Fixed Income Analytics

Girish Hisaria
Debt Valuation
Basic Concept 14
 Features of debt securities
 Risk associated with Debt Securities
 Overview of Bond sector
 Understanding yield Spread

Analysis and Valuation 15

 Introduction to valuation
 Yield measures, spot rates and forward rates

Introduction to measurement of Interest rate Risk
Features of Debt Securities
Features of Debt Securities.
Instrument Features.
Maturity
Coupon
Principal.
Modifying the coupon of Bond (ZC, STRIPS, FRB,
other variations-Step up, step down, extendable reset
bond etc.
Modifying the term to Maturity of a Bond-Callable,
Putable, convertible bonds
Modifying the principal Repayment-Amortizing
Bonds, bonds with Sinking fund provision.
Asset Backed Securities
Indenture and covenants

Bond’s Indenture The contract that specifies specifies

all the rights and obligation of the issuer and the
owner of a fixed income security is called a bonds
indenture. The indenture defines the obligation and
restriction on the borrower and forms the basis for all
future transactions between the bond holder and the
issuer.
These contract provisions are known as “covenants”
and include both negative covenants(prohibition on
the borrower) and affirmative covenants( actions that
the borrower agrees to perform
Accured Interest, Full Price and Clean
Price
Other provisions in Bonds
Redemption-early retirement
Prepayment Options gives the issuer-
borrower the right to accelerate the
principal on a Loan. These options are
present in mortgages and other amortizing
loans.
The significance of prepayment option to
an investor is that there is additional
uncertainty about the cash flows to be
received.
Redemption-early retirement
Call provision gives the right (but not the
obligation) to retire all or a part of an issue prior to
maturity.
Call features gives the issuer the opportunity to
replace higher-than market coupon bonds with
lower coupon issues.
Typically there is a period after issuance during
which the bonds cannot be called-Call protection.
However after the period of call protection has
passed, the bonds are referred as currently
callable.
Redemption-early retirement..

There may be several call dates specified in

the indenture each with a lower call price.
Customarily, when a bond is called on the
first permissible call date, the call is price is
above the par value.
If a bonds are not called entirely, the call
price declines over time according to a
schedule.
Redemption-early retirement..

Nos of Yrs Redemption price

Maturity 20 Yrs 100.00
1st Call 15 Yrs 110.00
2nd Call 10 Yrs 105.00
3rd Call 5 Yrs 100.00
Non-Refundable prohibits the call of an issue the
proceeds from a lower coupon bond issue. Thus a
bond may be callable but not refundable
Redemption-early retirement..
Non-Refundable prohibits the call of an issue the
proceeds from a lower coupon bond issue. Thus a
bond may be callable but not refundable
A bond is that is non-callable has a absolute
protection against a call prior to maturity.
In contrast, a callable but non-refundable bond can
be called for any reason other than refunding.
Various Coupon Structures
Zero Coupon bonds:
Accrual bonds: are similar to ZCB in that they make
no periodic interest payment prior to maturity, but
different in that they are sold originally at par. There
is a stated coupon rate, but the coupon accrues at a
compound rate until maturity. At maturity the par
value plus all the interest that has accrued over the
life of a bond
Step up bonds:
Deferred Coupon bonds:Initially the coupons are
differed and compounded and paid lump sum.
Structures of Floating Rate
Securities
Floating Rate securities are bonds for which
the coupon Interest payments over the life of
the security vary based on a specified interest
rate or index.
These bonds have coupons that are reset
periodically, based on prevailing market
interest rate.
New coupon Rate=Reference rate+- quoted
margin
RISK ASSOCITED WITH
INVESTING IN BONDS
RISK ASSOCITED WITH
INVESTING IN BONDS…
Interest Rate risk
Call Risk.
Prepayment Risk
Yield Curve Risk: arises from the possibility of
changes in the shape of the yield curve, changes in
the shape of the yield curve mean that yield
changes by different amounts for bonds with
different maturities
RISK ASSOCITED WITH
INVESTING IN BONDS…
Re-investment Risk: Investors can be faced with a
choice between reinvestment risk and Price Risk.A non-callable
ZC bond has no reinvestment risk over the life of the bond since
there are no cash flows to invest but a ZC has more interest rate
risk than a coupon bearing bond with the same maturity.
Therefore, the coupon bond will have more reinvestment rate
risk and less price risk
Credit Risk
Liquidity Risk
Exchange Rate Risk
Exchange Rate Risk
RISK ASSOCITED WITH
INVESTING IN BONDS…
Volatility Risk: is present FIS that have
embedded options such as call option, put
option and pre-payment option, changes in
the Interest rate volatility affect the value of
these options and thus affects the value of
securities with embedded options.
Inflation Risk: might be better described as
unexpected inflation risk & more
descriptively as purchasing power risk.
Event Risk.
Relationship Between bonds Coupon Rate,
YTM and Bonds Price

