Tutorial 3:

Bonds/Fixed Income Securities

1. Define Yield to Maturity(YTM). Explain the importance of YTM and
why it is less practical to use YTM for the valuation of bond in a callable
bond?
Yield to maturity (YTM) is the true yield a bond earns when held to maturity. YTM is the most important
and widely used yield calculation. YTM is important for the bond valuation, which is used in calculating
the bond price based upon PV of interest received and the appreciation of the bond if held until
maturity.

It is less practical to use YTM for the valuation of a bond in a callable bond because it assumes that all
interest income is reinvested at a rate equal to the market rate at the time of YTM calculation, and no
reinvestment risk. It is appropriate for non-callable bonds. For callable bond, the bond may be called
back before the maturity by the issuers.(Reinvestment risk) – may use yield to call .
2. Given two bonds with identical risk, coupons and maturity date, with the
only difference between the two being that one is callable, which bond will
sell for the higher price?
Non-callable bonds will sell for a higher price because they are less risky than callable bonds. Non-
callable bonds have no reinvestment risk and therefore can be sold at a higher price, while callable
bonds may be at risk of being called back and should be sold at a lower price.
3. Define two characteristics of a bond that determine its reinvestment rate
risk?
The first characteristics of bond that will affect the reinvestment risk is maturity. The maturity is
the date on which the final payment is due on a loan or other financial instrument, such as a
bond or term deposit, at which point the principal is due to be paid.
The second characteristic is coupon rate. It is defined as a coupon is the interest payment
received by a bondholder from the date of issuance until the date of maturity of a bond. In
short, it is the effective interest rate earned on the bond investment . Also, price of bonds are
quoted in relation to their yield. The investors will look at the effective interest rate given thus
considering whether to reinvest.
4. Explain the conditions that affect the bond to be sold at premium or
discount.
Firstly, premium bond has a market value that is above par value. It will occur when market interest rates
are below bond’s coupon rate. While for discount bond has a market value that is below par value.
Discount bond will occur when market interest rates are above the bond’s coupon rate. It given a lower
coupon rate than market, therefore it allows investors to buy low sell high, and earn by capital gain. To
conclude,the market interest rate and the bond coupon rate is the condition that will affect the bond to
be sold at premium or discount.
5. What is the value of a zero-coupon bond paying semiannually that
matures in 20 years, has a maturity of $1 million, and is selling to yield
7.6%? (CFA Question)

N=20 x 2=40 PV= FV/ (1+i)n

I/Y=7.6 i=0.076/2=0.038
FV=1,000,000
P/Y=2

Bond Price= RM224,960.29

6. Suppose a 10-year 9% coupon bond is selling for $112 with a par value of
$100. What is the current yield for the bond? What is the limitation of the
current yield measure? (CFA Question)
Annual interest income= 0.09 x 100=9

Current yield= Annual interest income/ Current market price of the bond

= 9/112

=0.0804

=8.04%

The limitation is that it doesn’t account for the return of principal, whether at maturity or upon
redemption during a sale or call. It does not consider that semiannual coupon payments can be
reinvested.
7. Determine whether the yield to maturity of a 6.5% 20-year bond that pays interest semiannually and is selling for
$90.68 is 7.2%, 7.4%, or 7.8%. (CFA Question)

Bond price=-Coupon[1-1/(1+i)n/i]+FV/(1+i)n
When the rate is 7.2%,Semiannually: 7.2%/2=3.6%
Bond price= 3.25(1-1/(1.036) 40/0.036]+(100/(1.036)40)=92.64
When the rate is 7.4%,Semiannually: 7.4%/2=3.7%
Bond price= 3.25[1-1/(1.037) 40/0.037]+(100/(1.037)40)=90.68
When the rate is 7.8%,Semiannually: 7.8%/2=3.9%
Bond price= 3,25[ 1-1/(1.039) 40/0.039]+(100/(1.039)40)=86.94

Thus, when the rate=7.4%, bond price=90.68

8. What effect does the use of semiannual discounting have on the value of a bond in relation to annual discounting?

Semiannual bond compound is twice as much as annual bond. When the coupon rate is more than
discount rate, the price of semiannual discount will be higher than annual discounting, investors will
prefer the semiannual bond since they can start to earn compound interest at the higher market rate six
months sooner.

When coupon rate is lower than discount rate, the price of semiannual discounting is leeser than annual
discounting because investors are willing to pay more for the extra six months of higher accrued
interest.
9.Explain the term “bond immunization” and how can it reduce
interest rates risk.
It is an investment strategy that protects investors from interest rate fluctuations by providing a specific
rate of return to a portfolio, independent of changes in market interest rates, and independent of price and
reinvestment effects during the holding period.

Interest rate affecting bond price which if the interest rate increase, the demand of bond will decrease
because the fix interest rate paid are lower than the market interest rate, thus resulting in the declining of
bond value. But using the bond immunization strategy, the changing of interest rate will not affect your
bond value as duration of bond portfolio are equal to investment time horizon. With application of the
bond immunization strategy, the interest rate risk can be minimize with retiring bond at duration than hold
it to maturity.
10. A 10-yr bond is paying 8% coupon compounded annually, with a par value of RM1000. If it
is yield at 6%, estimate the followings:

a) duration of the bond

Yield to maturity: 6%

Par value: RM1000

Coupon rate: 8%

Coupon payment: 0.08*1000=RM 80

n: 10

Bond duration=7.45 years

b.

b) the changes of price for a 25 basis point changes in interest rate

Change in price:-Modified Macaulay Duration*Bond Price*Change in Rate

25 basis point: 0.0025

-7.03*1147.20*0.0025=-RM20.16
11. Calculate the price of a 30-year bond with 7% coupon rate which is callable in 5 years at a
price of RM1,030. Assume that the yield to call is 7% and coupon payments are made semi-
annually.
Yield to call: 0.07/2=0.035

Coupon rate: 7%

Coupon payment: (0.07/2)*RM1000=RM35

N:5*2=10

Call price: RM 1030

Bond price: RM 1021.27