Bonds Analysis Valuation

Bonds Analysis and Valuation Investments
1.A. Introduction to the Valuation of Debt Securities
LOS: 1.A.a. Describe the fundamental principles of bond valuation.
Determination of bond value is an application of the general valuation principal from the time
value of money concept. The value of any financial security, including that of a bond fixed or
floating rate, is the present value of future expected cash flows. This requires a three-step
process. Note that the first two steps are really inputs into the third and final step. The process is
also shown in a diagram for ease of understanding.
1. Cash flows: Project future expected cash flows and their timing during the life of
the bond, or financial security. No distinction is made between income and
principal.
2. Discount rates: Estimate appropriate discount rate for computing the present
value of each cash flow. If necessary, use a different discount rate for different
cash flows due to the shape of the yield curve (upward or downward sloping).
Treasury rate is used as a starting point with an adjustment for risk.
3. Present value: Compute the present value of each future cash flow by
discounting it to the present and add all the present values together to get the
current bond, or financial security, value.
Present value
Future expected model:
cash flows discount future
cash flows at the Bond value
specified
Risk-adjusted discount rate(s)
Discount rate(s) and add the
results together
LOS: 1.A.b. Identify the types of bonds for which estimating the expected cash flows is
difficult, and explain the problems encountered when estimating the cash flows for these
bonds.
There are two reasons why estimation of cash flows for bonds may be difficult. These are:
existence of embedded options and adjustment of coupon in the future on the basis of an as yet
unknown value of a reference rate.
More specifically, the following situations will be fraught with cash flow as well timing
uncertainty:
i. when the issuer or the investor holds an option that will shorten the maturity of
the bond and the final cash flow will be different from the bonds face or maturity
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value. Examples include callable and putable bonds. If interest rates fall below
the coupon rate on a fixed rate bond, the issuer is likely to call the bond and retire
it at the call price. The latter depends upon when the call is made. Thus, there is
uncertainty about the timing as well as the amount. If market yields rise above
some benchmark rate, a putable bonds value may drop far enough for the
investor to exercise her put option by forcing a sale of her bond to the issuer. In
order to estimate the timing of a call or a put, an analyst has to investigate and
model the potential course of market yields in the future. Since the future is
unpredictable, this is a difficult problem.
ii. when the investor holds a bond with an embedded option that entitles him to
convert the bond into common shares, such as in the case of a convertible bond.
While the conversion ratio of a convertible bond is pre-specified, there is
uncertainty about the conversion value, i.e., price of stock at the time of the
conversion. Furthermore, if the stock price remains low the bond will not be
converted. This, once again gives rise to the problem of estimating the amount
and its timing. This requires forecasting the probable price path of the stock price.
Many such bonds are also callable, compounding the problem.
iii. when the coupon rate of a bond is reset periodically according to a pre-specified
formula that depends on the value of a reference rate in the future, such as the
Treasury rate or LIBOR. Uncertainty about the rate and its probable path creates a
problem for the analyst who is trying to project future cash flows of the bond.
LOS: 1.A.c. Determine the appropriate interest rates to use in discounting a bonds cash flows.
If a security is issued by the US government, or US Treasury, it is considered default or risk free.

In order to value a Treasury security, Treasury yields would be appropriate. However, non-US
Treasury issues carry some risk of default. An investor would require a premium in the form of
yield spread for this risk. Thus, the appropriate discount rate for a risky cash flow would equal
the risk free rate for the corresponding maturity plus a risk premium to compensate the investor
for additional risk borne. Thus,
discount rate = corresponding maturity risk free rate + yield spread (default risk premium)
While a single discount rate is often used for all maturities, different discount rates may be more
appropriate when the yield curve is not flat. If a single rate is used for discounting when the yield
curve is not flat, it would represent an average of the different rates. Use of both single and
multiple discount rates is discussed in the following LOSs.
Editors Note: Yield spread is based on the credit rating (risk) of the risky security and also
includes a premium for lack of liquidity if the issue is not traded actively. The lower the credit
rating, higher is the yield spread, all else being equal.
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LOS: 1.A.d. Compute the value of a bond, given the expected cash flows and the appropriate
discount rates.
Using a single discount rate: The formula for discounting each future cash flow is simple.
Cash Flow
Present value of a single future Cash Flow =
(1 + y )
Where Cash Flow is the coupon or interest payment at time and y is the appropriate discount

rate. After present values of all future cash flows have been calculated, they are simply added to
arrive at the value of a bond maturing at time T.
Bond value = Present value1 + Present value2 + . . . Present value + . . . + Present valueT

Example 1:
Assume that Yakamichi Electronics has a 4-year 6% annual payment coupon issue
outstanding. The bonds have a par value of 100,000 each. Compute the value of the
Yakamichi bond if the market yield for similar bonds is 7%. Assume a single discount
rate for all cash flows.
Answer:
Each future cash flow is discounted according to the formula given earlier. Results are
shown in the table below.
Time Cash Flow Present Value (PV)

6, 000
1 (Coupon) 6% x 100,000 = 6,000 = 5,607.48
(1 + 0.07)1
6, 000
2 (Coupon) 6% x 100,000 = 6,000 = 5,240.63
(1 + 0.07) 2
6, 000
3 (Coupon) 6% x 100,000 = 6,000 = 4,897.79
(1 + 0.07)3
6, 000
4 (Coupon) 6% x 100,000 = 6,000 = 4,577.37
(1 + 0.07) 4
100, 000
4 (Maturity or Par Value) 100,000 = 76,289.52
(1 + 0.07) 4
Bond Value (Total PV) 96,612.79
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The value of the bond is the total of the present values (last column) and equals
96,612.79. You can also compute the value of this bond with the help of a financial
calculator. You will enter the following values:
N = 4; I/Y = 7%; PMT = 6,000; FV = 100,000 and then press CPT PV (TI BA II PLUS).
The result will be the same as the value computed above.
Using multiple discount rates: The formula for discounting each future cash flow is still simple.
Cash Flow
(1 + y )

Where Cash Flow is the coupon or interest payment at time and the only change is in the

discount rate. Now y is the appropriate discount rate, which is different for different maturities.

After present values of all future cash flows have been calculated, they are simply added to
arrive at the value of a bond maturing at time T as before.
Bond value = Present value1 + Present value2 + . . . Present value + . . . + Present valueT

Example 2:
Continuing with Yakamichi Electronics 4-year 6% annual payment coupon issue with a
par value of 100,000 each, compute the value of the Yakamichi bond if the discount rate
for similar bonds is maturity dependent and given as: 7% for the 1st payment, 6.5% for
the 2nd payment, 7.5% for the 3rd payment, and, 8% for the last years payments.
Answer:
shown in the table below.

6, 000
1 (Coupon) 6% x 100,000 = 6,000 = 5,607.48
(1 + 0.07)1
6, 000
2 (Coupon) 6% x 100,000 = 6,000 = 5,289.96
(1 + 0.065) 2
6, 000
3 (Coupon) 6% x 100,000 = 6,000 = 4,829.76
(1 + 0.075)3
6, 000
4 (Coupon) 6% x 100,000 = 6,000 = 4,410.18
(1 + 0.08) 4
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100, 000
(1 + 0.08) 4
93,640.37.
Editors Note: Unfortunately the above multiple discount rate calculation cannot be done on the
financial calculators (HP or TI). The only way to value a bond under this scenario is to discount each cash
flow at its corresponding discount rate and add the present values manually. However, you can still use
the financial calculator to compute the present value of each payment. For example, for the second
payment you would enter the following:
N = 2; I/Y = 6.5%; FV = 6,000 and then press CPT PV (TI BA II PLUS). Note that you do not use the
PMT key for any of the individual calculations coupon payment or the maturity value. Repeat this
process for all cash flows.
Extension to semi-annual coupon payments
If a bond pays its coupon semi-annually, the same formula as given above can be used with a
slight modification. Since each coupon payment will be halved, the number of payments will
double (two per year). To adjust for the discounting period, market yield would have to be
halved as well. The rest of the process remains the same.
Example 3:
Assume now that Yakamichi Electronics has a 4-year 6% semi-annual payment coupon
issue outstanding. The bonds have a par value of 100,000 each. Compute the value of
the Yakamichi bond if the market yield for similar bonds is 7%. Assume a single discount
rate for all cash flows.
Answer:
shown in the table below. Note that the number of payments have been doubled and the
amount of each coupon payment has been halved (@ 3%). Discount rate has been
adjusted by a factor of half (@ 3.5%) as well. Maturity principal remains the same.

3, 000
1 (Coupon) 3% x 100,000 = 3,000 = 2,898.55
(1 + 0.035)1
3, 000
2 (Coupon) 3% x 100,000 = 3,000 = 2,800.53
(1 + 0.035) 2
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3, 000
3 (Coupon) 3% x 100,000 = 3,000 = 2,705.83
(1 + 0.035)3
3, 000
4 (Coupon) 3% x 100,000 = 3,000 = 2,614.33
(1 + 0.035) 4
3, 000
5 (Coupon) 3% x 100,000 = 3,000 = 2,525.92
(1 + 0.035)5
3, 000
6 (Coupon) 3% x 100,000 = 3,000 = 2,440.50
(1 + 0.035)6
3, 000
7 (Coupon) 3% x 100,000 = 3,000 = 2,357.97
(1 + 0.035)7
3, 000
8 (Coupon) 3% x 100,000 = 3,000 = 2,278.23
(1 + 0.035)8
100, 000
(1 + 0.07)8
96,563.02. You can also compute the value of this bond with the help of a financial
calculator. You will enter the following values:
N = 8; I/Y = 3.5%; PMT = 3,000; FV = 100,000 and then press CPT PV (TI BA II PLUS).
The result will be the same as the value computed above.
LOS: 1.A.e. Explain how the value of a bond changes if the discount rate increases or
decreases, and compute the change in value that is attributable to the rate change.
Let us revisit the present value formula for a single payment given in the previous LOS.
Cash Flow
(1 + y )
The discount rate y appears in the denominator. Thus, mathematically, if y increases, the present
value of the cash flow decreases. This is known as an inverse relationship between discount rates
and present values. Since the present value of each cash flow decreases, the sum of their present
values, or the value of a bond or a financial security, also decreases if the discount rate increases.
The opposite is true if the discount rate decreases the value of the bond increases.
We illustrate this with the help of Yakamichi bonds. Let us first see the impact of an increase in
the discount rate on the present value of one of the cash flows. We consider the coupon payment
in year 3, under the annual coupon assumption and a single discount rate to keep things simple.
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The present value of the third-year coupon, 6,000, discounted at 7% was 4,897.79. This is given
in the table under Example 1 in the previous LOS. If the discount rate increases to 8%, the
present value would decline to 4,762.99. This is a drop of 134.80 (= 4,762.99 4,897.79).
Let us now assume that the discount rate drops to 5.5% from 7%. Under this scenario, the present
value of the third coupon payment increases to 5,109.68. This amounts to an increase of 211.89
(= 5,109.68 4,897.79).
The value of Yakamichi bonds under these two discount rates is given below. They are based on
annual coupon with a single discount rate for all cash flows. We have used the financial
calculator and detailed calculations are not shown.
Discount rate Bond Value Change in Value

