INTEREST RATES AND SECURITY

VALUATION
 TOPIC OUTLINE
• Required, Expected and Realized Return.
• Valuation of bonds
• The sensitivity of bond prices to interest rate,
coupon rates and maturity periods.
• Duration: meaning , types and computation.
• Convexity computation and use
• Duration in a portfolio set up.
 VARIOUS INTEREST RATE MEASURES
• Coupon rate
• Required rate of return
• Expected rate of return(Yield to maturity)
• Realized rate of return
 COUPON RATE

• Coupon rate is an interest rate used to calculate

the annual cash flow(coupon) the bond issuer
promises to pay the bond holder.
Coupon = Coupon Rate x Bond Par Value
• Different coupon structures include: zero coupon,
step up note, deferred coupon, floating rate etc.
• Coupon is only one component of total return
measures.
 REQUIRED RATE OF RETURN

• The interest rate an investor should receive on

a security , given its risk.
• Various methods can be used to estimate a
bond’s required return. Recall this from our
earlier topic:
R = Real risk free interest rate + inflation premium + default
risk premium + liquidity premium + maturity premium.
 REQUIRED RATE OF RETURN

• It is an ex-ante measure of the interest rate on a

security.
• It is used to calculate the fair present value ( intrinsic
value) of a security.
FPV= E(CF1 ) + E(CF2 ) + E(CF3 ) +….E( CFn )
(1 + r) 1 (1 + r) 2 (1 + r) 3 (1 + r) n
• If the security’s :
Market price = Intrinsic value → its fairly priced
Market price ˃ Intrinsic value → its over priced
 REQUIRED RATE OF RETURN

• Market price ˂ Intrinsic value →its under priced

Example:
A 10 % coupon bond with semi-annual payment, a par
value of K 1,000 and has 3 years to maturity is
currently trading at K1,136. What is the bond’s
intrinsic value the investor has required return of
8.1%? Would be the appropriate investment decision
in this case?
 REQUIRED RATE OF RETURN

Solution:
Data: N= 3 x 2= 6, PMT= 0.1 x 1000 x 0.5= 50, FV= 1000
I/Y= 8.1% ÷ 2= 4.05%, PV = ?
From a Texas instrument BA II Plus professional
calculator, we get PV = - K 1,049.72. This when
compared to the current market price of K 1,136
indicates that the bond is over priced and the
appropriate decision is to sell it.
 REQUIRED RATE OF RETURN

• Similarly, given the fair value of an asset and

its estimated cash flows, we should be able to
back out the required rate of return. In our
example, if the fair price of the bond was
K1,090, the required rate of return will be
6.64% on bond equivalent basis(BEY).
 EXPECTED RATE OF RETURN

• The interest rate an investor would earn on a

security if he bought the security at its current
market price and received all expected
payments and sold it at the end of the
investment horizon.
• An ex-ante measure. Can be calculated from:
P= E(CF1) + E(CF2) +E(CF3) +….E(CFn)
(1 + re)1 (1 + re)2 (1 + re)3 (1 + re)n
 RELATIONSHIP OF REQUIRED AND
EXPECTED RETURN
RATE OF RETURN VALUE INTERPRETATION
re > r P < FPV Present value of cash flows
received is greater than what
is required to compensate for
the inherent risk. Buy signal.

re < r P > FPV Present value of cash flows

received is less than what is
required to compensate for
the inherent risk. Sell signal.

re = r P = FPV Present value of cash flows

received is equal to what is
required to compensate for
the inherent risk. Buy signal.
 REALIZED RATE OF RETURN
• This is the actual interest rate earned on an
investment in a financial security.
• It is an ex-post (historical) measure of return.
• It equates the actual price paid on a security
to the present value of the cash flows
received during the investment horizon.
P= E(CF1) + E(CF2) +E(CF3) +….E(CFn)
(1 + rr)1 (1 + rr)2 (1 + rr)3 (1 + rr)n
RELATIONSHIP BETWEEN REALISED &
REQUIRED RETURN
• The difference between realized return(rr )
and required (equilibrium market) return
called excess returns or alpha(Jensen’s alpha)
Jensen’s alpha(α) = Realized return – Required return
α = 0 → rr = r → performance equal to market
α = + → rr > r → out performed the market
α = - → rr < r → under performed the market
 YIELD TO MATURITY

