INTRODUCTION TO

FIXED INCOME VALUATION

1 Chapter 3
INTRODUCTION
 The fixed-income market, which is also called
the debt market or bond market.
 Pension funds, mutual funds, insurance

companies, and sovereign wealth funds,

among others, are major fixed-income
investors.
 Retirees who desire a relatively stable

income stream often hold fixed-income

securities.

2
BOND PRICING WITH A MARKET
DISCOUNT RATE
 Bond pricing is an application of discounted
cash flow analysis.
 The price of the bond at issuance is the

present value of the promised cash flows.

 The market discount rate is used in the

time-value-of-money calculation to obtain the

present value.
 The market discount rate is the rate of return

required by investors given the risk of the

investment in the bond.
 It is also called the required yield, or the
3
required rate of return .
BOND PRICING WITH A MARKET
DISCOUNT RATE

4
BOND PRICING WITH A MARKET
DISCOUNT RATE
 When the coupon rate is less than the market
discount rate, the bond is priced at a
discount below par value.
 When the coupon rate is greater than the

market discount rate, the bond is priced at a

premium above par value.
 When the coupon rate is equal to the market

discount rate, the bond is priced at par value.

5
6
YIELD-TO-MATURITY
 If the market price of a bond is known,
Equation 1 can be used to calculate its yield-
to-maturity (sometimes called the
redemption yield or yield-to-redemption).
 The yield-to-maturity is the internal rate of

return on the cash flows—the uniform

interest rate such that when the future cash
flows are discounted at that rate, the sum of
the present values equals the price of the
bond.
 It is the implied market discount rate.
7
YIELD-TO-MATURITY
 Suppose that a four-year, 5% annual coupon
payment bond is priced at 105 per 100 of par
value. The yield-to-maturity is the solution
for the rate, r , in this equation:

8
RELATIONSHIPS BETWEEN THE BOND
PRICE AND BOND CHARACTERISTICS
 The bond price is inversely related to the market
discount rate. When the market discount rate increases,
the bond price decreases (the inverse effect).
 For the same coupon rate and time-to-maturity, the
percentage price change is greater (in absolute value,
meaning without regard to the sign of the change) when
the market discount rate goes down than when it goes
up (the convexity effect).
 For the same time-to-maturity, a lower-coupon bond has
a greater percentage price change than a higher-coupon
bond when their market discount rates change by the
same amount (the coupon effect).
 Generally, for the same coupon rate, a longer-term bond
has a greater percentage price change than a shorter-
term bond when their market discount rates change by 9

the same amount (the maturity effect).

10
PRICING BONDS WITH SPOT RATES
 When a fixed-rate bond is priced using the market
discount rate, the same discount rate is used for each
cash flow.
 A more fundamental approach to calculate the price of
a bond is to use a sequence of market discount rates
that correspond to the cash flow dates.
 These market discount rates are called spot rates .
Spot rates are yields-to-maturity on zero-coupon bonds
maturing at the date of each cash flow.
 Sometimes these are called “zero rates.” Bond price (or
value) determined using the spot rates is sometimes
referred to as the bond’s “no-arbitrage value.”
 If a bond’s price differs from its no-arbitrage value, an
arbitrage opportunity exists in the absence of 11
transaction costs.
PRICING BONDS WITH SPOT RATES

12
PRICING BONDS WITH SPOT RATES
 Suppose that the one-year spot rate is 2%,
the two-year spot rate is 3%, and the three-
year spot rate is 4%.
 Then, the price of a three-year bond that

makes a 5% annual coupon payment is:

13
FLAT PRICE, ACCRUED INTEREST,
AND THE FULL PRICE
 When a bond is between coupon payment
dates, its price has two parts: the flat price
(PVFlat ) and the accrued interest ( A I ).
 The sum of the parts is the full price (PV
Full
), which also is called the invoice or “dirty”
price.
 The flat price, which is the full price minus

the accrued interest, is also called the quoted

or “clean” price.