8% (higher) 93,375.75 (lower) -3,237.04
7% (original base case) 96,612.79 (original) 0
5.5% (lower) 101,752.58 (higher) 5,139.79
Changes in bond value are also shown in the last column. When the discount rate goes up to 8%,
bond value declines to 93,375.75, a drop of 3,237.04 (= 93,375.75 96,612.79). When the
discount rate declines to 5.5%, the bond value rises to 101,752.58, an increase of 5,139.79 (=
101,752.58 96,612.79).
The inverse relationship between bond value and discount rate or market yield is shown below. It
is known as a convex relationship or curve. The curvature of this inverse relationship is known
as convexity. Note that the relationship between the two is non-linear (not a straight line).
bond price Convexity

or value
yield
Editors Note: So, what does all this mean? This means that if rates rise to very high levels,
the rate of drop in bond price decreases. In other words, convexity provides a cushion to falling
bond prices when market yields are rising. When market yields fall, bond price begins to
increase at an accelerating pace. Thus, convexity is good for bond investors.
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LOS: 1.A.f. Explain how the price of a bond changes as the bond approaches its maturity date,
and compute the change in value that is attributable to the passage of time.
In order to understand the impact of shortening maturity on bond values, let us revisit the present
value equation for a single cash flow.
Cash Flow
(1 + y )
As time remaining for a payment, , changes, the present value changes. If time decreases, the
present value of a single future payment increases. However, the relationship between time
remaining to maturity and present value of a coupon-bond is not straight forward. Whether the
present value of a coupon-bond decreases or increases depends upon the relationship between the
coupon rate and the discount rate.
Premium bond: If the coupon rate is above the discount rate or yield, the bond would sell above
par. We know that on the maturity date, the bond must equal its par value, ignoring the last
coupon payment. Thus, as maturity declines, the value of a premium bond decreases and
approaches its par value, assuming that the yield remains unchanged.
Discount bond: If the coupon rate is below the discount rate or yield, the bond would sell below
par. We know that on the maturity date, the bond must equal its par value, ignoring the last
coupon payment. Thus, as maturity declines, the value of a discount bond increases and
approaches its par value, assuming that the yield remains unchanged.
Par bond: If the coupon rate is equal to the discount rate or yield, the bond would sell at par. We
know that on the maturity date, the bond must equal its par value, ignoring the last coupon
payment. Thus, as maturity declines, the value of a premium bond would remain at par value,
assuming that the yield remains unchanged.
The different scenarios are summarized in the graph below.
Bond Premium bond

value
Par
Time
value
Maturity
Discount bond
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Example:
Assume that Gourmet Foods has a 6-year 5.5% semi-annual payment coupon issue
outstanding. The bonds have a par value of $1,000 each. (i) Compute the change in the
value of Gourmet bonds one year from now, if the yield remains at its current level of
7%. (ii) Compute the change in the value of Gourmet bonds one year from now, if the
yield remains at its current level of 5%. Assume a single discount rate for all cash flows.
Answer:
Case 1: Yield remains at its current level of 7%
Current price = 927.52
We enter the following values in the financial calculator
N=12; I/Y = 3.5%; PMT = 27.50; FV = 1,000; and, press CPT PV.
Price after 1 year = 937.63
Note that the passage of 1 year reduces the number of payments, N, by 2. The
change in value equals $10.11 (= 937.63 927.52), an increase because the
bond is selling below par, i.e., it is a discount bond.
Case 2: Yield remains at its current level of 5%
Current price = 1,025.64
Price after 1 year = 1,021.88
Note that the passage of 1 year reduces the number of payments, N, by 2. The
change in value equals $3.76 (= 1,021.88 1,025.64), a decrease because the
bond is selling above par, i.e., it is a premium bond.
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Coupon rate > Coupon rate = Coupon rate <

Discount rate Discount rate Discount rate
Type of bond Premium bond Par bond Discount bond
LOS: 1.A.g. Compute the value of a zero-coupon bond.
Valuation formula: A zero-coupon bond does not pay any coupon and has a bullet maturity
principal. Thus, it is the easiest bond to value using the present value model. In fact, its valuation
is based on the present value formula for a single future cash flow.
Maturity principal
value of zero-coupon bond =
y 2T
1 +
2
By convention, a zero-coupon bond is discounted semi-annually at the semi-annual yield to make

it comparable to a semi-annual coupon bond, and to ensure that the two are priced on the same
basis. After all, the maturity value of a coupon-bond, if stripped, is simply a zero-coupon bond.
In the US, most bonds pay interest semi-annually. Thus, in the above formula, annual yield, y, is
halved to y/2 and used as the discount rate. Since there are two semi-annual periods in a year, if
the bond matures in T years, there would be 2T discounting periods.
Example:
Qwan Motors is considering a 25-year zero-coupon bond issue for private placement.
Annualized yield on similar credit quality and maturity bonds averages 6.25%. At what
price can Qwan Motors expect to sell this issue? Assume a face value of $1,000 each.
Answer:
Using the above formula,
1, 000
value of Qwan zero-coupon bond = = 214.69
50
0.0625
1 +
2
The value can also be computed with the help of a financial calculator. Enter
N = 2 x 25 = 50; I/Y = 6.25% 2 = 3.125%; FV = 1,000 and press CPT PV.
LOS: 1.A.h. Explain the arbitrage-free valuation approach and the market process that forces
price of a bond toward its arbitrage-free value.
The traditional bond valuation approach emphasizes the use of a single discount rate to discount
all future cash flows from a coupon-bond. The arbitrage-free valuation approach states that this
2004 finSage Inc. 10

practice could lead to excess and instantaneous profits for shrewd traders who notice price
discrepancies between the single discount rate approach and the multiple discount rate approach.
Arbitrage free approach: Price discrepancies can arise from the fact that an investor may use
the yield on a five-year Treasury coupon note to discount cash flows of a corporate note, after
adjusting for credit risk with the help of yield spread. In other words, if the 5-year Treasury yield
is 7% and the yield spread is 0.75%, the appropriate discount rate for a corporate note would be
7.75%. However, due to differences in coupon rates between the two securities, using a single
discount rate is inappropriate. The arbitrage-free approach advocates the use of the Treasury
spot yield curve. Recall that each coupon payment as well as the maturity principal, can be
regarded as a bullet or a zero-coupon security if stripped from the rest of the note. This is true of
both Treasuries and corporates. Thus the proper discount rate for a coupon bond/note should be
based on the yields on Treasury zero-coupon securities corresponding to the maturities involved
in the security being valued. The structure of yields on different maturity zero-coupon Treasuries
is known as the spot yield curve and each yield is known as the Treasury spot rate. The arbitrage-
free approach essentially amounts to using multiple discount rates, and not a single rate.
LOS: 1.A.i. Determine whether a bond is undervalued or overvalued, given the bonds cash
flows, appropriate spot rates or yield to maturity, and current market price.
A bond is valued on the basis of the spot yield curve, using its coupon payments as potential
stripped securities. Each strip is valued independently on the basis of spot rates and the total
amount is compared with the bond price. If,
Sum of strip values > Bond price Buy the bond and strip coupons and sell separately
Sum of strip values < Bond price Buy the strips and reconstitute them and sell as a bond
Role of Treasury spot rates and an example: We will assume that the Treasury spot curve is
given. Let us value a 5-year, $1,000 face value, Treasury note with the help of the spot yields.
We ignore credit risk for now as it is easily incorporated. The Treasury note offers a coupon rate
of 6%, payable semi-annually. A hypothetical spot yield curve is given below. What is the value
of the 5-year Treasury note?
Years 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0
Spot
rate 3.75% 3.90% 4.25% 4.50% 4.65% 4.75% 4.82% 4.87% 4.91% 4.94%
Note: All spot rates or yields have been annualized.
In order to value the 5-year 6%, semi-annual Treasury note, we apply the multiple discount rate
approach using the above spot rates. The following table illustrates the process.

Years Period Spot Rate Cash Flow Present Value

30
= 29.45
0.5 (Coupon) 1 3.75% $30 1
0.0375
1 +
2
1.0 (Coupon) 2 3.90% $30 28.86
1.5 (Coupon) 3 4.25% $30 28.17
2.0 (Coupon) 4 4.50% $30 27.45
2.5 (Coupon) 5 4.65% $30 26.74
3.0 (Coupon) 6 4.75% $30 26.06
3.5 (Coupon) 7 4.82% $30 25.39
4.0 (Coupon) 8 4.87% $30 24.75
4.5 (Coupon) 9 4.91% $30 24.12
5.0 (Coupon) 10 4.94% $30 23.50
5.0 (Maturity principal) 10 4.94% $1,000 783.49
Total Present Value 1,047.98
Each cash flow is valued as if it were a zero-coupon security. The value of this notes equals
$1,047.98. The arbitrage-free approach forces the price to its equilibrium value where arbitrage
opportunities are eliminated by early movers. The process is known as strip and reconstitution
where the trader strips coupon payments and sells them separately or vice-versa. If the price of
the bond is less than the value of its stripped securities, the trader will buy the bond and sell the
strips separately. If the bond is priced higher, the trader will buy the strips, reconstitute them into
a single bond and sell them at a higher price for an arbitrage profit.
LOS: 1.A.j. Explain how a dealer can generate an arbitrage profit.
Pricing with a single discount rate: Suppose that the 5-year Treasury note in the preceding
example is priced using a single discount rate, based on an on-the-run (most liquid) 5-year
Treasury security with a yield of 5.0%. If we use this yield to price the bond in question, its price
would equal $1,043.76. We use the financial calculator to value the note. Enter
N = 10; I/Y = 5.0% 2 = 2.5%; PMT = 30; FV = 1,000 and press CPT PV.
Opportunity for arbitrage profits: Note that this price is less than the arbitrage-free price. A
dealer can buy the 5-year Treasury note selling at 1,043.76, and strip out all its payments and
sell them separately as zero-coupon bonds to investors. The investors would be willing to pay the
dealer a total of 1,047.98 the total of individual strip prices based on Treasury spot rates. Thus,
the dealer would make an arbitrage profit of $4.22 (= 1,047.98 1,043.76). Competition for this
profit will force the price of the note closer to its arbitrage-free value until all the profit
disappears. In equilibrium, the arbitrage-free price of 1,047.98 will prevail.
If the single discount rate price were higher, the dealer would do the opposite. She would buy
enough zero-coupon securities that would constitute the coupon bond and sell them at a higher

price as a single coupon paying synthetic security, pocketing the difference as her arbitrage
profit. In equilibrium, this profit would disappear and the arbitrage-free value will prevail.
Market equilibrium: This is known as the process of stripping and reconstitution. Existence
of the Treasury strip security market is the key to reaching the above equilibrium. Transaction
costs have been ignored for the illustration of this principle.
Quick Review
Bond valuation: Bond valuation consists of three steps: estimation of future bond cash flows,
estimation of an appropriate discount rate, and discounting of future cash flows for arriving at the
bonds present value as an estimate of its price. Two different assumptions are possible: a single
discount rate for all maturities, or multiple discount rates, one for each maturity.
Discount rate: The appropriate discount rate for a given maturity is based on the risk free rate
for the corresponding maturity plus a premium for default risk (risky bonds).
Effect of changing discount rates: Bond price sensitivity bears a negative relationship to the
discount rate (also known as yield). When the discount rate increases, bond prices fall and vice-
versa. Discount rates are based on market interest rates for risk free bonds and changes in market
interest rates directly affect discount rates on bonds.
Bond price and coupon rate: If a bonds coupon rate equals the prevailing market discount rate,
the bond would sell at par. If the discount rate were to exceed the coupon rate, the bond would
sell at a discount. Finally, if the coupon rate were to exceed the discount rate, the bond would
sell at a premium above par.
Bond price and maturity date: A bond may be a par, discount or a premium bond depending
upon the relationship between its coupon rate and the market discount rate. Irrespective of a
bonds price before maturity, it converges to its par value on the maturity date. A premium
bonds price will, therefore, decline over time, if market rates remain unchanged. A discount
bonds price will increase over time, if market rates remain unchanged.
Arbitrage profit: Arbitrage profit is profit earned by exploiting mispricing of securities in the
market. It enables a trader to earn a risk free profit with zero investment by simultaneously
entering into purchase and sell transactions on the same security.
Arbitrage-free valuation approach: Under the arbitrage-free valuation approach it is assumed

that a trader can strip the coupon payments of a bond and sell them individually on the basis of
their individual yields. By simultaneously buying a bond (if underpriced) and selling the strips, a
trader can earn arbitrage profits. As more and more traders attempt such a strategy, the price of
the bond will rise and that of strips will fall until the two are in an arbitrage-free equilibrium.
Arbitrage leads to a price where no further arbitrage is possible. It is a self-annihilating strategy.

