Basics of Bond Mathematics: Sankarshan Basu

4 May 2012 Sankarshan Basu, IIM Bangalore 1
Basics of Bond Mathematics

Sankarshan Basu
Basics of Bond Mathematics
What is Bond?
A bond is a debt instrument
It is used to raise funds for a defined period
of time at a specified interest rate by
corporate entities or government.
In exchange for the funds, the issuer of the
bond issues a certificate, or bond, that states
all the details about the interest rate as well
as maturity date of the bond.
Interest on bonds is usually paid every six
months (semiannually).
Some Preliminaries
Price - Yield Relationship
Measures of Price Sensitivity
PVBP
Duration:
Macaulay Duration
Modified Duration
Convexity
Some Preliminaries (continued)
Yield Curves and Term Structure
Spot Rate
Forward Rate
Yield Curve
Term Structure of Interest Rates
Fitting Term Structure to Bond Price Data
Conventional Theories of Term Structure
Expectations Theory
Market Segmentation Theory
Liquidity Premium Theory
Price Value of a Basis Point
(PVBP)
Definition: The change in the price of a given
bond if the required yield changes by one basis
point (that is one-hundredth of a percentage
point).

It is also called Dollar Value of a Basis Point (DV
01) as it indicates a measure of a bond's
price/yield relationship that specifies the dollar
value of a basis point change in yield.
Duration of a Bond
Duration is a weighted measure of when the
investment on a bond is recouped.
Duration considers coupon payments.
For a zero-coupon bond, the duration is the
same as the bond's maturity.
For two bonds that mature at the same time,
the one with a higher coupon has the lower
duration.
Types of Duration
There are two types of Duration:
Macaulays Duration: This is the traditional,
and more intuitive, measure of duration".
Modified Duration: This expresses the
measurable change in the value of a security
in response to a change in interest rates. This
is usually used to see what effect a change in
interest rates will have on the price of bonds.
Macaulays Duration

where,
k = no. of payments per year
N = no. of periods = no. of years * k
t = timing of cash flow CF
t

PVCF
t
= PV of all cash flows from bond
Thus, % change in Bond Price

=
+
=
N
t
t
t
M
PVCF k
tPVCF
D
1
100 * * *
1
1
Change Yield D
k
yield
M
|
.
|
\
|
+
=
Modified Duration

Thus,
% change in bond price
= - M
d
* Yield Change * 100
|
.
|
\
|
+
=
k
Yield
D
MD
M
1
Properties of Duration
Duration decreases with increase in coupon rate
Duration decreases with increase in YTM
Duration and Maturity
ZC Bonds: D = T; Increases with T
Coupon bonds: D 1 + 1/i as T
Premium and Par bonds: Coupon > Yield to maturity;
D increases with maturity and approaches (1+ 1/i)
Discount bonds: Coupon < yield to maturity; D first
increases with maturity. reaches a maximum then
decreases ,approaches (1+1/i)
Convexity of a Bond
Duration summarizes the most important
information about a bonds or a portfolios
sensitivity to interest rate changes (small
changes).

Convexity on the other hand measures the
second most significant information (for
medium to large changes in the interest rate)
Formula for Convexity
Convexity =

Dimension of convexity: (Years)
2

Also,

where B is the price of the bond and i

is the continuously compounded interest rate.

( )
=
+
|
.
|
\
|
+
N
t
t
t
PVCF k
PVCF t t
k
Yield 1
2 2
*
1
1
1
( )
( )
(
+ =
(
+ ~
A
2
2
2
2
*
2
1
*
2
1 1
di Convexity di MD
di
di
B d
di
di
dB
B B
B
The Yield Curve
The Yield to maturity (YTM) is the true rate of return an investor
would receive if the security were held until maturity.

Yield rates (spot interest rate) expressed as a function of maturity
is known as the term structure of interest rates.The graphical
plotting of this function is known as THE YIELD CURVE.

The yield curve is one of the most important indicators of the
level and changes in the interest rates in the economy.
Zero Rates
A zero rate (or spot rate), for maturity T, is
the rate of interest earned on an investment
that provides a payoff only at time T

Thus suppose the 5 year zero rate is 5% and
the amount invested is $100. Thus, the
payoff after 5 years is:
$(100 *
e(0.05*5)
) = $128.40
Zero Rates (continued)
Note that most of the interest rate observed
in the market is not the pure zero rate.
Consider a 5-year government bond that
provides 6% coupon. Thus the price of the
bond does not exactly determine the 5-year
Treasury zero rate as some of the return on
the bond is realized in the form of coupons
before the bond matures.
Bond Pricing
Most bonds provide coupons periodically
The owner also receives the principal or face value of the
bond on maturity.
The theoretical price can be calculated as the present value
of all the cash flows that shall be received using
appropriate zero rates as discount rates.

