****Definition of security

Securities are typically divided into debt securities and equities. A debt security is a type of
security that represents money that is borrowed that must be repaid, with terms that define the
amount borrowed, interest rate and maturity date. Debt securities include government and
corporate bonds, certificate of deposit (CDs), preferred stock and collateralized securities
(such as CDOs and CMOs)
Equities represent ownership interest held by shareholders in a corporation, such as a stock.
Unlike holders of debt securities who generally receive only interest and the repayment of the
principal, holders of equity securities are able to profit from capital gains.
Fixed income securities
A fixed-income security is a debt instrument issued by a government, corporation or other
entity to finance and expand their operations.
Fixed-income securities provide investors a return in the form of fixed periodic payments and
eventual return of principal at maturity. The purchase of a bond, treasury bill, Guaranteed
Investment Certificate (GIC), mortgage, preferred share or any other fixed-income product
represents a loan by the investor to the issuer.
Fixed-income securities can be an important part of a well-diversified portfolio. For many
investors, particularly retirees, fixed-income investments are a secure, low-risk way to
generate a steady flow of income. As long as they are held to maturity, fixed-income
securities will provide a guaranteed return on your investment, with payments known in
advance.
Types of fixed income securities
1) Preference shares:- preference shares are no longer regarded as inferior to equity
capital. High- tax paying companies or investors prefer to subscribe to preference
shares and investors with a low tax burden prefer to go in for debt instrument. The
biggest advantage is the tax-exempt status of the preference shares dividend.
2) Debentures:- corporate debentures are an option available to investors who are
willing t sacrifice liquidity for higher return. If the debentures are not actively traded
in the debt segment of the capital market, the investors have to hold the instrument till

maturity. If the instrument were actively traded in the secondary market, it would
have perhaps changed hands at a considerable premium, thereby lowering yield on a
par with the current interest rate. These reasons contribute toward high coupon rates
on debentures.
3) Bonds:- bonds are similar to debentures. However, they are issued by public sector
undertakings. The value of the bonds in the market depends upon the interest rate
maturity. The coupon rate is the nominal interest rate offered on the bonds. The
coupon rate is contractual as per the terms and condition of the issuance of the debt
security. Being contractual, it cannot be changed during the tenure of the instrument.
Investors are not affected by lowering of the bank rates. When the bank rates are
lowered, actually, the value of the bonds, which carry interest rates above the bank
rate, would appreciate. IDBI and ICICI have issued various bonds to suit the needs of
investors. Some of these are deep discount bond, education benefit bond, retirement
benefit bond.
4) Government securities:- the securities issued by the central government, state
government and quasi-government agencies are known as government securities. As
a government guaranteed security is a claim on the government, it is a secure financial
instrument, which guarantees the income and capital. The rate of interest on these
securities is relatively lower because of their high liquidity and safety.
5) Canada bonds:- the Canada government issues Canada bonds to raise money. A
bond is a promise to pay a specified amount of interest at intervals over a given period
of time and then to repay the principal on the bonds maturity date. The principal is
called the face value and is stated on the bond. Canada bonds are considered the safest
long term investment in Canada.
Main features:- i. safe and secure
ii. Terms to maturity range from a few months to 30 years.
iii.

Most liquid or readily traded, terms are two, three, five, ten and

30 years
iv.
. Same day settlement
6) Provincial bond: provincial governments issue bonds to raise money. Interest rates
and risk levels vary from province to province.
I.
Main features:- one of the safe Canadian investment
i. Higher yield than Canada bonds
ii. Terms to maturity range from a few months to 30 years.

iii. Most liquid or readily traded, terms are two, three, five, ten and
30 years.
iv. 3 day settlement.
7) Guarantee investment certificate (GICS):- A GICs is an investment that offers a
guarantee rate
Of return over a fixed period of time. It is most commonly issued by trust companies
or banks. Because of its guarantee rate, the return is generally less than other fixed
income investments such as corporate bonds.
I.
Main features:- redeemable only at maturity
i. Interest rate determined by frequency of interest payment
ii. Interest paid monthly, quarterly, semi-annually, annually or at
maturity.
iii. Terms to maturity range from 30 days to 5 years
iv. Insured up to $ 100000 when issued by a CDIC member
v. Same day settlement
8) Commercial mortgage- backed securities:- CMBS are investments secured by
mortgages on commercial property. The investment represents ownership of an
interest in a group of commercial mortgages held by the CMBS issuer in trust
principal and interest from the underlying mortgages are used to pay monthly
principal and interest on the CMBS. Commercial properties that may be mortgaged
include shopping centres hospitality industrial, mobile home parks, multi- family
building offices and retirement homes.
I.
Main features:- Terms are typically three , five or ten years.
i. Attractive rates of return
ii. Risk and return vary depending on the health of the real-estate
market.
iii. Same day settlement.
9) Provincial treasury bills(T-bills):- T-bills are short term debt instruments issued by
provincial governments in large denominations and sold at discount.
I.
Main features:- safe and secure
i. Not as readily traded as Canada treasury bills
ii. Slightly higher yield than Canada treasury bills
iii. Terms range from 1 to 365 days
iv. The difference between the issue price of the T-bills and its par
valve
v. represents the investors return in lieu of interest
vi. Same day settlement
10) Bankers acceptance:- BA is a short term money market instrument guaranteed by
banks. They are one of the safest Canadian investments. You wont get rich putting
your money in BA, but there can be a good place to park your money while youre
deciding what other investments to buy.
I.
Main features:- safe and secure

