BOND VALUATION

Bond Terminology
• Face Value
• Coupon rate
• Maturity Date and Maturity
• Redemption Premium
• Call Option
• Put Option
• Bond Price
• Basis Point

Bond Terminology
• Secured versus Unsecured Bonds
• Senior versus Subordinate Bonds
• Registered versus Unregistered Bonds
• Convertible and Non convertible Bonds

Bond Valuation By Nikunj Patel 1

BOND VALUATION
Ex. A debenture of Rs. 100 face value that
carries an interest rate of 14 percent is
redeemable after 6 years, at a premium of 2
percent. If you require a rate of return of 16
percent from this debenture, what will be the
present value?

Ex. Find out the present value in the above

investment, assume the compounding
frequency is semi-annually, monthly, fortnightly
and daily

BOND VALUATION
• Current Yield
CY = Coupon Interest
Prevailing Mkt. Price
Ex. An 8% bond (face value Rs. 100) selling
for Rs. 96, what would be CY?

• Yield To Maturity
Ex. Coupon rate 12.5%
Purchase price Rs. 80.60 (1/7/02)
Redemption date 1/7/05
Find YTM?
Approximation Formula

Bond Valuation By Nikunj Patel 2

 1.Avg. Annual Return = Annual Int. + Capt.
Gain
No. of Years
2. Avg. Annual Return = C + (F – P) /n
(F + P)/2
Ex. Consider a 13% Bond (Face value Rs. 200)
redeemable after 5 years at a premium of 5%.
Let the purchase price of the bond be Rs. 191.50

VALUING ZERO COUPON BOND

Ex. If a zero coupon bond is issued with a maturity value of
Rs. 1,00,000 and is issued for a price of Rs. 2,500 maturing
after 20 years, calculate Realized Yield.

PRICE – YIELD RELATIONSHIP

There will always negative correlation between price and
yield.

Consider an example:

A 10% bond with annual coupons redeemable at par

of Rs. 100. Compare Price – Yield Relationship for 7%,
10% and 13%.

Bond Valuation By Nikunj Patel 3

Coupon – Price Yield Relationship

1. The Market price of the bond will be equal to

the par value of the bond, if the YTM equals
its coupon rate.
Par Value = Rs. 1000
Coupon Rate = 10%

160
YTM = 10%
2. If the YTM increases above the coupon rate,
then the market value drops below the face
value.
Par Value = Rs. 1000
Coupon Rate = 10%
Bond Valuation By Nikunj Patel 4
 YTM = 12%
3. Inversely to the above principle, if YTM
drops below the coupon rate, the market value
will be more than the face value of the bond.
Par Value = Rs. 1000
Coupon Rate = 10%
YTM = 8%

Principles of Bond Price Movements

1. A bond’s price is inversely proportional to its
yield to maturity.
Par Value = Rs. 1000
Coupon Rate = 10%
YTM = 8%, 10%, 12% and so on.
2. For a given difference between the YTM and
the coupons rate of the bonds, the longer the
term to maturity, the greater will be the
change in price with change in the YTM.
BOND A BOND B
Par Value Rs. Rs. 1000
1000
Coupon Rate 10% 10%
YTM 10% 10%
Years 3 6
Mkt value at 10% YTM
Mkt value at 11% YTM
% Change in Price
Bond Valuation By Nikunj Patel 5
 3. The percentage price change described
above increases at a diminishing rate as the
bond’s maturity time increases.

From the above BOND B, find out the

percentage change with change in time to
maturity.
Time to Bond Price Change
Maturity (Rs.) (%)
1
2
3
4
5
6

4. Given the maturity, the change in bond price

will be greater with a decrease in the bond’s
YTM than the change in bond price with an
equal increase in the bond’s YTM. That is, for
equal fixed increases and decreases in the
YTM, price movements are not symmetrical.

Take the example in 2nd and 3rd Principles.

5. For any given change in YTM, the percentage
price change in case of bonds of high coupon

Bond Valuation By Nikunj Patel 6

 rate will be smaller than in case of bonds of
low coupon rate, other things remaining the
same.

