash flows, and can thus be applied to a wider range of instruments than can Macaulay duration. For every-day use, the equality (or near-equality) of the values for Macaulay and modified duration can be a useful aid to intuition. For example a standard ten-year coupon bond will have Macaulay duration somewhat but not dramatically less than 10 years and from this we can infer that the modified duration (price sensitivity) will be somewhat but not dramatically less than 10%. In contrast, a two-year coupon bond will have Macaulay duration somewhat below 2 years, and modified duration somewhat below 2%. (For example a ten-year 5% par bond has modified duration 7.8% while a two-year 5% par bond has modified duration 1.9%.)

Macaulay duration
Macaulay duration, named for Frederick Macaulay who introduced the concept, is the weighted average maturity of cash flows. Consider some set of fixed cash flows. The present value of these cash flows is:

Macaulay duration is defined as:[1][2] [3]

(1)

where:
i indexes the cash flows, PVi is the present value of the ith cash payment from an asset, ti is the time in years until the ith payment will be received, V is the present value of all cash payments from the asset.

In the second expression the fractional term is the ratio of the cash flow PVi to the total PV. These terms add to 1.0 and serve as weights for a weighted average. Thus the overall expression

is a weighted average of time until cash flow payments, with weight the asset's present value due to cash flow i.

being the proportion of

For a set of all-positive fixed cash flows the weighted average will fall between 0 (the minimum time), or more precisely t1 (the time to the first payment) and the time of the final cash flow. The Macaulay duration will equal the final maturity if and only if there is only a single payment at maturity. In symbols, if cash flows are in order (t1,...,tn), then:

with the inequalities being strict unless it has a single cash flow. In terms of standard bonds (for which cash flows are fixed and positive), this means the Macaulay duration will equal the bond maturity only for a zero-coupon bond. Macaulay duration has the diagrammatic interpretation shown in figure 1.

Fig. 1: Macaulay Duration

This represents the bond discussed in the example below, two year maturity with a coupon of 20% and continuously-compounded yield of 3.9605%. The circles represents the PV of the payments, with the coupon circles getting smaller the further out they are and the final large circle including the final principal repayment. If these circles were put on a balance beam, the fulcrum of the beam would represent the weighted average distance (time to payment), which is 1.78 years in this case. For most practical calculations, the Macaulay duration is calculated using the yield to maturity to calculate the PV(i):

(2)

(3)

where:
i indexes the cash flows, PVi is the present value of the ith cash payment from an asset, CFi is the cash flow of the ith payment from an asset, y is the yield to maturity (continuously-compounded) for an asset, ti is the time in years until the ith payment will be received, V is the present value of all cash payments from the asset until maturity. Expression (1) is MacaulayWeil duration which uses zero-coupon bond prices as discount factors, and Expression (3) which uses the bond's yield to maturity to calculate discount factors.

Macaulay gave two alternative measures:

The key difference between the two is that the MacaulayWeil duration allows for the possibility of a sloping yield curve, whereas the second form is based on a constant value of the yield y, not varying by term to payment. With the use of computers, both forms may be calculated but expression (3), assuming a constant yield, is more widely used because of the application to modified duration.

[edit] Modified duration

In contrast to Macaulay duration, modified duration (sometimes abbreviated DM) is a price sensitivity measure, defined as the percentage derivative of price with respect to yield:

It turns out that when the yield is expressed continuously-compounded, Macaulay duration and modified duration are numerically equal, while for periodically-compounded yields the relation between Macaulay duration and modified duration is:

where k is the compounding frequency (1 for annual, 2 for semi-annual, etc.) We can derive this expression from the derivative definition of modified duration above. First, consider the case of continuously-compounded yields. If we take take the derivative of price or present value, expression (2), with respect to the continuously-compounded yield y we see that:

In other words, for yields expressed continuously-compounded, ModD = MacD.[1] In financial markets yields are usually expressed periodically-compounded (say annually or semi-annually) instead of continuously-compounded. Then expression (2) becomes:

and expression (3) becomes:

where k is the compounding frequency (1 for annual, 2 for semi-annual, etc.) In this case, when we take the derivative of the value V with respect to the periodically-compounded yield we find
[4]

This gives the well-known relation between Macaulay duration and modified duration quoted above. It should be remembered that, even though Macaulay duration and modified duration are closely related, they are conceptually distinct. Macaulay duration is a weighted average time until repayment (measured in units of time such as years) while modified duration is a price sensitivity measure, the percentage change in price with respect to yield. BOND CONVEXITIES In finance, convexity is a measure of the sensitivity of the duration of a bond to changes in interest rates. In general, the higher the convexity, the more sensitive the bond price is to decreasing interest rates and the less sensitive the bond price is to increasing rates.

