Securities &

Investment
(FINUCFS)
Bond
Valuation
SPECIAL CASES
Bond Fundamentals
Features of fixed income securities
Most fixed income instruments specify a number of features including
the following:

• The maturity date – the date that the obligation is to be fully repaid,
according to its provisions.

• The coupon – the income that the investor will receive each year.

• The par value – the principal value of the obligation; usually the
original value and also the amount to be returned to the investor on
the maturity date.
Classes of fixed-income securities

• Alternative bond issues

- Domestic government bonds

- Government agency issues
- Municipal bonds
- Corporate bonds
- International bonds
Domestic government bonds: UK
• U.K. government bonds are known as Gilts

(This term is also used in Ireland and in South Africa)

• Issued through the Bank of England

• Highest rating from Moody’s (Aaa) and S&P (AAA); therefore default risk
free
[After Brexit result, there was a downgrade from Fitch (AA),
Moodys (Aa2), S&P (AA)]

• Now: Fitch (AA-), Moodys (Aa3), S&P (AA), DBRS (AA)]

• Like Treasury bonds and Treasury notes, they pay semi-annual coupons
Corporate bonds

• Debt securities issued by corporations.

• Vary by:

– Level of claim (security)

– Credit quality (rated for default risk)

– Term to maturity

– Special features
Bond ratings
• Most bonds are rated for default, or credit risk by one or more rating
agency.

• Big four: Fitch, Moody’s, Standard & Poors (S & P), DBRS

• Ratings from AAA to D, some agencies give slightly different modifiers or

letters

• Top four ratings (AAA down to BBB): Investment Grade Securities

• Below the top four ratings: Speculative Grade Securities (High-yield or

junk bonds)
Bond Valuation
Fundamentals of bond valuation
Like other financial assets, the value of a bond is the present value of its expected
future cash flows
• To incorporate the specifics of bonds:

• This is the present value model where:

– Pm is the current market price of the bond
– n is the number of years to maturity
– C is the (yearly) coupon payment (usually constant over time)
– i is the yield to maturity of the bond
– Pp is the par value of the bond
Variations: Semi-annual coupons and zero-coupon
bonds
Pricing of Bonds
• Example: 10-yr, 4% Coupon (semi-annually), Face = £100, yield
= 6%
Pricing of Bonds
• Example: 10-yr, 4% Coupon (semi-annually), Face =
£100, yield = 8%
Pricing of Bonds
• Example: 10-yr, 4% Coupon (semi-annually), Face =
£100, yield = 10%
Bond price/yield relationships
Bond price/yield relationships
Pricing of Bonds
• Example: 10-yr, 4% Coupon (semi-annually), Face =
£100, yield=10%
Pricing of Bonds
• Example: 9-yr, 4% Coupon (semi-annually), Face =
£100, yield=10%
Pull to Maturity
Computing bond yields
Current yield
Current yield example
• Bonds of Zello Corporation
- Par Value $1,000
- Market Price $960
- Mature in 5 Years
- Annual coupon rate 7% (paid semi-annually)

• Calculate the Current Yield:

CY= C / Pm = (0.07x1000) / 960 = 7.29%

Shortcomings of the current yield
Promised yield to maturity
Promised yield to maturity (2)
Promised yield to maturity (3)
Example
Shortcomings of yield to maturity
Promised yield to call
Calculating promised yield to call
Example
Example cont’d
Shortcomings of yield to call
(Realized) Horizon Yield
(Realized) Horizon Yield – Example
(1)
(Realized) Horizon Yield – Example
(2)
Let’s do some practice!

What is the price of a 3-year bond with a semi-annual coupon of 5%, if

its yield to maturity is 12%? Assume a face value of £1,000.

