Valuation of fixed-income securities

Responsible teacher: Anatoliy Malyarenko

November 19, 2003
Abstract
Contents of the lecture:
Bonds.
Linear systems.
Examples and problems.

Fixed-income securities
Fixed-income securities are debt instruments which do not imply any ownership of a firm
on the part of the buyer.
Example: the simple fixed-coupon bond. It is characterised by the next parameters:

The settlement date.

The maturity date.
The period.
The basis.
The end-of-month rule.
The issue date.
The first coupon date and last coupon date.

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Terminology
The settlement date of a bond is the date when money first changes hands; i.e., when
a buyer pays for a bond. It need not coincide with the issue date, which is the date a bond is
first offered for sale.
The first coupon date and last coupon date are the dates when the first and last coupons
are paid, respectively. Although bonds typically pay periodic annual or semiannual coupons,
the length of the first and last coupon periods may differ from the standard coupon period.
The maturity date of a bond is the date when the issuer returns the final face value, also
known as the redemption value or par value, to the buyer.
The period of a bond refers to the frequency with which the issuer of a bond makes
coupon payments to the holder.
Period Value

0
1
2
3
4
6
12

Payment Schedule
No coupons. (Zero coupon bond.)
Annual
Semiannual
Tri-annual
Quarterly
Bi-monthly
Monthly
Table 1: Period of a bond

The basis of a bond refers to the basis or day-count convention for a bond. Basis is
normally expressed as a fraction in which the numerator determines the number of days
between two dates, and the denominator determines the number of days in the year. For
example, the numerator of actual/actual means that when determining the number of days
between two dates, count the actual number of days; the denominator means that you use the
actual number of days in the given year in any calculations (either 365 or 366 days depending
on whether or not the given year is a leap year).
The end-of-month rule affects a bonds coupon payment structure. When the rule is in
effect, a security that pays a coupon on the last actual day of a month will always pay coupons
on the last day of the month. This means, for example, that a semiannual bond that pays a
coupon on February 28 in non-leap years will pay coupons on August 31 in all years and on
February 29 in leap years.

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The simple fixed-coupon bond: example

For instance: given a face value of $100, a maturity of five years and semiannual
payment, a coupon rate of 8% implies that we will receive a payment of $4 every six months
and a final payment of $104.
We see that when we buy a bond, we actually buy a cash flow. The term foxed income
stems from the fact that in simple bonds the cash flow is fixed and known from the beginning (at
least if we assume that the issuer will not default). Since there is a well-developed secondary
market for bonds, there is no need to buy a bond right when it is issued, nor to keep it to
maturity.

The basic problems

There are two basic problems one has to deal with:

Valuing bonds, i.e., determining a fair price for them.

Managing a portfolio of bonds, shaped according to ones particular needs.

Valuing bonds
Let t0 , t1 , . . . , tn and C0 , C1 , . . . , Cn be a cash flow of the bond. The present value of
this cash flow can be calculated as (Lecture 5)

P=

n
X
k=0

Ct
k
.
t
(1 + r) k t0

(1)

What rate r should we use in pricing? If the bond is default-free, as in the case of government
bonds, this should be the prevailing risk-free interest rate, no more, no less. To see why, we
may use a common principle in finance, i.e., the no-arbitrage principle.

The no-arbitrage principle

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Consider a zero-coupon bond, with a face value F , a maturity of one year, and a price P
on the issue date. According to (1) we have

P=

F
.
1+r

Assume that the bond is underpriced, i.e., it sells for a price P1 such that

P1 < P =

F
.
1+r

and that we may take out a loan at the risk-free interest rate r. Then we can borrow an amount
L and use it to purchase L/P1 bonds. Then, at maturity, we must pay L(1 + r) to our money
lender, and we get an amount FL/P1 when the face value is refunded for each bond. The
cash flow at maturity will be

!
F
F
L(1 + r) = L
1 r > 0.
L
P1
P1
Hence, we pay nothing in the beginning and receive a positive amount in the future. This is
what is called arbitrage.
Assume that the bond is overpriced:

P1 > P =

F
.
1+r

In this case we should borrow the bond itself rather than the cash needed to buy it. Let us
assume that we borrow bonds for a total value L, we sell them at price P1 and we invest the
money we obtain. At maturity, we get L(1+r) from our investment, and we have to pay the face
value F to the owner for each bond that we have borrowed. Hence the cash flow at maturity is
again positive:
!