COUPON=YILED  PRICE=PAR VALUE

COUPON<YILED  PRICE<PAR VALUE

COUPON > YILED

 PRICE>PAR VALUE

PAR VALUE PRICE YIELD COUPON

100 100 10.00% 10%
100 90 10.50% 10%
100 110 9.50% 10%
Relationship between bond price and
required yield appears as a negative curve:

 
PRM
                                                                                            

Discount
Affect of Maturity and embedded options on
Interest rate Risk

Maturity: If 2 bonds are identical except for maturity

-long maturity: long duration

-short maturity: Lower Duration.

Coupon : If 2 bonds are identical except for coupon

-High Coupon : Low Duration: Low Risk.
-Lower coupon: High Duration: High risk
Call Feature : limits the upside price movement when interest
rates decline. Bond price will not move above the call price
Put Feature : limits the downside price movement when
interest rates rise . Bond price will not fall below the Put price
Relationship between bond price and
required yield, Coupon, and maturity

Interest Rate Risk Duration

Maturity Up High Up
Coupon Up Down Down
Add Call Option Down Down
Add Put Option Down Down

Maturity & duration: + relation to interest rate risk

Coupon, YTM and P-C: - relation to Int rate risk
 Relationship among the price of a callable bond, price
of option free bond and price of embedded call option

Call
price

As yield falls the difference in price of option free bond and callable bond
increases.
Callable Bond= Value of Option free bond-Value of embedded call option.
Callable and put able bonds are less sensitive to interest rate changes.
Interest rate risk for FRN, why such a security’s
price may differ from par value;

Objective of resetting is to bring the coupon rate in line with the

market yield, so the bond sales at or near par.
This makes price of FRN. Much less sensitive to changes in the
market yield that a fixed coupon of equal maturity.
FRN are less sensitive to interest rate changes.
Shorter Reset Period=lower amount of potential price
fluctuation
Long reset period=greater amount of potential bond price
fluctuation.
The presence of Cap (maximum coupon rate), can increase the
interest rate risk for floating rate security. If the reference rate
increases enough that the cap rate is reached, further increase in
market yields will decrease the value of the floaters price
Duration.
WAM-Portfolio of Individual Bond as well as
Portfolio
Duration-of Individual Bond as well as Portfolio
Modified Duration- of Individual Bond as well as
Portfolio
Maculay Duration
•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.
•The Duration of bond is the weighted average
maturity of its cash flow stream, where the
weights are in proportion to the present value
of the cash-flow.
•The duration measure for bonds is a invention
that allows bonds of different maturities and
coupon rates to be compared directly.
Duration cont…

Duration is the first derivative of a fixed-

income security’s (bond’s)
price with respect to the interest rate.
Therefore, it tells us how the security’s
(bond’s) price changes in interest rates.
Zero-coupon bond – Duration is equal to its time
Duration of a Vanilla or Straight Bond

                                                                                     
Factors Affecting Duration

Duration changes as the coupons are paid to

the bondholder.
As the bondholder receives a coupon payment,
the amount of the cash flow is no longer on
the timeline, which means it is no longer
counted as a future cash flow that goes
towards repaying the bondholder.
Our model of the fulcrum demonstrates this: as the first
coupon payment is removed from the red lever (paid to
the bondholder), the lever is no longer in balance
(because the coupon payment is no longer counted as a

 
future cash flow).

                                                                            

Duration increases immediately on the day a coupon is paid, but

throughout the life of the bond, the duration is continually decreasing
as time to the bond's maturity decreases.
                                                    
Term Cash flow PV Facor PV PV weights Duration
1 10 0.93 9.35 0.0772 0.08
2 10 0.87 8.73 0.0721 0.14
3 10 0.82 8.16 0.0674 0.20
4 10 0.76 7.63 0.0630 0.25
5 10 0.71 7.13 0.0589 0.29
6 10 0.67 6.66 0.0550 0.33
7 10 0.62 6.23 0.0514 0.36
8 10 0.58 5.82 0.0481 0.38
9 10 0.54 5.44 0.0449 0.40
10 110 0.51 55.92 0.4619 4.62
Total 121.07 7.07
Properties of Duration.
For a Zero coupon bond, the duration is
simply equal to the maturity of the
bond.
Other things being equal, higher the
coupon rate shorter is the duration.
Other things being equal,higher the
YTM shorter is the duration.
Interpret the meaning of the duration of a bond, compute
duration, compute approximate price change and
approximate new price of a bond given bond duration

Duration is a measure of the price sensitivity of a bond to

changes in its yield.
Specifically, its an approximation of the % change in the
security price for a 1% change in the yield.
It is the ratio of the % change in the price to a change in
yield in %
Duration = - % change in bond price/yield change in %
Price change when yield increases !

