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Bond Valuation

Bond Valuation An Overview


Introduction to bonds and bond markets
What are they? Some examples

Zero coupon bonds
Valuation
Interest rate sensitivity

Coupon bonds
Valuation
Interest rate sensitivity

The term structure of interest rates
What is a Bond?

A bond is a security that obligates the issuer


to make specified interest and principal
payments to the holder on specified dates.
Coupon rate
Face value (or par)
Maturity (or term)

Bonds are also called fixed income


securities.

Bonds differ in several respects:


Repayment type
Issuer
Maturity
Security
Priority in case of default

Repayment Schemes

Pure Discount or Zero-Coupon Bonds


Pay no coupons prior to maturity.
Pay the bonds face value at maturity.

Coupon Bonds
Pay a stated coupon at periodic intervals prior to maturity.
Pay the bonds face value at maturity.

Floating-Rate Bonds
Pay a variable coupon, reset periodically to a reference rate.
Pay the bonds face value at maturity.

Perpetual Bonds (Consols)


No maturity date.
Pay a stated coupon at periodic intervals.

Annuity or Self-Amortizing Bonds


Pay a regular fixed amount each payment period.
Principal repaid over time rather than at maturity.


Types of Bonds: Issuers

Bonds Issuer
Government Bonds US Treasury, Government
Agencies
Mortgage-Backed Securities Government agencies (GNMA etc)
Municipal Bonds State and local government
Corporate Bonds Corporations
Asset-Back Securities Corporations
U.S. Government Bonds
Treasury Bills
No coupons (zero coupon security)
Face value paid at maturity
Maturities up to one year

Treasury Notes
Coupons paid semiannually
Face value paid at maturity
Maturities from 2-10 years

U.S. Government Bonds (Cont.)
Treasury Bonds
Coupons paid semiannually
Face value paid at maturity
Maturities over 10 years
The 30-year bond is called the long bond.
Treasury Strips
Zero-coupon bond
Created by stripping the coupons and principal
from Treasury bonds and notes.
No default risk. Considered to be risk free.
Exempt from state and local taxes.
Sold regularly through a network of primary dealers.
Traded regularly in the over-the-counter market.


Agency and Municipal Bonds
Agency bonds: mortgage-backed bonds
Bonds issued by U.S. Government agencies that
are backed by a pool of home mortgages.
Self-amortizing bonds. (mostly monthly
payments)
Maturities up to 30 years.
Prepayment risk.
Municipal bonds
Maturities from one month to 40 years.
Usually exempt from federal, state, and local
taxes.
Generally two types:
Revenue bonds
General Obligation bonds
Riskier than U.S. Government bonds.
Corporate Bonds

Bonds issued by corporations
Bonds vs. Debentures
Fixed-rate versus floating-rate bonds.
Investment-grade vs. Below investment-grade bonds.
Additional features:
call provisions
convertible bonds
puttable bonds
Seniority of Corporate Bonds

In case of default, different classes of bonds have different
claim priority on the assets of a corporation.

Secured Bonds (Asset-Backed)
Secured by real property.
Ownership of the property reverts to the
bondholders upon default.

Debentures
Same priority as general creditors.
Have priority over stockholders, but subordinate
to secured debt.
Bond Ratings
Moodys S&P Quality of Issue
Aaa AAA Highest quality. Very small risk of default.

Aa AA High quality. Small risk of default.

A A High-Medium quality. Strong attributes, but potentially
vulnerable.
Baa BBB Medium quality. Currently adequate, but potentially
unreliable.
Ba BB Some speculative element. Long-run prospects
questionable.
B B Able to pay currently, but at risk of default in the future.
Caa CCC Poor quality. Clear danger of default.

Ca CC High speculative quality. May be in default.

C C Lowest rated. Poor prospects of repayment.

D - In default.


The US Bond Market
Debt Instrument 2006 Q2
Treasury securities 4759.6
Municipal securities 2305.7
Corporate and foreign bonds 8705.3
Consumer Credit 2327.4
Mortgages 12757.7
Corporate equities 18684.5
Amount ($bil.). Source: U.S. Federal Reserve (Table L.4, September/2006)
Bond Valuation: Zero Coupon
Bonds
B = Market price of the Bond of bond
F = Face value
R = Annual percentage rate
m = compounding period (annual m = 1,
semiannual m = 2,)
i = Effective periodic interest rate; i=R/m
T = Maturity (in years)
N = Number of compounding periods; N = T*m

Two cash flows to purchaser of bond:
-B at time 0
F at time T
What is the price of a bond?
Use present value formula:
( )
N
i
F
B
+
=
1
Valuing Zero Coupon Bonds:
An Example
Value a 5 year, U.S. Treasury strip with face value of $1,000. The APR is
R=7.5% with annual compounding? What about quarterly compounding?