[edit] Calculation of convexity

Duration is a linear measure or 1st derivative of how the price of a bond changes in response to interest rate changes. As interest rates change, the price is not likely to change linearly, but instead it would change over some curved function of interest rates. The more curved the price function of the bond is, the more inaccurate duration is as a measure of the interest rate sensitivity. Convexity is a measure of the curvature or 2nd derivative of how the price of a bond varies with interest rate, i.e. how the duration of a bond changes as the interest rate changes. Specifically, one assumes that the interest rate is constant across the life of the bond and that changes in

interest rates occur evenly. Using these assumptions, duration can be formulated as the first derivative of the price function of the bond with respect to the interest rate in question. Then the convexity would be the second derivative of the price function with respect to the interest rate. In actual markets the assumption of constant interest rates and even changes is not correct, and more complex models are needed to actually price bonds. However, these simplifying assumptions allow one to quickly and easily calculate factors which describe the sensitivity of the bond prices to interest rate changes.

[edit] Why bond convexities may differ

The price sensitivity to parallel changes in the term structure of interest rates is highest with a zero-coupon bond and lowest with an amortizing bond (where the payments are front-loaded). Although the amortizing bond and the zero-coupon bond have different sensitivities at the same maturity, if their final maturities differ so that they have identical bond durations they will have identical sensitivities. That is, their prices will be affected equally by small, first-order, (and parallel) yield curve shifts. They will, however, start to change by different amounts with each further incremental parallel rate shift due to their differing payment dates and amounts. For two bonds with same par value, same coupon and same maturity, convexity may differ depending on at what point on the price yield curve they are located. Suppose both of them have at present the same price yield (p-y) combination; also you have to take into consideration the profile, rating, etc. of the issuers: let us suppose they are issued by different entities. Though both bonds have same p-y combination bond A may be located on a more elastic segment of the p-y curve compared to bond B. This means if yield increases further, price of bond A may fall drastically while price of bond B wont change, i.e. bond B holders are expecting a price rise any moment and are therefore reluctant to sell it off, while bond A holders are expecting further price-fall and ready to dispose of it. This means bond B has better rating than bond A. So the higher the rating or credibility of the issuer the less the convexity and the less the gain from risk-return game or strategies; less convexity means less price-volatility or risk; less risk means less return.

[edit] Mathematical definition

If the flat floating interest rate is r and the bond price is B, then the convexity C is defined as

Another way of expressing C is in terms of the modified duration D:

Therefore

leaving

Where D is a Modified Duration

[edit] How bond duration changes with a changing interest rate

Return to the standard definition of modified duration:

where P(i) is the present value of coupon i, and t(i) is the future payment date. As the interest rate increases the present value of longer-dated payments declines in relation to earlier coupons (by the discount factor between the early and late payments). However, bond price also declines when interest rate increases, but changes in the present value of sum of each coupons times timing (the numerator in the summation) are larger than changes in the bond price (the denominator in the summation). Therefore, increases in r must decrease the duration (or, in the case of zero-coupon bonds, leave the unmodified duration constant). Note that the modified duration D differs from the regular duration by the factor one over 1+r (shown above), which also decreases as r is increased.

Given the relation between convexity and duration above, conventional bond convexities must always be positive. The positivity of convexity can also be proven analytically for basic interest rate securities. For example, under the assumption of a flat yield curve one can write the value of a coupon-bearing bond as that , where ci stands for the coupon paid at time ti. Then it is easy to see

Note that this conversely implies the negativity of the derivative of duration by differentiating .

[edit] Application of convexity

1. Convexity is a risk management figure, used similarly to the way 'gamma' is used in derivatives risks management; it is a number used to manage the market risk a bond portfolio is exposed to. If the combined convexity and duration of a trading book is high, so is the risk. However, if the combined convexity and duration are low, the book is hedged, and little money will be lost even if fairly substantial interest movements occur. (Parallel in the yield curve.) 2. The second-order approximation of bond price movements due to rate changes uses the convexity:

What Is Bond Immunization?

Bond immunization is an investment strategy used to minimize the interest rate risk of bond investments by adjusting the portfolio duration to match the investor's investment time horizon. It does this by locking in a fixed rate of return during the amount of time an investor plans to keep the investment without cashing it in. Immunization locks in a fixed rate of return during the amount of time an investor plans to keep the bond without cashing it in. Normally, interest rates affect bond prices inversely. When interest rates go up, bond prices go down. But when a bond portfolio is immunized, the investor receives a specific rate of return over a given time period regardless of what happens to interest rates during that time. In other words, the bond is "immune" to fluctuating interest rates. To immunize a bond portfolio, you need to know the duration of the bonds in the portfolio and adjust the portfolio so that the portfolio's duration equals the investment time horizon. For example, suppose you need to have $50,000 in five years for your child's education. You might decide to invest in bonds. You can immunize your bond portfolio by selecting bonds that will equal exactly $50,000 in five years regardless of interest rate changes. You can buy one zero-coupon bond that will mature in five years to equal $50,000, or several coupon bonds each with a five year duration, or several bonds that "average" a five-year duration.