Calculate price change ?

Duration = 5, yield Increases from 7% to 8%, calculate app price
change
% price change = Duration * % change in yield = 5*1%=5%
decrease
Calculate duration ?
Yield rises from 7% to 8% and price falls by 5%.
Duration = % change in price/ % change in yield, 5%/1%=5
Calculate new price ?
MP = 1034.50 YTM = 7.38%, duration = 8.5. If YTM rises to 7.77%,
what is the new price ?
% change in Price = Duration * % change in YTM = 8.5*0.39%=
-3.315%
New price = (1-0.03315)*10.34.50 = 1000.20
Explain why duration does not account for
yield curve risk for a portfolio of bonds ?
The duration for a portfolio has the same interpretation as a single
bond, it is the approximate % change in portfolio value for a 1%
change in yield.
Duration for a portfolio measures the sensitivity of a portfolio’s
value to changes in interest rate.
Changing yield curve shapes lead to Yield curve risk, a risk of fixed
income securities that is not captured by the duration measure
If the yields on all bonds in the portfolio change by the same
absolute % amount we term that as a parallel shift.
For non parallel shift in the yield curve, the yield on different bond
in a portfolio can change by different and duration alone capture
the yield change on the value of this portfolio.
This risk from the decrease in portfolio value from the changes in
the yield curve is termed as Yield curve risk
Factors affecting Reinvestment
Risk of security

Cash Flows are higher

Call Feature
Amortizing Security
Contains Prepayment Options
Explain the disadvantages of a callable or prepay
able security to an investor

Timing of cash flow

Reinvestment risk
Appreciation in callable bonds is less
than option free bond. Because the call
price puts an upper limit on the bond
price.
Describe the various forms of credit risk (i.e., default risk,
credit spread risk, downgrade risk);

Credit Spread Risk

Downgrade Risk
Liquidity Risk why important ?
Liquidity Risk is important for investors
even if they expect to hold the bond till
maturity
Because of MTM.
Exchange Rate Risk in Bonds.
Depreciation in the value of Foreign
Currency will reduce the return to a
dollar based return.
Describe inflation risk and explain why it exists;

Inflation risk is purchasing power risk

 Explain how yield volatility affects the price of a bond with
an embedded option and how changes in volatility affect the
value of a callable bond and a put able bond

Value of Callable Bond=Value of Option free bond-value of Call option.

Increase in the Yield Volatility Increases the value of

the value of the call options and MV of Callable
bond.

Value of Put able bond =Value of Option free bond-value of Put option.

Increase in the Yield Volatility Increases the value of

the value of the Put options and MV of put able bond.
Explain how yield volatility affects the price of a bond with
an embedded option and how changes in volatility affect the
value of a callable bond and a put able bond

“Volatility Risk “ changes in the value of the call

or Put Option.
Without volatility in interest rates, a call
provision or a put provision have little if any
value, assuming no changes in the credit quality.
Therefore, in general an Increase in the yield
price volatility of bond increases the value of
both call and put options.

.
Explain how yield volatility affects the price of a bond with
an embedded option and how changes in volatility affect the
value of a callable bond and a put able bond

Value Call option: If interest rates fall or volatility

increases , the difference between the callable
bond and option free bonds increases, thereby the
value of the call option increases. Advantage bond
issuer because he can call the bond at lower price
Value Put option: If interest rates rises or
volatility increases , the difference between the
callable bond and option free bonds increases,
thereby the value of the Put option increases.
Advantage bond holder, because he can sell the
bond at a higher price
 Bond A-Callable Bond B-Non Callable

Must pay a higher yield to Bond B will have no

compensate the investor for volatility, since it is non
the call risk, in other words callable bond.
all else the same the price of
Callable bond will be Lower
than than Non-callable
bonds.
Therefore Bond A, high
yield and high Volatility.