14
FLAT PRICE, ACCRUED INTEREST,
AND THE FULL PRICE
 The flat price usually is quoted by bond
dealers. If a trade takes place, the accrued
interest is added to the flat price to obtain
the full price paid by the buyer and received
by the seller on the settlement date .
 The settlement date is when the bond buyer

makes cash payment and the seller delivers

the security.
 The reason for using the flat price for

quotation is to avoid misleading investors

about the market price trend for the bond.
15
ACCRUED INTEREST

16
FLAT PRICE, ACCRUED INTEREST,
AND THE FULL PRICE

17
CALCULATE FLAT PRICE, ACCRUED
INTEREST, AND THE FULL PRICE
 Consider a 5% semi-annual coupon payment
government bond that matures on 15 February
2028. Accrued interest on this bond uses the
actual/actual day-count convention.
 The coupon payments are made on 15

February and 15 August of each year. The bond

is to be priced for settlement on 14 May 2019.
That date is 88 days into the 181-day period.
 The annual yield-to-maturity is stated to be

4.80%.
 As of the beginning of the coupon period on 15

February 2019, there would be 18 evenly 18

spaced semi-annual periods until maturity.
MATRIX PRICING
 Some fixed-rate bonds are not actively traded.
Therefore, there is no market price available to
calculate the rate of return required by investors.
 The same problem occurs for bonds that are not

yet issued.
 In these situations, it is common to estimate the

market discount rate and price based on the

quoted or flat prices of more frequently traded
comparable bonds.
 These comparable bonds have similar times-to-

maturity, coupon rates, and credit quality.

 This estimation process is called matrix pricing.
19
MATRIX PRICING
 Suppose that an analyst needs to value a three-
year, 4% semi-annual coupon payment corporate
bond, Bond X. Assume that Bond X is not actively
traded and that there are no recent transactions
reported for this particular security. However,
there are quoted prices for four corporate bonds
that have very similar credit quality:
 Bond A: two-year, 3% semi-annual coupon payment
bond trading at a price of 98.500
 Bond B: two-year, 5% semi-annual coupon payment
bond trading at a price of 102.250
 Bond C: five-year, 2% semi-annual coupon payment
bond trading at a price of 90.250
 20
Bond D: five-year, 4% semi-annual coupon payment
bond trading at a price of 99.125
MATRIX PRICING

21
ANNUAL YIELDS FOR VARYING
COMPOUNDING PERIODS IN THE
YEAR

22
23
YIELD MEASURES FOR FIXED-RATE
BONDS
 Yield measures that neglect weekends and holidays are
quoted on what is called street convention.
 The true yield-to-maturity is the internal rate of
return on the cash flows using the actual calendar of
weekends and bank holidays.
 The current yield is the sum of the coupon payments
received over the year divided by the flat price.
 A callable bond contains an embedded call option that
gives the issuer the right to buy the bond back from the
investor at specified prices on predetermined dates.
 The preset dates usually coincide with coupon payment
dates after a call protection period.
 A call protection period is the time during which the
issuer of the bond is not allowed to exercise the call 24
option.
YIELD MEASURES FOR FIXED-RATE
BONDS
 Suppose that a seven-year, 8% annual coupon
payment bond is first callable in four years. That
gives the investor four years of protection against
the bond being called.
 After the call protection period, the issuer might
exercise the call option if interest rates decrease
or the issuer’s credit quality improves.
 The “call schedule” for this bond might be that it is
first callable at 102 (per 100 of par value) on the
coupon payment date in four years, callable at 101
in five years, and at par value on coupon payment
dates thereafter.
 If the current price for the bond is 105 per 100 of 25
par value, the yield-to-first-call in four years is?
YIELD MEASURES FOR FLOATING-
RATE NOTES
 The reference rate on a floating-rate note
usually is a short-term money market rate, such
as three-month Libor (the London Interbank
Offered Rate).
 The principal on the floater typically is non-

amortizing and is redeemed in full at maturity.

 The reference rate is determined at the

beginning of the period, and the interest

payment is made at the end of the period.
 This payment structure is called “in arrears.”

 The most common day-count conventions for

calculating accrued interest on floaters are 26

actual/360 and actual/365.
YIELD MEASURES FOR FLOATING-
RATE NOTES

27
YIELD MEASURES FOR FLOATING-
RATE NOTES
 Suppose that a two-year FRN pays six-month
Libor plus 0.50%. Currently, six-month Libor
is 1.25%.
 Suppose that the yield spread required by

investors is 40 bps over the reference rate,

DM = 0.0040.
 Par value is 100. Find the price of the floater?

28
YIELD MEASURES FOR MONEY
MARKET INSTRUMENTS

29
YIELD MEASURES FOR MONEY
MARKET INSTRUMENTS
 Suppose that a 91-day US Treasury bill (T-bill)
with a face value of USD10 million is quoted
at a discount rate of 2.25% for an assumed
360-day year.
 FV = 10,000,000, Days = 91, Year = 360,

and DR = 0.0225.
 The price of the T-bill is?

30
YIELD MEASURES FOR MONEY
MARKET INSTRUMENTS

31
YIELD MEASURES FOR MONEY
MARKET INSTRUMENTS
 Investment analysis is made difficult for money
market securities because
 Some instruments are quoted on a discount rate
basis and others on an add-on rate basis
 Some are quoted for a 360-day year and others for
a 365-day year.
 Another difference is that the “amount” of a money
market instrument quoted on a discount rate basis
typically is the face value paid at maturity.
 However, the “amount” when quoted on an add-on
rate basis usually is the principal, the price at
issuance.
 A bond equivalent yield is a money market 32
rate stated on a 365-day add-on rate basis.
YIELD MEASURES FOR MONEY
MARKET INSTRUMENTS
 Suppose that an investor is comparing two
money market instruments:
 90-day commercial paper quoted at a discount
rate of 5.76% for a 360-day year and
 90-day bank time deposit quoted at an add-on
rate of 5.90% for a 365-day year.
 Which offers the higher expected rate of
return assuming that the credit risks are the
same? The price of the commercial paper is
98.560 per 100 of face value,

33
THE MATURITY STRUCTURE OF
INTEREST RATES
 Suppose the spot rates on government bonds
are 5.263% for one year, 5.616% for two
years, 6.359% for three years, and 7.008%
for four years. These are effective annual
rates.
 Calculate the one year, two year, three years

and four years par rate?

34
FORWARD RATE
 A forward market is for future delivery,
beyond the usual settlement time period in the
cash market.
 A forward rate is the interest rate on a bond

or money market instrument traded in a forward

market.
 Implied forward rates (also known as forward

yields) are calculated from spot rates.

 An implied forward rate is a break-even

reinvestment rate.
 It links the return on an investment in a shorter-

term zero-coupon bond to the return on an 35

investment in a longer-term zero-coupon bond.
IMPLIED FORWARD RATES
 The implied forward rate between period A
and period B is denoted IFRA ,B−A. It is a
forward rate on a security that starts in
period A and ends in period B . Its tenor is B
− A periods.

36
IMPLIED FORWARD RATES
 Suppose that the yields-to-maturity on three-
year and four-year zero-coupon bonds are
3.65% and 4.18%, respectively, stated on a
semi-annual bond basis.
 An analyst would like to know the “3y1y”

implied forward rate, which is the implied

one-year forward yield three years into the
future.
 Therefore, A = 6 (periods), B = 8 (periods), B

− A = 2 (periods), z6 = 0.0365/2 (per period),

and z8 = 0.0418/2 (per period).
37
SPOT RATES
 The spot rate can be calculated as the
geometric average of the forward rates.
 Calculate the spot rates?

38
SPOT RATES
 Suppose that an analyst needs to value a
four-year, 3.75% annual coupon payment
bond that has the same risks as the bonds
used to obtain the forward curve. Using the
implied spot rates, the value of the bond is?

39
YIELD SPREADS

40
THE G-SPREAD AND THE Z-SPREAD
 The yield spread in basis points over a
government bond is known as the G-
spread .
 A constant yield spread over a government

(or interest rate swap) spot curve is known as

the zero volatility spread (Z-spread) of a
bond over the benchmark rate.
 The Z-spread is also used to calculate the

option-adjusted spread (OAS) on a

callable bond.

41
THE G-SPREAD AND THE Z-SPREAD

42
THE G-SPREAD AND THE Z-SPREAD

43