BOND VALUE

Determination of the fair price of a bond. Theoretical Fair value of bond Present value of stream of cash flows it is expected to generate. Price of a bond is the sum of the present values of all expected coupon payments plus the present value of the par value at maturity.

There are 3 types of prices :

1) Premium - If the bond's price is higher than its par value, it will sell at a premium because its interest rate is higher than current prevailing rates. 2) Discount - If the bond's price is lower than its par value, the bond will sell at a discount because its interest rate is lower than current prevailing interest rates. 3) At Par - A bond that trades at par will have a yield equal to its coupon, and investors will expect a return equal to the coupon for the risk of lending to the bond issuer. Bonds are quoted at 100 when trading at par.

4 approaches to calculating price of a bond.

1) Present value approach :

Where

F = face value iF = contractual interest rate C = F * iF = coupon payment (periodic interest payment) N = number of payments i = market interest rate, or required yield, or yield to maturity M = value at maturity, usually equals face value P = market price of bond

2) Relative price approach

3) Arbitrage-free pricing approach 4) Stochastic calculus approach

Where

Et is the expectation with respect to risk-neutral probabilities R(t,T) is a random variable representing the discount rate

Annual rate of interest

Where,
C = coupon payment n = number of payments i = interest rate, or required yield M = value at maturity, or par value

Semiannual rate of interest.

Valuing bonds that pay interest semiannually involves three steps:

1. Determine the Number of Coupon Payments

2. Determine the Value of Each Coupon Payment: Because the coupon payments are semi-annual, divide the coupon rate in half. The coupon rate is the percentage off the bond's par value 3. Determine the Semi-Annual Yield: Like the coupon rate, the required yield must be divided by two because the number of periods used in the calculation has doubled.

Example : Calculate the price of a bond with a par value of $1,000 to be paid in ten years, a coupon rate of 10%, and a required yield of 12%. In our example we'll assume that coupon payments are made semiannually to bond holders and that the next coupon payment is expected in six months.

Calculating Bond price for any payment frequency.

Where, F - frequency of coupon payments, or the number of times a year the coupon is paid.

BOND YIELD
It is the rate of return on the bond, which takes into account the sum of the interest payment, the redemption value at the bonds maturity, the initial purchase price of the bond. There are many types of yields: Current Yield - The current yield calculates the percentage of the return that the annual coupon payment provides to the investor. It calculates the percentage of the actual dollar coupon payment is of the price the investor pays for the bond. This can be easily found by dividing the bonds coupon yield by its market price. Coupon Yield - The annual interest rate established when the bond is issued.

Yield to Maturity This is the return that the investor will receive from their entire investment in the bond. Yield to Call Yield to call (YTC) is the interest rate that the bond holders would receive if they held the bond until the call date. The call date is the date on which a bond may be redeemed by the issuer before the bonds maturity. If this happens, the bond will be redeemed at par or a higher value. Yield to Worst This is the lowest calculated rate that the bond holder will receive upon maturity or call date. It is typically calculated by conservative investors to determine the worst case scenario.

Yield is calculated using the following formula:

Yield = coupon amount / price

When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield. Example. If you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000). But if the price goes down to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200).

The modified current yield formula takes into account the discount or premium at which the investor bought the bond.

Now for example, if you purchased a bond with a par value of $100 for $95.92 and it paid a coupon rate of 5%, this is how you'd calculate its current yield normally -

Re-calculating the yield of the bond in our first example, which matures in 30 months and has a coupon payment of $5 , we get -

The adjusted current yield of 6.84% is higher than the current yield of 5.21% because the bond's discounted price ($95.92 instead of $100) gives the investor more of a gain on the investment.

Yield to Maturity
Yield to maturity (YTM) measures the annual return an investor would receive if he or she held a particular bond until maturity YTM of a bond is the interest rate that makes the present value of the cash flows receivable from owning the bond equal to the price of the bond

P = price of the bond n = number of periods C = coupon payment r = required rate of return on this investment F = maturity value t = time period when payment is to be received

Suppose your bond is selling for $950, and has a coupon rate of 7%; it matures in 4 years, and the par value is $1000. What is the YTM? The coupon payment is $70 (that's 7% of $1000), so the equation to satisfy is 2.70(1 + r)-1 + 70(1 + r)-2 + 70(1 + r)3 + 70(1 + r)-4 + 1000(1 + r)-4 = 950

Approximation Approach
The computation of YTM requires a trial and error procedure If you are not inclined to follow the trial and error approach, we can use linear interpolation to approximate the YTM at which present value equals the market price of the bond

