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Prices of a long term bond are more sensitive to interest rate changes
than prices of a short term bond.
Price of low-coupon bond are more sensitive to interest rate change than
prices of high coupon bonds.
Interest rate risk is inversely related to the bonds coupon rate i.e. prices
of high coupon bonds are less sensitive to changes in interest rate than
prices of low coupon bonds.
Annual Interest
Current Yields =
Price of the Bond
As is the case with all investment assets, the first step in calculating
bond portfolio is to calculate the market value of portfolio.
2)
3)
7/11/2001
Coupon Rate
Maturity
11.68%
YTM
No. of
Bonds
Market
Value
Weighted
Current Yield
8/6/2002
7.37%
5400
563436.00
41541.28
11.15%
9/1/2002
7.38%
5560
578406.80
42669.01
13.82%
5/30/2002
7.27%
5720
603460.00
43890.49
12.69%
5/10/2002
6.51%
5880
616812.00
40127.09
11.00%
5/23/2003
7.63%
6040
638669.60
48735.94
Sum
3000784.4
0
216963.82
Portfolio
Yield
7.23%
Realised yield to the investor is the rate which equates cash flow from all 3
sources to the initial cash flow.
Callable Bonds
Bonds that allow the issuer to alter the tenor of a bond, by redeeming it
prior to the original maturity date, are called callable bonds.
The inclusion of this feature in the bonds structure provides the issuer
the right to fully or partially retire the bond, and is therefore in the
nature of call option on the bond.
The call option provides the issuer the option to redeem a bond, if
interest rates decline, and re-issue the bonds at a lower rate.
The call option, therefore, can effectively alter the term of a bond, and
carries an added set of risks to the investor, in the form of call risk, and
re-investment risk.
Allows issuers to repay the investors principal early than specified date.
It is also Called when the issuer sees a surge in its credit quality.
If the bond is Called, then the call date is usually one of the two dates
that semiannual interest is due i.e. next payment date.
Reason for calling when market rate drops, new bonds can be issued
at a lower interest rate.
Bond market analyst believe that YTC is more relevant than YTM.
YTC is calculated the same way as YTM but the TTM will change to the amount of
time left for the bond to expire or mature and the call price replaces the par value.
Bonds are callable by the issuer if the prevailing market rate is below the Bonds
calculated YTM.
Call provisions, which must explicitly state the callable options by the
issuer, must be fully considered and understood by investors.
Horizon Analysis
The horizon date might be the end of a business cycle or some other
date determined in the perspective of the investors overall portfolio
requirement.
In principle, all bonds must offer identical rates of return over any holding
period.
In fact despite their different YTMs, each bond will provide a rate of return
over the coming years equal to this years short term rate.
Link: Holding Period
Example:
Zero Coupon Bond Face Value: $1000
Bond Price: $925.93
TTM: 1 year
Capital Gain: $74.07 (1000-925.93)
Rate of Return: $74.07 / $925.93 = 8%
Prices of a long term bond are more sensitive to interest rate changes than
prices of a short term bond.
Price of low-coupon bond are more sensitive to interest rate change than
prices of high coupon bonds.
Interest rate risk is inversely related to the bonds coupon rate i.e. prices of
high coupon bonds are less sensitive to changes in interest rate than prices
of low coupon bonds.
If the short term yield rates are lower, it is called a positive yield curve.
If the short term yield rates are higher, it is called a negative yield
curve.
If the difference between them is not significant, then we will have a flat
yield curve.
Bond Duration
Developed by a financial economist, Frederick R. Macaulay, duration is an
estimate of the economic life of a bond as measured by the weighted
average time to receipt of interest and principal payments.
In simplest of words, it indicates the time required to recover the cost
incurred i.e. the time it takes for the coupons and principal to cover the
bond price incurred.
More technically, we attach weight to each of this payments and the weight
applied to each payment time should be proportional to the total value
of the bond accounted for by that payment.
Link: Duration Explained
Bond Duration
In simple words, it measures bond price volatility by measuring the length
or life of a bond.
Significance:
Recall, Prices of a long term bond are more sensitive to interest rate
changes than prices of a short term bond.
2014 BSE Institute Limited
Convexity
In other words,
Modified duration measures the speed at which bond prices changes to
changes in YTM.
Convexities measures the rate of acceleration i.e. degree of acceleration at
T
which bond prices
toCF
changes in YTM.
1 changes
Convexities
P*(1+
=
y)2
( ( 1 +
t=1
t 2 + t)
y )t
2014 BSE Institute Limited
Convexity
Reasons for Yield Curve adopting convex shape:
As yield change, weights given to each cash flow timing fluctuates more than
yields.
In other words, lower the coupon, longer the maturity and lower the yield,
larger the convexity.
Bootstrapping
It is easy to find the r for a zero coupon bond once we know the bond price.
However in a coupon paying bond, we know that the r is not the same for
all the tenors of the bond. If r is assumed as being constant for all periods,
then yield curve would remain flat.
The r for each period or for each respective tenors is called Spot Rates.
These rates are also called Zero Coupon Rates and the yield curve drawn
from these rates are called ZERO COUPON YIELD CURVE.
Thus the process of finding the zero rates from the prices of the coupon bond
by substituting zero rates estimated for shorter duration is called
bootstrapping.
2014 BSE Institute Limited
Bootstrapping
It would be difficult to obtain zero rates for the first cash flow of the
bond, if we are unable to find a matching treasury bill with a matching
maturity date.
For Example:
Supposing that a coupon paying bond has 54 days for the next coupon
date. To find the present value of the coupon we need to find the
discount rate in order to value the bond. It would be difficult to find a
treasury bill having exactly 54 days to mature. This problem can be
resolved by using the Linear Interpolation method.
We can use the rates on bills maturing in 50 days and 60 days.
Thank You