Volatility Risk risk refers to the impact that a

change in the volatility of interest rates will have
on the value of the embedded option.
Bond Sector and Instruments
Different Types of International
Bonds
Foreign Bonds: bonds issued in one country by an issuer
that is domiciled in another country. Common names for
these bonds are derived from the country in which they
are issued and traded.Eg Yankee bonds, issued and traded
in US but issued by non-us corporation.
Samurai bonds: bonds issued by non-Japanese issuers but
traded in Japan.
Eurobonds: are issued outside the legal system of one
country. Euro bonds are identified by the currency in
which they are denominated EuroYen, EuroDollar etc.
Sovereign bonds
Off the run and on the run securities
Zero Coupon or "Strip" Bonds
Zero coupon or strip bonds are fixed income
securities that are created from the cash flows
that make up a normal bond.
The cash flows of a normal bond consist of
the regular interest or "coupon" payments,
that take place over the term of the bond, and
the principal repayment that occurs at
maturity of the bond.
Describe a Mortgage-backed security, and explain the cash
flows for a mortgage backed security

MBS are backed by a pool of mortgage

loans, which not only provide collateral but
also cash flow to service the debt.
Define prepayments and explain
prepayment risk
A CMO is repackaged cash flows from mortgages and
pass-through securities
A multiclass pass-through created with a number of
different bond holder classes differentiated by the order
in which each is paid off
Class A,B, and C Bond buyers
 A bonds have the shortest life, attractive to savings banks
and commercial banks
 B bonds, typically 5-7 years are attractive to pension funds
and life insurance companies
 C bonds, longest duration, pension funds and life ins. co.
Mortgage pass through (PTC)
A MPT is created by pooling a number of
mortgage together, usually several thousands
Shares of such mortgage pool are sold in the
form of participation certification
representing ownership of a fraction share of
the underlying mortgage
The interest and principal payment made by
the homeowners whose mortgage are in the
pool are collected and passed through to the
investors
Collateralized Mortgage Obligation
(CMO

CMO are created from mortgage PTC and

referred to as derivative mortgage backed
securities, since they are derived from a
simpler MBS
CMO has different tranches each of which has
a different type of claim on the cash flow
form the pool of mortgages ( their claims are
not just fraction claim on the cash flow from
the pool.
Collateralized Mortgage Obligation
(CMO
A CMO is repackaged cash flows from mortgages and pass-
through securities
A multi class pass-through created with a number of
different bond holder classes differentiated by the order in
which each is paid off
Class A,B, and C Bond buyers
 A bonds have the shortest life, attractive to savings
banks and commercial banks
 B bonds, typically 5-7 years are attractive to pension
funds and life insurance companies
 C bonds, longest duration, pension funds and life
ins. co.
Motivation for CMO
The motivation for creating CMO is to
distribute to distribute the prepayment risk
inherent in MBS- create securities with
various maturities.
CMO structure takes the cash flow from the
mortgage pool and in simple terms, allocates
any principal payment sequentially over time
to holders of different CMO tranches, rather
equally to all the security holders.
Motivation for CMO Continued..
CMO does not alter the overall risk of
prepayment, it redistributes the prepayment
risk.
Trench I : receives NI & Outstanding principal.
Trench II : receives its share of NI & starts
receiving all of the principal payment after
trench I has been completely paid off.
Trench III : receives NI & starts receiving all
principal repayment after Tranch I and II.
General obligation & Revenue
bonds
General obligation: are backed by the full
faith, credit and taxing power of the issuer.
Revenue Bonds: are supported only through
revenues generated by the project.
Insured Bonds & Pre funded
bonds
Insured bonds: carry the guarantee of a third
party that all principal and interest payment
will be made in a timely manner.
Pre funded bonds: are bonds for which
treasury securities are purchased and placed
in a special escrow account in an sufficient to
make all remaining required payments.
Factors considered by rating agencies in
assigning credit rating to a corporate debt
issue

Past payment history

Quality of management
Industry outlook
Overall debt level of the firm
Operating cash flow
Other sources of liquidity
Secured Debt:
Unsecured Debt
Credit Enhancement
Diff Corporate bond and medium term
note
MTN: once registered, such securities
can be placed off the shelf and sold in
the market over a period of time
Asset Backed Securities.
Credit card debt, auto loan etc are often
securitized in the same way as mortgage are
in a MBS structure.
These financial assets are the underlying
collateral for bonds, which are ABS.
A SPV is a separate legal entity to which the
corporation transfers the assets for an ABS
issue. The importance is that a legal transfer
of the assets is made to the SPV
State the motivation for a corporation to
issue an asset-backed security

The motivation for a corporation to

issue ABS is to reduce borrowing cost
By transferring the assets into a
separate legal entity, the entity can
issue bonds at a higher rating than the
unsecured debt of the corporation
 Describe the types of external credit
enhancements for asset-backed securities

Since ABS on their may not receive the

highest possible credit rating.
The issue may choose to enhance the
credit rating by providing additional
guarantee or security
External credit enhancement
YIELD SPREADS
Different shapes of Yield
Curve
Normal Upward sloping.
Inverted Downward Sloping.
Humped
Flat.
THEORIES OF TERM STRUCTURE OF
INTEREST RATES
The Pure expectations
hypothesis
It states that the yield for a particular maturity is an
average of the short term rates that are expected in
the future.
Long term yields will rise:If short term rates rise
Long term rates will fall: if short term rates fall
The yield curve depends on the expectation of the
investors.
If investor expect short term rates to Rise (fall) in
the future the yield curve be
ascending(descending)
The Liquidity Premium
hypothesis
In addition to expectation about future rates,
investors require a risk premium for holding long
term bonds.

