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Lecture 6
Chap 18
1-1
Interest Rates
Example:
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 %
17-2
Current Yields - Example
18-4
Yield to Maturity
17-6
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
17-7
Yield to Maturity
17-8
Zero Coupon Bond - Example
17-9
Zero Coupon Bond - Example
1/2n
YTM 2 {[MV/P] 1}
MV = $1000
P = $300
n=2
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%
17-10
Yield to Call
Most corporate bonds, as well as some
government bonds, are callable by the
issuers, usually after some deferred call
period
If a bond is likely to be called, the YTM
calculation will be unrealistic
Therefore, the yield is calculated based
on yield to call
17-11
Realized Compound Yield
Measures the compound yield on the
bond investment actually earned over
the investment period.
17-12
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
years.
The X dollars consist of
all the coupons received
coupons and
the $1,000 maturity value of the bond
17-13
Realized Compound Yield Example 1
17-14
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
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
investors
17-16
Bond Valuation
17-17
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
periods.
17-18
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
17-19
Bond Valuation Example
17-20
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
17-21
Why Buy Bonds?
18-22
Managing Price Volatility
18-24
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
17-25
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.
17-26
Calculating Duration
17-27
Calculating Duration - Example
17-28
Calculating Duration - Example
17-29
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.
17-30
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
maturity
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
18-31
Why is Duration Important?
17-32
Estimating Price Changes Using
Duration
Modified duration =D*=D/(1+r)
D*can be used to calculate the bonds
percentage price change for a given
change in interest rates
-D
% in bond price r
( 1 r)
17-33
Duration Conclusions
17-34
Modified Duration and Bond Price Volatility
where:
m = number of payments a year
YTM = nominal YTM
Modified Duration and Bond Price Volatility
where:
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
2-37
Tutorial Questions
Chapter 18
Questions: 5, 6, 12, 14, 15
Computation problems: 1, 2
2-38