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Valuation Using Multiple Discount Rates

Thus far, we have used one discount rate to compute the


present value of each cash flow. A more accurate way to value
th cashh flows
the fl off a bond
b d is
i to
t use a different
diff t discount
di t rate
t that
th t is
i
unique to the time period in which a cash flow will be received.

Example: Suppose that the appropriate discount rates are as


follows, calculate the present value for the 4-year 10% coupon
bond:

Year 1 2 3 4
Discount rate 6.8% 7.2% 7.6% 8.0%

1
Valuing Semiannual Cash Flows

The procedure is to adjust the coupon payments by dividing the


annual coupon payment by 2, and adjust the discount rate by
di idi the
dividing th annuall discount
di t rate
t by
b 2.
2

The time period t in the present value formula is treated in


terms of 6-month periods rather than years.
years

The convention in the bond market is to quote annual interest


rates that are jjust double semiannual rates.

2
Valuing Semiannual Cash Flows

Example:

Consider
C id againi a 4-year
4 b d 10% coupon, par value
bond, l US$100
US$100,
paying semiannual coupons. If the annual discount rate is 8%,
the cash flows for this bond are:

3
Valuing a Zero-Coupon Bond

For a zero-coupon bond there is only one cash flow the


maturity value. The value of a zero-coupon bond that matures N
years from
f now is
i

maturity value / (1 + i)no of years*2

Although zero-coupon bonds do not pay coupons, it is


customary to value zero-coupon bonds using semiannual
discount rates.

Note that N is now two times the number of years to maturity


and that the semiannual discount rate is one-half the yield to
maturity.

4
Valuing a Zero-Coupon Bond

Example:

Compute
C t the
th value
l off a 5-year
5 zero-coupon bond
b d with
ith a maturity
t it
value of US$100, discounted at an 8% rate.

5
Yield Measures

The holding period yield (HPY) or holding period return, is


the total return an investor earns between the purchase date and
th sale
the l or maturity
t it date.
d t HPY is i calculated
l l t d as:

HPY = (P1 P0 + D1) / P0 = [(P1 + D1) / P0] 1

where:

P0 = initial p
price of the instrument
P1 = price received for instrument at maturity
D1 = interest payment (distribution)

6
Yield Measures

Example:

Whatt is
Wh i the
th HPY for
f a T-bill
T bill priced
i d att US$98,500
US$98 500 with
ith a face
f
value of US$100,000 and 120 days remaining until maturity?

7
Yield Measures

The effective annual yield (EAY) is an annualized value, based


on a 365-day year, that counts for compound interest. It is
calculated
l l t d as:

EAY = (1 + HPY)365/t 1

8
Yield Measures

Example:

Calculate
C l l t the
th EAY using
i HPY off 1.5228%
1 5228% from
f the
th previous
i
example.

(1 015228)365/120 1 = 1.047042
EAY = (1.015228) 1 047042 1 = 4.7042%
4 7042%

Note that we can convert from EAY to HPY by using the


reciprocal
p of the exponent,
p , such as:

(1.047042)120/365 - 1 = 1.5228%

9
Forward Rates

A forward rate is a borrowing / lending rate for a loan to be


made at some future date. The notation used must identify both
th length
the l th off the
th lending
l di / borrowing
b i period
i d andd when
h ini the
th
future the money will be loaned / borrowed.

For example:

6-month forward rate six months from now


6-month forward rate three yyears from now
1-year forward rate one year from now
3-year forward rate two years from now
5-year forward rate three years from now

As a notation, 1f1 is the rate for a 1-year loan one year from
now, and 1f2 is the 1-year loan to be made two years from now,
etc.
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The Relationship Between Forward Rates and Spot Rates

The idea here is that borrowing for three years at the 3-year
rate or borrowing for 1-year periods, three years in succession,
should
h ld have
h the
th same cost.
t

(1 + S3)3 = (1 + 1f0) * (1 + 1f1) * (1 + 1f2), so

S = [(1 + 1f0) * (1 + 1f1) * (1 + 1f2)]1/3 1

which is the g
geometric mean.

11
The Relationship Between Forward Rates and Spot Rates

Example:

If the
th currentt 1-year
1 rate
t is
i 2%,
2% the
th 1-year
1 f
forward
d rate
t (1f1) is
i
3% and the 2-year forward rate (1f2) is 4%, what is the 3-year
spot rate?

12
The Relationship Between Forward Rates and Spot Rates

Example:

The currentt 1-year


Th 1 spott rate
t is
i 4%,
4% the
th currentt 2-year
2 spott rate
t is
i
8%, and the current 3-year spot rate is 12%. Calculate the 1-year
forward rates one and two years from now.

13
Computing the Value of a Bond Using Forward Rates

Example:

The currentt 1-year


Th 1 rate
t iis 4% and
d th
the 1 year fforward
d rate
t for
f
lending from time = 1 to time = 2 is 5%, and the 1-year forward
rate for lending from time = 2 to time = 3 is 6%. Value a 3-year
annual-pay bond with a 5% coupon and a par value of US$1,000.
US$1 000

14
Duration

Calculating Duration
Effective Duration
Approximating the Percentage Price Change Using Duration
Calculating the New Price of a Bond Using Duration
Calculating Portfolio Duration
Convexity Adjustment
Estimating Price Changes with Duration and Convexity
Price Value of a Basis Point

15
Duration

Duration is a measure of the approximate price sensitivity of a


fixed income instrument to interest rate (yield) changes

More specifically, it is the approximate change in price of a


fixed income instrument for a 100 basis point (1%) change in
rates (yields)

This relation is:

duration = - (prcentage change in bond price) / (yield change in


percent)
16
Duration
The formula for calculating the effective duration is:

effective duration = (bond prices when yields fall bond prices


when
h yields
i ld rise)
i ) / [2 * (i
(initial
iti l price)
i ) * (change
( h in
i yield
i ld in
i
decimal form)]

in another expression
expression,

effective duration = V- V+ / 2V0(y)

V- = bond value if the yield decreases by y


V+ = bond value if the yield increases by y
V0 = initial bond price
y = change in yield used to get V- and V+, expressed in decimal
form

17
Calculating Effective Duration

Example:

Consider a 20-year, semiannual-pay bond with an 8% coupon that


is currently priced at US$908.00 to yield 9%. If the yield declines
by 50 basis points (to 88.5%),
5%) the price will increase to
US$952.30, and if the yield increases by 50 basis points (to
9.5%), the price will decline to US$866.80. Based on the price
and yyield changes,
g , calculate the effective duration of this bond.

18
Approximating the Bond Price Change When Yields Increase

Example:

If a bond has a duration of 5 and the yield increases from 7% to


8%, calculate the percentage price change in the bond price.

19
Approximating the Bond Price Change When Yields Decrease

Example:

If a bond has a duration of 7.2 and the yield decreases from 8.3%
to 7.9%, calculate the percentage price change in the bond price.

20
Calculating Duration Given a Yield Increase

Example:

If a bonds yield rises from 7% to 8% and its price falls by 5%,


calculate the duration.

21
Calculating Duration Given a Yield Decrease

Example:

If a bonds yield decreases by 0.1% and its price increases by


1.5%, calculate the duration.

22
Calculating the New Price of a Bond

Example:

A bond is currently trading at US$1,034.50, has a yield of 7.38%,


and has a duration of 8.5. If the yield rises to 7.77%, calculate the
new price of the bond.
bond

23
Portfolio Duration

The duration of a portfolio of bonds is simply the weighted


average off the
th durations
d ti off th
the iindividual
di id l bonds
b d in
i the
th portfolio
tf li

Mathematically, the duration of portfolio is:

portfolio duration = w1D1 + w2D2 + ........ + wnDn

where:

wi = market value of bond i divided by the market value of the


portfolio
Di = the duration of bond i
N = the number of bonds in the portfolio

24
Calculating Portfolio Duration

Example:

Suppose you have a two-security portfolio containing Bonds A


and B. The market value of Bond A is US$6,000, and the market
value of Bond B is US$4
US$4,000.
000 The duration of Bond A is 8.5,
8 5 and
the duration of Bond B is 4.0. Calculate the duration of the
portfolio.

25
Convexity Adjustment

Convexity is a measure of the curvature of the price-yield


curve, such that the more curved the price-yield relation is, the
greater
t the
th convexity,
it where
h a straight
t i ht line
li has
h a convexity it off
zero.

The reason we care about convexity is that the more curved the
price-yield relation is, the worse our duration-based estimates of
bond price changes in response to changes in yield are.

If the price-yield relation were a straight line (meaning


convexity is zero), duration alone would provide good estimates
of bond price changes for changes in yield of any magnitude. The
greater the convexity, the greater the error in price estimates
based solely on duration.

26
Convexity Adjustment

convexity = (V+ + V- - 2V0) / [2V0(y)2]

convexity adjustment = C * (y)2

percentage change in price = duration effect + convexity effect =


{[-duration * (y)] + [convexity * (y)2]}

27
Estimating Price Changes With Duration and Convexity

Example:

Consider an 8% Treasury bond with a current price of US$908


and a YTM of 9%. Calculate the percentage change in bond price
of both 1) a 1% increase and 2) a 1% decrease in YTM based on
duration of 9.42 and of convexity of 68.33.

28
Price Value of a Basis Point (PVBP)

The PVBP is the dollar change in the price / value of a bond or


a portfolio
tf li when
h the
th yield
i ld changes
h by
b one basis
b i points
i t (0.01%).
(0 01%)
As a practical matter, we can use duration to calculate the PVBP
as:

PVBP = duration * 0.0001 * bond value

29
Price Value of a Basis Point (PVBP)

Example:

What is the PVBP of a bond that has a market value of


US$100,000 and a duration of 9.42.

30

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