What is the APR on a U.S. Treasury strip that pays $1,000 in exactly 7 years and
is currently selling for $591.11 under annual compounding? Semi-annual
compounding?




Interest Rate Sensitivity:
Zero Coupon Bonds
Consider the following 1, 2 and 10-year zero-coupon bonds,
all with
face value of F=$1,000
APR of R=10%, compounded annually.
We obtain the following table for increases
and decreases of the interest rate by 1%:





Bond prices move up if interest rates drop, decrease if interest
rates rise
Interest Rate Bond 1 Bond 2 Bond 3
1-Year 2-Year 10-Year
9.0% $917.43 $841.68 $422.41
10.0% $909.09 $826.45 $385.54
11.0% $900.90 $811.62 $352.18
Bond Prices and Interest Rates
$0
$200
$400
$600
$800
$1,000
$1,200
0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
1-Year
2-Year
10-Year
Bond prices are inversely related to
IR
Longer term bonds are more
sensitive to IR changes than short
term bonds
The lower the IR, the more sensitive
the price.
Measuring Interest Rate Sensitivity
Zero Coupon Bonds
We would like to measure the interest rate
sensitivity of a bond or a portfolio of bonds.
How much do bond prices change if interest rates
change by a small amount?
Why is this important?
Use Dollar value of a one basis point
decrease (DV01):
Basis point (bp): 1/100 of one percentage point
=0.01%=0.0001
Calculate DV01:
Method 1: Difference of moving one basis point down:
DV01= B(R-0.01%)-B(R).
Method 2: Difference of moving 1/2bp down minus
1/2pb up:
DV01=B(R-0.005%) -B(R+0.005%).
Method 3: Use calculus:


0001 . 0 01
c
c
=
R
B
DV
Computing DV01: An Example
Reconsider the 1, 2 and 10- year bonds
discussed before:









Method 3:
1 1
10 . 1
1
* 10 . 0 $ * 0001 . 0
10 . 1
000 , 1 $
0001 . 0
+ +
= =
c
c

T T
T T
R
B
Interest Rate Bond 1 Bond 2 Bond 3
1-Year 2-Year 10-Year
9.990% $909.1736 $826.5966 $385.8940
9.995% $909.1322 $826.5214 $385.7186
10.000% $909.0909 $826.4463 $385.5433
10.005% $909.0496 $826.3712 $385.3681
Method 1 $0.082652 $0.150283 $0.350669
Method 2 $0.082645 $0.150263 $0.350494
Method 3 $0.082645 $0.150263 $0.350494
DV01: A Graphical Approach
DV01 estimates the change in the Price-
Interest rate curve using a linear
approximation.
higher slope implies greater sensitivity
10-Year
$0.00
$200.00
$400.00
$600.00
$800.00
$1,000.00
$1,200.00
Interest Rate
Valuing Coupon Bonds
Example 1: Amortization Bonds
Consider Amortization Bond
T=2
m=2
C=$2,000 c = C/m = $2,000/2 = $1,000
R=10% i = R/m = 10%/2 = 5%
How can we value this security?
Brute force discounting
Similar to another security we already know how
to value?
Replication
0 1 2 3 4
Buy Coupon Bond -$3,545.95 $1,000.00 $1,000.00 $1,000.00 $1,000.00
Buy 6-Month Zero -$952.38
Buy 1-Year Zero -$907.03
Buy 1.5-Year Zero -$863.84
Buy 2-Year Zero -$822.70
Portfolio -$3,545.95
Valuing Coupon Bonds
Example 1: Amortization Bonds