i. Liquid, so theyre readily traded

ii. 30,60,90 days terms, terms from 1 to 365 days are available but
may be
iii. Less Liquid.
iv. Same day settlement.
11) Commercial paper:- Commercial paper is an unissued, short term investment issued
by a corporation, typically to raise money for financing accounts receivable and
inventory. Its actually a short term loan backed by the companys credit rating. The
stronger the company, the less risky the investment. A Commercial paper is usually
used to park money temporily before putting it into a higher yielding investment.
I.
Main features:- slightly higher risk than treasury bills an d bankers acceptance,
unless the
i. Commercial paper is asset backed.
ii. Term rage 1 to 365 days.
iii. 30, 90,182, and 365 days terms are the most liquid or readily
traded other
iv. Terms known as off- the run issues, may have a slightly
better yield
v. but may be less liquid
vi. The difference between the purchase price and the maturity
valve
vii. represents the return on investment.
viii. Same day settlement.
12) Canada treasury bills (t-bills):- Canada t-bills are short term debt instruments issued
by the federal government in large denominations and sold at a discount.
I.
Main features:- safe and secure
i. Terms range from 1 to 365 days
ii. 30, 90,182, and 365 days terms are the most liquid or readily
traded other
iii. Terms known as off- the run issues, may have a slightly
better yield
iv. but may be less liquid.
v. Same day settlement.

***FIXED INCOME SECURITIES:

A fixed-income security is a debt instrument issued by a government, corporation or other
entity to finance and expand their operations.
Fixed-income securities provide investors a return in the form of fixed periodic payments and
eventual return of principal at maturity. The purchase of a bond, Treasury bill, Guaranteed

Investment Certificate (GIC), mortgage, preferred share or any other fixed-income product
represents a loan by the investor to the issuer.
Fixed-income securities can be an important part of a well-diversified portfolio. For many
investors, particularly retirees, fixed-income investments are a secure, low-risk way to
generate a steady flow of income. As long as they are held to maturity, fixed-income
securities will provide a guaranteed return on your investment, with payments known in
advance.

RISK- RETURN ANALYSIS OF FIXED INCOME SECURITIES

As an integral part of a well-balanced and diversified portfolio, fixed income securities afford
opportunities for predictable cash flows to match investors individual needs, provide capital
preservation and may offset the volatility of the stock market. However, all investments have
some degree of risk. In general, the higher the return potential, the higher the risk. Safer
investments usually offer relatively lower returns.In general, investors demand higher yields
to compensate for higher risks. Discussed below are some of the most common risks
associated with fixed income securities.
Interest Rate Risk
The market value of the securities will be inversely affected by movements in interest rates.
When rates rise, market prices of existing debt securities fall as these securities become less
attractive to investors when compared to higher coupon new issues. As prices decline, bonds
become cheaper so the overall return, when taking into account the discount, can compete
with newly issued bonds at higher yields. When interest rates fall, market prices on existing
fixed income securities tend to rise because these bonds become more attractive when
compared to the newly issued bonds priced at lower rates.
Price Risk
Investors who need access to their principal prior to maturity have to rely on the secondary
market to sell their securities. The price received may be more or less than the original
purchase price and may depend, in general, on the level of interest rates, time to term, credit

quality of the issuer and liquidity. Among other reasons, prices may also be affected by
current market conditions, or by the size of the trade (prices may be different for 10 bonds
versus 1,000 bonds), etc. It is important to note that selling a security prior to maturity may
affect actual yield received, which may be different than the yield at which the bond was
originally purchased. This is because the initially quoted yield assumed holding the bond to
term.
As mentioned above, there is an inverse relationship between interest rates and bond prices.
Therefore, when interest rates decline, bond prices increase, and when interest rates increase,
bond prices decline. Generally, longer maturity bonds will be more sensitive to interest rate
changes. Dollar for dollar, a long-term bond should go up or down in value more than a shortterm bond for the same change in yield.
Liquidity Risk
Liquidity risk is the risk that an investor will be unable to sell securities due to a lack of
demand from potential buyers, sell them at a substantial loss and/or incur substantial
transaction costs in the sale process. Broker/dealers, although not obligated to do so, may
provide secondary markets.
Reinvestment Risk
Downward trends in interest rates also create reinvestment risk, or the risk that the
income and/or principal repayments will have to be invested at lower rates. Reinvestment
risk is an important consideration for investors in callable securities. Some bonds may be
issued with a call feature that allows the issuer to call, or repay, bonds prior to maturity.
This generally happens if the market rates fall low enough for the issuer to save money by
repaying existing higher coupon bonds and issuing new ones at lower rates. Investors will
stop receiving the coupon payments if the bonds are called. Generally, callable fixed
income securities will not appreciate in value as much as comparable non-callable
securities.
Prepayment Risk
Similar to call risk, prepayment risk is the risk that the issuer may repay bonds prior
to maturity. This type of risk is generally associated with mortgage-backed securities.
Homeowners tend to prepay their mortgages at times that are advantageous to their

