llnanclal ManagemenL l

S S S kumar
lndlan lnsLlLuLe of ManagemenL kozhlkode
CallcuL 673 370
ond valuaLlon
bond ls a
W securlLy LhaL obllgaLes Lhe lssuer Lo make
speclfled lnLeresL and prlnclpal paymenLs Lo
Lhe holder on speclfled daLes
W onds are someLlmes called flxed lncome
securlLles
Financial Management I 3
lssuers
W CovernmenL sLaLe as well as cenLral govLs
W CorporaLes
Financial Management I 4
@he bond Lermlnology
1 ar value lace amounL pald aL maLurlLy
2 Coupon lnLeresL raLe SLaLed lnLeresL raLe MulLlply by par value Lo
geL lnLeresL ln rupee Lerms Cenerally flxed
3 MaLurlLy Llme Lo reLurn Lhe prlnclpal as Llme elapses Lhls decllnes
4 lssue daLe uaLe when bond was lssued
3 uefaulL rlsk 8lsk LhaL lssuer wlll noL make lnLeresL or prlnclpal
paymenLs
Financial Management I 5
ond markeL reporLlng
Financial Management I 6
@rade uaLe lSln
LasL @rade
rlce (ln
8s)
LasL @rade
value (8s
ln lacs)
@oLal
@rade
value (8s
ln lacs)
LasL @rade
?leld
(?@M)
(nnuallz
ed) ()
WelghLed
verage
rlce
(8s)
WelghLed
verage
?leld
(?@M) ()
11nov11lnL134L0888 974127 1300 1300 93 974127 93
11nov11lnL11307v1 994974 300 1000 99969 994974 99969
11nov11lnL12107uS9 989626 230 230 108939 989626 108939
11nov11lnL02008391 9837 10 12010 97237 980307 97763
11nov11lnL134L08u84 971837 300 300 97988 971837 97988
11nov11lnL134L08uS2 972608 300 300 9799 972608 9799
11nov11lnL24308034 1036623 120 130 110627 10393 110163
11nov11lnL337l09336 330944 2300 2300 89438 330944 89438
11nov11lnL732L07ln3 992899 300 300 94887 992899 94887
11nov11lnL02008633 100 13000 20000 92373 100 92373
11nov11lnL043u08C81 969004 4300 4300 98781 969004 98781
11nov11lnL043u07740 100 3000 3000 90248 100 90248
11nov11lnL314L084 100 13000 13000 93833 100 93833
asls polnL deflned
W basls polnL (bp) ls 1 of 001 or 00001
W @he dlfference beLween a raLe of 300 and
301 ls one basls polnL
Financial Management I 7
Common feaLures
W Senlor versus subordlnaLed bonds
W ConverLlble bonds
W Callable bonds
W uLable bonds
W Slnklng funds
Financial Management I 8
aslc valuaLlon premlse
@he (markeL) value of any lnvesLmenL asseL ls
slmply Lhe presenL value of expecLed cash
flows
ln a coupon paylng bond
1herefore value of a bond
v of all expecLed lnLeresL and prlnclpal paymenLs
Financial Management I 9
ZC#s value
ln Lhe case of a zero coupon bond Lhe value of Lhe bond ls glven as
v lv/(1+ k)
n
where lv ls Lhe prlce aL whlch Lhe bond wlll be redeemed
k ls Lhe requlred raLe of reLurn
n ls Lhe number of years Lo maLurlLy
Financial Management I 10
ond valuaLlon conLd
Where
v
0
value of Lhe asseL aL Llme zero
Cl
L
cash flow expecLed aL Lhe end of year L
k approprlaLe requlred reLurn (dlscounL raLe)
n relevanL Llme perlod
Financial Management I 11
V
0
= CF
1
+ CF
2
+ . + CF
n
(1 + k)
1
(1 + k)
2
(1 + k)
n
aslc componenLs of Lhe dlscounL raLe
@he dlscounL raLe (k
l
) ls Lhe opporLunlLy cosL of funds le Lhe raLe
LhaL could be earned on alLernaLlve lnvesLmenLs of equal rlsk
ln general made up of some or all of Lhe followlng componenLs
Financial Management I 12
k
l
88 + l + M8 + u8 + L
lnflaLlon and reLurns
@he relaLlonshlp beLween real and nomlnal reLurns ls descrlbed by Lhe llsher LffecL
LeL
8 Lhe nomlnal reLurn
r Lhe real reLurn
h Lhe lnflaLlon raLe
ccordlng Lo Lhe llsher LffecL
1 + 8 (1 + r) x (1 + h)
lor example Lhe real reLurn ls 476 Lhe nomlnal reLurn ls 10 and Lhe lnflaLlon raLe
ls
W (1 + 8) 110
W (1 + r) x (1 + h) 110 and h 3
Financial Management I 13
Corp ond Spreads (bps) as on 10 nov 2011
Financial Management I 14
1enor AAA AA+ AA