Liquidity premium hypothesis is that the markets

adds premia Lt to yields for term-to-maturity t that
would otherwise exist, with 0=L1<L2<L3<….<Ln
implying that these liquidity premia are positive
and rise with longer maturity.
The Market segmentation
hypothesis
Based on the idea that investors and borrowers have
preference for different maturity ranges.
Under this theory, the supply of bonds and demand
for bonds determine equilibrium yields for various
maturity ranges
Institutional Investors may have a preference for
long term papers
Group A- Short term preference (Bank, Primary
Dealers, etc)
Group B- Long term preference (lnsurance
company,Provident Fund,etc).
Describe the implications of each theory for the
shape of the yield curve;

Pure Expectation theory: the pure expectation

theory by itself has no implication of the Yield
curve. The various expectations and the shapes
that are consistent with them are”
• Short term rates expected to rise in the future= Upward Sloping curve
• Short term rates are expected to fall in the future= downward sloping yield
curve
• Short term rates expected to rise then fall = Humped curve
• Short term rates expected to remain constant = Flat yield curve

• The shape of yield curve under the pure

expectation theory provides us with information
about future short term rates
Describe the implications of each theory for the
shape of the yield curve;

Under liquidity preference theory the yield curve

make take any of the shapes we have identified. If
rates are expected to fall a great deal in the future,
even adding a liquidity premium to the resulting
negatively sloped yield curve can result in a
downward sloping curve
A humped yield curve could be still humped even
with liquidity premium added to all yields.
An upward sloping yield curve can be consistent
with declining short term rates in future
Describe the implications of each theory for the
shape of the yield curve;

The market segmentation theory is

consistent with any shape of yield
curve.
Under this shape of yield curve, it is the
supply and demand for debt securities
at each maturity range that determines
the yield for that maturity range
Different types of yield
spreads.
Absolute yield:
Relative Yield: Absolute yield spread
Yield on lower bond
Shortcoming of the absolute yield spread is that is
remains constant, even though overall rates rise or
fall. In this case the effect of rising or falling yield on
spreads is captured by the relative yield spread or
ratio.
Inter market Spread: Treasury bonds & Corporate
Intra market Spread: T & T or Corp & Corp
Example:
Consider 2 bonds at yield of 6.50 and
6.75
Absolute yield = 25 bps
Relative yield = 0.25%/6.50% = 3.8%
Yield Ratio = 6.75%/6.50% = 1.038
Identify how embedded options affect
yield spread

Yield spread on callable bonds are

higher as compared to option free
bonds.
Inclusion of put option will have
opposite effect
Impact of liquidity on Spreads-translate
in to lower liquidity.
Taxable yield of Taxable bond and Tax
equivalent yield of Tax exempt bond

After tax Yield=Taxable Yield*(1-T).

compare with Tax Exempt Yield

Tax equivalent Yield=Tax Free Yield

(1-t)
Compare with Taxable Yield
PART II Analysis and Valuation
Introduction to Valuation of
Debt Securities
Fundamental Principle of Bond
Valuation
The cash flows for a bond are made up
of the interest payments, which are
received periodically ( also called
coupons) and the maturity value(also
called balloon payment).
Pricing of Bonds. Cont…
In general, price of the bond can be computed
using the formula
c1 c2 cn  M
P0    .......
(1  r) (1  r) 2
(1  r) n
Where c1 …cn are the coupon payments,
M is the maturity value
r is the discount rate and P the price of the
bond
Difficulty in pricing bonds
Principal Repayment Stream is not
known
Coupon Flows are not known
Bond is convertible or exchangeable
Appropriate discount rate ?
Valuing Zero Coupon Bonds
What is the current market price of a U.S. Treasury strip that
matures in exactly 5 years and has a face value of $1,000. The
yield to maturity is rd=7.5%.

1000
5  $696.56
1.075

What is the yield to maturity on a U.S. Treasury strip that pays

$1,000 in exactly 7 years and is currently selling for $591.11?

1000
591.11  7
1  rd
 Bond Valuation:
An Example
 What is the market price of a U.S. Treasury bond that has a
coupon rate of 9%, a face value of $1,000 and matures
exactly 10 years from today if the required yield to maturity
is 10% compounded semiannually?