needs, which may be in conflict with the holders of the mortgage-backed securities. If
the bonds are repaid early, investors face the risk of reinvesting at lower rates.
Purchasing Power Risk
Fixed income investors often focus on the real rate of return, or the actual return minus the
rate of inflation. Rising inflation has a negative impact on real rates of return because
inflation reduces the purchasing power of the investment income and principal.
Credit Risk
The safety of the fixed income investors principal depends on the issuers credit quality
and ability to meet its financial obligations, such as payment of coupon and repayment of
principal at maturity. Rating agencies assign ratings based on their analysis of the issuers
financial condition, economic and debt characteristics, and specific revenue sources
securing the bond. Issuers with lower credit ratings usually have to offer investors higher
yields to compensate for additional credit risk. A change in either the issuers credit rating
or the markets perception of the issuers business prospects will affect the value of its
outstanding securities. Ratings are not a recommendation to buy, sell or hold and may be
subject to review, revision, suspension or reduction, or may be withdrawn at any time. If a
bond is insured, attention should be given to the credit worthiness of the underlying issuer
or obligor on the bond as the insurance feature may not represent additional value in the
marketplace or may not contribute to the safety of principal and interest.
Default Risk
The risk of default is the risk that the issuer will not be able to make interest payments
and/or return the principal at maturity.
Legal risk :
Is the risk that changes in the law may adversely affect the price of the fixed income
investments. Most legal risk is associated with the tax exemption of particular bonds,
especially municipal bonds. The second type of legal risk occurs because tax-exempt
securities have to satisfy specific legal requirements, and if it is later determined that
the security does not satisfy these requirements, its tax-exempt status may be
eliminated
ALTERNATIVES INVESTMENTS OF FIXED INCOME SECURITIES

An alternative investment is an investment in asset classes other than stocks, bonds, and
cash. The term is a relatively loose one and includes tangible assets such as precious
metals, art, wine, antiques, coins, or stamps and some financial assets such as real estate,
commodities, private equity, distressed securities, hedge funds, carbon credits, venture
capital, film production and financial derivatives. Investments in real estate and forestry
are also often termed alternative despite the ancient use of such real assets to enhance and
preserve wealth. Alternative investments are to be contrasted with traditional investments.
Alternative investments are sometimes used as a way of reducing overall investment risk
through diversification.
Some of the characteristics of alternative investments may include:

Low correlation with traditional financial investments such as stocks and bonds

It may be difficult to determine the current market value of the asset

Alternative investments may be relatively illiquid.

Costs of purchase and sale may be relatively high

A high degree of investment analysis may be required before buying

***INTRODUCTION TO BONDS
For an investor, bonds are just one of the wide varieties of options available to choose from
when building an investment portfolio. Before investing in bonds, its important to have a
general understanding of what they are and the potential advantages and risks they carry.
A bond is a long-term debt instrument that promises to pay a fixed annual sum as interest for
a specified period of time. The basic features of the bonds are as follows:

Bonds have face value. This is known as par value. The bonds may be issued at par, or

at a discount.
The interest is fixed. It may sometimes vary as in the case of a floating rate bond. The
interest is paid semi-annually or annually and is known as the coupon rate. The
interest rate is specified in the certificate.

The maturity date of the bond is usually specified at the time of issue, except in the

case of perpetual bonds.

The redemption value is also stated in the bonds. It may be at par value or at a

premium.
Bonds are stated in the stock market. When they are traded, the market value may be
at par, at a premium or discounted. The market value and the redemption value need
not be the same.

In simple words a bond is a debt investment in which an investor loans money to an entity
(typically corporate or governmental) which borrows the funds for a defined period of time at
a variable or fixed interest rate. Bonds are used by companies, municipalities, states and
sovereign governments to raise money and finance a variety of projects and activities.
Owners of bonds are debtholders, or creditors, of the issuer.
Bonds are commonly referred to as fixed-income securities and are one of the three main
generic asset classes, along with stocks (equities) and cash equivalents. Many corporate and
government bonds are publicly traded on exchanges, while others are traded only over-thecounter (OTC).
TYPES OF BONDS
1. Corporate bond: It is a bond that a corporation issues to raise money in order to expand
its business. The term is usually applied to longer-term debt instruments; generally with a
maturity date falling at least a year after their issue date.Large corporations have a lot of
flexibility as to how much debt they can issue: the limit is whatever the market will bear.
Generally, a short-term corporate bond is less than five years; intermediate is five to 12
years, and long term is over 12 years. Corporate bonds are characterized by higher yields
because there is a higher risk of a company defaulting than a government. The upside is
that they can also be the most rewarding fixed-income investments because of the risk the
investor must take on. The company's credit quality is very important: the higher the
quality, the lower the interest rate the investor receives.
2. Government bonds: are medium or long term debt securities issued by sovereign
governments or their agencies. Typically they carry a lower rate of interest than corporate
bonds, and serve as a source of finance for governments. This kind of bonds is usually
issued in the open market operations. According to the length of duration, government
bonds can be classified into three main categories. They are as follows
Bills: debt security whose maturity period is less than one year.

