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Bonds and Securities Part 2

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Marvin Mondragon
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26 views

Bonds and Securities Part 2

Uploaded by

Marvin Mondragon
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 PPTX, PDF, TXT or read online on Scribd
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Determining the Price of a Bond

The price of a bond is the present value of its future cash


flows, which include:
 The annual coupon payments
 The repayment of the principal (face value) at maturity
EXAMPLE
This formula gives the present value of both the coupon payments and the face value.
Let's break it down:
1.Coupon Payments: The bondholder receives periodic coupon payments, and the
present value of these payments is calculated by discounting them at the market
interest rate.
2.Face Value (Principal): The face value is paid at the end of the bond's term (maturity),
and its present value is discounted at the same market interest rate.
Example of Calculating Bond Price
Let’s say you have a 10-year bond with the following characteristics:
 Face Value (F): $1,000
 Coupon Rate: 5% (meaning annual coupon payments of $50, or 5% of $1,000)
 Market Interest Rate (r): 4% (the current yield on similar bonds in the market)
The price of the bond is the sum of the present value of the coupon payments and the
face value:
1.The coupon payments are $50 per year for 10 years.
2.The face value of $1,000 is paid at the end of 10 years .
The bond price can be calculated using the formula:
EXAMPLE
Factors That Influence Bond Price
1.Interest Rates (Yield to Maturity):
oWhen market interest rates rise, the price of existing bonds falls because
newer bonds are issued with higher coupon rates, making the older bonds
less attractive.
When market interest rates fall, the price of existing bonds rises because
the fixed coupon payments on older bonds are now more attractive relative to
new bonds with lower rates

.
2 Credit Quality (Credit Rating):
oBonds issued by highly rated entities (e.g., government bonds) are
less risky and tend to maintain their price better.
oBonds from lower-rated entities (e.g., junk bonds) are riskier and can
have more price volatility.
EXAMPLE
3.Time to Maturity:
oThe longer the time to maturity, the more sensitive a bond’s price is
to interest rate changes. Longer-term bonds have higher duration,
meaning their prices fluctuate more when interest rates change.
oShort-term bonds are less sensitive to interest rate changes because
there’s less time for the market interest rate to affect the value of
the bond.
4.Coupon Rate:
oBonds with a higher coupon rate tend to be priced higher because
they pay more interest, which investors find attractive.
oBonds with a lower coupon rate tend to trade at a discount if
interest rates in the market are higher than the bond’s coupon rate.
EXAMPLE
Bond Price Relative to Par Value
 At Par: If the bond’s coupon rate is equal to the market
interest rate (yield), the bond price will be at par (i.e., it will
trade at its face value).
 Premium: If the coupon rate is higher than the market
interest rate, the bond will trade at a premium (i.e., above its
face value).
 Discount: If the coupon rate is lower than the market
interest rate, the bond will trade at a discount (i.e., below its
face value).
Other key bond formulas
 In addition
:
to the basic bond pric
e formula, there are
several other import
ant formulas related
to bonds that
help in evaluating th
eir performance, yie
ld, and risk. These
formulas are useful f
or both investors and
analysts who
need to assess the re
turn and characteristi
cs of a bond.
 Here’s a bre
akdown of the other
key bond formulas:
1. Yield to Maturity (YTM)

 Yield to Maturity (YTM) is the most widely used measure of a bond's return. It
represents the annualized return an investor can expect to earn if the bond is
held until maturity, considering both the bond’s current price and its coupon
payments.
The formula for YTM involves solving for r in the following equation, which is similar
to the bond price formula:
Since YTM involves solving for r :
So, the approximate YTM is 9.23%.
2. Current Yield
The current yield is a simple way to measure the income
(interest) you can expect to earn from a bond relative to its current
market price. It's calculated as the annual coupon payment divided
by the bond's current market price.

Note: The current yield does not


take into account the time value
of money or the bond's face value
repayment at maturity. It's a quick
measure of income return but
does not reflect the bond’s total
return over its life.
Conclusion:
The current yield of this bond is 5.71%. This means that based on the bond's current price, you would
earn 5.71% of your investment back in the form of annual coupon payments.
3. Yield to Call (YTC)
Some bonds, such as callable bonds, can be redeemed (called) by
the issuer before maturity. The Yield to Call (YTC) is similar to the
Yield to Maturity (YTM) but assumes that the bond will be called at
the earliest possible date (i.e., before the maturity date).

 YTC is useful for callable bonds because if interest rates fall, the issuer is more likely to
call the bond to refinance at a lower rate. This means the investor would have their
bond repaid early and receive the face value of the bond sooner.
Conclusion
By using trial and error, the yield to call r for this
bond is approximately 5.5% (although a financial
calculator or spreadsheet would make this more
precise).
4. Duration
Duration is a measure of a bond's sensitivity to interest rate changes. It
represents the weighted average time it takes for an investor to receive the
bond's cash flows (coupon payments and principal repayment). A bond with a
longer duration will typically have more price volatility in response to changes in
interest rates.

Duration can also be used to estimate a bond's price sensitivity to interest rate
changes. For example, if the bond's duration is 5 years, a 1% increase in interest rates
would result in a 5% decrease in the bond price.
5. Convexity
Convexity measures the curvature in the relationship between bond
prices and interest rates. While duration gives a linear approximation of price
changes, convexity accounts for the fact that the price-yield curve is not perfectly
straight. Bonds with higher convexity are less affected by interest rate changes.

 Higher convexity generally means a bond will have a higher price increase
when rates fall and a lower price decrease when rates rise.
Problem:
You are given the following information about a bond:

•Coupon Payment (C): $50 (annual coupon payment)


•Face Value (M): $1,000 (maturity value)
•Yield to Maturity (r): 5% or 0.05 (annual yield)
•Years to Maturity (T): 5 years
•Bond Price (P): $1,050 (current price of the bond)

We want to calculate the convexity of the bond.


Final Answer:
The convexity of the bond is approximately 24.61.
QUIZ
TIME
Than
ks!

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