Bond under- or overvaluation: A bond may be over- or undervalued on the basis of the
Treasury spot rates. A spot rate is the discount rate for a given maturity zero-coupon bond. Under
and overpriced bonds offer arbitrage opportunities to traders.

1.B. Yield Measures, Spot Rates, and Forward Rates
LOS: 1.B.a. Explain the sources of return from investing in a bond (i.e., coupon interest
payments, capital gain/loss, reinvestment income).
Coupon or interest income: This is the income earned by an investor in the form of regular
coupon payments. If a bond pays 6% coupon, semi-annual payments, for 10 years, an investor
would receive $30 (or 3% = 6% 2) every six-months on the basis of $1,000 par value (= 3% x
1,000).
Capital gain: An investor receives a gain in the form of price appreciation if the liquidation
value of a bond exceeds its purchase price for the investor. There are three ways in which a bond
can be liquidated: sold in the market before maturity, called by the issuer before maturity or
redeemed at maturity by the issuer. These are illustrated in the diagram below.
Sold prior to maturity at a price of

992. Capital gain = 992-975 = 17
Coupon
bond Called prior to maturity at a price
purchased of 1,050. Capital gain = 1,050-975
at 975 = 75
Redeemed at maturity at face value

of $1,000. Capital gain = 1,000-
975 = 25
Capital loss: An investor incurs a loss in the form of price depreciation if the liquidation value
of a bond is less than its purchase price for the investor. There are three ways in which a bond
can be liquidated: sold in the market before maturity, called by the issuer before maturity or
redeemed at maturity by the issuer. These are illustrated in the diagram below.
Sold prior to maturity at a price of
992. Capital loss = 992-1,165 = -173
Coupon
Called prior to maturity at a price of
bond
1,050. Capital loss =1,050-1,165 = -
purchased
115
at 1,165
Redeemed at maturity at face value of

$1,000. Capital loss = 1,000-1,165 =
-165

Reinvestment income: When an investor receives periodic coupon payments from a bond, she
may need to reinvest them instead of consuming them. The interest income earned from
reinvestment of coupon payments is known as reinvestment income. Some bonds that are
amortizing, such as sinking fund bonds and mortgages, also make periodic principal repayments.
Income earned from their reinvestment is also known as reinvestment income.
LOS: 1.B.b. Compute the traditional yield measures for fixed-rate bonds (e.g., current yield,
yield to maturity, yield to first call, yield to first par call date, yield to put, yield to worst, cash
flow yield).
This is a long LOS! So, be forewarned.
Current yield: This is the simplest of the seven yields mentioned in this LOS. It simply relates
the coupon payment to the current market price of the bond, not the price paid. In other words,
current yield changes continuously as the bond price changes.
annual coupon interest

current yield =
current price
For example, assume that a 7-year 5%, $1,000 face value bond is selling for 986.75. Its current
yield will be:
50
current yield = = 0.0507 or 5.07%
986.75
Note that even if the bond pays semi-annual coupon, current yield is expressed on annual basis.
Current yield ignores potential capital gains or losses and reinvestment income.
Yield to maturity: This yield, which is most commonly used, assumes that the bond will be held
until maturity if purchased at the current market price, and, the coupon income will be reinvested
at a rate equal to the yield to maturity. This is an internal rate of return calculation. All future
cash flows are discounted at a single discount rate and their total present value is set equal to the
price of the bond. The analyst then searches for the right discount rate that will achieve the
equality of the two sides of the equation.
For example, a 5-year 5%, $1,000 face value bond is selling for 986.75. Coupon is paid semi-
annually. Its yield to maturity (YTM), or simply yield, will be computed from the following
equation,

25 25 25 25 25 25
986.75 = 1
+ 2
+ 3
+ 4
+ 5
+ 6
+
y y yy y y
1 + 1 + 1 +
1 + 1 + 1 +
2 2 2
2 2 2
25 25 25
1, 000 25
7
+ 8
+ 9
+ 10
+ 10
y y y y y
1 + 1 + 1 + 1 + 1 +
2 2 2 2 2
The above equation, which is a total of present values of individual cash flows, can be solved for
y, the yield, in two ways. First, one can try different values, trial and error, until the right hand
side equals the left hand side price. Second, use a financial calculator. Enter
N = 5 x 2 = 10; PV = -986.75; PMT = 50 2 = 25; FV = 1,000 and press CPT I/Y.
Price is entered as a negative number because it is an outflow, whereas, coupon payments and
maturity principal are inflows. This gives us,
y
= semi-annual yield = 2.65%
2
After we annualize it we get,
y = 2.65% x 2 = 5.30%
Annualizing is just a convention. Annualized yield is also known as bond-equivalent yield.

Note that compounding has been ignored.
Editors Note: Accrued interest is ignored in our illustration. It would make computation very
complicated and the LOS does not call for it.
Yield to first call: Yield to first call is computed in a manner similar to yield to maturity. The
total present value of future expected cash flows is set equal to market price (plus accrued
interest, which we will ignore). The cash flows are projected only as far as the first call date and
the maturity principal is replaced by the call price. For example, a 5-year 5%, $1,000 face value
bond is selling for 986.75. Coupon is paid semi-annually. It can first be called after two years at
a call price of 1,020, with the call price declining by 10 every year thereafter. Thus its yield to
first call can be calculated on a financial calculator. Enter
The annualized yield to first call turns out to be
yield to first call = 3.335% x 2 = 6.67%
Yield to first par call date: After the first call date, the call price declines according to a call
schedule. Yield to first par call date is also computed in a manner similar to yield to maturity.

The total present value of future expected cash flows is set equal to market price (plus accrued
interest, which we will ignore). The cash flows are projected only as far as the first call at par
date. For example, a 5-year 5%, $1,000 face value bond is selling for 986.75. Coupon is paid
semi-annually. It can first be called after two years at a call price of 1,020, with the call price
declining by 10 every year thereafter. Thus its yield to first par call date can be calculated on a
financial calculator. Enter
Note that the FV equals the par value of 1,000 given the definition of yield to first par call date.
Further, since call price declines by 10 per year after the fourth year, the first call at par date will
be reached in the fourth year. The annualized yield to first par call date turns out to be
yield to first par call date = 2.686% x 2 = 5.37%
Yield to put: Yield to put is calculated in a manner similar to the yield to maturity, except cash
flows until the first put date only are considered. It assumes that coupon can be reinvested at the
yield to put. For example, an 8% putable bond with 1,000 face vale and 10 years to maturity is
putable after three years at par or face value. The bond pays semi-annual coupons and is selling
at 1,055.75. To compute the yield to put on a financial calculator, enter
N = 3 x 2 = 6; PV = - 1,055.75; PMT = 80 2 = 40; FV = 1,000 and press CPT I/Y
The annualized yield to put turns out to be
yield to put = 2.97% x 2 = 5.94%%
Yield to worst: Yield to worst is the lowest of all yields among different yields to call and yield
to maturity. For example, there may be five different call dates. For example, the following table
gives different yields to call and the yield to maturity.
Yield to Yield to Yield to Yield to Yield to

Call (1) Call (2) Call (3) Call (4) Maturity
5.9% 5.75% 5.6% 5.5% 6.5%
The worst or minimum yield is 5.5%, yield to call (4). There are several problems with this.
Yield to worst has little meaning as an indicator of return since it is not over a specific horizon
and is only one of several possibilities, however remote. It does not tell what return the investor
may realize. Moreover, there are different reinvestment rates for each yield with different
reinvestment risk exposure.
Cash flow yield: Cash flow yield is computed in a manner very similar to the yield to maturity
for a semi-annual bond. Consider the case of mortgage backed securities which are secured by a
pool of mortgages. Borrowers pay interest as well as principal repayment on a monthly basis.
Sometimes they also pay additional principal if houses are sold or mortgages are refinanced at
lower rates. Expected cash flow for such securities are based on: monthly interest, scheduled

principal repayments, and other prepayments. Thus, an average prepayment rate is assumed for
the last component. The present values of these future expected cash flows is set equal to the
security price plus accrued interest, and the monthly yield is obtained under the IRR method as
before. Since the cash flows occur monthly, the discount period is monthly and the resulting
discount rate or yield is also monthly. Computation of cash flow yield can be summarized in
three easy steps.
Step 1: Estimate the monthly discount rate based on projected cash flows using the IRR
technique explained earlier.
Step 2: Compound the monthly discount rate or yield over a six-month period to make
it comparable to a semi-annual bond.
Step 3: Compute the bond-equivalent yield by multiplying the semi-annual yield from
Step 2 by a factor of two, essentially annualizing it. This is the cash flow yield.
Example:
Greenlawn Mortgage Securities has a mortgage backed issue outstanding. Based on

projected monthly cash flows, it has estimated the monthly yield to be 0.45%. Compute
the cash flow yield.
Answer:
Step 1: The monthly yield is already given as 0.45%, or 0.0045.
Step 2: Compute the six-monthly yield on compounded basis. This is known as

effective yield
Effective semi-annual yield = (1 + 0.0045)6 1 = 0.0273 or 2.73%
Step 3: Compute the cash yield by doubling the effective semi-annual yield
Cash flow yield = 2 x 2.73% = 5.46%
Cash flow yield, as computed in the last step is the bond-equivalent annual yield
given the semi-annual yield. The above process is a matter of convention in
bond markets.
LOS: 1.B.c. Explain the assumptions underlying traditional yield measures and the limitations
of the traditional yield measures.
Assumptions: The two primary assumptions underlying traditional yield calculations are:
1. periodic cash flow from a financial security can be reinvested at the yield to
maturity for ordinary bonds and at cash flow yield for mortgage and asset backed
securities.

2. the financial security is held until the terminal date (or maturity) by an investor.
Limitations: The following limitations restrict the applicability and interpretation of the
traditional yield measures:
1. many investors do not hold financial securities until maturity. If they sell a
security before maturity, then yield to maturity is meaningless as a gauge of
expected return since the selling price is not known with certainty.
2. in the case of regular bonds, reinvestment rate for interest and sinking fund
payments is uncertain as interest rates change and are never static in the real
world. As a result the reinvestment rate is never equal to the yield to maturity, or
even yield to call during the life of a bond.
3. in the case of asset and mortgage backed securities, projected cash flows are
based on an assumed prepayment rate. If actual prepayments differ the realized
yield will depart considerably from the estimated cash flow yield.
Selling a bond at a capital loss before its maturity is known as price risk. Investing cash flows at
a lower rate is known as reinvestment rate risk. Together, these two are known as interest rate
risk.
LOS: 1.B.d. Explain the importance of reinvestment income in generating the yield computed
at the time of purchase, and calculate the amount of income required to generate that yield.
Reinvestment rate assumption and types of bonds: The only bond which is unaffected by
reinvestment risk is the zero-coupon bond. Since it pays no coupon or interest there is nothing to
reinvest and hence no reinvestment rate risk. On the other hand, non-callable coupon bonds have
reinvestment risk due to reinvestment of coupon payments required until the maturity of the
bond. Reinvestment risk of sinking fund coupon bonds is higher because they return principal in
addition to coupon payments prior to maturity. Callable bonds have the highest potential for
reinvestment risk because the entire principal (plus premium) is payable before maturity in the
event of a call necessitating reinvestment at lower interest rates since bonds are called when
market yields are below the coupon rate. Reinvestment income can be a considerable portion of
the total income which includes: interest income, capital gains/losses, and reinvestment income.
In the case of pure amortizing securities such as mortgages, asset and mortgage backed
securities, reinvestment risk is considerable as the interest as well as scheduled principal
repayments need to be reinvested. Since such securities can be prepaid without penalty, they are
like callable bonds and also expose the principal to reinvestment risk over the maturity period.
Dynamic interest rate environments: The yield to maturity calculation inherently assumes that
the reinvestment rate for intermediate cash flows would equal the yield to maturity. Thus, when
bonds are purchased during high yield or high interest rate environments the assumed
reinvestment rate is high. In the real world, interest rates are not static. They rise and fall with the
business cycle. This renders the above reinvestment rate assumption untenable in the real world.
When yields are high, reinvestment rates are likely to fall and when yields are low reinvestment

rates are likely to rise. In the former case, the actual earned yield will be less than estimated at
the time of the purchase. In the latter case, the actual earned yield will be more than estimated.
Calculating reinvestment income needed to earn a specific yield: Assume that an investor
pays $980 for $1,000 face value bond. The bond offers a coupon of 6%, paid semi-annually, for
5 years. The reinvestment rate that is required to be earned on coupon payments should equal the
yield to maturity. This is the simple and straight forward answer to the LOS. The rest of the
calculations below illustrate this with the help of dollar amounts and an accounting identity.
There are three sources of dollar return from a bond investment:
Capital gain or loss when the bond is redeemed