YTM = C+(M-P)/n 0.4M+0.6P

YTM = approx. YTM value C = annual interest payment M = maturity value of bond P = present price of the bond N = years to maturity

Realised Yield to Maturity

The assumption that cashflows received are reinvested at a rate equal to YTM may not be valid Realised YTM necessitates defining the future investment rates

Par value of bond = Rs. 1000 Interest rate = 15% Maturity = after 5yrs Present Market price = Rs. 850 Reinvestment rate = 16%

The future value of the benefits receivable from this bond works out to Rs. 2032

Then the Realised YTM is r* in the following equation:

Present market price x (1+r*)5 = Future value 850 (1+r*)5 = 2032 (1+r*)5 = 2032/850 r* = 0.19 = 19%

Relationship between yield and price

Inverse Relationship Yield decreases present value of cash flow increases price increases

PRICE

YIELD

Relationship between yield and price

curvature of this graph convexity signifies the sensitivity of the yield of the bond to its price allows you to compare different bonds higher convexity

less sensitive to changes in interest rates When interest rates fall or rise will have a higher price

YIELD CURVE

The yield curve is the graph between the yields to maturity of different bonds and their respective time to maturity. The term structure of interest rates The slope, shape, and level of yield curves may vary over time with changes in interest rates help you assess bond market investments get an idea of what the market feels about future interest rates

Slope, shape & shifts

slope -the direction of future short-term interest rates

upward sloping curve - financial markets expect higher future interest rates downward sloping - expectations of lower rates in the future.

shape-clues to future interest rate movements

a humped curve indicating that short-term rates (over the next year) are expected to rise, but that over the long-run (several years) rates are expected to fall.

The overall level of the yield curve also may shift up or downat least in part because of changes in inflationary expectations over time.

There are three major types of yield curves that are observed in different economic scenarios

Normal Yield Curve

an increasing pattern it gets flatter as it moves towards right investors associate a higher risk with long term bonds, which results in higher yields The market sentiment is normal expectation of some growth no major risks on the horizon

Inverted Yield Curve

downward sloping curve yields for bonds with short term maturities are lower than those of long term bonds indicates that the market believes interest rates will soon go down

Flat Yield Curve

yields for bonds with short term and long term maturities are very similar market is uncertain never stays for a long time

Yeild to Maturity and Default risk

Corporate bonds are subject to default risk.the stated or promise YTM will be realised only if the issuing firm meets al the obligation on the bond issue.The expected YTM,however takes into account the possibility of a default

Yield to maturity versus Holding Period Returns

The YTM is the single discount rate at which the present value of payment reeived from the bond equals its price.it represent the average rate of return from the bond over a given holding periios as a percentage of its price at beginning of the period

Call Options on Bonds

Many bonds include a call feature that allows the issuer to redeem or call all or part of the issue before the maturity date. The call option has value to the issuer for several reasons. In the future the borrower may wish to remove restrictions placed on him by the bond indenture. For a corporation these might be restrictions on merger, the sale of assets, or the payment of dividends.

Without the call provision, the bondholders might be able to utilize their monopoly position to extract a large premium from the issuer before selling back the bonds or agreeing to change these clauses. A second source of value is that the borrower may find that he wants to decrease the amount of his borrowing before the bonds mature.

The same effect as retiring his own bonds could be obtained by buying on the market similar bonds issued by someone else. However, because of the transaction costs involved in making interest payments, the cost of bonds to the issuer will always be somewhat greater than their value on the market. There will therefore be some saving to the issuer in retiring his own bonds rather than buying someone elses.

The third and probably most significant source of value of the option to the issuer is the ability it gives him to refinance the issuer in the future if interest rates should fall. This implies three risks from the investor: (a) The cash flow pattern becomes uncertain; (b) The investor becomes exposed to reinvestment risk because the issuer will call the bond when interest rates drop; (c) The capital appreciation potential of a bond will be reduced, because the price of a callable bond may not rise much above the price at which the issuer will call the bond.

Yield to Call

The rate of return that an investor would earn if he bought a callable bond at its current market price and held it until the call date given that the bond was called on the call date. Call Date : For bonds which are callable, i.e., bonds which can be redeemed by the issuer prior to maturity, the call date represents the date at which the bond can be called.

Call Price : The amount of money the issuer has to pay to call a callable bond. When a bond first becomes callable, i.e., on the call date, the call price is often set to equal the face value plus one year's interest.

YTC can be calculated in 2 ways: Semi-annual calculation Annual calculation