Notes: debt security whose maturity period is 1 to 10 years.

Bonds: debt security whose maturity period is more than 10 years.

3. Sub sovereign government bonds: represent the debt of state, provincial, territorial,
municipal or other governmental units other than sovereign governments.
4. Supranational bonds:represent the debt of international organizations such as the World
Bank, The International Monetary Fund, regional multilateral development banks and
others.

5. Municipal bonds
Municipal bonds are issued by state on local governments and governmental agencies.
Generally they are exempt from federal income tax and from state taxes for purchasers
who live in the state of issue. These are called governmental agency bonds. These bonds
are not issued directly by the government but within the backing of the government. They
are used to finance public interest projects. Because of this tax advantage, the interest on
a municipal bond is normally lower than that of a taxable bond.
6. Fixed rate bond: is a type of debt instrument bond with a fixed coupon (interest) rate, as
opposed to a floating rate note. A fixed rate bond is a long term debt paper that carries a
predetermined interest rate. The interest rate is known as coupon rate and interest is
payable at specified dates before bond maturity. Due to the fixed coupon, the market
value of a fixed-rate bond is susceptible to fluctuations in interest rates, and therefore has
a significant amount of interest rate risk. That being said, the fixed-rate bond, although a
conservative investment, is highly susceptible to a loss in value due to inflation. The
fixed-rate bonds long maturity schedule and predetermined coupon rate offers an investor
a solidified return, while leaving the individual exposed to a rise in the consumer price
index and overall decrease in their purchasing power.
7. Floating rates bonds: Theyhave a fluctuating interest rate (coupons) as per the current
market reference rate.
8. Callable Bonds
Callable bonds, also known as "redeemable bonds," can be redeemed by the issuer prior
to maturity. Usually a premium is paid to the bond owner when the bond is called. The
main cause of a call is a decline in interest rates. If interest rates have declined since a
company first issued the bonds, it will likely want to refinance this debt at a lower rate. In

this case, the company will call its current bonds and reissue new, lower-interest bonds to
save money.
9. Serial bonds
Bond maturing over a period of time in installments is called serial bonds. In effect, a
$100,000, 5-year serial bond would mature in a $20,000 annuity over a 5-year interval.
Bond issues consisting of a series of blocks of securities maturing in sequence, the
coupon rate can be different.
10. Term Bonds
Term bonds are bonds from the same issue that share the same maturity dates. Term bonds
that have a call feature can be redeemed at an earlier date than the other issued bonds. A
call feature, or call provision, is an agreement that bond issuers make with buyers. This
agreement is called an "indenture," which is the schedule and the price of redemptions,
plus the maturity dates. Some corporate and municipal bonds are examples of term bonds
that have 10-year call features. This means the issuer of the bond can redeem it at a
predetermined price at specific times before the bond matures. A term bond is the
opposite of a serial bond, which has various maturity schedules at regular intervals until
the issue is retired.
11. Zero-coupon bonds: Also known as "strips" or "zeros," these are Treasury-based
securities that are sold by brokers at a deep discount and redeemed at full face value when
they mature in six months to 30 years. Although you don't actually receive your interest
until the bond matures, you must pay taxes each year on the "phantom interest" that you
earn (it's based on the bond's market value, which usually rises steadily during the time
you hold it). For that reason, they are best held in tax-deferred accounts. Because they pay
no coupon, zeros can be highly volatile in price.
12. High-yield bond (non-investment-grade bond, speculative-grade bond, or junk
bond): is a bond that is rated below investment grade. These bonds have a higher risk of
default or other adverse credit events, but typically pay higher yields than better quality
bonds in order to make them attractive to investors. Sometimes the company can provide
new bonds as a part of yield which can only be redeemed after its expiry or maturity.
13. Convertible bond or convertible note or convertible debt (or a convertible debenture if it
has a maturity of greater than 10 years) is a type of bond that the holder can convert into a
specified number of shares of common stock in the issuing company or cash of equal
value. It is a hybrid security with debt- and equity-like features. It originated in the mid-