1 8300 9800 12300
3 10100 12300 14800
ond valuaLlon conLd
ssume a company's bonds have a 8s1000 face value
W @he promlsed annual coupon ls 8s100
W @he bonds maLure ln 10 years
W @he markeL's requlred reLurn on slmllar bonds ls 10
Financial Management I 15
ond valuaLlon conLd
1 CalculaLe Lhe presenL value of Lhe face value
8s1000 x 1/110
10
8s1000 x 03833 8s38330
2 CalculaLe Lhe presenL value of Lhe coupon paymenLs
8s100 x 1 (1/110
10
)/10 8s100 x 61446
8s 61446
3 @he value of each bond 8s 1000 (barrlng roundlng off errors)
Financial Management I 16
racLlce quesLlon
company proposes Lo sell 10 yr debenLures of 8s 10000 each
@he co would repay 8s 1000 aL Lhe end of every year and wlll
pay lnLeresL annually aL 13 on Lhe ouLsLandlng amounL
ueLermlne Lhe presenL value of Lhe debenLure aL 16
caplLallzaLlon raLe
Financial Management I 17
MicrosoL Oice
Fxcel WorksheeL
LeL#s go a llLLle deeper
Suppose you purchase Lhe C Sec descrlbed earller and
lmmedlaLely LhereafLer expecLed lnflaLlon rose by
3 causlng k 13?
!' of annuity 543.315
!' of principal 295.85
Bond value 839.165
Financial Management I 18
When the interest
rute goes up the
bond price wiII
uIwuys go down,
ConLd
W WhaL would happen lf lnflaLlon fell and k
decllned Lo 7?
Financial Management I 19
!' of annuity 702.4
!' of principal 508.0
Bond value 1210.
4
When inferesf rofes
go down, bond
prices wiII oIwoys
go up.
ConLd
ond prlces are lnversely relaLed Lo lnLeresL raLes (or ylelds)
bond sells aL par only lf lLs coupon raLe equals Lhe requlred
reLurn
bond sells aL a premlum lf lLs coupon ls above Lhe requlred
reLurn
bond sells aL a dlscounL lf lLs coupon ls below Lhe requlred
reLurn
Financial Management I 20
rlce Converges Lo ar aL MaLurlLy
Financial Management I 21
It is also important to note that a bonds price will
approach par value as it approaches the maturity date,
regardless of the interest rate and regardless of the
coupon rate.
nferesf Price Price
Pofe Z0 Yeors I Yeor
07 3,000 $ I,I00 $
I07 I,000 $ I,000 $
Z07 bI3 $ 9I7 $
I07 Coupon 8ond
ulled Lo par
Financial Management I 22
Maturity
Bond price
1000
Premium bond
Discount bond
llnanclal ManagemenL l 23
?lelds
@he CurrenL ?leld measures Lhe annual reLurn Lo an lnvesLor based
on Lhe currenL prlce
CurrenL nnual Coupon lnLeresL
?leld CurrenL MarkeL rlce
lor example a 10 coupon bond whlch ls currenLly selllng aL 8s 1130 would have a
currenL yleld of
CurrenL 100 87
?leld 1130
@he ?@M sLory
We have seen how Lo value a bond can we reverse Lhe dynamlcs??
le leLs flnd ouL reLurn on a bond glven lLs prlce
llnanclal ManagemenL l 24
v Cl
1
+ Cl
2
+ + (Cl
n
+
n
)
(1+l)
1
(1+l)
2
(1+l)
n
@hls ls Lhe same equaLlon we saw earller when we solved for prlce ln
Lhls case we know Lhe markeL prlce buL are solvlng for reLurn
llnanclal ManagemenL l 23
?lelds
@he yleld Lo maLurlLy measures Lhe compound annual reLurn Lo an
lnvesLor and conslders all bond cash flows lL ls slmllar Lo Lhe l88 ln
caplLal budgeLlng conLexL (we wlll see whaL l88 means ln due course of
Llme)
ln oLher words lL ls Lhe slngle raLe LhaL when used Lo dlscounL a bond#s
Cashflows produces Lhe bond#s markeL prlce
CompuLlng ?@M
?@M compuLaLlon lnvolves one of Lhe followlng meLhods
(1) lnLerpolaLlon Lechnlque (Lrlal and error by yourself)
(2) llnanclal calculaLor (may be llke Lxcel)
llnanclal ManagemenL l 26
Cf course you have Lo use solver from Lhe @ools menu on Lxcel Lo
deLermlne ?@M or you may use l88 funcLlon also
?@M an approxlmaLlon
Financial Management I 27
0.6P 0.4M
P)/n (M C

