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Bond Prices and Yields

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Bond Prices and Yields

CHAPTER 14

- Face or par value
- Coupon rate
- Zero coupon bond

- Compounding and payments
- Accrued Interest

- Indenture

Bahattin Buyuksahin, Derivatives Pricing

- U.S. Treasury
- Notes and Bonds

- Corporations
- Municipalities
- International Governments and Corporations
- Innovative Bonds
- Floaters and Inverse Floaters
- Asset-Backed
- Catastrophe

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- Secured or unsecured
- Call provision
- Convertible provision
- Put provision (putable bonds)
- Floating rate bonds
- Preferred Stock

Bahattin Buyuksahin, Derivatives Pricing

- Give bondholders an option to exchange each bond for a specified nb of shares of common stock
- Conversion ratio
- = number of shares per convertible bond

- = conversion ratio * current market value per share

- = bond value - conversion value
- intuitively: extra amount to pay so as to become a shareholder

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- Inverse Floaters
- Asset-Backed Bonds
- Catastrophe Bonds
- Indexed Bonds

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- Time value of money and bond pricing
- Time to maturity and risk
- Yield to maturity
- vs. yield to call
- vs. realized compound yield

- risk, maturity, holding period, etc.

Bahattin Buyuksahin, Derivatives Pricing

PB=Price of the bond

Ct = interest or coupon payments

T = number of periods to maturity

y = semi-annual discount rate or the semi-annual yield to maturity

Bahattin Buyuksahin, Derivatives Pricing

Ct= 40 (SA)

P= 1000

T= 20 periods

r= 3% (SA)

Bahattin Buyuksahin, Derivatives Pricing

- Equation:
- P = PV(annuity) + PV(final payment)
- =

Bahattin Buyuksahin, Derivatives Pricing

- Prices and Yields (required rates of return) have an inverse relationship
- When yields get very high the value of the bond will be very low
- When yields approach zero, the value of the bond approaches the sum of the cash flows

Bahattin Buyuksahin, Derivatives Pricing

- P yield
- intuition

- Fig 14.3
- intuition: yield P price impact

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- Interest rate that makes the present value of the bond’s payments equal to its price
Solve the bond formula for r

Bahattin Buyuksahin, Derivatives Pricing

10 yr MaturityCoupon Rate = 7%

Price = $950

Solve for r = semiannual rate

r = 3.8635%

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Bond Equivalent Yield

7.72% = 3.86% x 2

Effective Annual Yield

(1.0386)2 - 1 = 7.88%

Current Yield

Annual Interest / Market Price

$70 / $950 = 7.37 %

Yield to Call

Bahattin Buyuksahin, Derivatives Pricing

A zero rate (or spot rate), for maturity T is the rate of interest earned on an investment that provides a payoff only at time T

- Discount bonds, also called zero-coupon bonds, are securities which “make a single payment at a date in the future known as maturity date. The size of this payment is the face value of the bond. The length of time to the maturity date is the maturity of the bond” (Campbell, Lo, MacKinley (1996)).

Bahattin Buyuksahin, Derivatives Pricing

- The promised cash payment on a pure discount bond is called its face value or par value. Yield (interest rate) on a pure discount bond is the annualized rate of return to investors who buy it and hold it until it matures.

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- To calculate the cash price of a bond we discount each cash flow at the appropriate zero rate
- The theoretical price of a two-year bond providing a 6% coupon semiannually is

Bahattin Buyuksahin, Derivatives Pricing

- The bond yield is the discount rate that makes the present value of the cash flows on the bond equal to the market price of the bond
- Suppose that the market price of the bond in our example equals its theoretical price of 98.39
- The bond yield is given by solving
to get y = 0.0676 or 6.76%.

Bahattin Buyuksahin, Derivatives Pricing

- The par yield for a certain maturity is the coupon rate that causes the bond price to equal its face value.
- In our example we solve

Bahattin Buyuksahin, Derivatives Pricing

In general if m is the number of coupon payments per year, d is the present value of $1 received at maturity and A is the present value of an annuity of $1 on each coupon date

Bahattin Buyuksahin, Derivatives Pricing

- A discount function is a set of discount factors, where each discount factor is just a present value multiplier. For example, d(1.0) is the present value of $1 dollar received in one year. The key idea is that each d(x) can be solved as one variable under one equation because we already solved for shorter-term discount factors.
- The most popular approach is to use bootstrap method

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- Reinvestment Assumptions
- Holding Period Return
- Changes in rates affect returns
- Reinvestment of coupon payments
- Change in price of the bond