0 6 12 18 24 ... 120 Months

45 45 45 45 1045

45  1  1000
B 1    $937.69
0.05  1.05 20 
1.05 20
Changes in Bond Values Over
Time
Time path of value of a 15% Coupon, $1000 par value
bond when interest rates are 10%, 15%, and 20%

Bond Value
$1,500
kd < Coupon Rate
$1,250
kd = Coupon Rate
$1,000
$750 kd > Coupon Rate
$500
$250
$0
1 3 5 7 9 11 13 15
Years
Arbitrage Free Valuation.
With arbitrage free valuation, we discount
each cash flow using a discount rate that is
specific to the maturity.
Arbitrage free valuation approach simply says
that the value of a bond must be equal to the
value of the parts. If this is not the case,
there must be arbitrage opportunity.
If the bond is selling at less than the sum of
its present value of its expected cash flow.
An arbitrager will buy the bond.
If spot is lower than MP=Undervalued.
If spot is Higher than MP=Overvalued
YIELD measures Spot and
Forward Rates. 15.2
Source of Return form Investing
in a Bond.

Periodic Coupon
Principal
Reinvestment.
Traditional Yield Measures.
Current Yield:
YTM: Yield to maturity
YTFC: Yield To first Call
YTC:Yield To call
YTW:The yield to maturity if the worst possible bond
repayment takes place. If market yields are higher than the
coupon, the yield to worst would assume no prepayment.
If market yields are below the coupon, the yield to worst
would assume prepayment. In other words, yield to worst
assumes that market yields are unchanged.
YTC:Yield To call
The yield to call is used to calculate the yield on callable bonds
that are selling at a premium to par.
For bonds trading at a premium to par, the YRC may be less
than the YTM. This can be the case when the call price is
below the current market price
The calculation is the same, except for that the call price is
substituted for the par value.
If the bonds were trading at a discount to the par, there is no
point calculating the YTC
YTC is important when rates are falling and the bond is
trading at premium and also at or above its call price !
YTP is important when rates are rising and the bond is trading
at a discount to the par
Yield To worse.
The bond yield computed by using
the lower of either the yield to
maturity or the yield to call on
every possible call date.
Calculate Bond Equivalent yield

5 Yr STRIP is priced @ 768, calculate

the SA and Annual YTM.
Semi Annual: 5.35%
Annual YTM: 5.42%
Assumption underlying
Traditional Yield Measure

Reinvestment assured at the YTM rate.

Reinvestment income is important
because if it is less than the realized
yield on the bond will be less than YTM.
Price Risk vs. Reinvestment Risk

When interest rates decline (increase),

bond prices rise (fall), but the income
from reinvesting the coupon payments
declines (increases).
Assumptions Underlying
YTM.
All coupons and principal are made on
schedule.
The bond is held to maturity.
The coupon payments are fully and
immediately reinvested at precisely the
same interest rate as the promised YTM
Calculate Reinvestment Income ?

Principal: 100 Rs
6% SA Coupon.
Tenure: 10 Yrs
Calculate Reinvestment Income?
FV= Principal*(1+r)^n
100*(1+0.03)^20=180.61.
180.61=160
Therefore the reinvestment income: 180.61-160=20.61
Calculate Compound Rate of Return-purchase Px & Coupons

 
Compute the bond equivalent yield of an annual pay
& compute the annual pay of an SA pay bond

Annual to semi-annual=Bond Equivalent yield.

{(1+YTM)^0.5-1}*2.(Compound)

SA to annual=Effective Annual yield.

{(1+YTM/2)^2}(Discount)
Calculate the Value of a bond
using Spot Rates.
Coupon= 4, Maturity=3 yrs.
Spot Rates:
1-year: 5%.
2-year 6%.
3-year 7%.
 Calculate Bond Price ?
Compute Theoretical Spot Rate
Forward Rates
Rs 94.34 Rs 100

1
Year 2 Year
0 Year
Rs 94.34 Rs 108
In effect we have created an investment where we lend Rs 100 after 1
year and will get Rs 108 after 2 year. This means that the Interest rate
from 1 year to 2 years forward is 8%
Forward Rates are also the expected
Spot Rates
If the market had expected the spot rate (from 1 to 2 years)
to be less than the forward rates indicated today, they
would have heavily started doing the above transactions
to look in the greater forward rate.
This would have meant additional demand for borrowing
1 year money and the lending 2 year money. This would
have pushed the 1 year spot rate up and 2 year spot rate
down till the implied forward forward rate was in line
with the market expectation.
Similar, construct the 2-3 forward rate and the 1-3 year
forward rate
 Ye a r S pot R a te
0-1 6
0-2 7
0-3 8