19th century. Convertible bonds are most often issued by companies with a low credit
rating and high growth potential. From the issuer's perspective, the key benefit of raising
money by selling convertible bonds is a reduced cash interest payment. The advantage for
companies of issuing convertible bonds is that, if the bonds are converted to stocks,
companies' debt vanishes. However, in exchange for the benefit of reduced interest
payments, the value of shareholder's equity is reduced due to the stock dilution expected
when bondholders convert their bonds into new shares.
14. Lottery bonds: are types of government bond in which some randomly selected bonds
within the issue are redeemed at a higher value than the face value of the bond. Lottery
bonds have been issued by public authorities in Belgium, France, Ireland, Pakistan,
Sweden, New Zealand, the UK and other nations. Outwardly, lottery bonds resemble
ordinary fixed rate bonds; they have a fixed, though usually long, duration and either pay
no interest or regular coupons. The individual bonds within each issue are numbered, like
ordinary bonds, but the serial numbers serve a different function from ordinary bonds. For
a lottery bond the serial number is an added incentive for the purchaser to buy the bond.
15. Perpetual bonds: are also often called perpetuities or 'Perps'. They have no maturity
date. The most famous of these are the UK Consols, which are also known as Treasury
Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade
today, although the amounts are now insignificant.
16. Bearer bond is an official certificate issued without a named holder. In other words, the
person who has the paper certificate can claim the value of the bond. Often they are
registered by a number to prevent counterfeiting, but may be traded like cash. Bearer
bonds are very risky because they can be lost or stolen.

**Bond valuation
Bonds are long term fixed income securities. Debentures are also long term fixed income
securities. Both of these are debt securities. In India debt securities issued by the government
and public sector units are referred to as bonds, while debt securities issued by private sector
joint stock companies are called debentures. The two terms however are often used
interchangeably.

The two major categories of bonds are government bonds and corporate bonds. Government
bonds represent the borrowing of the government. Since they are backed by the government
they are considered free from default risk. Corporate bonds represent debt obligation of
private sector companies. Corporate bonds are backed by the credit of the issuing companies.
It is the companys ability to earn money and meet the debt obligation that determines the
bonds default risk.
In the case of bonds the interest and principal and also the maturity are well specified and
fixed. This makes bonds valuation easier then stock valuation. Certain special features of
bonds such as callability and convertibility may make bond valuation complex. In the case of
callability bonds the bonds may be called for redemption earlier then its maturity date. As the
right to call rest with the companies callable bonds must offer a high interest to compensate
for disadvantageous call. Convertible bonds are those that can be converted into equity share
at a later date either fully or partly because the option to convert often rest with the bond
holder the interest offered on the bond can be less as the part of the return is the value of the
option.
Bond valuation is less glamorous than stock valuation for two reasons, one is the returns from
investing in bonds are less impressive and fixed and the second is that bond prices fluctuate
less than equity prices as the uncertainty associated with the cash flows occurring to a bond
holder is less. An investor in bonds should be on the lookout even small differential in prices
and return.

Bond Returns
Bond Returns can be calculated and expressed in different ways such as:
Coupon Rate:
It is the nominal rate of interest fixed and printed on the bond certificate. It is calculated at
the face value of the bond. It is at the rate at which interest is payable by the issuing company
to the bond holder.
For example: if the coupon rate on a bond of face value of Rs. 1000 is 12% then Rs. 120 is
payable by company to the bondholder annually till maturity.

Current Yield:
The current market price of a bond in the secondary market may differ from its face value. A
bond of face value Rs. 100 may be selling at a discount for Rs. 90 or may be selling at a
premium at Rs 115. The current yield relates the annual interest receivable on a bond to its
current market price. It can be expressed as
Current yield=

100
P0

Where
In denotes annual interest
P0 denotes current market price
For Example:
If a bond of face value Rs. 1000 and a coupon rate of 12% is currently selling for Rs. 800 the
current yield can be calculated as
= 120/ 800100
= 15%
The current yield can be higher than the coupon rate when the bond is selling at a discount
the current yield would be lower than the coupon rate for a bond setting at a premium. The
annual yield current yield measures the annual return accruing to a bondholder who
purchases the bond from the secondary market and sell it before maturity presumably at the
same price he bought the bond. It doesnt measure the entire returns accruing from a bond
held till maturity.
Spot Interest Rate
Zero coupon bonds are special type of bond which does not pay annual interests. The
returned on this bond is in the form of a discount on issue of the bond
For Example:

A two year bond of face value Rs. 1000 may be issued at a discount for Rs. 797.19. The
investor who purchases this bond for Rs. 797.19 now would receive Rs. 1000 two years later.
This kind of bond is also called pure discount bond or deep discount bond. The return
received from the zero coupon bond or a pure discount bond expressed on an annualized
basis is the spot interest rate. Spot interest rate is the discount rate that makes the present
value of the single cash inflow to the investor equal to the cost of the bond. Thus, in case of
two years bond of face value Rs. 1000, issued at a discount for Rs. 797.19
797.19= 1000/ (1+k)2
K=0.12 or 12%
Therefore the spot interest rate is 12% p.a. this is an annual rate.
Yield to Maturity (YTM)
This is the most widely used measure of return on bonds. It may be defined as the
compounded rate of return an investor is expected to receive from a bond purchased at the
current market price and held to the maturity. It is the internal rate of return earned from
holding a bond till maturity.
YTM depends upon the cash outflow for purchasing the bond this is the cost or current
market price of the bond as well as cash inflow from the bond namely the future interest
payments and the terminal principal repayment. YTM is the discount rates that make the
present value of cash inflows for purchasing the bond.
PD /Years

Y= C + ( maturity
( Po+ F ) /2
Y= yield to maturity
C= coupon interest rate
P=Perimeter
D= Discount
Po= Present value
F= Face Value