F
F
+ L(1 + r) = L
+ 1 + r > 0.
P1
P1

We value bond by (1). There exist no computational problems.

The yield of a bond

Definition 1. The yield of a bond is the internal rate of return of the bonds cash flow.
The price-yield curve is the relationship between the yield and the price of a bond.

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Priceyield curve

1600

1400

bond price

1200

1000

800

600

400

200

0.02

0.04

0.06

0.08
0.1
0.12
yield = internal rate of return

0.14

0.16

0.18

0.2

The price approximation

The price-yield curve is relatively complicated, because the yield is the solution to a nonlinear equation. We want to find a way to approximate the change in price with respect to a
change in yield.
Recall Taylors formula:

1
P() P(0 ) + P0 (0 )( 0 ) + P00 (0 )( 0 )2 .
2
Introduce the notation:

D=

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P0 ()
,
P()

C=

P00 ()
.
P()

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Now we have

1
P() P(0 ) DP(0 )( 0 ) + P(0 )C( 0 )2 .
2
D is the duration of a bond, C is the bonds convexity.

Managing a portfolio of bonds: example

Example 1. Three different kinds of bonds are available on the market. We want to construct
a bond portfolio with D = 9 and C = 110.
Maturity
Coupon rate
Yield

Bond 1

Bond 2

Bond 3

30.06.07
0.06
0.062

30.09.12
0.05
0.056

30.03.18
0.06
0.061

Both the duration and the convexity of the portfolio can be computed as weighted
combinations of the corresponding bond characteristics. Strictly speaking, this is not true
in general, but can be considered as a simple approximation.
Let C j and D j denote the bond durations and convexities, respectively (1 j 3).
Then

D1 w1 + D2 w2 + D3 w3 = D
C 1 w1 + C 2 w2 + C 3 w3 = C

w1 +
w2 +
where w j denotes the weight of the jth portfolio.

(2)

w3 = 1,

MATLAB program
% File: immunisation.m
% Immunisation of bond portfolio
% Author: Anatoliy Malyarenko
% e-mail: [email protected]
settle=19-Sep-2002;
maturities = [30-Jun-2007
30-Sep-2012
30-Mar-2018];
couponRates = [0.06; 0.05; 0.06];

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yields = [0.062; 0.056; 0.061];

% Compute durations and convexities
durations = bnddury(yields,...
couponRates,...
settle,...
maturities);
convexities = bndconvy(yields,...
couponRates,...
settle,...
maturities);
% Compute portfolio weights
A = [durations
convexities
1 1 1];
b = [9
110
1];
weights = A\b;
% Show the results
disp( );
disp(Portfolio 1 Portfolio 2 Portfolio 3);
disp( );
disp(sprintf(%6.4f

%6.4f

%6.4f, weights));

And the answer is

Portfolio 1

Portfolio 2

Portfolio 3

0.0014

0.3228

0.6758

Left and right division in MATLAB

Recall that the matrix A1 is called the inverse to the matrix A if

AA1 = A1 A = I,
where I denotes the identity matrix.

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MATLAB

Mathematics

A\B
A/B

A1 B
AB1

Equation (2) can be rewritten as

Aw = b.
Multiply both hand sides by A1 from the left. We obtain

w = A1 b.
Thats why we used left division.

Problems
1. Today is September 19, 2002. Three bonds are available on the market (Table 2). Find
weights for a bond portfolio with duration 10 years and convexities from 150 to 160 with
step 0.1. Show your results graphically.
2. (For pass with distinction). Today is September 19, 2002. Three bonds are available on
the market (Table 3). Find weights for a bond portfolio with duration 10 years convexities
from 145 to 155 with step 0.1. Show your results graphically. Hint. For information
on quoted and purchase prices see Financial Toolbox, p. 2-21. Use MATLAB function
bndyield from Financial Toolbox.

Maturity
Coupon rate
Yield

Bond 1
15.06.2015
0.07
0.059

Bond 2
1.03.2025
0.08
0.075

Bond 3
1.03.2020
0.06
0.049

Table 2: Available bonds, problem 1

Maturity
Coupon rate
Face value
Quoted price

Bond 1
1.03.2025
0.08
250
264.00

Bond 2
15.01.2013
0.08
100
108.36

Bond 3
1.08.2017
0.075
200
232.07

Table 3: Available bonds, problem 2

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