Let us now consider an example and price a 2-year
Treasury Bond using appropriate zero rates with
continuous compounding.
Example

Maturity
(years)
Zero Rate
(% cont comp)
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8
Bond Pricing (continued)
In our example, the theoretical price of a two-year
bond providing a 6% coupon semiannually is

39 . 98 $ ) 103
3 3 3 $(
0 . 2 068 . 0
5 . 1 064 . 0 0 . 1 058 . 0 5 . 0 05 . 0
= +
+ +

e
e e e
Yield of a Bond
The bond yield is the discount rate that makes the
present value of the cash flows on the bond equal
to the market price of the bond
Suppose that the market price of the bond in our
example equals its theoretical price of 98.39
The bond yield is given by solving

to get y=0.0676 or 6.76%.

3 3 3 103 9839
0 5 1 0 15 2 0
e e e e
y y y y
+ + + =
. . . .
.
Par Yield of a Bond
The par yield for a certain maturity is the coupon rate that
causes the bond price to equal its face value.
Suppose, in our example the coupon on the 2 year bond is
c% per annum and the face value is $100. Then

This implies c = 0.0687 or 6.87% per annum with semi
annual compounding
100
2
100
2 2 2
0 . 2 068 . 0
5 . 1 064 . 0 0 . 1 058 . 0 5 . 0 05 . 0
=
|
.
|
\
|
+ +
+ +

e
c
e
c
e
c
e
c
Determining Treasury Zero Rates
As discussed earlier, the market interest rates are not pure
zero rates.
We now discuss how to calculate Treasury Zero Rates
from prices of traded instruments.
One (and the most common) approach is the Bootstrap
Method.
Consider 5 bonds the first 3 pay no coupons. The zero
rates corresponding to these bonds are easy to calculate.
Using this information, we then calculate the zero rates
corresponding to the other bonds. Data is in the next slide.
Sample Data

Bond Time to Annual Bond
Principal Maturity Coupon Price
(dollars) (years) (dollars) (dollars)
100 0.25 0 97.5
100 0.50 0 94.9
100 1.00 0 90.0
100 1.50 8 96.0
100 2.00 12 101.6
The Bootstrap Method
An amount 2.5 can be earned on 97.5 during 3
months.
The 3-month rate is 4 times 2.5/97.5 or 10.256%
with quarterly compounding
This is 10.13% with continuous compounding
Similarly the 6 month and 1 year rates are 10.47%
and 10.54% with continuous compounding

The Bootstrap Method continued
To calculate the 1.5 year rate we solve

to get R = 0.1068 or 10.68%

Similarly the two-year rate is 10.81%
4 4 104 96
0 1047 0 5 0 1054 1 0 15
e e e
R
+ + =
. . . . .
Zero Curve Calculated from the Data

9
10
11
12
0 0.5 1 1.5 2 2.5
Zero
Rate (%)
Maturity (yrs)
10.127
10.469 10.536
10.681
10.808
Forward Rates
The forward rate is the future zero rate implied
by todays term structure of interest rates.
Alternately, Forward interest rates are the
rates of interest implied by current zero rates
for periods of time in the future.

Term structure of interest rates shows the
relationship between the interest rates on
various fixed income products (namely
bonds) and their maturities
Formula for Forward Rates
Suppose that the zero rates for time periods
T
1
and T
2
are R
1
and R
2
with both rates
continuously compounded.
The forward rate for the period between
times T
1
and T
2
is

R T R T
T T
2 2 1 1
2 1

Calculation of Forward Rates

Zero Rate for Forward Rate
an n -year Investment for n th Year
Year ( n ) (% per annum) (% per annum)
1 10.0
2 10.5 11.0
3 10.8 11.4
4 11.0 11.6
5 11.1 11.5
Instantaneous Forward Rate
The instantaneous forward rate for a
maturity T is the forward rate that applies
for a very short time period starting at T. It
is given by

where R is the T-year rate
R T
R
T
+
c
c
What is Yield of a Bond?
Definition 1: It is the annual rate of return on an
investment, expressed as a percentage.