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

HPR = [ I + ( P0 - P1 )] / P0

where

I = interest payment

P1= price in one period

P0 = purchase price

Bahattin Buyuksahin, Derivatives Pricing

CR = 8% YTM = 8%N=10 years

Semiannual CompoundingP0 = $1000

In six months the rate falls to 7%

P1 = $1068.55

HPR = [40 + ( 1068.55 - 1000)] / 1000

HPR = 10.85% (semiannual)

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- Rating companies
- Moody’s Investor Service
- Standard & Poor’s
- Fitch

- Rating Categories
- Investment grade
- Speculative grade/Junk Bonds

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- Coverage ratios
- Leverage ratios
- Liquidity ratios
- Profitability ratios
- Cash flow to debt

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- Sinking funds
- Subordination of future debt
- Dividend restrictions
- Collateral

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- Risk structure of interest rates
- Default premiums
- Yields compared to ratings
- Yield spreads over business cycles

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- Major mechanism to reallocate credit risk in the fixed-income markets
- Structured Investment Vehicle (SIV) often used to create the CDO
- Mortgage-backed CDOs were an investment disaster in 2007

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- The Term Structure of Interest Rates

Bahattin Buyuksahin, Derivatives Pricing

- Information on expected future short term rates can be implied from the yield curve
- The yield curve is a graph that displays the relationship between yield and maturity
- Three major theories are proposed to explain the observed yield curve

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- Yields on different maturity bonds are not all equal
- Need to consider each bond cash flow as a stand-alone zero-coupon bond when valuing coupon bonds

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- An upward sloping yield curve is evidence that short-term rates are going to be higher next year
- When next year’s short rate is greater than this year’s short rate, the average of the two rates is higher than today’s rate

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

fn = one-year forward rate for period n

yn = yield for a security with a maturity of n

Bahattin Buyuksahin, Derivatives Pricing

4 yr = 8.00%3yr = 7.00%fn = ?

(1.08)4 = (1.07)3 (1+fn)

(1.3605) / (1.2250) = (1+fn)

fn = .1106 or 11.06%

Bahattin Buyuksahin, Derivatives Pricing

Zero-Coupon RatesBond Maturity

12%1

11.75%2

11.25%3

10.00%4

9.25%5

Bahattin Buyuksahin, Derivatives Pricing

1yr Forward Rates

1yr[(1.1175)2 / 1.12] - 1 =0.115006

2yrs[(1.1125)3 / (1.1175)2] - 1 =0.102567

3yrs[(1.1)4 / (1.1125)3] - 1 =0.063336

4yrs[(1.0925)5 / (1.1)4] - 1 =0.063008

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- What can we say when future interest rates are not known today
- Suppose that today’s rate is 5% and the expected short rate for the following year is E(r2) = 6% then:
- The rate of return on the 2-year bond is risky for if next year’s interest rate turns out to be above expectations, the price will lower and vice versa

Bahattin Buyuksahin, Derivatives Pricing

- Investors require a risk premium to hold a longer-term bond
- This liquidity premium compensates short-term investors for the uncertainty about future prices

Bahattin Buyuksahin, Derivatives Pricing

- The term structure of interest rates (or yield curve) is the relationship of the yield to maturity against bond term (maturity).
- Typical shapes are: increasing (normal), decreasing, humped and flat.

Yield

Maturity

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- For an upward sloping yield curve:
Fwd Rate > Zero Rate > Par Yield

- For a downward sloping yield curve
Par Yield > Zero Rate > Fwd Rate

Bahattin Buyuksahin, Derivatives Pricing

- A number of theory have been proposed: Expectation Hypothesis, Liquidity Preference Theory, Preferred Habitats Theory, Segmentation Hypothesis.
- Fabozzi (1998): PureExpectation Hypothesis, Liquidity Preference Theory, Preferred Habitats Theory are different forms of the expectation theory ==> two major theories: expectation theory and market segmentation theory.

Bahattin Buyuksahin, Derivatives Pricing

- The Pure Expectation Hypothesis: Implied forward rates are unbiased expectations of future spot rates ==> a rising term structure indicate that market expects short-term rates to rise in the future; a flat term structure reflects expectations that the future short term structure will be constant; and so on; Hicks (1937). Problems: It neglects the risks inherent in investing in bonds: if forward rates were perfect predictors of future interest rates then the future prices of bonds will be known with certainty.
- The Liquidity Preference Theory (Keynes): Given that there is uncertainty, long bonds should have higher returns than short bonds ==> we should expect a risk premium arising out from investors liquidity preferences. It is consistent with the empirical results that yield curves are upward sloping ==> positive risk premium.

