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Lecture 6
Chap 18

Interest Rates

Rates and basis points

100 basis points are equal to one
percentage point

On January 30, 2006, the 10-year Treasury bond
yield was 4.54%, compared to 4.39% a week
earlier. Therefore, the yield had increased 15
basis points in a week or 0.15 %

Current Yields - Example

A 10 percent coupon bond has a current market

price of $1,052.42.

The current yield

= 100 / 1,052.42 = 9.5%

The market price of $1,052.42 is higher than

the par value (1,000) because market interest
rate has gone down after the bond was issued.
Therefore, the bond was selling at premium.
Promised Yield to Maturity (YTM)
Also known as Yield to Maturity (YTM)
Widely used bond yield measure
Is the periodic interest rate that equates the
present value of the expected cash flow (both
coupon and maturity value) to be received on the
bond on its current price.
It assumes
Investor holds bond to maturity
All the bonds cash flow is reinvested at the
computed yield to maturity

Yield to Maturity

Solve for YTM:

2n Ct / 2 MV
P t

t 1( 1 YTM/ 2 ) ( 1 YTM/ 2 )2n
Note: Formula assume semiannual interest payment

Investors earn the YTM if the bond is

held to maturity and all coupons are
reinvested at YTM
Same as Internal Rate of Return (IRR)
Yield to Maturity - Example
10% coupon bond with 3 years to maturity
Interest of $50 is paid every 6 months
Market price of bond is $1,052.42
Solve for YTM!

Yield to Maturity - Example
2n Ct / 2 MV
P t

t 1( 1 YTM/ 2 ) ( 1 YTM/ 2 )2n
Note: Formula assume semiannual interest payment
P = $1,052.42 ; n = 3 ; Ct /2 = $50 ; MV = $1,000

$1,052.42 = $50 X (present value of an annuity, 4% for 6 periods)

$1000 X (present value, 4% for 6 periods)

$1,052.42 = $50 (5.242) + 1,000 (0.790)

$1,052.42 = $1,052.10 (rounding difference)
Semiannual rate = 4%
Annual YTM = 4% X 2 = 8%

Yield to Maturity

For a zero coupon bond (based on semi

annual interest payment):
YTM 2 {[MV/P] 1}

Since zero coupon bond has no interest

payment, the only cash flow is the face
value of the bond to be received at

Zero Coupon Bond - Example

A zero coupon bond has 12 years to

maturity and is selling at $300.

Assuming a 24 semiannual periods,

what is the YTM ?

Zero Coupon Bond - Example
YTM 2 {[MV/P] 1}
MV = $1000
P = $300

YTM = 2 X {[1000/300]1/(2x12) 1}
= 2 X {[1000/300]0.04167 1}
= 2 X {1.05145 1}
= 2 X 5.145%
= 10.29%

Yield to Call
Most corporate bonds, as well as some
government bonds, are callable by the
issuers, usually after some deferred call
If a bond is likely to be called, the YTM
calculation will be unrealistic
Therefore, the yield is calculated based
on yield to call

Realized Compound Yield
Measures the compound yield on the
bond investment actually earned over
the investment period.

Can only be computed at the end of

the investment when all the cash flows
are known

Realized Compound Yield
If you invest $1,000 in a bond for 5 years,
reinvesting the coupons as they are received, you
will have X dollars at the conclusion of the 5
The X dollars consist of
all the coupons received

the amount earned from reinvesting the

coupons and
the $1,000 maturity value of the bond

Is the X dollars equal exactly to the returned as

promised by the original YTM?

Realized Compound Yield Example 1

Assume an investor purchased $1,000 of 10%

semi annual coupon bond with 3 years maturity
at face value. The promised YTM = 10%

Assume the investor reinvested each coupon

received at semiannual rate of 5% (exactly
same as YTM).

Realized Compound Yield Example 1
The investor will have a total ending wealth of
$1,340.10 which includes the initial investment
of $1,000 plus $340.10 earned

The Realized Compound Yield (Semi Annual) is:

[$1,340.10 / 1,000]1/6 - 1.0
= 0.05
= 5% i.e.
= Annual rate of 10% (same as promised YTM)
Bond Valuation Principle

Intrinsic value
An estimated value
Present value of the expected cash flows
Required to compute intrinsic value
Expected cash flows
Timing of expected cash flows
Discount rate, or required rate of return by

Bond Valuation

Value of a coupon bond:

2n Ct / 2 MV
V t
t 1( 1 r/ 2 ) ( 1 r/ 2 )
Biggest problem is determining the
discount rate or required yield
Required yield is the current market
rate earned on comparable bonds with
same maturity and credit risk

Bond Valuation Example
A new 3-year with 10% bond was sold at
par. Assuming semiannual interest
payment of $50 for each of next 6

What is the price of the bond ?