Definition 2: For bonds and notes, the coupon rate
divided by the market price. This is not an
accurate measure of total return, since it does not
factor in capital gains.

Yield Curve
The Yield to maturity (YTM) is the true rate of return an
investor would receive if the security were held until
maturity.

Yield rates (spot interest rate) expressed as a function of
maturity is known as the term structure of interest
rates.The graphical plotting of this function is known as
THE YIELD CURVE.

The yield curve is one of the most important indicators of
the level and changes in the interest rates in the economy.
Upward vs. Downward Sloping
Yield Curve
For an upward sloping yield curve:
Fwd Rate > Zero Rate > Par Yield

For a downward sloping yield curve
Par Yield > Zero Rate > Fwd Rate
Types of Bonds
Bonds can be generally classified into two
categories:
Zero Coupon Bonds: These are generally bonds issued
for very short periods of time and have a very small
chance of default.
Coupon Bearing Bonds: Most bonds are of this
category. These bonds are issued for relatively longer
periods of time and have a higher probability of default
as compared to Zero coupon bonds.
Pricing of Bonds
The simplest way to price a bond (value =
B) with coupon payments C per year,
principal P on maturity and an interest rate
of r is given by:

| | | | | | | |
n n
r
C P
r
C
r
C
r
C
r
C
B
+
+
+
+
+ +
+
+
+
+
+
=

1 1
......
1 1
1
1 3 2
Price of a Zero Coupon Bond
The price of a zero coupon bond is given by

where
r
t
= the short term interest rate at time t; 0s t s T
T = the time to maturity
b = discount factor (constant)
Note: r
t
can be a constant or stochastic in nature.
(
(
(
T
s
ds r b
e E
0
Coupon bearing bonds
Coupon bearing bonds could have the following
features:
Constant coupons Here the coupon payments are
constant over the entire life of the bond
Variable coupons Here the coupon payments vary
depending on the remaining tenor of the bond. These
are usually offered on bonds with options; i.e. the
holder / issuer has the right to return (put option) /
recall (call option) at some predetermined points before
the maturity of the bond.
Non-defaultable (Sovereign) Bonds
Here the probability of default by the issuer of the
bond is 0 all coupons and principal on maturity
is paid on time
Typically all government issuances in the
domestic market are of this type assumption
being that governments cannot default in the
domestic market as they have the right of
seniorage
Generally liquid instruments and can easily be
traded in the secondary market
Defaultable (Corporate) Bonds
These bonds have a non-zero probability of
default
At default all payments (coupons and principal)
ceases. Less liquid than non-defaultable bonds
Lot of work on the default probability model has
been done by Duffie, Singleton, Kan and Lando
they build in a default probability model in the
bond price equation
One Defaultable Bond Price Equation

where
D is the payment at default and C is the coupon rate
the first term is payment at default
the second term is final payment at maturity, no default
the third term represents coupon payments in case of default
the fourth term represents coupon payments, no default

u
is the default rate see Duffie, Singleton, Kan, etc.

Note:Price of a non-defaultable bond = second term + fourth term
(
(
(
}
+
}
+
}
+
}
} } } }

T du
ru
s
du T s
ru
ds b
r
T
s
du rs
T
u
s
u
T
s
s
u
e du e C ds e du e C e e ds e D E
0 0 0 0
0 0 0 0
) ( ) ) ( ( ) ( ) (

Sensitivity & Impact of Change
As is obvious, Price and Yield of a bond is
inversely related.
However, this relationship is highly non-
linear, especially towards the short end of
the yield curve.
Duration affects the price and yield of a
bond (as discussed earlier)
Interest Rate Features
Typically the benchmark rate is determined by the central
bank this is called the Bank Rate
Changes in the bank rate reflect the changes in the economic
scenario market determined
Not changed too frequently say on a daily basis
Based on the bank rate number of other rates exist
PLR Prime Lending Rate
Overnight / Call Rate the rate at which banks lend to each other
on a daily basis
Repo Rate the rate at which the central bank refinances banks
and financial institutions