For Example
A four year bond with 7% coupon rate and maturity value of Rs. 1000 is currently selling at
2.905 what is its yield to maturity? Given Pv @10% 0.909, 0.826, 0.751, 0.683
Years

cash flow

Pv @ 10%

Pv of cash flow

70(10007%)

0.909

63.63

70

0.826

51.82

70

0.751

52.57

1070

0.683

730.81

Total

904.83

PD /Years

Y= C + ( maturity
( Po+ F ) /2

=70+

95/4.1
1000
(904.83+
)
2

=93.75/1404.83
=0.0667
Yield to Call (YTC)
Some bonds may be redeemable before their full maturity period either at the option of the
issuer or of the investor. Such option would be exercisable at a specified period at a specified
price. If the option is exercised the bond would be called for redemption at the specified call
price on the specified call date.
For Example
A company may issue a 15 year bonds which can be redeemed at the end of five years at the
option of either the issuer or the investor at a premium of 5% on face value. There are two
ways to calculate yield on bonds that is yield on maturity that is after 15 years and yield on
call that is after 5 years. The yield to call is computed on the assumption that the bonds cash

inflow is terminated at the call date with the redemption of the bond at the specific call price.
If the yield to call is higher than the yield to maturity it would be advantageous to the investor
to exercise the redemption option at the call date and if the yield to maturity is higher it
would be better to hold the bond till final maturity.

***Introduction
A bond is a debt investment in which an investor loans money to an entity (typically
corporate or governmental) which borrows the funds for a defined period of time at a variable
or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign
governments to raise money and finance a variety of projects and activities. Owners of bonds
are debtholders, or creditors, of the issuer.

Pricing Of Bonds
All investments, including bonds and shares, derive value from cash flow they are expected
to generate. Because the cash flow will be received over future periods, there is a need to
discount these future cash flows to derive present value or price of the security. In the general
terms, the theoretical price of any security can be established as the present value of a future
stream of cash flows, as described by the following formula
n

Po =

CFt
( 1k
)t
1=t

The model indicates that the present value or, alternatively, current price Po of a security is
the cash flow (CF) received over the time horizon n, discounted back at the rate k
The value of a bond is equal to the present value of its expected cash flows. The cash flow
from a bond consist of the annual or semi-annual interest payments as well as the principal
repayment at maturity. In the case of a bond, these cash flows as well as time period over
which these flows occur are known. These cash flows have to be discounted at appropriate
discounted rate to determine the present value. The present value calculations are made with
the help of the following equation:
It
MV
+
( 1+ k ) t
( 1+k ) n
Po =

t=1

Where
Po = Present value of the bond

lt = Annual interest payments

MV = Maturity value of the bond
n = Number of years to maturity
k = Appropriate discount rate
For using the above equation, the appropriate discount rate has to be determined. The current
market interest rate which investors can earn on other comparable investments is the proper
discount rate to be used in the present value model.
Let us consider an example. A bond of face value Rs. 1000 was issued 5 years ago at a
coupon rate of 10 per cent. The bond had a maturity period of 10 years and as of today,
therefore, five more years are left for final repayment at par. If the current market interest rate
is 14 per cent, the present value of the bond can be determined as follows:
RS . 100
Rs .1000
+
( 1.14 ) t
( 1.14 ) 5
Po =

t =1

= (100 * PV factor for 5 years annuity at 14 per cent) + (1000 * PV factor at 14 per cent for 5
years)
= (100 * 3.4331) + (1000 * 0.5194)
= 343.31 + 519.40
= Rs. 862.71
Most bonds pay interest at half yearly intervals. Where interest payments are semi-annual, the
PV equation has to be modified as follows:
It /2
MV
+
( 1+ k /2 ) t ( 1+k /2 ) 2 n
Po =

2n

t =1

Assuming semi-annual interest payments in the above example, the value of the bonds can be
determined as shown below:
Rs .50
Rs .1000
+
( 1.07 ) t
( 1.07 ) 10
Po =

10

t=1

= 859.48

BOND PRICING THEOREMS

Bonds are generally issued with a fixed rate of interest known as the coupon rate. This is
calculated on the face value of the bond and remains fixed till maturity. At the time of issue
of the bond its coupon rate will generally be equal to the prevailing market interest rate. As
time passes, the market interest rate may change either upwards or downwards. If the current
market interest rate rises above the coupon rate of a bond, the bond provides a lower return
and hence, becomes less attractive. The price of the bond declines below its face value. This
can be seen in the example considered above. The current market interest rate (14%) is higher
than the coupon rate of 10 per cent. The price of the bond is below its face value.
If the market interest rate declines below the coupon rate, the bond price will increase and the
bond will begin to be sold at a premium on its face value. Thus, bond prices vary inversely
with changes in market interest rates. The amount of price variation necessary to adjust to a
given change in interest rates is a functionof the number of years to maturity. In the case of
long-maturity bonds, a change in market interest rate results in a relatively large price change
when compared to a short-maturity bond. In other words, the long-term bond is more
sensitive to interest rate changes than the short-term bonds, i.e. the long-term bonds generally
have greater exposure to interest rate risk.
The relation between bond prices and changes in market interest rates have been stated by
Burton G. Malkiel in the form of five general principles. These are known as Bond pricing
theorems. They explain the bond pricing behaviour in an environment of changing interest
rates.
The five principles are:
1. Bond prices will move inversely to market interest changes.
2. Bond price variability is directly related to the term to maturity; which means, for a given
change in the level of market interest rates, changes in bond prices are greater for longerterm maturities.
3. A bonds sensitivity to changes in market interest rate increases at a diminishing rate as the
time remaining until its maturity increases.
4. The price changes resulting from equal absolute increases in market interest rate are not
symmetrical, i.e. for any given maturity, a decrease in market interest rate causes a price
rise that is larger than the price decline that results from an equal increase in market
interest rate.
5. Bond price volatility is related to the coupon rate, which implies that the percentage
change in a bonds price due to a change in the market interest rate will be smaller if its
coupon rate is higher.
These theorems were derived and proven from the basic bond pricing equation.