Coupon income
Reinvestment income from coupons
In the above example, the YTM is computed as 3.24% semi-annual or 6.48% annual on bond-
equivalent basis. Thus, the coupons should be reinvested at 6.48% to guarantee the yield at the
time of purchase. Let us break this down into the three components.
Capital gains: This is the difference between the face value and purchase price,
Capital gain = 1,000 980 = 20
Coupon income: This is the total of all six-monthly coupons.
Coupon income = 0.03 x 1,000 x 10 = 300 (there are 10 semi-annual periods in 5 years)
Reinvestment income from coupons: Since the YTM is 3.24%, s.a., it is easy to project
the total cash investor should have after 5 years.
Future value at maturity = 980 x (1.0324)10 = 1,348.05

Reinvestment income needed = 1,348.05 980 20 300 = 48.05
We have subtracted the initial investment (980), capital gain (20) and the coupon income
(300). The remainder needs to be earned from reinvestment of coupons. The coupons are
an annuity of 10 periods. Each payment equals $30, and the total future value of these
payments should be $348.05 (= 300 + 48.05). This amount includes coupon as well as
their reinvestment income for a total future value of 348.05. We use the financial
calculator to estimate the rate of return required to get this future value in 5 years.
PMT = 30; N = 10; FV = 348.05
Solving for the yield,
I/Y = 3.25% semi-annually. This is the YTM we had computed earlier (difference due
to rounding) and proves the point.

The coupon payments need to be reinvested at the YTM to guarantee the yield implied at the time
of the purchase, if the bond is held until maturity. The reinvestment rate fluctuates and is not
guaranteed over the life of the bond, and this results in reinvestment rate risk, which is one of the
two components of interest rate risk. The other being price risk, i.e., sale of the bond prior to
maturity at a yield above the yield at the time of purchase, resulting in a loss.
LOS: 1.B.e. Discuss the factors that affect reinvestment risk.
If we fix the yield to maturity and the coupon rate of a bond, then longer the maturity, greater
will be the reliance on reinvestment income. Thus,
Factor 1: Maturity greater maturity implies that reinvestment risk is greater. Long-term
bonds have greater reinvestment risk since reinvestment income can be a very
high proportion of their total income.
If we fix the yield to maturity and maturity of a bond, then higher the coupon rate, greater will
be the reliance on reinvestment income.
Factor 2: Coupon rate premium bonds (higher coupon rate) will depend highly on
reinvestment income to more than offset the expected capital loss at maturity as
they are retired at par, which will be below the purchase price. Alternatively,
discount bonds (lower coupon rate) will not rely on reinvestment income as much
since they will experience a capital gain at retirement as they will be retired at par,
which will be above the purchase price.
As stated earlier, zero-coupon bonds do not suffer from reinvestment risk.
LOS: 1.B.f. Compute the bond equivalent yield of an annual-pay bond, and compute the
annual pay yield of a semiannual-pay bond.
Most bonds in the US pay semi-annual interest whereas non-US bonds usually pay annual
interest. Therefore, a common yardstick for comparing the two is needed. You should be able to
convert a semi-annual yield to an annual-pay yield and vice-versa.
Converting semi-annual yield to annual pay: Assume that a semi-annual pay bond has a bond-
equivalent yield of 7%. Its annual-pay yield is:
yield on annual pay basis =
2
bond equivalent yield
1 + 1 = (1 + 0.035) 1 = 0.0712 or 7.12%
2
This is also known as effective yield.

Converting annual yield to semi-annual pay: Assume that an annual pay bond has an annual
yield of 7%. Its equivalent semi-annual pay yield is:
yield on semi-annual pay basis =
2 x [(1 + annual pay yield )0.5 1] = 2 x [(1 + 0.07)0.5 1] = 0.0688 or 6.88%
This is the annualized bond-equivalent yield on semi-annual pay basis for an annual-pay bond.
LOS: 1.B.g. Compute the value of a bond using spot rates.
This is old wine in a new bottle. Recall LOS: 1.A.h. In that LOS you learned how to value a
Treasury bond using the arbitrage-free approach that relied upon Treasury spot rates. Treasury
spot rates are yields on Treasury zero-coupon bonds (or strips) and represent rates that an
investor can earn if the strips are held until maturity. Valuation of risky bonds using Treasury
spot rates is straight forward as shown in the following equation, which has already been seen.
C/2 C/2 C/2 C/2 F

Price = 1
+ 2
+ 3
+ ...+ T
+ T
y1 y2 y3 yT yT
1 + 1 + 1 + 2 1 + 1 +
2 2 2 2
In other words, the multiple-discount rate model is used for pricing a bond on the basis of spot
rates. C is the annual coupon payment and F is the face or maturity value. The bond is assumed
to be semi-annual. Note that the discount rates, y1, y2, . . . yT are all different. This is so because
they are based on Treasury spot rates for corresponding maturities. Each of these rates is
computed after adding a risk premium, or spread, to the underlying Treasury spot rate (z ). For
t
example, if the third period Treasury spot rate is 5.5% and the appropriate spread is 1.25% (125
bp), then the resulting y3 would be 6.75% (= 5.5% + 1.25%). In general, for any period t,
discount rate = y = Treasury spot rate for period t + spread = z + spread

t t t
Note that the spread remains constant for all periods, only z changes.
t
Let us value a 5-year 6.5%, $1,000 face value semi-annual payment corporate bond, using the
following spot rates. The rest of the table illustrates the process. Assume a spread of 0.75% (or
75 bp).

Spot
Years Period Discount Rate(y ) Cash Flow Present Value
Rate(z ) t
t
30
= 31.78
0.5 1 3.75% 4.50% $32.50 1
0.045
1 +
2
1.0 2 3.90% 4.65% $32.50 31.04
1.5 3 4.25% 5.00% $32.50 30.18
2.0 4 4.50% 5.25% $32.50 29.30
2.5 5 4.65% 5.40% $32.50 28.45
3.0 6 4.75% 5.50% $32.50 27.62
3.5 7 4.82% 5.57% $32.50 26.81
4.0 8 4.87% 5.62% $32.50 26.04
4.5 9 4.91% 5.66% $32.50 25.28
5.0 10 4.94% 5.69% $32.50 24.55
5.0 10 4.94% 5.69% $1,000 755.38
Value 1,036.44
The discount rate for the first coupon is given by the following equation. The rest are computed
similarly.
y = z + spread = 3.75 + 0.75 = 4.50%

1 1
Note: Do not forget to divide the discount rate by 2 to reflect semi-annual payments for
US bonds. Also note that the annual coupon amount has been divided by 2 for
consistency. For non-US bonds, that pay annual coupon, division by 2 is not
necessary.
The value of the bond equals $1,036.44. The spread used in the above calculation is known as
zero-volatility (z-spread) spread. It is assumed to stay constant over the life of the bond, hence
the name. Note that the difference in this multiple discount rate approach and the single discount
rate approach is that for the latter, the (nominal) spread is applied to a single maturity Treasury
yield. It is known as nominal spread. Under the spot rate approach, the (zero-volatility) spread
is applied across the entire maturity spectrum of Treasury spot rates.
LOS: 1.B.h. Compute the theoretical Treasury spot rate curve, using the method of
bootstrapping and given the Treasury par yield curve.
Theoretical spot rate curve: Bootstrapping refers to estimating the spot rate based on yields to
maturity for different Treasury maturities. The idea is fairly simple. Assume that we know the
YTM on two securities with maturities of 1 period and 2 periods respectively. Let YTM1 and
YTM2 be the respective yields. The following equation for the 1-period bond is straight forward:

C1 + FV
P01 =
(1 + YTM 1 )
Given that there is only one cash flow left, YTM1 is the spot rate for the 1st period, i.e., S1 =
YTM1. We now set up the valuation equation for the two-period bond.
C2 C2 + FV
P02 = +
(1 + YTM 2 ) (1 + YTM 2 ) 2
The above equation is equivalent to the following equation where each cash flow is discounted at
its own spot rate, i.e., the rate that discounts that periods cash flow to time 0, such as a zero-
coupon security of that maturity.
C2 C + FV
P02 = + 2
(1 + YTM 1 ) (1 + S 2 ) 2
Where S2 is the 2-year spot rate. Once it is estimated, the analyst moves on to the next maturity
and so on. For a three period bond, since the spot rates for the first and second period are already
known, S3 is easily estimated from,
C3 C3 C + FV
P03 = + + 3
(1 + S1 ) (1 + S2 ) 2
(1 + S3 )3
Example: Given the following Treasury par value yield curve, estimate the theoretical
spot rate curve.
Years Par Value Yield

(Annualized BEY)
0.5 3.50%
1.0 3.72%
1.5 4.15%
2.0 4.35%
2.5 4.70%
3.0 4.95%
Answer: We apply the bootstrapping method, iteratively, starting with the shortest
maturity. Note that par value yield implies that a bond offering the stated yield as coupon,
sells at par. Thus, we can use the yields as the coupon rates. Note that yield for 0.5 years
is the spot rate for the first six months and no computations are necessary.
Thus, S1 = YTM1 = 3.50%
We now compute S2.

1.86 1.86 + 100

100 = + ; annualized yields have been halved
(1 + 0.0175) (1 + 0.5S 2 ) 2
Solving the above equation, we get, S2 = 3.722%. We have assumed the par value as 100
for convenience. Any other number will do.
We now compute S3.
2.075 2.075 2.075 + 100

100 = + +
(1 + 0.01750) (1 + 0.01861) (1 + 0.5S3 )3
2
Solving the above equation, we get, S3 = 4.161%. Continuing this process, we can
estimate the remaining spot rates. These are shown in the table below.
Par Value Yield

Years Spot Rate (BEY)
(Annualized BEY)
0.5 3.50% 3.500%
1.0 3.72% 3.722%
1.5 4.15% 4.161%
2.0 4.35% 4.365%
2.5 4.70% 4.730%
3.0 4.95% 4.994%
Note that each succeeding spot rate is increasing since the par value yield curve is rising.
Note on par value yield curve (YTM): The par value yield curve is derived from on-the-run
securities. These are available for 3-month, 6-month, 2-year, 5-year, and 10-year maturities in
the US. The last available 30-year issue (whose maturity has shortened with passage of time), is
used for the long-end. Par value yields for all intervening years are estimated with the help of a
straight-line interpolation, and are thus approximations. For example, if 2-period (5%) and 5-
period (6%) yields are known, 3- and 4-period yields are approximated as follows.
Slope of the line joining the two yields = (6% 5%) 3 = 0.33%. Thus for year n we use
the following formula:
Yield for nth year = 5% + (n 2) x 0.33%
When n = 3,
Yield = 5% + (3 2) x 0.33% = 5.33%
When n = 4,
Yield = 5% + (4 2) x 0.33% = 5.66%