6
50 1000
𝑃= ∑ 𝑇
+ 6
=£ 950.83
𝑇=1 (1+0.06) (1+0.06)
More practice! (2)

Suppose you observe the following term structure

t=0 t=1 t=2 t=3

Yield to 3% 5% 7%
maturity

Compute the prices of 1,2 and 3-year zero-coupon bonds with a face value of £1,000.
More practice! (2)
More practice! (3)

• Suppose that a firm issues a bond at a price of £1,100

and an annual coupon of 5%. The bond is callable after
2 years at a price of £1,300. Compute the yield to call of
the bond.
More practice! (3)
We can compute the yield to call from the following equation:

Where: nc is the number of years until the first call, k is the number of coupon payments per year and c is
the coupon. The market price (£1,100) is higher than the par value (£1,000) plus one year of interest
($1,000+$50= $1,050).The yield to call is then computed as follows:

The above is a second order equation, so it can be solved manually. Alternatively, one can use trial and
error (necessary for equations of order higher than 2). Therefore:
Set: and solve:

,942,500
Hence the roots of the equation are:
The Term Structure of Interest Rates
What determines interest rates?
Forecasting interest rates?
Determinants of interest rates
Determinants of interest rates (2)
Determinants of interest rates (3)
Historical US yield curves
Using the term structure
Bond valuation using the term
structure
Example
Calculation of forward rates
Converting From Spot to Forward
Rate

where:
ra​=The spot rate for the bond of term T+1​period.
rb​=The spot rate for the bond with a shorter term T​
period.​
Calculation of forward rates (2)
Calculation of forward rates (3)
Calculation of forward rates (4)
Let’s do some practice!
• Given the following spot rates with maturities of 1-4 years:
- tR1= 3%
- tR2 = 3.3%
- tR3 = 4.1%
- tR4 = 4.7%

Calculate the forward rates from:

- Year 0 to year 1
- Year 1 to year 2
- Year 2 to year 3
- Year 4 to year 5
 Let’s do some practice!
• Year 0 to year 1: 3%
• Year 1 to year 2:
(1+ tR1 )(1+ t+1R1) = (1+ tR2)2 => (1+0.03)(1+ t+1R1)=(1+ 0.033)2 => t+1R1
=0.036~3.6%

• Year 2 to year 3:
(1+ tR2)2(1+ t+2R1)=(1+ tR3)3 =>(1+0.033)2(1+ t+2R1)=(1+0.041)3 =>
R1=0.0572~5.72%
t+2

• Year 3 to year 4:
(1+ tR3)3(1+ t+3R1)=(1+ tR4)4 =>(1+0.041)3(1+ t+3R1)=(1+0.047)4=>
R1=0.0652~6.52%
t+3
Bond price volatility
Bond Price Volatility
• A bond with high price volatility or high interest rate
sensitivity is one that experiences a relatively large price
change for a given change in yields.

• Malkiel (1962) used the bond valuation model to demonstrate

that the market price of a bond is a function of four factors:

1. Its par value

2. Its coupon
3. The number of years to its maturity
4. The prevailing market interest rate
 Bond Price Volatility
• Malkiel’s mathematical proofs showed the following relationships between
yield (interest rate) changes and bond price behaviour:

1. Bond prices move inversely to bond yields (interest rates).

2. For a given change in yields (interest rates), longer maturity bonds
experience larger price changes; thus, bond price volatility is directly
related to term to maturity.
3. Bond price volatility increases at a diminishing rate as term to
maturity increases.
4. Bond price movements resulting from equal absolute increases or
decreases in yield are not symmetrical. A decrease in yield raises bond
prices by more than an increase in yield of the same amount
lowers prices.
5. Higher coupon issues show smaller percentage price fluctuation for a given
change in yield; thus, bond price volatility is inversely related to
coupon.
Duration (1)
Duration (2)
Macaulay Duration - Example
Duration and bond price volatility
Let’s do some practice!
• Consider a 3-year bond with 4% coupon paid annually, a
face value of £1,000 and a YTM of 7%. Compute the
Modified Duration of the bond.
Let’s do some practice!
• The Macaulay duration of the bond is defined as follows:
Let’s do some practice!
 Example
Suppose you observe the following
term structure of interest rates:
=0 t=1 t=1 t = 3 i. Compute the prices of 1, 2 and 3-
year zero-coupon bonds with a
Yield to face value of £1,000.
4% 5% 7%
maturity ii. Consider a 3-year bond with a 4%
annual coupon and a face value of
£1,000. Compute the Modified
Duration of the bond. (Use the
above term structure for your
answer)
Answer to Question 1