Interest Rate Dynamics
Typically interest rate is assumed to be positive
Difficult to get a term structure of interest rate in
an emerging market scenario due to lack of
historical data
Interest rate is assumed to be mean reverting that
is in the long run it should revert back to a stable
equilibrium value
However, this does not ensure positivity of interest
rates
One simple way to ensure positive interest rate is
to take the exponential process (e
x
)
History of Indian Bank Rate
0.00
2.00
4.00
6.00
8.00
10.00
12.00
14.00
7
/
5
/
3
5
7
/
5
/
3
8
7
/
5
/
4
1
7
/
5
/
4
4
7
/
5
/
4
7
7
/
5
/
5
0
7
/
5
/
5
3
7
/
5
/
5
6
7
/
5
/
5
9
7
/
5
/
6
2
7
/
5
/
6
5
7
/
5
/
6
8
7
/
5
/
7
1
7
/
5
/
7
4
7
/
5
/
7
7
7
/
5
/
8
0
7
/
5
/
8
3
7
/
5
/
8
6
7
/
5
/
8
9
7
/
5
/
9
2
7
/
5
/
9
5
7
/
5
/
9
8
7
/
5
/
0
1
Date
B
a
n
k

R
a
t
e
Interest rate models
Number of models have been used to describe the
interest rate process assuming stochastic term in
the interest rate process some are:
Vasicek (1977)
Ho and Lee (1986)
Hull and White (1990)
Heath, Jarrow and Morton (1992)
Brace, Gatarek and Musiela (1997)
Cox, Ingersoll and Ross (1985)

Yield Curve Modeling
The Yield Curve
The Yield to maturity (YTM) is the true rate of return an investor
would receive if the security were held until maturity.

Yield rates (spot interest rate) expressed as a function of maturity
is known as the term structure of interest rates.The graphical
plotting of this function is known as THE YIELD CURVE.

The yield curve is one of the most important indicators of the
level and changes in the interest rates in the economy.
Why do we need a ZCYC
Strictly, speaking, the most suitable bonds for
yield curve generation and analysis are the pure
discount bonds such as the treasury bills and zero
coupon bond as these securities do not involve
periodic coupon payments.

The reason behind this is in coupon bonds there is
intermediate cash flow which is supposed to be re-
invested at the same discount rate.
Importance of yields on Government securities ?
Government securities are usually free from credit
risk, hence, it serves as a benchmark for setting
yields in all other segments of the debt market.
Example: Corporate debt, Bank loans,

Usually the government bond market happens to
be the largest and the most liquid segment of the
debt market. Accordingly the data are more
current compared to data on, say, yield on
corporate debt.
Mechanics of the construction of
The Yield Curve
STRICTLY speaking, most suitable bonds for yield curve
analysis are the pure discount bonds such as the treasury bills and
zero coupon bond as these securities do not involve periodic
coupon payments.
The reason behind this is in coupon bonds there is intermediate
cash flow which is supposed to be re-invested at the same
discount rate.
So for coupon bonds we construct the yield curve that comes
close to the ideal curve by following an approach that treats each
coupon bond as a sum of individual zero coupon bonds.
Mechanics of the construction of
The Yield Curve (continued)
The yield on a coupon bond then can be viewed as a
mixture of spot rates of various maturities.

The choice of the function usually depends upon a
compromise between :
i) smoothness of the curve
ii) the goodness of fit

In general it is better to have a yield curve that fits the
data reasonably well and makes sense economically.
Different Models
Term Structure Models:
Vasicek (1979)
Hull and White (1990)
Heath, Jarrow and Morton (1992)
Cox, Ingersoll and Ross (1985)
Brace, Gatarek and Musiela (1997)
Alternative Models:
Nelson and Siegel (1987)
Nelson, Siegel and Svensson (1994)
Apart from these are are also spline fitting models
advocated by McCullough and Nelder (1971) and others.
Which class of models to use?
In the Indian context, the Term Structure of Interest Rate
models are difficult to use because of lack of data. Even
though we have interest rate data for about 70 years, most
of this data is administered and hence not applicable to
market scenarios.

The most commonly used models in the Indian context are
the Nelson and Siegel (1987) model or its extension
suggested by Svensson in 1994. These models fit the
Indian context very well as shall be shown later.
Nelson Siegel Model
This model proposes a class of models, motivated
by but not dependent on the Expectations theory
of the term structure.

It offers representation of the shapes traditionally
associated with yield curves.