C coupon M maLurlLy value
currenL prlce n no of years
Financial Management I 28
@he 8elnvesLmenL 8aLe ssumpLlon
lL ls lmporLanL Lo noLe LhaL Lhe compuLaLlon of Lhe ?@M lmpllclLly assumes LhaL
lnLeresL raLes are relnvesLed aL Lhe ?@M
ln oLher words lf Lhe bond pays a 8s 100 coupon and Lhe ?@M ls 8 Lhe
calculaLlon assumes LhaL all of Lhe 8s 100 coupons are lnvesLed aL LhaL raLe
lf markeL lnLeresL raLes fall however Lhe lnvesLor may be forced Lo relnvesL aL
someLhlng less Lhan 8 resulLlng a reallzed reLurn whlch ls less Lhan
promlsed
Cf course lf raLes rlse coupons may be relnvesLed aL a hlgher raLe resulLlng ln
a hlgher reallzed reLurn
8elnvesLmenL raLe
3year 10 bond Lrades aL 8s 9319634 lmplylng a ?@M of 12
. 11 1 404 . 1
1.634
1337.44
realized Return
3 1

Financial Management I 29
1.634 100 100 1100
1337.44
12.44
12 Ior 2 years
112
12 Ior 1year
Malklel#s Lheorems
1 ond prlces move lnversely wlLh lnLeresL raLes
2 lor a glven bond Lhe absoluLe rupee prlce lncrease caused by a fall ln ylelds
wlll exceed Lhe prlce decrease caused by an lncrease ln ylelds of Lhe same
magnlLude
3 onds wlLh lower coupon raLes experlence more changes for a glven
change ln lnLeresL raLes
4 onds wlLh longer maLurlLy experlence greaLer percenLage change for a glven
change ln lnLeresL raLes
3 @he prlce senslLlvlLy of bonds lncreases wlLh maLurlLy buL lL lncreases aL a
decreaslng raLe
Financial Management I 30
Malklel#s Lheorems
1 ond prlces move lnversely wlLh lnLeresL raLes
a) lor very small changes ln ?@M Lhe change ln bond prlce ls roughly equal
wheLher Lhe ?@M lncreases or decreases
b) lor large changes Lhe prlce lncrease ls greaLer Lhan Lhe prlce decrease
Financial Management I 31
Malklel#s Lheorems conLd
2 Coupon LffecL lor a glven Lerm Lo maLurlLy and lnlLlal ?@M
Lhe prlce volaLlllLy of a bond ls greaLer Lhe lower Lhe coupon
raLe
Financial Management I 32
Malklel#s Lheorems conLd
3 MaLurlLy LffecL lor a glven coupon raLe and lnlLlal ?@M Lhe
longer Lhe Lerm Lo maLurlLy Lhe greaLer Lhe prlce volaLlllLy
Financial Management I 33
DndersLandlng Malklel#s Lheorems
lour bonds prlced lnlLlally Lo yleld 9
9 coupon 3 years Lo maLurlLy lnlLlal prlce 100
9 coupon 20 years Lo maLurlLy lnlLlal prlce 100
3 coupon 3 years Lo maLurlLy lnlLlal prlce 841746
3 coupon 20 years Lo maLurlLy lnlLlal prlce 631968
Financial Management I 34
Coupon LffecL
Financial Management I 35
MicrosoL Oice
Fxcel WorksheeL
MaLurlLy LffecL
Financial Management I 36
MicrosoL Oice
Fxcel WorksheeL
lnferences
Financial Management I 37
rlce change ls greaLer Lhe lower Lhe coupon
raLe
rlce change ls greaLer Lhe longer Lhe Lerm Lo
maLurlLy