LOS: 1.B.i. Explain the limitations of the nominal spread.
The nominal spread assumes a single discount rate for all cash flows of a bond. Thus, if the yield
curve is not flat but steeply upward or downward sloping, there will be a difference between
bond prices based on nominal spread and z-spread. The steeper the yield curve slope, the greater
the difference. The only time when the difference will be zero is when the yield curve is flat or
the bond does not pay any coupons (zero-coupon bond). Furthermore, the greater the maturity of
a bond, the greater the difference in prices. If a security is an amortizing security such as a
mortgage or asset backed security, the difference will also be greater. We know that the spot rate
approach is superior as it is based on the arbitrage-free model of pricing. In general, price
discrepancy with nominal spread will depend on the shape of the yield curve, the coupon rate of
the bond, its time to maturity and whether it is an amortizing or a non-amortizing security.
LOS: 1.B.j. Differentiate among the nominal spread, the zero-volatility spread, and the option
adjusted spread for a bond with an embedded option, and explain the option cost.
Nominal spread: Nominal spread is the difference between the yield on a bond and the
corresponding maturity Treasury yield. It corresponds to one maturity on the Treasury yield
curve. It ignores the possibility that the yields for different coupon payments or cash flows at
different times may be different.
Zero-volatility or z-spread: This corrects for the problem associated with the nominal yield, in
that it takes into account the entire Treasury spot yield curve, not just one maturity. However, it
assumes that the spread will not change. This is not realistic since many bonds have embedded
options and interest rate volatility will affect the spread on such bonds. It assumes that interest
rate volatility is zero. Each bond cash flow is discounted at its corresponding Treasury spot rate
plus a spread. The spread that sets the present value equal to bond price is known as the z-spread.
It is obtained through a trial-and-error process.
Option-adjusted spread (OAS): OAS corrects for the effect of embedded options on a bonds
yield. It is simply the z-spread adjusted for the effect of embedded call or put options and is
comparable with the yield-spread on bonds that do not have embedded options. Another way to
understand this spread is to remember that z-spread assumes interest rate volatility to be zero,
whereas OAS does not make that assumption. It is also computed over the entire yield curve,
similar to the z-spread.
Option cost: Option cost is the difference between the z-spread and the OAS. Recall that the z-
spread ignores the effect of embedded options whereas OAS takes the effect of options into
account (it is measured net of option effect). Option cost here is measured in basis points or
percentage/yield terms, not dollar or currencies. Thus,
option cost = z-spread OAS

Is the option cost positive or negative? The answer depends on whether the bond option favors
the issuer or the investor.
1. Option favors the issuer In this case, the option cost will be positive because the
investor has granted the issuer an option (such as a call option) and she is
compensated by the issuer in the form of a higher spread. Recall that issuers will
call a bond if interest rates fall. The call price will act as a cap on the value of a
callable bond and its price will not rise above the call price, imposing an
opportunity loss on the investor. A positive option cost is a way for the investor to
recoup her expected opportunity loss.
2. Option favors the investor In this case, the option cost will be negative because
the issuer has granted the investor an option (such as a put option) and the issuer
is compensated by the investor in the form of a lower spread. Recall that investors
will put a bond for sale to the issuer if the value of the bond falls below the
threshold. The put price will act as a floor on the value of a putable bond and the
bond price will not fall below the put price, imposing an opportunity loss on the
issuer. A negative option cost is a way for the issuer to recoup its expected
opportunity loss.
Nominal spread limitation revisited: If we assume, for simplicity, that the yield curve is
approximately flat, then the nominal spread will be close to the z-spread. Or,
nominal spread z-spread
Substituting this approximation in the option cost equation, we get
option cost = nominal spread OAS nominal spread = option cost + OAS
If an investor focuses only on the nominal spread, unadjusted for option cost, he may
overestimate his potential return. For example, if the nominal yield were 150 bp and the option
cost were 135 bp, the OAS would only be 15 bp (= 150 135). This may be inadequate given the
credit risk of the bond. In other words, high nominal yield may be due to high option cost and the
investor needs to control for it before making an investment decision.
Editors Note: The above shortcoming of nominal spread should be read in conjunction with
the limitations discussed in LOS: 1.B.h.
LOS: 1.B.k. Explain a forward rate, and compute the value of a bond using forward rates.
In order to understand forward rates, we need to revisit spot rates. A spot rate for a given
maturity is the yield on a zero-coupon Treasury (strip). It is that rate which equates the present
value of the future single payment equal to the current price of the strip.

Spot Rate = zT
Current price Future cash flow (CT)
0
Maturity (T)
Alternatively, we can imagine future single period rates, f1, f2, f3, . . . fT-1, fT, such that when the
future cash flow (CT) is discounted one period at a time, at each of these rates, we get the current
price of the bond. This is shown in the diagram below:
Spot Rate = zT
f f f f f
1 2 3 T-1 T

0 1 2 3 T-2 T-1 T (Maturity)
Mathematically, if we discount the future cash flow , CT, for one period, we have its value at T-1,
CT
VT-1 =
(1 + fT )
If we discount VT-1 for one period, we have the value at T-2,
VT 1 CT
VT-2 = =
(1 + fT 1 ) (1 + fT 1 )(1 + fT )
Recursively, if we discount VT-2 all the way back to time t = 0, we have the value, V0.
CT
V0 =
(1 + f1 )(1 + f 2 )(1 + f3 ) . . . (1 + fT 1 )(1 + fT )
f1, f2, f3, . . . fT-1, fT are known as forward one period rates or simply forward rates. They are the
markets consensus expected future one period interest rates. For example, after two periods, the
market expects the one period rate to equal f3 during the third period. In other words, under this
approach, each future period has its own discount rate. Under the traditional approach we use
one discount rate for all periods. Note that these forward rates are applied to all the cash flows
associated with a bond.

Example:
A 3-year Treasury note offers 4.5% coupon, paid semi-annually. Given the following
forward rates, compute the price of this note assuming a face value of $1,000.
Years (t) 0.5 1.0 1.5 2.0 2.5 3.0

Forward
rate (ft) 3.50% 3.75% 4.10% 4.40% 4.55% 4.65%
Note: All forward rates have been annualized.
Answer:
Years Period Fwd Cash Present value

rate flow
22.50
= 22.11
0.5 1 3.50% 22.50 0.035
1 +
2
22.50
= 21.71
1.0 2 3.75% 22.50 0.035 0.0375
1 + 1 +
2 2
22.50
= 21.27
1.5 3 4.10% 22.50 0.035 0.0375 0.0410
1 + 1 + 1 +
2 2 2
2.0 4 4.40% 22.50 20.81
2.5 5 4.55% 22.50 20.35
3.0 6 4.65% 22.50 19.89
3.0 6 4.65% 1,000 883.86
Value 1,010.00
The first three calculations using forward rates have been shown in the last column. The
rest are similar. The last two cash flows will be discounted identically since they are both
received at the end of the 6th semi-annual period. The value of this bond equals
$1,010.00.
Note that since the bond pays semi-annual coupon, all interest payments as well as
forward rates have been divided by 2. For annual bonds, division by 2 is not necessary.
LOS: 1.B.l. Explain and illustrate the relationship between short-term forward rates and spot
rates.
We reproduce the previous diagram to show the relationship between forward rates and spot
rates.

Spot Rate = zT
f f f f f
1 2 3 T-1 T

0 1 2 3 T-2 T-1 T (Maturity)
Using the spot rate approach, the current price of the single cash flow bond is given as,
CT
P0 =
(1 + zT )T
Using the forward rate approach, the current value of the single cash flow bond is given as,
CT
V0 =
(1 + f1 )(1 + f 2 )(1 + f3 ) . . . (1 + fT 1 )(1 + fT )
In equilibrium, the two approaches should give the same value. Thus,
CT CT
P0 = =
(1 + zT ) T
(1 + f1 )(1 + f 2 )(1 + f3 ) . . . (1 + fT 1 )(1 + fT )
Quick inspection tells us that the numerator of both expressions is CT. Since the two expressions
are equal to one another, their denominators must also be equal. Therefore, we have,
(1 + zT )T = (1 + f1 )(1 + f 2 )(1 + f 3 ) . . . (1 + fT 1 )(1 + fT )
If we take the Tth root on both sides and subtract one we get,
zT = [(1 + f1 )(1 + f 2 )(1 + f 3 ) . . . (1 + fT 1 )(1 + fT )]1/ T 1
This means that the spot rate for period T, zT, is the geometric average of the future one-period
forward rates for all periods between 1 and T. Similarly, the spot rate for period T-1, zT-1, is the
geometric average of the future one-period forward rates for all periods between 1 and T-1.
zT 1 = [(1 + f1 )(1 + f 2 )(1 + f 3 ) . . . (1 + fT 1 )]1/(T 1) 1
If we extend this logic all the way down to two period 2, z2 is given by
z2 = [(1 + f1 )(1 + f 2 )]1/ 2 1 = (1 + f1 )(1 + f 2 ) 1
and furthermore,

z1 = (1 + f1 )1/1 1 = (1 + f1 ) 1 = f1
The last equation says that the one-period spot rate for period 1 is equal to the forward rate for
period 1. This should be obvious from the present value of a cash flow one period away which
only requires one discount rate. For example, if a six-month Treasury strip has a price of 985.75
(face value = 1,000), its spot rate is given by,
1, 000
985.75 =
(1 + z1 )
After rearranging the above equation,
1, 000
z1 = 1 = 1.0145 1 = 0.0145 or 1.45%
985.75
The annualized (bond-equivalent) yield equals,
bond equivalent 1-period spot rate = 2 x 1.45% = 2.90%
This is also the one-period forward at the current time, t = 0.
LOS: 1.B.m. Compute spot rates given forward rates, and forward rates given spot rates.
We have already seen how to compute the spot rate if we are given forward rates. To recap, spot
rate is nothing but the geometric average of the forward rates.
Alternatively, if we are given spot rates, we can find out the embedded or implicit forward rates.
The process is known as bootstrapping. We know that the forward rate for the first period is
also the spot rate for the first period. Therefore,
f 1 = z1
We also know that,
(1 + z2 ) 2
(1+z2)2 = (1+z1)(1+f2) f2 = 1
(1 + f1 )
Since we know f1, and are given z2, f2 can be calculated easily.
Similarly,
(1 + z3 )3
f3 = 1
(1 + z1 )(1 + f 2 )

After substituting the values for the variables in the right hand side, f3 can be calculated. In
general,
(1 + zt )t (1 + zt ) t
ft = 1=
(1 + z1 )(1 + f 2 )(1 + f3 ) . . . (1 + f t 2 )(1 + f t 1 ) (1 + z ) t-1
t-1
Forward rates are calculated from the default-free spot rate curve. These forward rates are
collectively known as the short-term forward-rate curve. The last expression in bold gives us a
short-cut for computing forward rates, one at a time, given spot rates
Example 1: Computing spot rates from forward rates.
Use the following forward rates to compute the corresponding spot rates.
Year 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0

Forward
4.12% 4.25% 4.55% 4.80% 4.70% 4.75% 4.90% 5.05%
Rate
Note: All semi-annual forward rates have been annualized.
Answer:
Year Forward Annualized spot rate

rate
0.5 4.12% 4.12%
1.0 4.25% 0.0412 0.0425
2 1 + 1 + 1 = 0.0419 or 4.19%

2 2
1.5 4.55% 0.0412 0.0425 0.0455
2 3 1+ 1+ 1+ 1 = 0.0431 or 4.31%
2 2 2
2.0 4.80%
(
2 4 1+

0.0412 0.0425 0.0455 0.0408
2
1+
2

1+
2

1+
2 )
1 = 0.0443 or 4.43%
2.5 4.70% 4.48%

3.0 4.75% 4.53%
3.5 4.90% 4.58%
4.0 5.05% 4.64%
For formulas please see the preceding LOS. Detailed calculations are shown for the first
four spot rates. The rest are similar.
Example 2: Computing forward rates from spot rates.
Given the following spot rates, compute the implicit forward rates.