• Yield to maturity(YTM) is an annualized IRR,

based on a bond’s price and its promised cash
flows.
• For a coupon bond with semi-annual
payments the YTM is stated as two times
semi-annual IRR implied by the bond price.
P = c1 + c2 +…. (cn + par)
( 1+ytm/2)1 ( 1+ytm/2)2 ( 1+ytm/2)n
 YIELD TO MATURITY

• If markets are efficient with security prices

being accurately priced the following
relationship will subsist:
YTM=Realized=Required= Expected Return.
• YTM to maturity is considered to be a good
measure of return because captures return
from all three sources namely; income ,
reinvestment and capital gains.
ASSUMPTIONS AND LIMITATIONS OF
YTM
• YTM assumes that a bond shall be held till
maturity and that;
• All cash flows prior to maturity are re-invested
at the yield to maturity.
• The limitations of YTM lies in the fact that it is
based on unrealistic assumptions.
 COUPON RATES & YTM

• Coupon rate = YTM → bond trades at par

• Coupon rate > YTM → bond trades at a discount
• Coupon rate < YTM → bond trades at a premium
• As a premium bond approaches maturity, its price
for to par. Similarly , the price of a discount bond will
appreciate towards par as maturity approaches.
• At maturity, a bond will trade at par.
 VALUATION OF BONDS
• Valuation of any asset involves getting the
present values of the expected cash flows and
then summing them up.
• The process involves:
1. Estimating the cash flows over the life of the
bond: (a) coupon payments (b) return of
principal.
2. Determine the appropriate discount rate.
3. Calculate the present value of the cash flows.
 PROBLEMS IN ESTIMATING CASH
FLOWS
• In addition to credit risk, the principal is not
know with certainty. This includes bonds with
calls , puts, prepayments options and
accelerated sinking fund provisions.
• The coupon payments are not known with
certainty as the cash is with floating rate
securities and inflation indexed bonds.
• The bond is convertible or exchangeable into
another security.
EXAMPLE ON VALUATION OF BONDS
Example:
A 12 % coupon annual pay bond has a par value
of K 1,000 and has 3 years to maturity. What is
the value of the bond if the market interest rate
is : (1) 9% ( 2) 12% and ( 3) 12.95% ?
EXAMPLE ON VALUATION OF BONDS
• The basic valuation formula is:
PV= C1 + C2 + C3 +…. Cn + Par
(1 + r) 1 (1 + r) 2 (1 + r) 3 (1 + r) n
using the 9% market rate scenario will give:
PV= 120 + 120 + 1120 = 1075.93
1.091 1.092 1.093
EXAMPLE ON VALUATION OF BONDS
Solution: (using Texas instrument BA II Plus
professional calculator)
Data: N= 3, PMT= 0.12 x 1000 = 120, FV= 1000
I/Y= 9 % , PV = ?
PV = - K 1075.93 .
(b) Similarly at 12% value is K1000 and ( c ) at
12.9% it is K 977.55
THE PRICE-YIELD PROFILE
 VALUATIONS OF ZERO-COUPON
BONDS
• A zero coupon bond only has a single payment at
maturity.
• Given the yield to maturity:
bond value= face value
(1 + r)years x 2
Example: find the value of a 10 year,K1,000 face
value zero coupon with a yield of 8%.
Bond value= 1000 =K456.39
(1.08) 10 x 2
 VALUATIONS OF ZERO-COUPON
BONDS
• Conversely , given the price of a zero coupon
bond , face and term to maturity, we can find
its yield to maturity as:
BEY= face value ⅟n x 2 - 1 x 2 or
price
YTM= face value ⅟n - 1
Price
 SENSITIVITY OF PRICE TO CHANGES IN
INTEREST RATES
• As interest rate increase , the bond price
decreases.
• Thus ,there is an inverse relationship between
price and yield.
• The sensitivity of bond’s price to yield is:
1) greater as maturity period increases.
2) lesser for bonds paying higher coupons.
 DURATION
• Duration is the most widely used measure of
bond price volatility.
• A bond’s volatility is a function of its maturity ,
coupon, and initial yield.
• Duration captures all three of variables in a
single measure.
• Duration is only a linear approximation of
price changes for an option free bond.
• It is good only for small changes in yields.
 MEANINGS OF DURATION
• Duration is the weighted average of time to maturity
on a financial security using the relative present values
of cash flows as weights .The duration of a zero
coupon bond is equal to its maturity . Duration of
coupon bond is less than its term to maturity.
• Economically , duration measures the
sensitivity(Elasticity) of a security’s value to small
changes in interest rates.
• The slope of the price-yield curve. Mathematically, it is
the first derivative of the price-yield curve with
respect to yield.
 TYPES OF DURATION
• Modified Duration
• Macaulay Duration
• Effective Duration
 MODIFIED DURATION

• Modified duration is the approximate

percentage change in the price of a bond from
any given change in yield.
modified duration:
= 1 x 1 x sum of time-weighted
P 1 + y/2 PV of a bond’s cash flows
Where:
P = bond’s price; and Y= annual yield
 MACAULAY DURATION
• Is the weighted average term to maturity of a
bond’s cash flow.
• It is measured in the number of
periods(usually years).
• Can be computed from the following
relationship:
Macaulay= 1 + y/2 x modified duration
MODIFIED & MACAULAY DURATION

Example:
Compute the modified duration and the
Macaulay duration of a 3-year, 4%, semi
annual coupon bond yielding 3.5% on bond
equivalent basis.
 MODIFIED & MACAULAY DURATION
Solution to problem: sum of time weighted PVs of cash flows

Period Term (j) Cash PVIFj PVCFj J X PVCFj

Flow(K)
1 0.5 2 0.9828 1.97 0.98

2 1 2 0.9659 1.93 1.93

3 1.5 2 0.9659 1.90 2.85

4 2 2 0.9330 1.87 3.73

5 2.5 2 0.9169 1.83 4.58

6 3 102 0.9011 91.92 275.75

TOTAL 112 101.41 289.83

Bond Price( P)
MODIFIED & MACAULAY DURATION
Solution to problem:
Modified duration=
1 1
101.41 X 1 + 0.035/2 X (289.82)=2.81

and
Macaulay Duration= 1 + 0.035 x 2.81= 2.86
2
MODIFIED & MACAULAY DURATION:
COMPUTING PERCENTAGE PRICE CHANGE(PPC)

Approximate PPC= - Dmodified x ( % yield change)

Example:
If the yield of our bond in the immediate example
above changed increased by 25 basis points,
compute the approximate PPC.
Solution:
PPC = - 2.81 x 0.25% = - 0.7025%
A 0.25% increase in yield would lead to a 0.7025%
decrease in bond price.
 EFFECTIVE DURATION

• Effective duration is the approximate

percentage change in a bond’s price for 1%
change in yield.
• Effective duration is the only measure of
bond’s price sensitivity that can measure the
sensitivity of bonds with embedded options.
• It works well for small changes in yield.
• In a portfolio set up, it only works well when
there is a parallel shift in yield.
 EFFECTIVE DURATION

• The formula for effective duration , more

commonly referred to as “ duration” is:
duration = V- – V+
2 x V0 x ∆y
where:
V- =estimated price if yield decreases by a
given amount, ∆y
 EFFECTIVE DURATION

V+ = estimated price if yield increases by a

given amount, ∆y
V0 = Initial bond price
∆y = change in required yield in decimal
form
 EFFECTIVE DURATION

Example:
suppose there is a 15- year, option free non-
callable bond with an annual coupon of 7%
trading at par. Compute and interpret the
bond’s duration for a 50 basis point increase and
decrease in yield.
 EFFECTIVE DURATION

Solution:
∆y = 50 basis points = 0.5%= 0.005
If yield decreases from 7% to 6.5% the bond
value(V-) = 104.701 and
If yield increases from 7% to 7.5% the bond
value(BV+∆y) = 95.586
Duration = 104.701 – 95.586 = 9.115
2(100)(0.005)
 EFFECTIVE DURATION

Interpretation:
For 100 basis point (1%) change in yield, the
bond’s price will change by 9.115%. If yield goes
up by 1%, price will fall by 9.115%. Conversely ,
if the yield rises by 1%, the bond’s price goes up
by approximately 9.115%.
 COMPARING DURATION MEASURES
• Both Macaulay and modified duration are
calculated directly from the promised cash flows.
They make no adjustment for embedded options
like puts and calls.
• Effective duration is calculated from expected
price changes in response to changes in yield that
explicitly take into account a bond’s option
provisions.
• For option-free bonds(based on small changes in
yield), effective duration and modified duration
are similar.
 EFFECT OF YIELD,COUPON AND
MATURITY ON DURATION

All else equal, as:

•Higher(lower) coupon means lower( higher)
duration.
•Longer(shorter) maturity means higher(lower)
duration.
•Higher (lower) market yield means lower
(higher) duration.
 CHAPTER SUMMARY
• Different types of returns
• Effects of coupon, yield and maturity changes
on bond price.
• The price- yield profile
• Duration as a measure of interest risk
• Duration in a portfolio of bonds.
• Convexity