Document name Bond Math

Version Number  V1

Approved by Marisha Purohit

Approval Date  03/05/2020

Creator Ravindra A. Kamath

Audience  Students/Faculty/Management

BSE - INTERNAL
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 Bond
Mathematics

BSE - INTERNAL
Types of Yields
￮ Coupon Yield
￮ Nominal yield is the annual interest rate percentage payable specified in the
indenture and printed on the face of the bond certificate. Nominal is fixed and
not related to market value.
￮ Current Yield
￮ It is calculated by dividing annual interest income by the current market price.
This yield takes into account the relationship between the interest received and
the actual investment made.
• Current yield is greater than the coupon rate if the bond
￮ is selling at a discount.
• Current yield is less than the coupon rate if the bond is
￮ selling at a premium.
• Current is equal to the coupon rate if the bond is
￮ available at a par value.
BSE - INTERNAL
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Yield to Maturity
It is an average rate of return involving collective consideration of a bond
(a) Interest rate
(b) Current price
(c) Number of years remaining until maturity.

If the bond is available at a discount then,

Coupon + Prorated Discount
Yield to Maturity =
(Face Value + Purchase Price)/2
If a bond is available at premium then,
Coupon - Prorated Premium
Yield to Maturity =
(Face Value + Purchase Price)/2
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Use of Time Value of Money Concept in
Computation of YTM and Bond Pricing

￮ Bond Pricing
￮ The value of a bond - or any asset, real or financial - is equal to the present value of
the cash flows expected from it. Hence determining the value of a bond requires :
• An estimate of expected cash flows.
• An estimate of the required return.
• The coupon interest rate is fixed for the term of the
￮ bond.
• The coupon payments are made every year and
￮ the next coupon payment is receivable exactly a year
￮ from now.
• The bond will be redeemed at par on maturity.

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 
C M
 
t 1 (1  r ) (1  r )
t n

Where  = value (in rupees)

n = number of years
C = annual coupon payment (in rupees)
r = periodic required return
M = maturity value
t = time period when the payment is received

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 2
C/2 M
 
t 1 (1  r / 2 ) t
(1  r / 2) 2n

= C/2 (PVIFAr/2,2n) + M(PVIFr/2,2n)

Where  = value of the bond
C/2 = semi-annual interest payment
r/2 = discount rate applicable to a half-year
period
M = maturity value
2n = maturity period expressed in terms of half-
yearly period
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 Price Yield Relationship
A basic property of a bond is that its price varies inversely with yield. The
reason is simple. As the required yield increases, the present value of
the cash flow decreases; hence the price decreases. When the
required yield decreases, the present value of the cash flow increases;
hence the price increases.

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 Interest rate risk is measured by the percentage change in the value of
a bond in response to a given interest rate change of the maturity
period of the bond and its coupon interest rate.
Current price = Present value of Present value of
of bond interest payments + principal repayment

C M
 
(1  r ) t
(1  r ) n

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An examination of this formula reveals that :
Longer maturity period Greater sensitivity of
price to changes in
interest rates

Larger coupon (interest)Lesser sensitivity of

payment price to changes in interest rates
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Sensitivity to bond prices to changes in market rates :
1. There is an inverse relationship between bond prices and yields.
2. An increase in yield causes a proportionately smaller price change than
a decrease in yield of the same magnitude.
3. Prices of long-term bonds are more sensitive to interest rate changes
than prices of short-term bonds.
4. As maturity increases, interest rate risk increases but at a decreasing rate.

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5. Prices of low-coupon bonds are more sensitive to interest rate changes
than prices of high-coupon bonds.
6. Bond prices are more sensitive to yield changes when the bond is initially
selling at a lower yield.

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￮ The duration of a bond is the weighted average maturity of its cash
flow stream, where the weights are proportional to the present value
of cash flows. Formally, it is defined as :
￮ Duration = [PV(C1)x1 + PV (C2)x2 + … PV (Cn)xn]/V0
￮ where PV(C t) = present value of the cash flow receivable at the end of
year t
￮ (t = 1,2, …, n)
￮ V0 = current value of the bond
￮ of the bond issue is used as the discount rate

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Duration is a key concept in bond analysis for the following reasons :
• It measures the interest rate sensitivity of a bond
• It is a useful tool for immunising against interest rate risk.

Duration and Volatility

The proportional change in the price of a bond in response to the change in its yield
is as follows :

P  (1  y )
 D  ( )
P 1 y
where P / P = proportional price change
D = duration of the bond
y = yield 14
￮ The following rules relate to duration :
￮ 1. The duration of a zero coupon bond is the same as its maturity.
￮ 2. For a given maturity, a bond’s duration is higher when its coupon rate is lower.
￮ 3. For a given coupon rate, a bond’s duration generally increases with maturity.
￮ 4. Other things being equal, the duration of a coupon bond varies inversely with
its yield to maturity.
￮ 5. The duration of a level perpetuity is :
￮ (1 + yield)/yield
￮ For example, at a 9 per cent yield, the duration of a perpetuity that pays Rs. 100
per year forever will be equal to : (1.09/.09) = 12.11

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 Duration and Immunisation
If the interest rates goes up it has two consequences for a bondholder :
(i) the capital value of the bond falls, and (ii) the return on
reinvestment of interest income improves. Interest rate change has
two effects in opposite directions. If the investor chooses a bond
whose duration is equal to his investment horizon. For example, if an
investor’s investment horizon is 5 years he should choose a bond that
has a duration of 5 years if he wants to insulate himself against
interest rate risk. If he does so, whenever there is a change in interest
rate, losses (or gains) in capital value will be exactly offset by gains (or
losses) on reinvestments.

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Limitations to Using Modified Duration

There are limitations in using Modified Duration in predicting the

price/yield relationship. It is only valid for small changes in yield; for
parallel shifts in the yield curve; and for small time horizons. The
price/yield relationship estimated from the Modified Duration of a
bond is linear however the actual price/yield relationship is a curve.
There is therefore an error when using Modified Duration to estimate
price movements. The following graph shows that the larger the
change in yield, the greater the degree of error in the price change
calculated using modified duration. This error is primarily accounted
for by convexity.

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 Error in estimating price change for a
change in yield, using modified duration

Actual Relationship
Price

Po
Price/yield relationship
from modified duration
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Yield
Convexity
Modified Duration indicates how the price of a bond varies for small
changes in yield. However, for large changes in yield, two bonds that
have the same yield and the same Modified Duration can behave
quite differently. This is due to the `error’ in using modified duration.
This error is explained by convexity, which is the second derivative of
a bond’s price with respect to yield. Used in conjunction with
Modified Duration, convexity provides a more accurate approximation
of the percentage price change, resulting from a specified change, in a
bond’s yield, than using modified duration alone.

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THANK YOU

BSE - INTERNAL