Bond Market Maths

Group Members Swarana Biyani ---- 01 Sanket Desai ------02 Rohan Jadhav -----08
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Shama Lonare 11 14 ----

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Topic

Index

Slide Number

Features Of Debt Securities. Bond Sector and Instruments. Convexity and Duration. Yield Spread. Yield Measures.
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3---8 9 -- 23 24 -- 37 38 -- 65 65 -- 76
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Bond Indenture:- It is the contract which specifies all the rights and obligation of Issuer and holder of the debt security.

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Straight (Option free bond):- Consider a treasury bond

with 6% coupon and matures in 5 years in amount of 1000 Rs.

It will make 4 payments if 60 Rs annually for 4 years and a payment of 1060 at the end of 5th year.
Zero coupon Bond:- They do not pay periodic interest, instead they are issued at discount to par value and pay the par values at the end of maturity. Eg A treasury bond issued at 98.5$ with a par value of 100% will pay 100$ at the end of maturity with effective return of 2.5%.
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Step Up Notes :- A bond that pays an initial coupon rate for the first period, and then a higher coupon rate for the following periods. For example a five-year bond may pay a 4% coupon for the first two years of its life and a 6% coupon for the final three years. Deferred coupon bond:- The initial interest/coupon payments are

deferred for a period. The coupon payments accumulate at compound rate till deferred period after which they are paid as lump sum. After deferred period the bond start paying regular coupon payments. Eg A bond with face value of 100Rs and coupon rate of 5%, deferred period of 4/15/12 5 years will pay 34.01Rs at the end of 5 years and will start 55 making annual payments if 5Rs thereafter.

Caps and Floors.:- The upper limit which is a cap puts

maximum limit on the interest rate paid by the issuer. Floor is the lower limit which puts minimum on the interest rate received by the owner.

Prepayment option:- This option gives the issuer the right to

pre pay the principle and hence in effect constitutes a pre payment risk to the holder.

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Put Option:- It gives the right to the bond holders to sell the bond to the issuer at a specified price. If the bond price falls below certain level the bond holder can force the issuer to buy back the bond at a specified price. As the put option gives the holder an advantage the yields on such bonds are lower than straight bonds. Eg 6.72%GS2012 bond issued in 2002 with the put option exercisable after every 2.5 years.
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Call option:- This option gives the right to the issuer to buy back
the bond at a specific price. If the bond prices rise above certain level the issuer can buy back the bonds at a specified price. Since this option gives the issuer an advantage the yields on such callable bonds are greater than straight bonds. The same 6.72%GS2012 bond had a call option whereby the Govt could call in the bonds after every 2.5 years.
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Click to edit Master subtitle style

BOND SECTOR & INSTRUMENTS

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Corporate Debt Securities

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UNSECURED DEBT: They are not backed by any collateral. Referred as debentures

If pledged assets generate excess funds they are used for unsecured debt. CREDIT ENHANCEMENT :

Guarantee given that the corporate debt will be repaid.

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Types Of Bonds

Fixed rate bondshave a coupon that remains constant throughout the life of the bond. Floating rate notes(FRNs) Zero-coupon bonds Inflation linked bonds Asset-backed securities Registered bond
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Subordinate bonds Perpetual bonds Bearer bonds Treasury bonds Lottery bonds Municipal bonds

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Valuation Of Debt Securities

1) 2) 3) ) 1) 2)

Basic steps Estimate the cash flow The interest rate Present value Difficulties involved: Principal repayment in unknown Coupon payments
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Computation Valuation of bond when

PV= FV/(1+r)n

1) single coupon rate E.g. cash inflow= Rs100 N= 10 years Future value= Rs 1000 Discount rate= 8% 100/(1.08)+ 100/(1.08)2+ 100/(1.08)3. +100/(1.08)10 4/15/12 =Rs(1134.20)
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2) Zero coupon bonds

Bond value= maturity value/(1+i)n*2 E.G. N=10 years (semi annual) YTM =8% Face value= Rs1000 Zero coupon Bond 1000/(1+.08/2)10*2=1000/ (1.04)20=Rs456.39
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Securitization

Securitization is the process of conversion of existing assets or future cash flows into marketable securities. It deals with the conversion of assets which are not marketable into marketable ones.