pplylng Malklel#s @heorems
W LeLs assume lnLeresL raLes are llkely Lo go down and
you are bond fund manager wlLh a long poslLlon
W wlll galn more by shlfLlng from hlgh coupon
bonds Lo low coupon bonds
Financial Management I 38
pplylng Malklel#s @heorems
W LeLs assume lnLeresL raLes are llkely Lo go up and you are bond
fund manager speclallzlng ln a shorL porLfollo
W @he sLraLegy you adopL wlll
Financial Management I 39
lmpllcaLlons of Malklel#s Lheorems
W bond buyer ln order Lo recelve Lhe maxlmum prlce lmpacL of
an expecLed change ln lnLeresL raLes should purchase low
coupon long maLurlLy bonds
W lf an lncrease ln lnLeresL raLes ls expecLed an lnvesLor
conLemplaLlng Lhelr purchase should conslder Lhose bonds wlLh
large coupons or shorL maLurlLles or boLh
Financial Management I 40
lrom Malklel#s Lheorems Lo
Conslder Lwo bonds
93 8 yr bond and
11 9 yr bond
Whlch one ls more lnLeresL raLe senslLlve?
@o address such quesLlons Malklel#s Lheorems may noL be sufflclenL
Financial Management I 41
uuraLlon
Comblnes Lhe effecLs of dlfferences ln coupon raLes and
dlfferences ln maLurlLy
Financial Management I 42
Macaulay#s duraLlon
P
y) (1
.
y) (1
t.c
Duration
1 t
n t

3
3
Financial Management I 43
Where
t = number of periods to the receipt of cashflow
C = cash flow to be delivered in t periods
n= term-to-maturity
y = yield to maturity
! = price of the bond
uuraLlon
Financial Management I 44
Weighted sum of the number of periods in the
future of each cash flow, (weighted by
respective fraction of the !' of the bond as a
whole).
For a zero coupon bond, duration equals
maturity since 100% of its present value is
generated by the payment of the face value,
at maturity.
uuraLlon conLd
W uuraLlon ls shorLer Lhan maLurlLy for all bonds excepL zero coupon
bonds
W uuraLlon of a zerocoupon bond ls equal Lo lLs maLurlLy
Financial Management I 45
CompuLaLlon of duraLlon
Financial Management I 46
MicrosoL Oice
Fxcel WorksheeL
DndersLandlng duraLlon
Financial Management I 47
Nicrosoft Office
Excel Worksheet
WhaL ls Lhe use of uuraLlon?
W no Dse????
Financial Management I 48
@radlng SLraLegles Dslng uuraLlon
W LongesLduraLlon securlLy provldes Lhe maxlmum prlce varlaLlon
W lf you expecL a decllne ln lnLeresL raLes lncrease Lhe average duraLlon of
your bond porLfollo Lo experlence maxlmum prlce volaLlllLy
W lf you expecL an lncrease ln lnLeresL raLes reduce Lhe average duraLlon Lo
mlnlmlze your prlce decllne
W noLe LhaL Lhe duraLlon of your porLfollo ls Lhe markeLvaluewelghLed
average of Lhe duraLlon of Lhe lndlvldual bonds ln Lhe porLfollo
Financial Management I 49
Modlfled duraLlon
Dur Mac
1
1 1
c