This model introduces enough flexibility to
represent the range of shapes associated with yield
curves: monotonic, humped or S-shaped.
Nelson Siegel Model (continued)
Instantaneous forward rate at maturity m is given
by:
r(m) =
0
+
1
e
-m/
+
2
[(m/) e
-m/
]

YTM on a bill is the average of forward rates:
R(m) =
0
+ (
1
+
2
).[1-e
-m/
]/(m/) -
2
.e
-m/

Discount function: d(m) = e
-(R(m).m/100)

Nelson Siegel Model - Parameters
The four parameters of the Nelson Siegel
Model (described in the earlier slide) are:

0
is long-term component

1
is short-term component

2
is medium-term component

is the time constant of the curve

Nelson Siegel Model Estimation Procedure
1. Select a vector of starting parameters (
0
2
).
2. Using this starting vector of parameters, calculate the discount
factor function, present value of the bond cash flows and
thereby determine a vector of starting model bond prices.
3. The best-fitting values of
0
,
1
,
2
,

are then compared using
linear least squares.
4. Determine the spot rate function from the estimated set of
parameters.
5. Now create a series of maturity values and use the estimated
parameters for the required day to derive corresponding spot
rates.
6. With maturity on the X-axis, plot the spot rates on Y-axis.
7. The curve thus obtained is the Yield Curve for the day.

Nelson-Siegel-Svensson Model
In 1994 Svensson suggested a flexible form for the
forward rate function, an extension of Nelson and Siegel
model, using 6 parameters.

Instantaneous forward rate at maturity m ;
r(m) =
0
+
1
e
-m/
1+
2
[(m/
1
)e
-m/
1]+
3
[(m/
2
)e
-m/
2]

YTM on a bill is the average of forward rates ;
R(m)=
0
+
1
[1-e
-m/
1]/(m/
1
) +
2
[{1-e
-m/
1}/(m/
1
)-

e
-m/
1]
+
3
[{1-e
-m/
2}/(m/
2
)-

e
-m/
2]
Parameters of NSS Model

0
is a constant and must be positive to ensure that long forward
rates are positive.

1
e
-m/
1is an exponential term.When the time to settlement
approaches zero,forward rate approaches (
0
+
1
), which must be
non-negative.

2
[(m/
1
)e
-m/
1] generates a hump-shape (or U-shape) as a
function of the time to settlement.

3
[(m/
2
)e
-m/
2 ] generates another hump or U-shape : thus this
curve allows up to two hump shapes,whereas,the original NS
function has only one hump shape.

1
&
2
are parametric time constants of the curve.
Estimation Procedure for NSS Model
The estimation procedure is the same as the
Nelson and Siegel model (as discussed earlier).

The only issue that has to be considered while
estimating the parameters of Nelson, Siegel and
Svensson model is the fact that there are 2 extra
parameters here and hence estimation is more
complicated and time consuming.
Estimated Curves for 21
st
May, 2003
4.7
4.9
5.1
5.3
5.5
5.7
5.9
6.1
6.3
6.5
6.7
6.9
0 2 4 6 8 10 12 14 16 18 20 22
Terms to Maturity(in yrs)
Y
T
M
(
a
n
n
u
a
l
i
s
e
d

i
n

%
)
Yield using NS Yield using Svensson NSE curve
Comparing the two models
In most cases the Nelson & Siegel model gives a satisfactory fit,
but sometimes with complex shape of forward rate curve the
extended variant results is a better fit.

Computation of linear least square can hang if
1
becomes equal
to
2
in Svensson model, in this case model is over-
parameterized, this however does not happen with original NS
model.

Due to an additional term the Svensson model is more capable
of handling more complex and volatile environment.
Nelson Siegel approach is widely used by most financial
institutions at least in India

The curve obtained by the Nelson Siegel method is very
close to the curve published by NSE everyday (as shown in
the example with the date on 21
st
May).

Nelson-Siegel model is regarded to produce more regular
or smoother functions than a splines interpolation.
Remarks
Some sources of the ZCYC
National Stock Exchange of India
Reuters
Fixed Income Money Market Dealers
Association (FIMMDA)
Internally constructed based on market data
(most commonly used by major players)
Some Issues to Think About!!!
Remarks
Should there be one benchmark yield curve that is
followed by all participants in the market for uniformity
Should issues like Duration and Convexity be given more
importance than they are right now extend this
information top the public domain
Should stochastic interest rate models be used for interest
rate modeling and bond pricing
Should detailed economic analysis be carried out either by
market players or an independent agency funded by the
market as to the correct mean reversion level of interest
rates in India
Remarks (continued)
Appropriate regulation and control by the
exchange of interest rate products what is
the level of acceptable level
Uses of Interest Rate Futures hedging
and/or speculation
Thank You!!!

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4 May 2012 Sankarshan Basu, IIM Bangalore 1

Basics of Bond Mathematics

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