Bahattin Buyuksahin, Derivatives Pricing

- The Preferred Habitat Theory: It adopts the view that the term structure is composed by two components: Expectations plus risk premium (= liquidity preference theory). However, the risk premium might be negative as well as positive to induce market participants to shift out of their preferred habitat (Modigliani & Sutch (1966)).
- The Segmentation Hypothesis (Culbertson (1957)): It also recognises that investors have preferred habitat (= preferred habitat theory) ==> individuals have strong maturity preferences ==> there need be no relationship between bonds with different maturities ==> bonds with different maturities are traded in different markets.

Bahattin Buyuksahin, Derivatives Pricing

- Observed long-term rate is a function of today’s short-term rate and expected future short-term rates
- Long-term and short-term securities are perfect substitutes
- Forward rates that are calculated from the yield on long-term securities are market consensus expected future short-term rates

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- Long-term bonds are more risky
- Investors will demand a premium for the risk associated with long-term bonds
- The yield curve has an upward bias built into the long-term rates because of the risk premium
- Forward rates contain a liquidity premium and are not equal to expected future short-term rates

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- If the yield curve is to rise as one moves to longer maturities
- A longer maturity results in the inclusion of a new forward rate that is higher than the average of the previously observed rates
- Reason:
- Higher expectations for forward rates or
- Liquidity premium

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- In general, forward rates will not equal the eventually realized short rate
- Still an important consideration when trying to make decisions :
- Locking in loan rates

- Still an important consideration when trying to make decisions :

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- Managing Bond Portfolios

Bahattin Buyuksahin, Derivatives Pricing

- Inverse relationship between price and yield
- An increase in a bond’s yield to maturity results in a smaller price decline than the gain associated with a decrease in yield
- Long-term bonds tend to be more price sensitive than short-term bonds

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- As maturity increases, price sensitivity increases at a decreasing rate
- Price sensitivity is inversely related to a bond’s coupon rate
- Price sensitivity is inversely related to the yield to maturity at which the bond is selling

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- A measure of the effective maturity of a bond
- The weighted average of the times until each payment is received, with the weights proportional to the present value of the payment
- Duration is shorter than maturity for all bonds except zero coupon bonds
- Duration is equal to maturity for zero coupon bonds

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Price change is proportional to duration and not to maturity

D*= modified duration

Bahattin Buyuksahin, Derivatives Pricing

Rule 1 The duration of a zero-coupon bond equals its time to maturity

Rule 2 Holding maturity constant, a bond’s duration is higher when the coupon rate is lower

Rule 3 Holding the coupon rate constant, a bond’s duration generally increases with its time to maturity

Rule 4 Holding other factors constant, the duration of a coupon bond is higher when the bond’s yield to maturity is lower

Rules 5 The duration of a level perpetuity is equal to: (1+y) / y

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- The relationship between bond prices and yields is not linear
- Duration rule is a good approximation for only small changes in bond yields

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Correction for Convexity:

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- As rates fall, there is a ceiling on possible prices
- The bond cannot be worth more than its call price

- Negative convexity
- Use effective duration:

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- Among the most successful examples of financial engineering
- Subject to negative convexity
- Often sell for more than their principal balance
- Homeowners do not refinance their loans as soon as interest rates drop

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- They have given rise to many derivatives including the CMO (collateralized mortgage obligation)
- Use of tranches

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- Bond-Index Funds
- Immunization of interest rate risk:
- Net worth immunization
Duration of assets = Duration of liabilities

- Target date immunization
Holding Period matches Duration

- Net worth immunization

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing

- Automatically immunize the portfolio from interest rate movement
- Cash flow and obligation exactly offset each other
- i.e. Zero-coupon bond

- Cash flow and obligation exactly offset each other
- Not widely used because of constraints associated with bond choices
- Sometimes it simply is not possible to do

Bahattin Buyuksahin, Derivatives Pricing

- Substitution swap
- Intermarket swap
- Rate anticipation swap
- Pure yield pickup
- Tax swap

Bahattin Buyuksahin, Derivatives Pricing

- Select a particular holding period and predict the yield curve at end of period
- Given a bond’s time to maturity at the end of the holding period
- Its yield can be read from the predicted yield curve and the end-of-period price can be calculated

Bahattin Buyuksahin, Derivatives Pricing

- A combination of active and passive management
- The strategy involves active management with a floor rate of return
- As long as the rate earned exceeds the floor, the portfolio is actively managed
- Once the floor rate or trigger rate is reached, the portfolio is immunized

Bahattin Buyuksahin, Derivatives Pricing

Bahattin Buyuksahin, Derivatives Pricing