• Where:
 P(0) is the price of the zero-coupon bond at time o,
 Fv is the face value of the bond (in this case, £1,000),
 i​is the yield to maturity at time t,
 t is the time in years.
 Cont.
We are given the following yields to maturity:
 r1=4% for the 1-year bond,
 r2=5% for the 2-year bond,
 r3=7% for the 3-year bond.
• We will now calculate the price of each zero-coupon bond.
• Price of the 1-year bond:
• P=1,000(1+0.04)1​= 961.54
• Price of the 2-year bond:
• P=1,000(1+0.05)2 ​= 907.03
• Price of the 3-year bond:
• P=1,000(1+0.07)3 = 816.30
 Answer to the Question 2
Step 1: Calculate the Price of the Bond
The bond has the following characteristics:
Coupon Rate = 4%
Face Value (F) = £1,000
Coupon Payment (C) = £1,000 × 4% = £40 annually
Maturity (T) = 3 years
the term structure of interest rates is as follows:
t = 0: Yield = 4%
t = 1: Yield = 5%
t = 2: Yield = 7%
Where:
• CCC is the coupon payment (£40),
• FFF is the face value (£1,000),
• r1​, r2​, and r3​are the interest rates for years 1, 2, and 3 (4%, 5%, and
7%, respectively).
• Thus, the bond price becomes:
The P = + + = 38.46 + 36.28 + 848.95 = 923.69
 Macaulay Duration:

Bond with a maturity of 3 years, a 4% annual coupon and a face value of

£1,000.Using term structure: 4%, 5% and 7%.

Time Period 1 2 3

C 40 40 1040

PV of C 38.46 36.28 848.95

Value of the Bond 38.46 + 36.28 + 848.95 = 923.69

PV of C / Value of the Bond 0.0416 0.0393 0.919

t*PV of C / Value of the Bond 0.0416 0.0786 2.757

Macaulay Duration: Sum of t*PV of C / 2.8772

Value of the Bond
 Cont.
To compute the Modified Duration, using the third year’s YTM

𝑴𝑫=𝑫/(𝟏+𝒚/𝒌) = 2.8772/1.07 = 2.69 years.

Or ……..
Weighted Average Yield = w1​⋅r1​+w2​⋅r2​+w3​⋅r3​

• Substituting the values:

• Weighted Average Yield=(0.0416×4%)+(0.0393×5%)+(0.9205×7%)

• Weighted Average Yield=0.001664+0.001965+0.064435=0.068064 or

6.81%

• = 2.8772/1.0681 = 2.6938
Black-Scholes Model of Option
Pricing
Black-Scholes (2)

is the discount function for continuously compounded

variables
Black-Scholes (3)
Dividends and Black/Scholes
 Example
• The stock of Stirling PLC is currently trading at £45. The
risk-free rate is 8% per annum and the volatility is 30% per
annum. The company decides to issue options written on
its stock. The options are European. The underlying stock
pays no dividend.
Suppose you purchase a call option on Stirling’s stock with
a strike price of K = £42 and a maturity of 1 year.

• Compute the price of the option using the Black-Scholes-

Merton option pricing formula.
Answer
• The price of a call option according to the BSM formula
is computed as follows:

• Where: is the current stock price, K is the strike price, r

is the annual risk-free rate and T is the time to maturity.
Also:
Let’s do some practice (1)!
• We know that: . Thus we first compute:

• The values of are and from the tables of the normal

distribution.
• Thus, the price of the call option is: