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Bond Return and Valuation

This chapter discusses bond returns, valuation, and risk. It defines different types of bond returns including holding period return, current yield, and yield to maturity. It also outlines the main risks bonds carry, such as interest rate, default, marketability, and callability risk. The chapter then explains bond valuation theorems and the concept of duration as a measure of interest rate risk. Finally, it discusses immunization as a technique to mitigate uncertainty about future cash flows from a bond.

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45 views

Bond Return and Valuation

This chapter discusses bond returns, valuation, and risk. It defines different types of bond returns including holding period return, current yield, and yield to maturity. It also outlines the main risks bonds carry, such as interest rate, default, marketability, and callability risk. The chapter then explains bond valuation theorems and the concept of duration as a measure of interest rate risk. Finally, it discusses immunization as a technique to mitigate uncertainty about future cash flows from a bond.

Uploaded by

chitkarashelly
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Chapter 10

Bond Return
and
Valuation
Chapter Objectives
 To understand the basics of bond
 To know the concept of bond return and valuation
 To learn about the types of bond risk
 To understand the bond value theorems
 To understand the concept of duration and
immunisation
Concept of Bond
 It is a contract between a borrower and a lender in
which the borrower is required to pay a certain
amount of interest income to the lender.

 In general, bonds carry a fixed payment of interest


till the maturity date.

 The rate of interest is also known as coupon rate.


Bond Risk
 Bonds are considered to be quite safe but they also
carry a certain amount of risk.
 Types of bond risk:
 Interest rate risk: The value of bonds changes due to
variability of the market interest rates.
 Default risk: The borrower fails to pay the agreed value of
debt instrument on time.
 Marketability risk: There is difficulty in liquidating the
bonds in the market.
 Callability risk: There is an uncertainty created in the
returns of the investor by the issuer’s right to call the bond
any time.
Bond Return
There are several ways of describing a rate of return on
bond. Some of them are:
 Holding period return

 The current yield

 Yield to maturity
Holding Period Return
 It is a return in which an investor buys a bond and
liquidates it in the market after holding it for a
definite period of time.
 The formula for calculating holding period of return
is as follows:
Price gain + Coupon payment
Purchase price
 It can be calculated on a daily, monthly or annual
basis.
The Current Yield

 It is a measure through which the investors can easily


figure out the rate of cash flow on the investments
made by them every year.

 It is calculated as:

Annual Coupon Payment


Purchase Price
Yield to Maturity
 It is the single discount factor that makes the present
value of future cashflows from a bond equivalent to
the current price of the bond.
 The following assumptions are used to calculate yield
to maturity:
 There should not be any default.
 The interest payments are reinvested at yield to maturity.
 The investor has to hold the bond till its maturity.
 It is calculated as:

Coupon1 Coupon 2 (Coupon n + Face value)


Present value = 1
+ 2
+....+
(1+y) (1+y) (1+y)n
Bond Value Theorems
 These are evolved on the basis of three factors:
(i) coupon rate (ii) years to maturity (iii) expected rate of return.
 The five bond value theorems are as follows:
 Theorem 1: If the bond’s market price increases then its yield declines
and vice versa.
 Theorem 2: If the bond’s yield remains constant over its life, then the
discount or premium depends on the maturity period.
 Theorem 3: If the yield remains constant over its life, the discount and
premium on bonds will decline at an increasing rate as its life gets
shorter.
 Theorem 4: A raise in the bond’s price for a decline in the bond’s yield
is greater than the fall in the bond’s price for a raise in the yield.
 Theorem 5: The percentage change in the bond’s price owing to
change in its yield will be small if the coupon rate is high.
Duration
 It measures the time structure and interest rate risk of
the bond.
 The formula for calculating the duration is as follows:
T
Pv (C t )
D= t =1 P0
×t

where D = Duration
C = Cashflow
R = Current yield to maturity
T = Number of years
Pv(ct) = Present value of the cashflow
P0 = Sum of the present value of cashflow
Immunisation
 It is a technique that makes a bondholder relatively
certain about the promised cash stream.

 An immunisation can be achieved by reinvesting the


coupons in the bonds that offer higher interest rate.
Chapter Summary
By now, you should have:

 Understood the basics of bond

 Understood the concept of bond return and valuation

 Learnt about the types of bond risks

 Understood the various bond value theorems

 Learnt the concept of immunisation

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