Bond Valuation Example
2n Ct / 2 MV
V t

t 1( 1 r/ 2 ) ( 1 r/ 2 )2n

n= 3
2n = 6
Ct/2 = 50
r/2 = 0.05
MV = 1,000

V = $1,000
Bond Valuation Example

A bond with 3-year maturity and coupon

of 7%. The semiannual interest payment
will be $35 for each of next 6 periods.

Assuming the current discount rate is

10%, what is the price of the bond ?

Bond Valuation Example
2n Ct / 2 MV
V t

t 1( 1 r/ 2 ) ( 1 r/ 2 )2n

n= 3
2n = 6
Ct/2 = 35
r/2 = 0.05
MV = 1,000

V = $923.85
Why Buy Bonds?

Attractive to investors seeking steady

income and aggressive investors
seeking capital gains
Promised yield to maturity is known at
the time of purchase
Can eliminate risk that a rise in rates
decreases bond price by holding to

Managing Price Volatility

Bond prices are affected by:

However, coupon and maturity affect
the bond price differently.
To properly manage bond price
volatility we need a measure that
combines both coupon and maturity
The Duration Measure
Coupon and maturity affect the bond price
Price volatility of a bond varies inversely with its
coupon but directly with its term to maturity.
Therefore, it is necessary to determine the best
combination of these two variables to achieve
your objective
To properly manage bond price volatility we need
a measure that combines both coupon and
maturity - Duration.

10% semiannual coupon selling at $1,000
$50 will be received every 6 months for Interest
$1000 will be received at the end of 5 years

When will you be able to recover the $1000 you

paid for the bonds ?
Answer is surely NOT 5 years because you
receive $50 every 6 months!
Time-value-of-money weighted average of years
needed to recover the $1,000 is calculated (using
DURATION) to be 4.054 years

Calculating Duration
Need to time-weight present value of
cash flows from bond
n PV(CFt )
D t
t 1Market Price
t = The time period at which the cash flow
is expected to be received.
n = The number of periods to maturity
PV (CFt) = Present Value of Cash Flow in
period t discounted at the yield to maturity
Note: Market Price will also equal to the
present value of all cash flows.

Calculating Duration

Duration depends on three factors

Maturity of the bond
Coupon payments
Yield to maturity

Calculating Duration - Example

Calculate the duration of a bond with a

8% coupon and a 3-year maturity.
Current YTM is 7%. Interest is paid

Calculating Duration - Example

Cash Flow: 80 (in 1 year time)

Cash Flow: 80 (in 2 years time)
Cash Flow: 1080 (in 3 years time)

Discount factor will be the YTM which is


Calculating Duration - Example
(1) (2) (3) (4) (5)
Year Cash flow Present Value PV of CF PV/ Price Year X PV/Price
1 80 0.9346 74.77 0.073 0.073
2 80 0.8734 69.87 0.068 0.136
3 1080 0.8163 881.60 0.859 2.577
1026.24 2.786

Note that 1,026.24 is actually the present value of all future cash flow which
is also the current price of the bond.

Duration Relationships
The Characteristics
Duration of a bond with coupons is always
less than its term to maturity
A zero-coupon bonds duration equals its
Duration and coupon is inversely related
There is a positive relationship between
term to maturity and duration, but
duration increases at a decreasing rate
with maturity
YTM and duration is inversely related
Why is Duration Important?

Allows comparison of effective lives of

bonds that differ in maturity, coupon
Used in bond management strategies
particularly immunization
Measures bond price sensitivity to
interest rate movements, which is very
important in any bond analysis

Estimating Price Changes Using
Modified duration =D*=D/(1+r)
D*can be used to calculate the bonds
percentage price change for a given
change in interest rates

% in bond price r
( 1 r)

Duration Conclusions

To obtain maximum price volatility,

investors should choose bonds with the
longest duration
Duration is additive
Portfolio duration is just a weighted average
Duration measures volatility which isnt
the only aspect of risk in bonds
Can be used for bond immunization

Modified Duration and Bond Price Volatility

Modified Duration Formula (D mod )

m = number of payments a year
YTM = nominal YTM
Modified Duration and Bond Price Volatility

As A Measure of Bond Price Volatility

Bond price movements will vary proportionally
with modified duration for small changes in yields

P = change in price for the bond
P = beginning price for the bond
Dmod = the modified duration of the bond
i = yield change in basis points divided by 100
The End

Tutorial Questions

Chapter 18
Questions: 5, 6, 12, 14, 15
Computation problems: 1, 2