Par Value = Rs. 1000

Maturity Years = 4 Years
Coupon Rate = 10% for A and 12% for B

BOND A BOND B
Mkt. price at
10% YTM
Mkt. price at
12% YTM
Change in Price

6. A change in the YTM affects the bonds with a

higher YTM more than it does the bonds with
a lower YTM

BOND A BOND B
Par Value Rs. Rs. 1000
1000
Coupon Rate 12% 12%
YTM 10% 20%
Maturity Years 6 6
Mkt value
Change in Price
Bond Valuation By Nikunj Patel 7
Bond Valuation By Nikunj Patel 8
Term Structure of Interest Rate
Theories
Longer the maturity, the greater is systematic
risk of the market
1. The Expectations Hypothesis
The slope of the curve can be
explained by the expectations of
investors about the future interest rate
The theory asserts that long term rates
are the geometric mean of the short
term rates expected to prevail between
the current period and the maturity
date of the bond
The theory considers two rates
1. Spot Rate
2. Forward Rate
 Spot rate is the present YTM on a
bond, Forward Rate refers to YTM
for bonds which are expected to
exist in future
 Assuming the expectations are
unbiased, the relationship between
current spot rate and forward rates
can be expressed as follows:
YTMn = [(1+YTM1)(1+F2)(1+F3) ……….
(1+Fn)1/n - 1]
Where YTMn = Current Spot Rate
Bond Valuation By Nikunj Patel 9
 Fn = Forward Rate for nth year

Bond Valuation By Nikunj Patel 10

 There are three reasons for the investors to
anticipate the fall in interest rate
(I) Anticipate of the fall in the inflation rate
(II) Anticipation of balanced budget or cure in
the fiscal deficit
(III) Anticipation of recession in the economy
and fall in the demand for funds by
corporate

2. Liquidity Preference Theory

 Investors pay a price premium on
short maturities to avoid interest rate
risk resulting into lower yields
 Long term yield should average
higher than short term yield
3. Segmentation Theory
Insurance companies, Pension funds etc.
prefer the long tem securities to avoid the
possible fluctuation in interest rate
 E.g. Insurance Company  Long term

investment
 E.g. Banking  Short term investment

Bond Valuation By Nikunj Patel 11

Bond Duration

The concept of Duration was first introduced by

F. MACAULAY; duration is also called Macaulay’s
Duration.

• Duration is a measure of the effective

maturity of a bond, defined as the weighted
average of the times until each payment, with
weights proportional to the present value of
the payment.
• The duration of a bond is the weighted
average maturity of its cash flow stream,
where the weights are proportional to the
present value of cash flows.
• The duration of a bond, in effect, represents
the length of time that elapses before the
average rupee of present value from the bond
is received.

Duration is a concept, which means the

weighted Average measure of time period
of bond’s life.

Simple Formula;
n
Bond Valuation By Nikunj Patel 12
 D=∑ PVCF X t
t=1 P0

Consider the Example:

Face value Rs. 100
Coupon Rate 15% annually
Discount Rate 12%
Years to Maturity 6 Years
Redemption Value Rs. 100

Face value Rs. 100

Coupon Rate 15% annually
Years to Maturity 6
Redemption Value Rs. 100
Current Market Price Rs. 89.50

Calculate Duration of the Bond.

Bond Valuation By Nikunj Patel 13

INTEREST RATE ELASTICITY

The volatility of the bond’s price to change

in Interest Rate is called bond’s price
elasticity or Interest rate elasticity.
It is defined as;
Ie = % Change in Price For Bond
% Change in YTM of Bond
P1 – P0
P0__ ___
= YTM1 – YTM0
YTM0

= ∆ P1 X YTM
∆YTM1 PO

IE is always a negative number.

• Anything which causes the bond’s
Duration to increase (longer YTM / Lower
Coupon Rate) will also increase the
bond’s price elasticity.

Bond Valuation By Nikunj Patel 14

Find out the Interest Elasticity from
following information;
YTM PRICE OF BOND
10% 1000
11% 833

-MD [∆ BP]
Change in price = 100

Where MD =Modified Duration

____D ______
= 1+r
Int

Bond Valuation By Nikunj Patel 15

Example:
Arun Buys a bond with four years to
maturity. The bond has a coupon rate of
9%, and YTM 9% and its price is Rs. 100 in
the market.

A. What is the duration of the bond?

B. What will be the %change in the
price of the bond if the YTM rises
to 10%
Types of Risk Associated with the Bonds

• Price Risk
o Default Risk
o Interest Rate Risk
 Call Risk
 Reinvestment Risk
 Marketability Risk

Bond Valuation By Nikunj Patel 16