Compare with a portfolio of zero coupon
bonds:
A First Look at Arbitrage
Reconsider amortization bond; suppose bond trades
at $3,500 (as opposed to computed price of
$3,545.95)
Can we make a profit without any risk?
What is the strategy?
What is the profit?
A First Look at Arbitrage
Reconsider amortization bond; suppose bond
trades at $3,500 (as opposed to computed
price of $3,545.95)
Can make risk less profit
Buy low: buy amortization bond
Sell high: Sell portfolio of zero coupon bonds






riskless profit of $45.95
no riskless profit if price is correct
0 1 2 3 4
Buy Coupon Bond -$3,500.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00
Sell 6-Month Zero $952.38 -$1,000.00 $0.00 $0.00 $0.00
Sell 1-Year Zero $907.03 $0.00 -$1,000.00 $0.00 $0.00
Sell 1.5-Year Zero $863.84 $0.00 $0.00 -$1,000.00 $0.00
Sell 2-Year Zero $822.70 $0.00 $0.00 $0.00 -$1,000.00
Portfolio $3,545.95 -$1,000.00 -$1,000.00 -$1,000.00 -$1,000.00
Net Cash Flow $45.95 $0.00 $0.00 $0.00 $0.00
Time Period
What is the market price of a U.S. Treasury
bond that has a coupon rate of 9%, a face
value of $1,000 and matures exactly 10 years
from today if the interest rate is 10%
compounded semiannually?

0 6 12 18 24 ... 120
Months

45 45 45 45 1045


Valuation of Coupon Bonds:
Example 2: Straight Bonds
What is the market price of a bond that has an
annual coupon C, face value F and matures
exactly T years from today if the required rate
of return is R, with m-periodic compounding?
Coupon payment is: c = C/m
Effective periodic interest rate is: i = R/m
number of periods N = Tm

0 1 2 3 4 ...
N
c c c c
c+F




Valuing Coupon Bonds
The General Formula
| | | |
( ) ( )
(

+
+
(

+
=
+ =
N N
i
F
i
i
c
Zero Annuity B
1 1
1
1
The Concept of a Yield to
Maturity
So far we have valued bonds by using a given interest rate,
then discounted all payments to the bond.
Prices are usually given from trade prices
need to infer interest rate that has been used
Definition: The yield to maturity is that interest rate that
equates the present discounted value of all future payments to
bondholders to the market price:
Algebraic:



( ) ( )
N N
m yield
F
m yield
m yield
c
B
/ 1 / 1
1
1
/
+
+
|
|
.
|

\
|
+
=
Yield to Maturity
A Graphical Interpretation
$0.00
$500.00
$1,000.00
$1,500.00
$2,000.00
$2,500.00
0
%
2
%
4
%
6
%
8
%
1
0
%
1
2
%
1
4
%
1
6
%
1
8
%
2
0
%
2
2
%
2
4
%
Consider a U.S. Treasury bond that has a coupon rate of 10%, a face value of
$1,000 and matures exactly 10 years from now.
Market price of $1,500, implies a yield of 3.91% (semi-annual compounding);
for B=$1,000 we obviously find R=10%.
Interest Rate Sensitivity:
Coupon Bonds
Coupon bonds can be represented as portfolios of zero-
coupon bonds
Implication for price sensitivity

Consider purchasing the US Treasury bond discussed earlier
(10 year, 9% coupon, $1,000 face)
Suppose immediately thereafter interest rates fall
to 8%, compounded semiannually.
Suppose immediately thereafter interest rate rises
to 12% compounded semiannually.
Suppose the interest rate equals 9%, compounded
semiannually.

What are the pricing implications of these scenarios?

Recall the general formula:








What is the price of the bond if the APR is 8%


compounded semiannually?


Similarly:
If R=12%: B=$ 827.95
If R= 9%: B=$1,000.00


Implication of Interest Rate
Changes on Coupon Bond Prices
( ) ( )
(

+
+
(

+
=
N N
i
F
i
i
c
B
1 1
1
1
Relationship Between Coupon
Bond Prices and Interest Rates
Bond prices are inversely related to interest rates (or yields).

A bond sells at par only if its interest rate equals the coupon
rate

A bond sells at a premium if its coupon rate is above the
interest rate.

A bond sells at a discount if its coupon rate is below the
interest rate.
DV01 and Coupon Bonds
Consider two bonds with 10% annual coupons
with maturities of 5 years and 10 years.
The APR is 8%
What are the responses to a .01% (1bp)
interest rate change?