YIELD CURVE
The bond portfolio manager is often concerned with two aspects of interest rates - the interest
rate level and the term structure of interest rates. The relationship between the yield and time

or years to maturity is called the term structure. The term structure is also known as yield
curve. In analysing the effect of maturity on yield and all other influences are held constant.
Usually, pure discount instruments are selected to eliminate the effect of coupon payments.
The selected bonds should not have early redemption features. The maturity dates are
different, but the risks, tax liabilities, and redemption possibilities are similar.
The general perception is that the curve will be upward moving up to a point and then
become flat. This is shown in Figure below:

There are at least three competing theories that attempt to explain the term structure of
interest rates the expectation theory, the liquidity preference theory and the preferred habitat
or segment theory.

A rising yield curve (a) indicates investors expectations of a continuous rise in interest rates.
A flat yield curve (b) means that investors expect the interest rate to remain constant. A
declining yield curve (c) shows that investors expect the interest rate to decline.

** BOND DURATION

Duration is the weighted average measure of a bonds life. The various time periods in which
the bond generates cash flows are weighted according to the relevant size of the present value
of those flows.
The equation consists of setting out the series of cash flows, discounting them and
multiplying each discounted flow by the time period in which it occurs. The sum of these
cash flows is then divided by the price of the bond obtained using the present value model.
The formula for calculating duration may be expressed in a format as follows:

t =1

( t ) (Ct )
(1+ k ) t

D= ___________________
n

t =1

Ct
(1+ k ) t

Where
ct = Annual cash flow including interest and repayment of principal.
n = Holding period.
k=Discount rate which is the market interest rate.
t =The time period of each cash flow.

CONVEXITY
A bonds price and yield are inversely related. The rise in bond prices would cause a fall in
yield and vice versa. The quantum increase in the bonds price for a given decline in the yield
is higher than the decline in bonds price for a similar amount of increase in the bonds yield.
It is not linear in nature. This relationship is often referred to as convexity. The convexity
concept is applicable to all types of bonds. The degree of convexity differs from bond to

bond depending upon the size of the bond, the years of maturity , and the current market
price.

Immunization
Immunization is a technique that allows the bond portfolio holder to be relatively certain
about the promised stream of cash flows. The bond interest rate risk arises from changes in
the market interest rate. The market rate affects the coupon rate and the price of the bond. In
the immunization process, the coupon rate risk and the price risk can be made to offset each
other. Whenever there is an increase in the market interest rate, the price of the bonds falls. At
the same time, the newly issued bonds offer higher interest rates. The coupon can be
reinvested in the bonds offering higher interest rate and losses that occur due to the fall in the
price of the bond can be offset and the portfolio is said to be immunized.
The process: The bond portfolio manager or investor has to calculate the duration of the
promised outflow of the funds and invest in a portfolio where the bonds have identical
durations. The bond portfolio duration is the weighted average of the durations of the
individual bonds in the portfolio. For example, if an investor has invested an equal amount of
money in three bonds, namely A,B and C with durations of two, three, and four years
respectively, then the bond portfolio duration is
D= 1/3 *2+1/3*3+4*1/3
=0.66+1+1.33
D=2.99(or) three years
The bond manager can offset the interest rate and price risks by matching the outflow
duration with cash inflow duration from bond investment. The portfolio of money to be
invested between the different types of bonds also can be found by using the following
equation:
Investment outflow = (x1 * duration of bond 1) + (x2 *duration of bond 2)
Where x1,x2 refer to the proportions of investment in bond 1 and 2.