Duration measures a bond's market risk and price volatility in response to a given change in interest rates. Duration is a weighted average of the bond's cash flows over its life. The weights are the present value of each interest payment as a percentage of the bond's full price. The longer the duration of a bond, the greater its price volatility. Duration is used to determine how a bond will react to changing interest rates. For example, if interest rates rise 1%, a bond with a two-year duration will fall about 2% in value. You needn't worry about doing the calculations as you can obtain a bond's (or bond fund's) duration from a broker or advisor. Using bonds' durations, you can build a bond portfolio immune to interest rate risk. Effects of Bond Immunization Changes to interest rates actually affect two parts of a bond's value. One of them is a change in the bond's price, or price effect. When interest rates change before the bond matures, the bond's final value changes, too. An increase in interest rates means new bond issues offer higher earnings, so the prices of older bonds decline on the secondary market. Interest rate fluctuations also affect a bond's reinvestment risk. When interest rates rise, a bond's coupon may be reinvested at a higher rate. When they decrease, bond coupons can only be reinvested at the new, lower rates. Interest rate changes have opposite effects on a bond's price and reinvestment opportunities. While an increase in rates hurts a bond's price, it helps the bond's reinvestment rate. The goal of immunization is to offset these two changes to an investor's bond value, leaving its worth unchanged. A portfolio is immunized when its duration equals the investor's time horizon. At this point, any changes to interest rates will affect both price and reinvestment at the same rate, keeping the portfolio's rate of return the same. Maintaining an immunized portfolio means rebalancing the portfolio's average duration every time interest rates change, so that the average duration continues to equal the investor's time horizon. A more direct form of immunization, "dedicating" a portfolio not only matches its duration to the investor's long-term time horizon, but also matches specific anticipated receipts of cash to the investor's specific anticipated liabilities along the way. To pay for college, for example, a parent might construct a bond portfolio so that interest and principal payments will be paid each year in September, when tuition is due.

Efficient-market hypothesis

In finance, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made. There are three major versions of the hypothesis: "weak", "semi-strong", and "strong". The weak-form EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information. The semi-strong-form EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. The strong-form EMH additionally claims that prices instantly reflect even hidden or "insider" information. There is evidence for and against the weak-form and semistrong-form EMHs, while there is evidence against strong-form EMH.[citation needed] Various studies have pointed out signs of inefficiency in financial markets.[1] Critics have blamed the belief in rational markets for much of the late-2000s financial crisis.[2][3][4] In response, proponents of the hypothesis have stated that market efficiency does not mean having no uncertainty about the future, that market efficiency is a simplification of the world which may not always hold true, and that the market is practically efficient for investment purposes for most individuals.

Theoretical background
Beyond the normal utility maximizing agents, the efficient-market hypothesis requires that agents have rational expectations; that on average the population is correct (even if no one person is) and whenever new relevant information appears, the agents update their expectations appropriately. Note that it is not required that the agents be rational. EMH allows that when faced with new information, some investors may overreact and some may underreact. All that is required by the EMH is that investors' reactions be random and follow a normal distribution pattern so that the net effect on market prices cannot be reliably exploited to make an abnormal profit, especially when considering transaction costs (including commissions and spreads). Thus, any one person can be wrong about the marketindeed, everyone can bebut the market as a whole is always right. There are three common forms in which the efficient-market hypothesis is commonly statedweak-form efficiency, semi-strong-form efficiency and strong-form efficiency, each of which has different implications for how markets work. In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past. Excess returns cannot be earned in the long run by using investment strategies based on historical share prices or other historical data. Technical analysis techniques will not be able to consistently produce excess returns, though some forms of fundamental analysis may still provide excess returns. Share prices exhibit no serial dependencies, meaning that there are no "patterns" to asset prices. This implies that future price movements are determined entirely by information not contained in the price series. Hence, prices must follow a random walk. This 'soft' EMH does not require that prices remain at or near equilibrium, but only that market participants not be able to systematically profit from market 'inefficiencies'. However, while EMH predicts that all price movement (in the absence of change in fundamental information) is random (i.e., non-trending), many studies have shown a marked tendency for the stock markets to trend over time periods of weeks or longer[17] and that, moreover, there is a positive correlation between degree of trending and length of time period studied[18] (but note that over long time periods, the trending is sinusoidal in appearance). Various explanations for such large and apparently non-random price movements have been promulgated.

The problem of algorithmically constructing prices which reflect all available information has been studied extensively in the field of computer science.[19][20] For example, the complexity of finding the arbitrage opportunities in pair betting markets has been shown to be NP-hard.[21] In semi-strong-form efficiency, it is implied that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information. Semi-strong-form efficiency implies that neither fundamental analysis nor technical analysis techniques will be able to reliably produce excess returns. To test for semi-strong-form efficiency, the adjustments to previously unknown news must be of a reasonable size and must be instantaneous. To test for this, consistent upward or downward adjustments after the initial change must be looked for. If there are any such adjustments it would suggest that investors had interpreted the information in a biased fashion and hence in an inefficient manner. In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns. If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored. To test for strong-form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. Even if some money managers are consistently observed to beat the market, no refutation even of strong-form efficiency follows: with hundreds of thousands of fund managers worldwide, even a normal distribution of returns (as efficiency predicts) should be expected to produce a few dozen "star" performers.