Year 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0

Spot
4.12% 4.19% 4.31% 4.43% 4.48% 4.53% 4.58% 4.64%
Rate
Note: All semi-annual spot rates have been annualized.
Answer:
Year Spot rate Annualized forward rate

0.5 4.12% 4.12%
0.0419 2 0.0412
1.0 4.19% 2 1 + 1 + 1 = 0.0425 or 4.25%
2 2

0.0431 0.0419
3 2
1.5 4.31% 2 1 + 1 + 1 = 0.0455 or 4.55%
2 2

0.0443 0.0431
4 3
2.0 4.43% 2 1 + 1 + 1 = 0.0480 or 4.80%
2 2

0.0448 5 0.0443 4
2.5 4.48% 2 1 + 1 + 1 = 0.0470 or 4.70%
2 2

0.0453 0.0448
6 5
3.0 4.53% 2 1 + 1 + 1 = 0.0475 or 4.75%
2 2

0.0458 7 0.0453 6
3.5 4.58% 2 1 + 1 + 1 = 0.0490 or 4.90%
2 2

0.0464 0.0458
8 7
4.0 4.64% 2 1 + 1 + 1 = 0.0505 or 5.05%
2 2

For formulas please see this LOS. Note that by using the spot rates obtained from
Example 1, we get back the forward rates given in that example. This also serves as a
check for the accuracy of our calculations.
Quick Review
Sources of bond returns: There are three sources of bond returns: coupon income, reinvestment
income, and income from capital gain or loss when the bond is sold, called or redeemed.
Yield measures: The various bond yield measures are:

current yield this measures coupon income as a percent of current bond price.
yield to maturity this is the rate of return earned by a bond holder on her
purchase price if the bond is held until maturity and all coupons are reinvested at
this yield.
yield to first call this is the rate of return earned by a bond holder on his
purchase price until the bond is called on its first callable date, if all coupons are
reinvested at this yield.
yield to first par call date call price usually declines with time and this yield
measures the return until the date the bond is called at par, if all coupons are
reinvested at this yield.
yield to refunding this measures the return until such time bonds are redeemed
and replaced by lower cost debt, if all coupon payments are reinvested at this
yield.
yield to worst this is the lowest among yields to all possible calls and the yield
to maturity.
cash flow yield this is similar to yield to maturity but is calculated for pools of
mortgages which are affected by prepayment and principal repayments.
Assumptions for yield measures: There are two main assumptions periodic cash flows
(coupons and amortizations) are reinvested at the calculated yield, and the bond is held until the
terminal date or maturity as the case may be.
Reinvestment income: All yield calculations assume that coupon income is reinvested at the
calculated yield. If the reinvestment rate is different, the yield may not be a good estimate of an
investors rate of return. Depending upon the size of coupon payments and the remaining life of
a bond as well as the implied yield, reinvestment income could be sizeable and have a material
impact on an investors rate of return.
Reinvestment risk: Reinvestment risk is affected by the maturity of a bond and the size of the
coupon payments. All else constant, longer maturities imply greater reinvestment risk. All else
constant greater coupon payments imply greater reinvestment risk. Zero-coupon bonds have no
reinvestment risk as they do not have coupon payments. On the other hand, they suffer from the
highest price risk.
Spot rates: A spot rate is the discount rate applicable to a zero-coupon bond of a given maturity.
A coupon bond can be valued by discounting different cash flows at their corresponding spot
rates. This is different from yield to maturity which assumes that all cash flows are discounted at
the same rate, i.e., YTM.
Theoretical treasury spot rate curve: A bootstrapping method is used to estimate the
theoretical spot rates by successively solving for spot rates, beginning with the shortest maturity.
The resulting yield curve is known as the theoretical spot rate yield curve. Par bonds are used as
inputs into spot rate calculations.
Spreads: There are three different bond spreads:

Nominal spread this is the difference between the yield to maturity on a bond
and the corresponding maturity risk free rate (Treasury yield).
Z-spread this is based on the difference between the Treasury yield curve for
different maturities and the discount rates for different maturities associated with
the cash flows of a bond. It assumes a constant spread and that interest rate
volatility is zero.
Option Adjusted Spread (OAS) this is based on adjusting a bonds yield for the
effect of embedded options. OAS is comparable to the yield on an option-free
bond. Callable bonds have higher yields and putable bonds have lower yields.
Comparing such yields with yields on option-free bonds would be erroneous due
to option effects. The cost of an option (measured in terms of yield) equals the
difference between the OAS spread and the z-spread.
Forward rate: Forward rate is the future spot rate that is expected to prevail according to the
markets expectations. It is the future one-period rate embedded in a spot rate. For example, a
two-period spot rate is a composite of the current one-period spot rate and the forward rate for
the second period.

1.C. Introduction to the Measurement of Interest Rate Risk
LOS: 1.C.a. Distinguish between the full valuation approach (the scenario analysis approach)
and the duration/convexity approach for measuring interest rate risk, and explain the advantage
of using the full valuation approach.
Full valuation approach: For an investor who holds a bond, interest rate risk is the effect of
rising interest rates on her investment. Bonds are generally priced with the help of a valuation
formula. If the valuation model is reliable, the investor can model different possible interest rate
scenarios and analyze the impact of changes in interest rates on her holdings. This approach is
known as the full valuation approach or scenario analysis.
Duration/convexity approach: Duration is a measure that enables an analyst to estimate bond

price changes for a small change in bond yields. This is an approximate approach that relies upon
the slope of the relationship between bond prices and yields, a relationship that we known is
negatively sloped. Convexity increases the accuracy of this approach by taking into account the
curvature or the rate of change of slope.
Full valuation approach can be time consuming, whereas, duration provides a ready answer.
However, the latter is an approximation unless convexity is taken into account. The duration
approach is based on price volatility of a bond for small changes in yield. If yield changes are
large, convexity effect will be large. Otherwise it can be ignored.
Advantage of full valuation approach: The full valuation approach is simple and straight
forward as long as the analyst has a good valuation model. Effect of interest rate changes can be
estimated for many different scenarios. Analysis of extreme scenarios, known as stress testing,
can be performed. Based on historical data and statistical modeling, a likely set of shifts in yield
curve can be estimated. Effect of leverage in a portfolio can also be incorporated.
LOS: 1.C.b. Compute the interest rate risk exposure of a bond position or of a bond portfolio,
given a change in interest rates.
Interest rate exposure of a bond position: We illustrate this with the help of an example.
Example:
Assume that Marilyn Schmidt manages a $2 billion portfolio and owns some option-free
bonds issued by Manhattan Trading, Inc. (MTI). MTI bonds have a coupon of 6.5%, paid
semi-annually, with a face value of $1,000 each and a remaining time to maturity of 7
years. Marilyn wants to know the impact of an increase in interest rates on her position.
The yield on MTI bonds is currently at 5% and she is worried about rising interest rates.
She wants to evaluate the adverse impact of an instantaneous increase of 50 bp, 100 bp,
and 150 bp in the market yield on her bond position. Assume that the yield curve will
remain flat and one discount rate can be used for all cash flows.

Answer:
MTI bonds are evaluated using the standard (present value) model under three different
interest rate scenarios.
Scenario Yield Bond value Change

Current (base case) 5.00% 1,087.68 NA
1 5.50% (+50 bp) 1,057.46 -30.22 (-2.78%)
2 6.00% (+100 bp) 1,028.24 -59.44 (-5.47%)
3 6.50% (+150 bp) 1,000.00 -87.68 (-8.06%)
The three scenarios can be summarized in a diagram as shown below.
Yield = 5.50% (+50 bp)

Change = -30.22 or 2.78%
Current value Yield = 6.00% (+100 bp)

= 1,087.68 Change = -59.44 or 5.47%
Yield = 6.50% (+150 bp)

Change = 87.68 or 8.06%
Interest rate exposure of a bond portfolio: Change in a bond portfolio can be calculated by
estimating changes in each bond holding and adding all the changes. Under this approach one
can even assume that different maturity yields change by different amounts (i.e., the yield curve
does not undergo a parallel shift but twists). This is illustrated with the help of an example.
Example:
Chris Spencer is an analyst with a large asset management company. He has been asked
to evaluate the impact of changes in interest rates on a bond portfolio consisting of two
bonds: a long-term 25-year bond paying 7.25% semi-annual coupon, and a medium-term
10-year bond paying 6.0% semi-annual coupon. The long-term bond has a yield of 6.5%
and the medium-term bond has a yield of 5.5%. Chris believes that the yield curve is not
likely to shift in parallel. He comes up with the following three scenarios. Assuming a
$1,000 face value for each bond, estimate the change in the value of the portfolio for each
scenario. The portfolio owns 3,000 long-term (LT) and 1,200 medium-term (MT) bonds.

Alternate scenario LT Yield change MT Yield change

Scenario A +50 bp +20 bp
Scenario B +150 bp +50 bp
Scenario C +200 bp +100 bp
Answer:
The current as well as potential scenarios are analyzed in terms of portfolio value.
1. Current scenario Yield Bond value All bonds

LT bonds (3,000) 6.5% 1,092.07 3,276,210
MT bonds (1,200) 5.5% 1,038.07 1,245,684
Total Portfolio Value 4,521,894
2. Alternate scenario A Yield Bond value All bonds

LT bonds (3,000) 7.0% 1,029.32 3,087,960
MT bonds (1,200) 5.7% 1,022.63 1,227,156
Total Portfolio Value 4,315,116 (-4.57%)
3. Alternate scenario B Yield Bond value All bonds

LT bonds (3,000) 8.0% 919.44 2,758,320
MT bonds (1,200) 6.0% 1,000.00 1,200,000
4. Alternate scenario C Yield Bond value All bonds

LT bond (3,000) 8.5% 871.29 2,613,870
MT bond (1,200) 6.5% 963.65 1,156,380
The last column shows the percentage change in portfolio value for each of the three
scenarios.
LOS: 1.C.c. Demonstrate the price volatility characteristics for option-free bonds when
interest rates change (including the concept of positive convexity).
Let us revisit duration and convexity effects. They are shown in graphical form below.

Duration effect
bond price
or value
Convexity effect
P0
P1'
P1
y0 y1 yield
If the yield on a bond is y0, its price is P0. Assume that the bond yield increases to y1. Based on
the slope of the curve as shown above, or duration measure, this will cause a drop in price to P1,
a change of P1 P0. This is the duration effect. However, duration overstates the change in price
due to the curvature of the curve (convexity). The convexity effect cushions the price drop and
prevents the price from dropping below P1'. P1' P1 is the convexity effect. Note that this is a
positive effect. It shores up the price and is also known as positive convexity. Thus,
Total bond price change = Duration effect + Convexity effect
= (P1 P0) + (P1' P1) = P1' P0
While the duration effect is always negative (opposite to the change in bond yield), the convexity
effect is always positive (increases bond price). Thus, when yields rise convexity cushions the
price drop and when yields fall, it accelerates the price increase.
Price volatility characteristics of option-free bonds: Recognizing the negative relationship

between bond prices and interest rates or yields, we can make the following four claims:
1. Due to differences in coupon rates and maturities, the dollar and percentage price change
is different for different bonds, although inversely related to interest rates.
2. If the change in bond yields is small, the dollar and percentage price change for a bond is
symmetric or equal whether interest rates rise or fall.
3. If the change in bond yields is large, the dollar and percentage price change for a bond is
asymmetric or unequal whether interest rates rise or fall.
4. Following up on the previous claim, if the change in bond yields is large, the dollar and
percentage price change for a bond is greater for a fall in interest rates compared with a
rise in interest rates. This is a direct result of positive convexity.
LOS: 1.C.d. Demonstrate the price volatility characteristics of callable bonds and prepayable
securities when interest rates change (including the concept of negative convexity).
Callable bonds and negative convexity: We reproduce the price-yield relationship for option-
free bonds.