***

1. INTRODUCTON:
Dividend discount models are the first type of discounted cash flow models. The model
simply discounts cash flows at a given rate just like any other DCF model. The difference lies
in the fact that dividend discount models consider only dividends as being legitimate cash
flows.Therefore, if a firm pays no dividends at all, this model cannot be applied to the firm
regardless of how profitable or cash flow efficient its operations are. This is one of the most
popular models used to value businesses worldwide.
2. SHARE VALUATION MODEL:
The valuation model used to estimate the intrinsic value of a share is the present value model.
The intrinsic value of a share is the present value of all future amounts to be received in
respect of the ownership of that share, computed at an appropriate discount rate.
The major receipts that come from the ownership of a share are the annual dividends and the
sale proceeds of the share at the end of the holding period. These are to be discounted to find
their present value, using a discount rate that is the rate involved and the investors other
investment opportunities. Thus, the intrinsic value of a share is the present value of all future
benefits expected to be received from that share.
3. DIVIDEND DISCOUNT MODEL:
A procedure for valuing the price of a stock by using predicted dividends
and discounting them back to present value. The idea is that if the value obtained from the
DDM is higher than what the shares are currently trading at, then the stock is undervalued.
Dividend discount models are as follows:
3.1One Year Holding Period
It is easy to start share valuation with one year holding period assumption. Here an investor
intends to purchase a share now hold it for one year and sell it off at the end of one year. In
this case, the investor would expected to receive an amount of divided as well as selling price
after one year. The present value of the share may be expressed as:

So

( 1+k )

D1

( 1+k )

D2

Where
D1=Amount of divided expected to be received at end of year.
S1=Selling price expected to be realize on sale of the share at end of year.
K=Rate of return required by the investor.

For example, if an investor expects to get Rs. 3.50 as dividend from a share next year and
hopes to sell off the share at Rs. 45 after holding it for one year and if his required rate of
return is 25 per cent, the present value of this share to the investor can be calculated as
follows:
So = 3.50

45
(1.25)1

(1.25)

+ Rs. 2.80 + Rs. 36 = RS. 38.80

This is the intrinsic value of the share. The investor would buy this share if its current market
price is lower than value.

3.2 Multiple-Year Holding Period

An investor may hold a share for a certain number of years and sell it off at the end of his
holding period. In this case, he would receive annual dividends each year and the sale price of
the share at end of the holding period. The present value of the share may be expressed as:

So

( 1+k )

D1

2
2

( 1+k )
( 1+k )
+

D2
D3

+ ... +

( 1+k )

Dn+ Sn

D1 ,D2, D3......, Dn = Annual dividends to be received each year.

Sn = Sale price at end of the holding price.
K = Investors required rate of return.
N= Holing period in years.

For example, if an investor expects to get Rs 3.50, Rs. 4.50 as dividend from a share during
the next three years and hopes to sell it off at Rs. 75 at the end of third year, and if his

required rate of return is 25 per cent, the present value of this to the investor can be calculated
as follows:

So= 3.50

(1.25)1

4.00

(1.25)2

4.50

(1.25)3

2.80+2.56+2.30+28.40

Rs. 46.06

75
(1.25)3

In order to use the present value model for share valuation, the investor has to forecast the
future dividends as well as the selling price of the share at end of holding period. It is not
possible to forecast these variables accurately. Hence, this model is practically infeasible.
Modification of this model has been developed to render it useful for practical purposes of
stock valuation.
3.3 Constant Growth Model
In this model, the basic assumption is that dividends will grow at same rate (g) into an
indefinite future.
Po = D(1+g)

D(1+g)2 +

1+r(1+r)2(1+r)3

D(1+g)3

D(1+g)N

(1+r)n

When the period approaches to infinity the equation takes the form

Po = D1
r-g
Po = Present value of the stock
r

= required rate of return

=Growth rate

D1 =Next year dividend

This model is based on the following assumption:

The firms dividend policy will be stable.

The firm will earn a stable return over time.

This model is applicable when the analyst able to predict all the three variables in the
equation, name (1)Next years dividend (2) the firms long-term growth rate, and (3)
the required rate of return of the investor. Once the three values are known to the
analyst, the theoretical value or the present value of stock can be computed and
compared with prevailing price.
Theoretical value > Actual price=buy
Theoretical value<Actual price=sell
Another advantage of this model is that with the present selling price, the next years
dividend and growth rate as well as the rate of return of stock can be estimated.
Present rate return>Required rate of return=buy
Present rate of return<Required rate of return=sell
3.4 Two Stage Growth Model/ Multiple Growth Model.
The constant growth assumption may not be realistic in many situations. The growth in
dividends may be at varying rates .A typical situation for many companies may be that a
period of extraordinary growth (either good or bad) will prevail for certain number of
years, after which growth will change at a level at which it is expected to continue
indefinitely. This situation can be represented by two stage growth model.
The constant growth model is extended to two stage growth model. Here the growth stage
is divided into two, namely a period of extraordinary growth (or decline) and a constant
growth period of infinite nature. The extraordinary growth period will continue for some
period followed by the constant growth rate. The information technology industry is at
present experiencing an extraordinary growth rate. And this may continue for some time
afterwards, it may maintain constant growth rate.
Present value of dividend during the above
The present value of the stock or price =
Present value of stock price at the end of the
Above normal growth period
r
1
( 1+r s ) N
D o ( 1+ g s ) t D N +1
+
( 1+rs ) t

( sgn )

Po

t=1

normal growth period

Do=Dividend of the previous period

Gs=above normal growth rate
Gn=normal growth rate.
Rs=required rate return
N=Period of above normal growth