BOND VALUATION

THEOREMS
Introduction
A bond is a loan, typically made by investors to
a corporation or government.
The value of a bond depends upon three factors
:-
1.Coupon Rate
2. Years to Maturity
3. Expected yield to Maturity (or) Required
Rate of Return.
On the basis of this Bond Valuation theorems
have been evolved.
Characteristics of Bond Prices
The cash flows on a bond are constant
(fixed income).

A bonds market price changes in response
to the market interest rate.
When market rates increase, the fixed
payments from the bond are worth less so the
price falls.
If rates decrease, the fixed payments are now
worth more.

Example - Annual Coupon
4
1000 10 year bond paying a 10% annual coupon

What is the value when the interest rate is 10%?




If r = 11%?


If r = 9%?
00 . 1000
) 10 . 1 (
1000
) 10 . 1 (
1
1
10 .
100
10 10
0
= +
(

= B
11 . 941
) 11 . 1 (
1000
) 11 . 1 (
1
1
11 .
100
10 10
0
= +
(

= B
18 . 1064
) 09 . 1 (
1000
) 09 . 1 (
1
1
09 .
100
10 10
0
= +
(

= B
Bond Theorems
Price and interest rates move inversely.
A decrease in interest rates raises bond
prices by more than a corresponding
increase in rates lowers price.
Price volatility is inversely related to
coupon.
Price volatility is directly related to
maturity.
Price volatility increases at a diminishing
rate as maturity increases.
THEOREM 1
If the market price of the bond increases, the yield
would decline and vice versa.

MARKET PRICE YIELD


MARKET PRICE YIELD
Bond A Bond B
Par Value Rs. 100 Rs.100
Coupon Rate 10 % 10 %
Maturity Period 2 yrs 2 yrs
Market Price Rs.874.75 Rs.1035.66
Yield 18 % 8 %
Illustration of Bond Theorems
A decrease in interest rates raises bond prices by more than a
corresponding increase in rates lowers price. This is known as
convexity.

$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
4% 6% 8% 10% 12% 14% 16%
Interest Rate
B
o
n
d

P
r
i
c
e
30 yr, 15%
30 yr, 10%
20 yr, 10%
10 yr, 10%
30 yr, 5%
Illustration of Bond Theorems
Price volatility is inversely related to
coupon.

-40%
-20%
0%
20%
40%
60%
80%
100%
4% 6% 8% 10% 12% 14% 16%
Interest Rate
P
r
i
c
e

V
o
l
a
t
i
l
i
t
y

(
|
%

C
h
a
n
g
e

f
r
o
m

p
a
r
|
)
30 yr, 5%
30 yr, 10%
30 yr, 15%
Illustration of Bond Theorems
Price volatility is directly related to
maturity.

0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
4% 6% 8% 10% 12% 14% 16%
Interest Rate
P
r
i
c
e

V
o
l
a
t
i
l
i
t
y

(
|
%

C
h
a
n
g
e

f
r
o
m

p
a
r
|
)
30 yr, 10%
20 yr, 10%
10 yr, 10%
Illustration of Bond Theorems
Price volatility increases at a diminishing
rate as maturity increases.


Illustration of Bond Theorems
0%
20%
40%
60%
80%
100%
120%
140%
160%
180%
200%
0 5 10 15 20 25 30
Years to Maturiy
P
e
r
c
e
n
t
a
g
e

P
r
i
c
e

C
h
a
n
g
e
5% Interest Rate
10% Interest Rate
15% Interest Rate
Duration Theorems: A Summary
I. The duration of a zero coupon bond always equals its
time to maturity.

II. The lower the coupon rate the longer the duration,
other things held constant.

III. The longer the maturity, the longer the duration, other
things held constant.

IV. The lower the yield to maturity, the longer the
duration, other things held constant

THANK YOU