Negative convexity
bond price bond price Callable
or value Option free or value bond
bond
Option value
Pc
yield yN y1 yield
The first diagram on the left depicts the price-yield relationship for an option-free bond with
positive convexity. The second diagram on the right depicts the price-yield relation for a callable
bond in comparison with an option-free bond. When the yield is high, such as y1, the callable
bond exhibits characteristics of an option-free bond. This is because a callable bond is called by
the issuer only if its yield drops below its coupon rate. When the yield is high, a callable bond is
not called and the value of the call option, although positive, is insignificant. Callable and
prepayable bonds are treated as same for this analysis.
Negative convexity: When market interest rates fall, such as below yield yN, the bond may
be called by the issuer if the yield is below the bonds coupon rate. Since the bond can be
called at a pre-determined call price, the latter acts as a cap on the value of the bond as
yield falls further. Instead of displaying a price-yield relationship similar to an option-
free bond, callable bonds price-yield curve flattens out at low yields as shown. This
flattening is known as negative convexity. This implies that when yields fall, the
increase in a callable bonds value is less than the drop in the value of a callable bond
when yields rise. This is exact opposite of option-free bonds where the increase in value
exceeds the drop in value. Negative convexity leads to what is known as price
compression. When yields fall, the value of the call option increases and equals the
difference between the value of an equivalent option-free bond and the callable bond.
This is shown by the dashed vertical line in the second diagram.
Price-volatility characteristics: A callable bond displays the following characteristics
1. For high levels of yield, a callable bond behaves like an option-free bond for large
changes in yield. This means that the price increase when yields fall exceeds the
price decline when rates rise.
2. For low levels of yield, a callable bond behaves opposite of an option-free bond
for large changes in yield. This means that when the yield drops price
appreciation is less than the price decline when yield rises.
LOS: 1.C.f. Compute the effective duration of a bond, given information about how the
bonds price will increase and decrease for a given change in interest rates.
Recall that duration was defined in SS15: LOS: 1.B.g. Its mathematical form is presented below:

P P+
Effective duration =
2 x P0 x y
where, P- = price of the bond for a drop in yield equal to y
P+ = price of the bond for an increase in yield equal to y
P0 = price of the bond before the change in yield
y = change in yield (measured as a decimal)
The difference in the two prices in the numerator is averaged by dividing them by 2. When this
average difference is divided by P0, the ratio represents a fractional change in price. After
dividing this by y we get duration. Therefore,
Effective duration = fractional change in price y, or
percentage change in price Effective duration x y x 100
Note: The change is only approximate because convexity has been ignored. For small
changes in yield, this approximation does not deviate much from the true value.
The last equation gives us a quick way to estimate the percentage change in a bonds price, given
its duration and change in yield. Remember that when the yield change is positive (yield rises)
change in price will be negative and vice-versa.
Example:
Bonds of Napoli Manufacturing have a remaining maturity of 8 years. They have an

annual coupon of 6.75% and a face value of 1,000. They are currently selling at a market
yield of 7.5%. Compute the duration of Napoli bonds assuming a 25 bp change in yield.
Answer:
Napoli bonds are priced at the prevailing yield, as well as two other yields, 25 bp.
Scenario Yield Bond price

Prevailing yield 7.50% 956.07 (P0)
Increase in yield (+25 bp) 7.75% 941.98 (P+)
Increase in yield (25 bp) 7.25% 970.43 (P-)
Based on the information in the above table, we can compute the duration for Napoli
bonds. Recall that y is expressed as a decimal. Thus,

y = 25 bp = 25 x 0.0001 = 0.0025, and
970.43 941.98
Effective duration = = 5.95
2 x 956.07 x 0.0025
Greater duration implies greater sensitivity of bond price to yield changes.
LOS: 1.C.g. Compute the approximate percentage price change for a bond, given the bonds
effective duration and a specified change in yield.
We rely on the formula provided in the previous LOS to compute the price change.
percentage change in price Effective duration x y x 100
Example:
Napoli bonds have a duration of 5.95. If the yield on Napoli bonds were to change by 15
bp, what would be the approximate percentage price change for Napoli bonds?
Answer:
approximate percentage price change = 5.95 x 0.0015 x 100 = 0.89%
Thus, if the yield on Napoli bonds were to increase by 0.15% (15 bp), Napoli bonds
would experience a price decline of approximately 0.89%, and vice-versa.
LOS: 1.C.h. Distinguish among modified duration, effective (or option-adjusted) duration, and
Macaulay duration.
LOS: 1.C.i. Explain why effective duration, rather than modified duration or Macaulay
duration, should be used to measure the interest rate risk for bonds with embedded options.
These two LOSs are discussed together.
There are several bond duration measures and they all attempt to measure interest rate sensitivity
of bond prices. Some of them work better than others depending upon the type of bond being
analyzed.
A. Option-free bonds
The following two measures apply only to option-free bonds. Option-free bonds assume that the
investor or the issuer cannot alter future bond cash flows. Thus, only interest rate volatility is
captured in these measures.

Macaulay duration: This is the oldest measure of duration and is a weighted average
measure of the maturity of a bond. It is calculated as:
Macaulay duration = w1 x 1 + w2 x 2 + w3 x 3 + . . . + wt x t + . . . wT x T
1, 2, 3 . . . t, . . . T represent the timing of cash flows coupons and/or principal

repayments. The above example assumes annual cash flows. If the cash flows are semi-
annual, the timing coefficients would be 0.5, 1, 1.5, 2, . . . t, t+0.5, . . . T. In general, they
will be 1/n, 2/n, 3/n, etc. where n is the number of payments per year.
The weights are calculated by dividing the present value of a particular cash flow by the
total present value of all cash flows, i.e., the price of the bond. Thus,
PV of CFt
wt =
Price
Macaulay duration is not used directly as a measure of interest rate risk due to an error in
its concept. However, it is related to the next measure, which is used more often.
Modified duration: This measure is based on the slope of the price-yield curve and relies
upon calculus, or the mathematics of very small changes. If dP is a small change in the
price of a bond, P, and dy is a very small change in the yield, y, then,
dP 1 percentage change in price

modified duration = x =
P dy change in yield
Note that a negative sign is inserted before the expression to represent the negative
relationship between yields and bond prices, i.e., bond prices fall if yields rise and vice-
versa.
Interpretation: Modified duration can also be interpreted as the percentage change in

bond price for 100 bp (1.00%) change in bond yield.
Link with Macaulay duration: Modified duration and Macaulay duration are linked
as shown below:
Macaulay duration
Modified duration =
(1 + y )
For semi-annual bonds, replace y with y/2. In general, it will be (1 + y/n), where n is
the number of payments per year.

B. Option-embedded bonds
Effective duration (or, option-adjusted duration): Effective duration assumes that

investors or issuers can alter the future bond cash flows by their actions, such as exercise
of a call or a put option. Thus, it takes into account both interest rate volatility as well as
changing cash flows. It is the only measure that is universal. It can also be used for
option-free bonds. The other two measures, Macaulay and modified duration, cannot be
used with option-embedded bonds because they assume that cash flows cannot be altered
by issuers and investors, giving misleading results for option-embedded bonds.
This is the same formula that was introduced in LOS: 1.C.f.
P P+
Effective duration =
2 x P0 x y
where, P- = price of the bond for a drop in yield equal to y
P+ = price of the bond for an increase in yield equal to y
P0 = price of the bond before the change in yield
y = change in yield (measured as a decimal fraction)
Conclusion: Effective duration is the most commonly used duration measure, followed by
modified duration. Macaulay duration can be used in the calculation of modified duration as the
link between the two, listed above, shows.
LOS: 1.C.j. Describe why duration is best interpreted as a measure of a bonds or portfolios
sensitivity to changes in interest rates.
Interpretations: There are several interpretations for the duration measure all of which are
correct. However, from a practical standpoint and ease of understanding not all of them are
equally appealing, especially when the concept is being explained to a non-expert, such as a
client, who is unfamiliar with financial mathematics.
A. Duration as price sensitivity to yield: The easiest and simplest way to understand
duration as a risk-measure for bonds is to realize that it tells us how the bond price
fluctuates if bond yield changes by 100 bp or 1%. For example, if a bond has a duration
of 6.5, and bond yield changes by 1%, bond price will change by 6.5% (= 6.5 x 1%).
B. Duration as the first derivative or slope measure: Recall the definition for modified
duration given in the previous LOS.
dP 1
modified duration = x
P dy

Upon rearranging the above equation, we get

dP 1
modified duration = x
dy P
dP
is the slope or the first derivative of the bond price-yield curve as discussed in
dy
LOS: 1.C.c. for very small changes in bond yield. In other words, duration is based on
the first derivative which is a calculus concept.
C. Duration as a time related measure: Macaulay duration represents the weighted average
time to coupon and principal payments of a bond and is measured in years. For example,
if a coupon bond has a Macaulay duration of 7 years, it means that its price sensitivity to
bond yield changes is equivalent to that of a 7-year zero-coupon bond.
Conclusion: Why price sensitivity is the best interpretation?
1. Duration as the first derivative of the price-yield curve is a very difficult concept for non-
mathematicians to comprehend, and is certainly not appealing to a lay person.
2. Macaulay duration expresses duration in terms of time or an equivalent zero-coupon
bonds price sensitivity but does not tell us how a bonds price would change for a given
yield change. Furthermore, duration can be negative for interest only mortgage backed
securities, i.e., if yields rise, their value rises. Short-term options may have durations that
are very high, such as 50, 60 or 70. They cannot be interpreted in terms of years or time.
3. Duration as a price sensitivity measure is the best interpretation. It represents the
percentage change in the price of a bond for a 1% change in yield. The other two
measures are operationally meaningless.
LOS: 1.C.k. Compute the duration of a portfolio, given the duration of the bonds comprising
the portfolio.
Duration of a portfolio is a weighted average concept. Weight (wi) represents the proportion of
the portfolio invested in bond i based on its market value. Weights are multiplied by their
respective bond durations (Di). Results are added together to get portfolio duration.
Portfolio duration = w1 x D1 + w2 x D2 + w3 x D3 + . . . + wi x Di + . . . + wn x Dn
wi = market value of bondi market value of portfolio
n = number of bonds in the portfolio
Depending upon the type of bonds held in the portfolio either the modified duration or the
effective duration measure can be used in the above equation.

Example:
Austrian Capital Management (ACM) has four bonds in its portfolio as shown below.
What is the duration of the bond portfolio? Assume that the bonds are option-free.
Bond Bond price No. of bonds Modified duration

A 976.50 12,200 5.37
B 1,003.75 8,150 7.98
C 1,123.25 14,500 11.54
D 955.00 13,700 9.43
Answer:
We compute the market-value based weights for each of the four bonds below:
Bond Bond price No. of bonds Market value Weight

A 976.50 12,200 11,913,300.00 0.24
B 1,003.75 8,150 8,180,562.50 0.17
C 1,123.25 14,500 16,287,125.00 0.33
D 955.00 13,700 13,083,500.00 0.26
TOTAL 49,464,487.50 1.00
Note: Market value = Bond price x No. of bonds
Portfolio duration = 0.24 x 5.37 + 0.17 x 7.98 + 0.33 x 11.54 + 0.26 x 9.43 = 8.91
This means that if the yield on all the bonds changes by 1%, portfolio value will change
by 8.91% (= 8.91 x 1%). We can use modified duration as the bonds are option-free.
Very important: Yields on all the four bonds must change by 1% (in the same direction).
This is a crucial assumption behind the weighted-average portfolio duration calculation..
LOS: 1.C.l. Explain the limitations of the portfolio duration measure.
Portfolio duration measure has several limitations. These are:
1. Non-parallel shift in yield curve: Since all cash flows of a bond are assumed to be
discounted at a single rate, duration assumes that the yields on all maturities change by
the same amount, i.e., the yield curve undergoes a parallel shift. If the yield curve twists,
the duration measure will be inaccurate and misleading. A portfolio would contain
several different maturities and twisting of the yield curve would be problematic.
2. Perfect correlation among bond yields: Portfolio duration requires that the yields on all
bonds contained in a portfolio change by the same amount and in the same direction. This
assumption is often violated in view of the non-parallel yield curve shift problem.