c
5 /
/5
Financial Management I 50
ModiIied duration
MD can be interpreted as the approximate change in price
Ior a 100 bp change in yield
uollar duraLlon
/ ! /5

5 /
/5

) 1 (
duration Macaulay
MD
duration Mac
1
1 1

c
Financial Management I 51
Dollar duration
Modlfled duraLlon (Mu)
ulrecL measure of prlce senslLlvlLy Lo lnLeresL raLe changes
Can be used Lo esLlmaLe petceotoqe ptlce volotlllty of a bond
/
!
/5
L
Financial Management I 52

,.:,,

1
Lxample
W Modlfled duraLlon of Lhe earller bond
W lf ylelds lncrease Lo 1010 how much
does Lhe bond prlce change?
W @he percenLage prlce change of Lhls bond ls
glven by
37907 x 01 037907
Financial Management I 53
707 . 3
10 . 1
16 . 4

W WhaL ls Lhe predlcLed change ln rupee Lerms?
new predlcLed prlce 100 037909 9962091
cLual dollar prlce (uslng v equaLlon)996219
3707 . 0
1 . 0 100 707 . 3

1
.

/ ! /5

5 /
/5
Financial Management I 54
Reasonable
approximation!
redlcLlng prlce change
W SLep 1 llnd Macaulay duraLlon of bond
W SLep 2 llnd modlfled duraLlon of bond
W SLep 3 8ecall LhaL when lnLeresL raLes change Lhe change ln a bond#s prlce can
be relaLed Lo Lhe change ln yleld accordlng Lo Lhe rule
100 100 L L L /
!
/5
Financial Management I 55
an approxlmaLe measure
W uuraLlon and lLs dlfferenL avaLars ls only
approxlmaLe measures
W LeLs go back Lo Lhe flve year bond example
W lf raLes change Lo 11 whaL wlll be Lhe
expecLed change ln bond prlce uslng
duraLlon?
Financial Management I 56
W WlLh an Mu of 37908 we can expecL a prlce
dep Lo 8s 962092
W nd Lhe acLual prlce decllned Lo 8s 963041
W So duraLlon overesLlmaLed Lhe prlce decllne
and Lhls ls due Lo
Financial Management I 57
uuraLlon and ConvexlLy
Financial Management I 58
Yield
!rice
Duration
!ricing Error from
convexity
ConvexlLy
@he convexlLy ls Lhe measure of Lhe curvaLure
and ls Lhe second derlvaLlve of prlce wlLh
respecL Lo yleld (
2
9$y
2
)


2
n
1 t
2
2
2
) 1 (
1

dy
p d
or Convexity

9 9
9

Financial Management I 59
ConvexlLy measure
!
/
! /
2
2
measure Convexity
Financial Management I 60
ConvexlLy d[usLmenL
2
) ( measure convexity
2
1
/ /
!
/!
L L L
Financial Management I 61
Cne lasL Llme Lo Lhe 3 year bond
W ConvexlLy measure of Lhe bond 1937
W @aklng ln Lo conslderaLlon Lhe convexlLy ad[usLmenL Lhe exp change ln
Lhe bond prlce ls
0364 . 0
100
1
100
1
37 . 1
2
1
100
1
70 . 3 L L L L
Financial Management I 62
Or -3.694% works out to a new bond price of Rs 96.3060
away by an epsilon!!!