Ye a r Forwa rd ra te
1x2 8
2x3 10

Ye a r S pot R a te
0-1 6
0-2 7
0-3 4

87.3438728 100
98.2499782 1.750021836

Forward rates can never be negative

This is because computation shows that 2-3
forward rate is –1.7%. If the forward rate
were negative, one can borrow 3-year money
and invest it for 2 yrs and sit on cash from
year 2 to year 3 to make a risk free profit
If we have n year spot rate as Rn, and m
year spot rate as Rm and m>n , and
we want to compute the Forward rate
Fmn from year n to year m, then
 
(1+Rn)^n*(1+Fmn)^m-n=(1+Rm)^m

(1+Fmn)^m-n = (1+Rm)^m

(1+Rn)^n*
YTM Spot Rate 1 Forward
6.90% 7.00% 1.07 1.07
79.00% 8.00% 1.08 1.1664 1.090093 9.01%
89.00% 9.00% 1.09 1.295029 1.110279 11.03%
9.00% 10.00% 1.1 1.4641 1.130554 13.06%
10.00% 11.00% 1.11 1.685058 1.150917 15.09%
11.90% 12.00% 1.12 1.973823 1.171368 17.14%
12.50% 13.00% 1.13 2.352605 1.191903 19.19%
13.50% 14.00% 1.14 2.852586 1.212522 21.25%
14.50% 15.00% 1.15 3.517876 1.233223 23.32%
INTRODUCTION TO THE
MEASUREMENT OF
INTEREST RATE RISK 15.3
Distinguish between the full valuation approach (the scenario
analysis approach) and the duration/convexity approach for
measuring interest rate risk, and explain the advantage of using
the full valuation approach

Full valuation approach to measure interest rate risk is based on

applying the valuation technique that we have already learnt
Duration/convexity approach provides an approximation of the
actual interest rate sensitivity of a bond or bond portfolio
Its main advantage is the simplicity as compared to full
valuation approach
Full valuation is is quite complex and time consuming
We limit our analysis only to parallel shifts in the yield curve
However the full valuation approach is more precise and
accurate and it can be used for non parallel shifts in the yield
curve
Compute the interest rate risk exposure of a
bond position or of a bond portfolio, given a
change in interest rates;

Coupon Term YTM Price Face Value MV

Bond X 8% 5 6% 108.4 10,000,000.00 10842470
Bond Y 5% 15 7% 81.78 10,000,000.00 8178420
19020890
 Compute the interest rate risk exposure of a
bond position or of a bond portfolio, given a
change in interest rates;

Market Value Portfolio

Scenerio Yield change Bond X Bond Y Portfolio Change in
Current 0 10,842,470.00 8,178,420.00 19,020,890.00 0
1 50 bp 10,623,350.00 7,783,220.00 18,416,570.00 -3.18
2 100 bp 1,041,002.00 7,432,160.00 17,842,180.00 -6.2
Its worth noting that on an individual bond basis, the
effect of an Increase in yield on the bonds value is less for
X than for Y.simply because bond Y is a longer maturity
bond and the coupon is less
Demonstrate the price volatility characteristics for
option-free bonds when interest rates change
(including the concept of “positive convexity”);

We have established the relationship

between price and yield of a bond for a
straight bond. An increase in the
discount rate leads to a decrease in the
value of the bond
115
Option free bond Px-yield
relationship is convex
110

105

100 Price falls a decreasing rate

95

90
1 2 3
Demonstrate the price volatility characteristics for
option-free bonds when interest rates change
(including the concept of “positive convexity”);

Important Points
PX-yield relationship is negatively sloped, so as price
rises the yield falls.
The relationship is not a straight line. Since the curve
is convex (to the origin) we say that an option free
bond has a positive convexity. Because of convexity,
the price of an option free bond increases more when
rates falls than it decreases when yield rises

1% decrease In YTM 10.67% increase in price

1% increase in YTM 9.22% decrease in price
Demonstrate the price volatility characteristics for
option-free bonds when interest rates change
(including the concept of “positive convexity”);

If the Price yield relationship were a straight line there

would be no difference between price increase and price
decline in response to equal increase or decrease in yields
Convexity is good for bond owners, for a given volatility of
yields. Price increases are larger than price decreases
Duration/convexity are slope of a line
Note Duration of a bond at any yield is the (absolute value
of ) the slope of the price yield function. The convexity of
the price yield relation for an option free bond can help u
remember a result presented earlier, that the duration of a
bond is less risk at higher market yields
Demonstrate the price volatility characteristics of callable
bonds and prepay able securities when interest rates change
(including the concept of “negative convexity”);