3. Convexity effect: Recall from LOS: 1.C.c. that the bond price-yield curve is non-linear
and has a convexity effect. This means that the change in the price of a bond computed
on the basis of slope (duration or first derivative) alone would be incorrect if the change
in yield were large due to the presence of convexity as shown below.
Total bond price change = Duration effect + Convexity effect
The more convex the curve for a bond the greater the inaccuracy, even if the yield change
is small and convexity is ignored only duration is relied upon. Different bonds in a
portfolio would have different convexities and ignoring them would lead to significant
errors.
LOS: 1.C.m. Discuss the convexity measure of a bond.
Definition: The curvature of the bond price-yield curve is interpreted as convexity. The degree
of convexity is measured in the following manner:
P+ + P 2 P0
convexity measure = . . . (1)
2 x P0 x (y ) 2
Symbols have the same meaning as given in Part B of LOS: 1.C.h.
convexity adjustment = + C x (y)2 . . . (2)
Note: The reading states that there are many ways of scaling the convexity measure. In the
above definition, 2 appears in the denominator of equation (1). Alternatively, if 2 is
dropped in the denominator of this equation, then convexity adjustment in equation (2)
must be divided by 2. The second approach essentially doubles the convexity measure
and its effect cancels out in convexity adjustment, giving us the same result. Both
approaches are correct. We recommend that candidates follow the first approach (with 2
in the denominator), and be aware of the alternative approach.
net percentage change in bond price = [ D x y + C x (y)2] x 100. . . (3)
The net percentage change in the price of a bond, equation (3), is the sum of duration effect
(first term) and convexity effect (second term). y is entered as a decimal. We multiply the
result with 100 to get the percentage change since y is entered as a decimal.
Interpretation: Convexity measure does not have any operational meaning. Only when it is
used in equation (2) for convexity adjustment it tells us the percentage change in bond price due
to convexity for a given yield change.
The following diagram shows how convexity affects the change in the price of a bond. A bond
with greater convexity experiences greater price appreciation when yields fall and a lower price

decline when yields rise. Thus, greater convexity is a desirable quality in a bond so far as long
positions are concerned.
Bond with greater

bond price convexity
or value
Bond with lower

convexity
yield
Whereas duration is the slope or the first derivative of the bond price-yield curve, convexity is
the rate of change of that slope or the second derivative of the bond price-yield curve. While the
impact of convexity can be significant, it is less than the impact of duration in absolute
magnitude. Convexity is always positive for option-free bonds.
LOS: 1.C.n. Estimate a bonds percentage price change, given the bonds duration and
convexity measure and a specified change in interest rates.
The estimation procedure is illustrated with the help of an example.
Example:
Korea Industry Development Fund (KIDF) has issued long-term bonds with the
following duration and convexity parameters:
Duration = 8.95; Convexity = 56.88
Compute the percentage change in the price of KIDF bonds if yields fall by 25 bp.
Answer:
We employ the equation given in the previous LOS:
net percentage change in bond price = [ D x y + C x (y)2] x 100 . . . (3)
= [ 8.95 x (0.0025) + 56.88 x (0.0025)2] x 100 = [0.0224 + 0.0004] x 100 = 2.28%
Note that the duration effect, 2.24%, is much greater than the convexity adjustment (or
effect) at 0.04%. We multiply the result by 100 to express it as a percentage since y is
entered as a decimal. Note that the yield change is negative as yield falls.

LOS: 1.C.p. Compute the price value of a basis point (PVBP), and explain its relationship to
duration.
PVBP: Price value of a basis point is the change in price of a bond if the underlying yield
changes by 1 bp. It is nothing but an application of the duration concept. We repeat the equation
for fractional change in bond price, ignoring convexity.
dP
fractional change in bond price = = D x y
P
D is duration modified or effective. If we multiply both sides of this equation by P, we get
dP = D x y x P
Note that we do not multiply the right hand side by 100 because we are focusing on fractional
(decimal) change and not percentage change in price.
If we set y = 0.0001 (or 1 bp), we get
PVBP = dP = D x 0.0001 x P . . . (4)
The negative sign is usually dropped when computing PVBP since the direction of change in
yield is not specified. The inverse relationship between bond price and yield, however, remains
implicit. PVBP is simply the dollar duration of a bond for 1 bp change in yield.
We stay with the Korean Industry example from LOS: 1.C.m to illustrate this concept.
Example:
Korea Industry Development Fund (KIDF) has issued long-term bonds with the
following duration parameter:
Duration = 8.95
Compute the PVBP for KIDF bonds assuming that they are currently selling at $989.25.
Answer:
Using equation (4) given above,
PVBP = 8.95 x 0.0001 x 989.25 = 0.885 ~ $0.89
The change in the price of the bond for 1 bp (0.0001) change in bond yield is $0.89. This
is PVBP for KIDF bonds.

If the yield changed by 25 bp, bond price change would be $22.13 (= 25 x 0.885). This
equals 2.24% of the bonds price before the yield change. Or,
22.13
percentage price change = x 100 = 2.24%
989.25
This is the same change we had computed earlier on the basis of duration, ignoring
convexity adjustment. PVBP can be multiplied with the number of basis points to
compute the total change in the price of a bond. Note that PVBP ignores convexity and
applies only to small changes in yield. Recall that absolute (magnitude of) price change is
the same whether the yield goes up or down in small increments. Convexity should be
considered for large changes in yield.
Editors Note: We can also compute the PVBP for a portfolio by simply inserting the
duration of the portfolio for D and market value of the portfolio for P in the PVBP equation.
Quick Review
Duration: Duration enables measurement of percentage bond price changes for a small change
in the yield to maturity. Bond prices are inversely related to interest rates.
Convexity: This is a measure of the effect of the rate of change of duration on bond price for a
small change in the yield to maturity. It is a second order effect, and when added to the duration
effect, measures the total percentage change in bond price. Convexity always has a positive
effect on the price of a bond, whether interest rates rise or fall.
Full valuation approach: This approach relies upon valuing a bond under all possible interest
rate scenarios. Duration-convexity approach focuses on changes in interest rates and their effects
on bond prices.
Interest rate exposure: When interest rates rise bond prices fall and vice-versa. This is known
as price risk. When interest rates fall, coupons can only be reinvested at lower rates and vice-
versa. The latter is known as reinvestment risk. Price risk , together with reinvestment risk, is
known as interest rate risk or exposure.
Price volatility of option-free bonds: There are two effects of rising or falling interest rates on
bond prices: duration and convexity. While duration always acts in a direction opposite to the
interest rate change, convexity is always positive. Thus,
Bond price change = Duration effect + Convexity effect
Convexity shores up bond prices when interest rates change, irrespective of the direction of the
change. Convexity is a desirable property of bonds.

Price volatility of callable bonds: Callable bonds experience a price cap when interest rates fall
due to the possibility of their being called at the call price, which is fixed according to a formula,
and is likely to be lower than the theoretical price of the bond on option-free basis. This
introduces negative convexity when rates are low, preventing callable bond prices from rising as
much as they would otherwise rise, when interest rates fall.
Price volatility of putable bonds: Putable bonds have a floor placed on their price (equal to par
value), and their prices do not fall as much as they would otherwise fall, when interest rates rise.
Modified duration: Modified duration is a mathematical (calculus based) or an exact measure

of bond price sensitivity of option-free bonds to interest rate changes. See duration above.
Macaulay duration: Macaulay duration is an old measure of duration that has an error in it.
After dividing Macaulay duration by (1 + periodic yield), modified duration can be computed.
Do not use Macaulay measure for bond price sensitivity calculations without making the
adjustment. Macaulay duration is a weighted-average bond-life concept, equivalent to a zero
coupon bond.
Effective duration: Effective duration is duration of a bond that has embedded options, such as
callable and putable bonds. Modified duration is not a good measure for such bonds since it does
not take option effects into account. Effective duration is an empirical measure, which relies
upon bond valuation according to the full valuation approach under different interest rate
scenarios and focuses on the resulting price differences for computation of effective duration.
Portfolio duration: Duration of a portfolio is a weighted average measure of the (effective)

durations of component bonds. Weights are based on market values.
Limitations of duration: All duration measures assume parallel shifts in the yield curve. This is
rarely true in the real world. They also assume that all yields (different maturities) are perfectly
correlated with each other. This is often violated. Finally, duration ignores the effect of
convexity (second order) by assuming bond prices are linearly related to interest rates, which is
not so. Duration, as an approximation, works for small changes in yield where the linear
approximation may hold. It breaks down when yield changes are large.
Effective convexity: Effective convexity is the second order effect for option embedded bonds.
It is computed empirically in a manner similar to effective duration. Effective duration and
effective convexity are superior to duration and convexity for bonds with embedded bonds as
they take options effects into account.
Price value of a basis point: This is a bond price sensitivity measure for one basis point change
in the underlying bond yield. A basis point equals one-hundredth of one percent, i.e., 0.0001. It
uses duration or effective duration in its calculation, as the case may be, and ignores convexity.
Recall that for small yield changes, the convexity effect can be ignored.

Bonds Analysis Valuation

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Bonds Analysis Valuation

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Bonds Analysis and Valuation Investments

1.A. Introduction to the Valuation of Debt Securities

LOS: 1.A.a. Describe the fundamental principles of bond valuation.

2004 finSage Inc. 1

If a security is issued by the US government, or US Treasury, it is considered default or risk free.

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Time Cash Flow Present Value (PV)

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Time Cash Flow Present Value (PV)

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Extension to semi-annual coupon payments

Time Cash Flow Present Value (PV)

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Discount rate Bond Value Change in Value

bond price Convexity

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The different scenarios are summarized in the graph below.

Bond Premium bond

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Case 1: Yield remains at its current level of 7%

Current price = 927.52

We enter the following values in the financial calculator

Price after 1 year = 937.63

We enter the following values in the financial calculator

Case 2: Yield remains at its current level of 5%

Current price = 1,025.64

We enter the following values in the financial calculator

Price after 1 year = 1,021.88

We enter the following values in the financial calculator

2004 finSage Inc. 9

Coupon rate > Coupon rate = Coupon rate <

LOS: 1.A.g. Compute the value of a zero-coupon bond.

By convention, a zero-coupon bond is discounted semi-annually at the semi-annual yield to make

Using the above formula,

N = 2 x 25 = 50; I/Y = 6.25% 2 = 3.125%; FV = 1,000 and press CPT PV.

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Years Period Spot Rate Cash Flow Present Value

LOS: 1.A.j. Explain how a dealer can generate an arbitrage profit.

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Arbitrage-free valuation approach: Under the arbitrage-free valuation approach it is assumed

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1.B. Yield Measures, Spot Rates, and Forward Rates

Sold prior to maturity at a price of

Redeemed at maturity at face value

Redeemed at maturity at face value of

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This is a long LOS! So, be forewarned.

annual coupon interest

2004 finSage Inc. 16

N = 5 x 2 = 10; PV = -986.75; PMT = 50 2 = 25; FV = 1,000 and press CPT I/Y.

After we annualize it we get,

Annualizing is just a convention. Annualized yield is also known as bond-equivalent yield.

N = 2 x 2 = 4; PV = -986.75; PMT = 50 2 = 25; FV = 1,020 and press CPT I/Y.

The annualized yield to first call turns out to be

yield to first call = 3.335% x 2 = 6.67%

2004 finSage Inc. 17

N = 4 x 2 = 8; PV = -986.75; PMT = 50 2 = 25; FV = 1,000 and press CPT I/Y.

yield to first par call date = 2.686% x 2 = 5.37%

N = 3 x 2 = 6; PV = - 1,055.75; PMT = 80 2 = 40; FV = 1,000 and press CPT I/Y

The annualized yield to put turns out to be

yield to put = 2.97% x 2 = 5.94%%