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Bond Prices and Yields: Mcgraw-Hill/Irwin

Bond prices are found by adding together the present value of a bond's coupon payments and its face value. Bond prices can be calculated by trying different yields until we come across the one that produces the current price of the bond. If a bond has a coupon rate that is higher than its current yield, it's called a discount bond.

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100 views24 pages

Bond Prices and Yields: Mcgraw-Hill/Irwin

Bond prices are found by adding together the present value of a bond's coupon payments and its face value. Bond prices can be calculated by trying different yields until we come across the one that produces the current price of the bond. If a bond has a coupon rate that is higher than its current yield, it's called a discount bond.

Uploaded by

Ashutosh Kalra
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 24

Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin
10
Bond Prices and Yields
10-2
Bond Prices and Yields

Our goal in this chapter is to understand the relationship


between bond prices and yields.

In addition, we will examine some fundamental tools that


fixed-income portfolio managers use when they assess
bond risk.
10-3
Bond Basics, II.

Two basic yield measures for a bond are its


coupon rate and its current yield.
value Par
coupon Annual
rate Coupon
price Bond
coupon Annual
yield Current
10-4
The Bond Pricing Formula

Recall: The price of a bond is found by adding together the


present value of the bonds coupon payments and the present
value of the bonds face value.
The formula is:

In the formula, C represents the annual coupon payments (in $),


FV is the face value of the bond (in $), and M is the maturity of the
bond, measured in years.
( ) ( )
2M 2M
2
YTM
1
FV
2
YTM
1
1
1
YTM
C
Price Bond
+
+
1
1
1
]
1

+

10-5
Example: Using the Bond Pricing Formula

What is the price of a straight bond with: $1,000 face


value, coupon rate of 5%, YTM of 6%, and a maturity of
10 years?
( ) ( )
( ) ( )
$925.61.
553.68 0.44632) (833.33
2
0.06
1
1000
2
0.06
1
1
1
0.06
50
Price Bond
2
YTM
1
FV
2
YTM
1
1
1
YTM
C
Price Bond
10 2 10 2
2M 2M

+
+
+
1
1
1
]
1

+

+
+
1
1
1
]
1

+


10-6
Premium and Discount Bonds, I.

Bonds are given names according to the relationship


between the bonds selling price and its par value.

Premium bonds: price > par value


YTM < coupon rate

Discount bonds: price < par value


YTM > coupon rate

Par bonds: price = par value


YTM = coupon rate
10-7
Premium and Discount Bonds, II.
10-8
Relationships among Yield Measures
for premium bonds:
coupon rate > current yield > YTM
for discount bonds:
coupon rate < current yield < YTM
for par value bonds:
coupon rate = current yield = YTM
10-9
Calculating Yield to Maturity, I.

Suppose we know the current price of a bond, its coupon rate, and
its time to maturity. How do we calculate the YTM?
We can use the straight bond formula, trying different yields until
we come across the one that produces the current price of the
bond.
This is tedious. So, to speed up the calculation, financial
calculators and spreadsheets are often used.
( ) ( )
5 2 5 2
2
YTM
1
$1,000
2
YTM
1
1
1
YTM
$90
$1,083.17

+
+
1
1
1
]
1

+

10-10
Yield to Call

Yield to call (YTC) is a yield measure that assumes a bond will be


called at its earliest possible call date.
The formula to price a callable bond is:
In the formula, C is the annual coupon (in $), CP is the call price of
the bond, T is the time (in years) to the earliest possible call date,
and YTC is the yield to call, with semi-annual coupons.
As with straight bonds, we can solve for the YTC, if we know the
price of a callable bond.
( ) ( )
2T 2T
2
YTC
1
CP
2
YTC
1
1
1
YTC
C
Price Bond Callable
+
+
1
1
1
]
1

+

10-11
Interest Rate Risk and Maturity
10-12
Bond Prices and Yields
10-13
Duration

Bondholders know that the price of their bonds change when


interest rates change. But,
How big is this change?
How is this change in price estimated?
Macaulay Duration, or Duration, is the name of concept that
helps bondholders measure the sensitivity of a bond price to
changes in bond yields. That is:

Two bonds with the same duration, but not necessarily the same
maturity, will have approximately the same price sensitivity to a
(small) change in bond yields.
( )
2
YTM
1
YTM in Change
Duration Price Bond in Change Pct.
+

10-14
Example: Using Duration

Example: Suppose a bond has a Macaulay Duration of 6 years,


and a current yield to maturity of 10%.

If the yield to maturity declines to 9.75%, what is the resulting


percentage change in the price of the bond?
( ) [ ]
( )
-1.4286%
2
0.10
1
0.10 0.0975
6 - Price Bond in Change Pct.


10-15
Modified Duration

Some analysts prefer to use a variation of Macaulays


Duration, known as Modified Duration.

The relationship between percentage changes in bond


prices and changes in bond yields is approximately:

,
_

2
YTM
1
Duration Macaulay
Duration Modified
YTM in Change Duration Modified - Price Bond in Change Pct.
10-16
Calculating Macaulays Duration
10-17
Calculating Macaulays Duration

In general, for a bond paying constant semiannual


coupons, the formula for Macaulays Duration is:

In the formula, C is the annual coupon rate, M is the


bond maturity (in years), and YTM is the yield to maturity,
assuming semiannual coupons.
( )
( )
1
]
1

+ +
+ +

1
2
YTM
1 C YTM
YTM C M
2
YTM
1
YTM
2
YTM
1
Duration
2M
10-18
Calculating Macaulays Duration
for Par Bonds

If a bond is selling for par value, the duration formula can


be simplified to:
( )
1
1
1
]
1

2M
2
YTM
1
1
1
YTM
2
YTM
1
Duration Bond Value Par
10-19
Properties of Duration
10-20
Immunization by Duration Matching
10-21
Useful Internet Sites

www.bondmarkets.com (Check out the bonds section)

www.bondsonline.com (Bond basics and current market


data)

www.jamesbaker.com (A practical view of bond portfolio


management)
10-22
Chapter Review, I.

Bond Basics
Straight Bonds
Coupon Rate and Current Yield

Straight Bond Prices and Yield to Maturity


Straight Bond Prices
Premium and Discount Bonds
Relationships among Yield Measures
10-23
Chapter Review, II.

More on Yields
Calculating Yields
Yield to Call

Interest Rate Risk and Malkiels Theorems


Promised Yield and Realized Yield
Interest Rate Risk and Maturity
Malkiels Theorems
10-24
Chapter Review, III.

Duration

Macaulay Duration

Modified Duration

Calculating Macaulays Duration

Properties of Duration

Dedicated Portfolios and Reinvestment Risk


Dedicated Portfolios
Reinvestment Risk

Immunization
Price Risk versus Reinvestment Rate Risk
Immunization by Duration Matching
Dynamic Immunization

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