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Special Purpose Vehicle

The SPV is a separate entity formed exclusively for the facilitation of the securitization process and providing funds to the originator. The SPV will act as an intermediary which divides the assets of the originator into marketable securities. These securities issued by the SPV to the investors and are known as pass-throughcertificates (PTCs)
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Collateralized Debt Obligation

Assemble an entire portfolio of credit risk exposures, segment that exposure into tranches with unique risk/return/maturity profiles, which are then transferred or sold to investors. Securitization issues backed by debt obligations are called CDO

CDOs reference (underlying) portfolio can be assembled with physical cash flow assets such as bonds, loans, MBS, ABS etc 4/15/12 2121

Mortgage Backed Securities (MBS)

Securitization issues backed by mortgages are called MBS

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Assets Backed Securities

Securitization issues backed by consumer-backed products - car loans, consumer loans and credit cards, among others are called ABS

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Risk Associated

Interest Rate Risk

- Uncertainty about bond prices due to change in market interest rates

Call Risk

- The risk that the bond will be called prior to maturity under the terms of call provision and the funds must be reinvested at the then current yield.

Prepayment Risk

- The uncertainty about the amount of bond 4/15/12 2424 principal that will be repaid prior to maturity

Risk Associated

Liquidity Risk

- The risk that an immediate sale will result in a price below fair value

Exchange Rate Risk

- The risk that the domestic currency value of bond payments in a foreign currency will decrease

Event Risk

- The risk of decrease in a security value from disasters, corporate restructuring, or regulatory changes that negatively affect the firm

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Risk

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Bonds Price Relative To Par

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Bond Characteristic & Interest Rate Risk

Characteristic Maturity Up Coupon Up Add a Call Add a Put Interest Rate Risk Interest Rate Risk Up Interest Rate Risk Down Interest Rate Risk Down Interest Rate Risk Down Duration Duration Up Duration Down Duration Down Duration Down

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Duration

The term duration has a special meaning in the context of bonds. It is a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. For each of the two basic types of bonds the duration is the following:

1. Zero-Coupon Bond Duration is equal to its time to maturity. 2. Vanilla Bond - Duration will always be less than its time to maturity.
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Duration of a Zero Coupon Bond

The entire cash flow of a zero-coupon bond occurs at maturity, so the fulcrum is located directly below this one payment.
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Duration of a Vanilla or Straight Bond

Consider a vanilla bond that pays coupons annually and matures in five years.

The straight bond pays coupon payments 4/15/12 3030 throughout its life and therefore repays the full

Factors Affecting Duration

Duration is decreasing as time moves closer to maturity But duration also increases momentarily on the
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Duration: Other factors

Other factors that affect a bond's duration: the coupon rate and its yield Bonds with high coupon rates and, in turn, high yields will tend to have lower durations than bonds that pay low coupon rates or offer low yields.
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Types of Duration
Types of durations are :

Macaulay duration Modified duration Effective duration

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Macaulay Duration

The formula usually used to calculate a bond's basic duration is the Macaulay duration, which was created by Frederick Macaulay in 1938

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n = number of cash flows t = time to maturity C = cash flow i = required yield M = maturity (par) value P = bond price

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Example

Example 1: Betty holds a five-year bond with a par value of $1,000 and coupon rate of 5%. For simplicity, let's assume that the coupon is paid annually and that interest rates are 5%. What is the Macaulay duration of the bond?

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Modified Duration

Modified duration is a modified version of the Macaulay model that accounts for changing interest rates. Modified formula shows how much the duration changes for each percentage change in yield

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Example

Betty's bond and run through the calculation of her modified duration. Currently her bond is selling at $1,000 or par, which translates to a yield to maturity of 5%. If the bond's yield changed from 5% to 6%, the duration of the bond = 4.33 years

We calculated a Macaulay duration of 4.55 Years.

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Effective Duration

Cash flows from securities with embedded options or redemption features will change when interest rates change. For calculating the duration of these types of bonds, effective duration is the most appropriate.

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Convexity

For any given bond, a graph of the relationship between price and yield is convex.

The degree to which the graph is curved shows how much a bond's yield changes in response to a change in price.

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Convexity and Duration

The exact point where the two lines touch represents Macaulay duration. The yellow portions of the graph show the ranges in which using duration for estimating price would be inappropriate.

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Convexity shows how much

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Properties of Convexity

A bond with greater convexity is less affected by interest rates than a bond with less convexity.

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Bonds with greater convexity will have a higher price than bonds with a lower convexity, regardless of whether interest rates rise or fall.
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Graphical Illustrations

If two bonds offer the same duration and yield but one exhibits greater convexity, changes in differently 4/15/12 interest rates will affect each bond 4242

Kinds of Convexities Plain Vanilla bond Callable bond Negative convexity at Positive convexity.

The price-yield curve will increase as yield decreases, and vice versa. As market yields decrease, the duration increases .

certain price-yield combinations.

Negative convexity means that as market yields decrease, duration decreases as well.

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Convexity allows the investor :

To better comprehend the way in which duration is best measured

how changes in interest rates affect the prices of both plain vanilla and callable bonds.
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Understanding Yield Spreads

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Yield Curve & Various Shapes of Yield Curve

Yield Curve: Yield curve gives the relationship between the maturity and the yield of the bond. Various shapes of Yield Curve
1.

Normal or Upward Sloping Inverted or Downward Sloping Flat Humped

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2.

3.

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Theories of term structure of interest rates

Pure Expectation Theory

The yield for a particular maturity is an average of the short-term rates that are expected in the future. If short-term rates are expected to rise in future, interest rate yields on longer maturities will be higher and the yield curve will be Upward sloping.

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Theories of term structure of interest rates

Liquidity Preference Theory

Investors require a risk premium for holding long term bonds. Interest rate risk is greater for longer maturity bonds. The size of the liquidity premium depends on how much additional compensation investor requires to take on a greater risk for long term bonds.

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Theories of term structure of interest rates

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Theories of term structure of interest rates

Market Segmentation Theory

Investors & borrowers have different pref. for different maturity ranges. The supply and demand determines equilibrium yields for various maturity ranges. Eg: Life insurers & pension funds may prefer long maturities due to their long term liablities.

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Theories of term structure of interest rates

Preferred Habitat Theory

This is somewhat weaker version of Market Yields depends on the supply and demand for various maturity ranges but investors can be induced to move from their preferred maturity ranges when yields are 4/15/12 5151 sufficiently higher in

Spot Rate
Q. An annual-pay bond of 1000 with 10% coupon rate and 3 years to maturity. Suppose the spot rates are: 1 year = 8% 2 year = 9% 3 year = 10% Find the value of bond?
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Spot Rate
Solution: Value of bond = 100/1.08 + 100/(1.09) + 1100/(1.10) = 1003.21 Spot rate is the discount rate for individual future payments.
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Yield Spread

Yield spread is the difference between the yields on two bonds or two types of bonds. Three different yield measures are:
1.

Absolute Yield Spread Relative Yield Spread Yield Ratio

2.

3.

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Yield Spread

Absolute Yield Spread

It is the difference between yields on two bonds. It is expressed in basis point (100th of 1%) Absolute yield spread = yield on the higher yield bond yield on the lower yield bond
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Yield Spread

Relative yield spread

It is absolute yield spread expressed as a percentage of the yield on the benchmark bond. Relative yield spread = spread absolute yield

---------------------------------benchmark bond yield

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Yield Spread

Yield ratio

It is the ratio of the yield on the subject bond to the yield on the benchmark bond Yield ratio = subject bond yield ----------------------------------benchmark bond yield
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Yield Spread
Q. Consider two bonds X & Y Their resp. yields are . 6.50% & 6.75%. Using bond X as the benchmark bond, Compute the absolute yield spread, relative yield spread & yield ratio.

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Yield Spread
Solution: Absolute yield spread = 6.75% - 6.50% = 0.25% or 25 basis Relative yield spread = 0.25% / 6.50% = 3.8% Yield ratio = 6.75% / 6.50% = 1.038
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After-tax yield
Computing after-tax yield on taxable securities After-tax yield = taxable yield x (1- marginal tax rate) Q. Calculate after-tax yield on a corporate bond with yield of 10% for an investor with 40% marginal tax rate?
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After-tax yield
Solution: After-tax yield = 10% (1-40%) = 10% (1-0.4) = 6% after tax

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Tax-equivalent yield
Taxable-equivalent yield: It is a yield a particular investor must earn on a taxable bond to have the same after-tax return the investor may receive from a tax-exempt bond. Taxable-equi. yield = tax free yield

-------------------------------(1-marginal tax rate)

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Tax-equivalent yield
Q. Municipal bond offers yield of 4.5%. If an investor consider buying taxable Treasury security offering 6.75% yield. Should the investor buy the Treasury security or municipal bond, given the marginal tax rate is 35%.

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Tax-equivalent yield
Solution: Taxable-equivalent yield = ------------------------(1 - 0.35) = 6.92% Therefore, municipal bond is preferred over treasury security as taxable-equivalent on municipal bond is higher than that of treasury security. 4/15/12 6464 4.5%

Yield Measures

Current yield is the simplest measure of valuing a bond Current yield = annual cash interest payment / Bond Price Consider a 20 year bond with a face value of $ 1000 which pays 6% annually, the bond is trading at $ 802.07. The current yield is 6% * 1000 / 802.07 = 7.48%.
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Yield Measures.

Yield to Maturity : - It values the bond on the PV of the future payments. Bond Price = ( CP (T) / ( 1 + YTM) ) + ( CP (2) / ( 1 + YTM )^2 ) . +( CP ( N ) + par / ( 1 + YTM )^ N). YTM and price give the same information, given YTM we can calculate price and given price we can calculate YTM.
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Yield Measures.

Consider an annual pay 20 year $ 1000 par value bond with a 6% coupon rate trading at a price of $ 802.07 Calculate 4/15/12 6767 the YTM.

Yield Measures.

Yield to call : - It is used to measure yield on callable bonds which are trading at premium. Typically callable bonds cant be called for a fixed period of time after issuance. If within that period the bond price goes above the call price yield to call is used.
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Yield Measures.

Consider a 10% semiannual pay bond with a current price of $112 that can be called in 5 years at 102. Calculate the YTM and YTC.
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Yield to put : - It measures the yield of bonds having put option which are trading a discount. Typically put option in a bond cant be invoked for a fixed period of time after issuance. If within that period the bond price starts trading at discount to the actual value of the bond then yield to put is used. yield to put is higher than YTM due to7070 bond lower price.

Yield Measures.

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Yield Measures.

Consider a 3 year, 6%, $ 1000 semiannual pay bond. The bond is selling for a price of 925.40. The opportunity for put is at par in 4/15/12 years. Calculate YTM and YTP. 7171 2

Reinvestment Income.

If a bond holder holds a bond until maturity and reinvests the interest payments then the total amount generated by the bond over the life is Bond Principle. Interest payments. Interest on reinvested Income. If the reinvestment income is less than YT, of the bond the total return generated will be less than YTM.
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2.

3.

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Reinvestment Income.

If you purchase a 6% 10 year bond how much reinvestment income must be generated over its life to provide the investor with a compound return of 6% on annual basis. The par value of bond is Rs 100. If the investment yields 6% compounded annual return the total value will be 100 * ( 1.06 ) ^ 10 = 179.084. The bond will make 10 annual payments of Rs 6 and an end payment of Rs 100.
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There fore it will make total payment of 160RS

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The required reinvestment Income is 179.084 160 =

The End

Thank You
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