With a callable or pre payable securities the the upside

price appreciation in response to decreasing yields is
limited(price compression). Consider the case of a bond
that is currently callable @ 102. The fact that the issuer can
call the bond any time for 102 of the face value puts an
effective upper limit on the price of the bond. As yields
falls and the price approaches 102, the price yield curve
rises more slowly than that of an identical option free
bond
When the price begins to rise at a decreasing rate in
response to further decrease in yields, the price yield curve
“bends over “ to the left and exhibits negative convexity
Demonstrate the price volatility characteristics of callable
bonds and prepay able securities when interest rates change
(including the concept of “negative convexity”);

At higher yields the value of the call option becomes very

small so that a callable bond a callable bond will act very
much like an option free bond.
It is only at lower yields the callable bond exhibits
negative convexity
In terms of price sensitivity, the slope of the price yield
curve tells the story.
Note that, as yield falls the slope of the price yield for a
callable bond decreases, becoming almost zero at very low
yields. This tells us how a call feature affects price
sensitivity to changes in yields
Demonstrate the price volatility characteristics of callable
bonds and prepay able securities when interest rates change
(including the concept of “negative convexity”);

At higher yields, the interest rate risk for both callable and
non callable bond is similar. At lower yields the price
volatility of a callable bond will be much lower than that
of a non callable bond.
Volatility of callable bond is higher at higher yields and
lower at lower yields.
The effect of a prepayment options is quite similar to that
of call, at lower yields it will lead to negative convexity
and reduce price volatility
When yields are lower, callable and pre payable securities
exhibit less interest rate risk, reinvestment rate risk rises
Describe the price volatility characteristics of put
able bonds;

The value of put option increases at higher yields

and decreases at lower yields opposite to call option
Compared to option free bond, putable bonds will
have less price volatility at higher yields
The price of putable bonds falls more slowly in
response to increase in yields because the value of
the put option rises at higher yields
The slope of the price yield relation is flatter at
higher yields indicating less price sensitivity to
changes in yield
Compute the effective duration of a bond, given information
about how the bond’s price will increase and decrease for
given changes in interest rates;

Duration is the ratio of a % change in price to

change in yield.
Now that we understand convexity, we know
that the price change in response to rising
yields is less than price change in response to
falling rates for option free bond.
Effective duration uses the average price
change in response to equal increase or
decrease in yield to account for this fact
Compute the effective duration of a bond, given information
about how the bond’s price will increase and decrease for
given changes in interest rates;

Effective Duration=price when yield falls –price

when yield rises/2* initial price *change in yield in
decimal points
Compute the approximate percentage price change for a
bond, given the bond’s effective duration and a specified
change in yield;

% change in price = duration *%

change in yield
Explain why effective duration, rather than modified
duration or Macaulay duration, should be used to measure
the interest rate risk for bonds with embedded options;

As noted earlier, in comparing the various

duration measures, both macauly duration
and modified duration are calculated from
promised cash flow for a bond with no
adjustment for any embedded options
Effective duration is calculated from
expected price changes in response to yield
changes that explicitly take into account a
bonds provision
Limitation of portfolio Duration

The limitation of portfolio duration as a

measure of interest rate sensitivity stem
from the fact that yields may not
change equally on all bonds in the
portfolio
Yield curve risk
Discuss the convexity measure of
a bond;
Convexity is a measure of the curvature of the price
yield curve. The more curved the price yield
relationship, the greater the convexity. A straight
has a zero convexity.
If price yield curve were in fact a straight line, the
convexity would be zero.
The reason we care about convexity is that more
curved the price yield relationship is, the worse our
duration based estimates of bond price changes in
response to yield changes
 Duration Based Estimates
Duration 9.72
yield 9%
Price change for % change in yield ( 8% & 10 %)
New price @ 8% 993.5336
New Price @10% 822.47

Actaul Price Changes

New price @8% 1000
New price @10% 828

Price estimates based on duration are less than the

actual prices for both 1% increase and 1% decrease
This is why Convexity of bonds is important
and that’s is why estimates based solely on
duration are inaccurate
If the price yield relationship were a straight
line, duration alone would be sufficient
However greater the convexity, greater the
errors in duration based estimates of price
changes
Estimate a bond’s percentage price change, given the
bond’s duration and convexity measure and a specified
change in interest rates;

By combining duration and convexity we can

obtain a better estimate of the % change in the
price of a bond, especially for relative large
changes in yield
The formula for estimating the bonds price %
change based on duration and convexity is
% change in price=Duration effect +convexity effect
THANK YOU