Does the sensitivity of a coupon bond always
increase with the term to maturity?
Yield 5-Year Bond $ Change % Change 10-Year Bond $ Change % Change
7.995% $1,080.06 $0.21019 0.0195% $1,134.57 $0.36585 0.0323%
8.000% $1,079.85 $1,134.20
8.005% $1,079.64 -$0.21013 -0.0195% $1,133.84 -$0.36569 -0.0322%
DV01 $0.42032 $0.73154
$0.00
$500.00
$1,000.00
$1,500.00
$2,000.00
$2,500.00
0
%
2
%
4
%
6
%
8
%
1
0
%
1
2
%
1
4
%
1
6
%
1
8
%
2
0
%
2
2
%
2
4
%
Interest Rate (R)
P
r
i
c
e

(
P
)
5-Year Bond
10-Year Bond
Bond Prices and Interest Rates
Longer term bonds are more sensitive to
changes in interest rates than shorter term bonds, in general.
Consider the following two bonds:
Both have a maturity of 5 years
Both have yield of 8%
First has 6% coupon, other has 10% coupon,
compounded annually.
Then, what are the price sensitivities of these
bonds, measured by DV01 as for zero coupon
bonds?






Why do we get different answers for two
bonds with the same yield and same maturity?
Bond Yields and Prices
Yield 6%-Bond $ Change % change 10%-Bond $ Change % change
7.995% $920.33 $0.1891 $1,080.06 $0.2102
8.000% $920.15 $1,079.85
8.005% $919.96 ($0.1891) $1,079.64 ($0.2101)
0.0411% 0.0389%
DV01 $0.3782 $0.4203
Maturity and Price Risk
Zero coupon bonds have well-defined relationship
between maturity and interest rate sensitivity:

Coupon bonds can have different sensitivities for the
same maturity
DV01 now depends on maturity and coupon

Need concept of average maturity of coupon bond:
Duration
Duration
Duration is a weighted
average term to maturity
where the weights are
relative size of the
contemporaneous cash
flow.



Duration is a unitless
number that quantifies the
percentage change in a
bonds price for a 1
percentage change in the
interest rate.



B
F PV
N
T
B
N
c PV
N
T
B
c PV
T
B
c PV
T Duration
) (
) ( )
2
(
2
)
1
(
1
+ + + + =
|
.
|

\
|
+
c
|
.
|

\
|
c
=
+

c
c
=
R
R
B
B
B
R
R
B
Duration
1
1
Duration (cont.)
The duration of a bond is less than its time to maturity (except
for zero coupon bonds).
The duration of the bond decreases the greater the coupon
rate. This is because more weight (present value weight) is
being given to the coupon payments.
As market interest rate increases, the duration of the bond
decreases. This is a direct result of discounting. Discounting
at a higher rate means lower weight on payments in the far
future. Hence, the weighting of the cash flows will be more
heavily placed on the early cash flows -- decreasing the
duration.
Modified Duration = Duration / (1+yield)

Bills
MATURITY DISCOUNT/YIELD DISCOUNT/YIELD TIME
DATE CHANGE
3-Month 08/16/2007 4.72 / 4.84 0.01 / .010 13:41
6-Month 11/15/2007 4.78 / 4.98 0.01 / .015 13:41



Notes/Bonds
COUPON MATURITY CURRENT PRICE/YIELD TIME
DATE PRICE/YIELD CHANGE
2-Year 4.500 04/30/2009 99-1214 / 4.84 -0-02 / .035 14:08
3-Year 4.500 05/15/2010 99-0812 / 4.77 -0-0312 / .040 14:06
5-Year 4.500 04/30/2012 98-2812 / 4.75 -0-06 / .043 14:07
10-Year 4.500 05/15/2017 97-15 / 4.82 -0-0912 / .038 14:07
30-Year 4.750 02/15/2037 96-17+ / 4.97 -0-17 / .035 14:07
A Few Bond Markets Statistics
U.S. Treasuries, May 20th 2007.
Spot Rates
A spot rate is a rate agreed upon today, for a loan that is to
be made today
r
1
=5% indicates that the current rate for a one-
year loan is 5%.
r
2
=6% indicates that the current rate for a two-
year loan is 6%.
Etc.
The term structure of interest rates is the series of spot
rates r
1
,

r
2
,

r
3
,

We can build using STRIPS or coupon bond
yields.
Explanations of the term structure.
The Term Structure of Interest
Rates
An Example
1 2 3
Yield
Maturity
5.00
5.75
6.00
Term Structure, July 1
st
2005.
Term Structure, September 12
th
,
2006
Term Structure, May 20
th
, 2007
Term Structure of Interest Rates
Summary
Bonds can be valued by discounting their future cash
flows
Bond prices change inversely with yield
Price response of bond to interest rates depends on
term to maturity.
Works well for zero-coupon bond, but not for coupon
bonds
Measure interest rate sensitivity using DV01 and
duration.
The term structure implies terms for future
borrowing:
Forward rates
Compare with expected future spot rates