Bond Prices and Yields

Goals for this chapter

• Understand the Pricing of bonds and concept of YTM, realized return and holding
period return, current yield.

• Understand the trading of bond and concept of clean price, dirty price and accrued
interest.

• Understand various types of bonds

• Credit analysis of a bond

 Bonds_Basics

• Bonds are debt. Issuers are borrowers and holders are creditors.

– The indenture is the contract between the issuer and the bondholder.
– Indenture contains covenants related to collateral, restrictions in terms of
payment of dividend, further borrowing, etc
– The indenture gives the coupon rate, maturity date, and par value.
 Bonds Basics

• Face or par value is typically Rs.100; this is the principal repaid at maturity.

• The coupon rate determines the interest payment.

– Interest is usually paid semiannually.
– The coupon rate can be zero.
– Interest payments are called “coupon payments”.
 Bond Basics

• Bond Price:
– Present value of the future coupons and principal.
– The present value is computed using the required rate of return or yield in
the market, also called as yield to maturity.

• Yield to Maturity
– Is the required rate of return, which usually is the interest rate in the market
for that security.
– This can be equal to, higher than or lower than the coupon rate.
– Defined as a return that equates the bond price to the present value of the
future cashflows
– Return earned by investor if the bond is held to maturity assuming
intermediate coupons are re-invested at YTM.
 A 5-year maturity bond (F.V.=100) with a coupon rate of 10% paid
annually is trading at a yield of 11%.

a) Compute the price of the bond.

b) What is the price if the coupons are paid semi-annually.
0 1 2 3 4 5
YTM 11%
Coupon 10 10 10 10 10
Principal 100
Total 10 10 10 10 110

PV 10/(1+11%)^1 10/(1+11%)^2 10/(1+11%)^3 10/(1+11%)^4 110/(1+11%)^5

PV 9.01 8.12 7.31 6.59 65.28

Bond 96.3
Price
 A 5-year maturity bond (F.V.=100) with a coupon rate of 10% paid
annually is trading at a yield of 11%.

a) Compute the price of the bond.

b) What is the price if the coupons are paid semi-annually.

Annual Coupons Semi-Annual coupons

𝐶𝑜𝑢𝑝𝑜𝑛 1 𝐴𝑚𝑜𝑢𝑛𝑡 𝐶𝑜𝑢𝑝𝑜𝑛 1 𝐴𝑚𝑜𝑢𝑛𝑡
𝑃𝑟𝑖𝑐𝑒 = (1 − (1+𝑟)𝑛 )+ (1+𝑟)𝑛 𝑃𝑟𝑖𝑐𝑒 = 𝑟
(1 − (1+𝑟)𝑛 )+ (1+𝑟)𝑛
𝑟

10 1 100 10/2 1 100

= (1 − )+ =11%/2 (1 − (1+11%/2)5∗2)+ (1+11%/2)5∗2
11% (1+11%)5 (1+11%)5

=36.96 + 59.34 =37.69 + 58.54

=96.30 =96.23
 Attempt the Quiz titled “Primary Markets” in Socrative.

How?

1. Go to [Link]
2. Click on “Login” (top right)
3. Click on “Student Login”
4. Room Name: SAIMTB
5. Enter your correct enrolment no.
A 5-year maturity bond (F.V.=100) with a coupon rate of 10% paid annually is
trading at a price of Rs.105 in the market. If an investor purchases the bond
then what is the yield to maturity?

0 1 2 3 4 5
Bond 105
price
Coupon 10 10 10 10 10
Principal 100
Total 10 10 10 10 110
PV 10/(1+r)^1 10/(1+r)^2 10/(1+r)^3 10/(1+r)^4 110/(1+r)^5
PV
YTM (r ) 8.72%
 Inference

• When YTM (11%) > Coupon rate (10%), then Price (96.3)< Face Value (100).
Bond trading at discount.

• When YTM (8.72%) < Coupon rate (10%), then Price (105)> Face Value (100).
Bond trading at premium.

• Inverse relationship between YTM and Bond Price.

• When YTM = Coupon rate, Price = Face value. Bond trading at par
 Bond Basics

• Realized Return:
– Actual return earned by investors when the bond is held to maturity.

• Yield to Maturity
– Return earned by investor if the bond is held to maturity (assuming
intermediate coupons are re-invested at YTM).

• Thus realized return may not be equal to YTM.

‘A’ ,‘B’ and ‘C’ separately purchased 5-year maturity bond (F.V.=100) with a coupon
rate of 10% for Rs.100 and held the bond till maturity. ‘A’ did not invest the
intermediate coupons. ‘B’ invested the intermediate coupons at 8% while ‘C’ invested
them at 10%. Compute the following

a) YTM for all three

b) Realized return for all three
• YTM is the rate:
• Which equates the price to present value of future cashflow

Price=100. Since price=Face value, YTM=Coupon rate=10%

So YTM for all three =10%.

 Realized return for ‘A’
1 2 3 4 5

Coupon 10 10 10 10 10

Principal 100
Total 10 10 10 10 110

FV 10*(1+0%)^4 10*(1+0%)^3 10*(1+0%)^2 10*(1+0%)^1 110*(1+0%)^0

FV 10 10 10 10 110

Sum of FV 150

150 = 100 ∗ 1 + 𝑟 5 , 𝑠𝑜𝑙𝑣𝑖𝑛𝑔 𝑟 = 8.44%

 Realized return for ‘B’

1 2 3 4 5
Coupon 10 10 10 10 10
Principal 100
Total 10 10 10 10 110
FV 10*(1+8%)^4 10*(1+8%)^3 10*(1+8%)^2 10*(1+8%)^1 110*(1+8%)^0
FV 13.60 12.60 11.66 10.8 110

Sum of FV 158.67

158.67 = 100 ∗ 1 + 𝑟 5 , 𝑠𝑜𝑙𝑣𝑖𝑛𝑔 𝑟 = 9.67%

 Realized return for ‘C’
1 2 3 4 5

Coupon 10 10 10 10 10

Principal 100
Total 10 10 10 10 110

FV 10*(1+10%)^4 10*(1+10%)^3 10*(1+10%)^2 10*(1+10%)^1 110*(1+10%)^0

FV 14.641 13.31 12.1 11 110

Sum of FV 161.05

161.05 = 100 ∗ 1 + 𝑟 5 , 𝑠𝑜𝑙𝑣𝑖𝑛𝑔 𝑟 = 10%

 Inference

• Realized return is the average annual return earned over the holding period.
• Realized return depends on the rate at which the coupons are re-invested till
the holding period.
• YTM may not be same as realized return, since YTM assumes that intermediate
coupons are re-invested at YTM.
 Investment period less than the maturity of the bond

‘A’ invested in a 10%, 5-year bond of Face value Rs.100 and plans to hold the bond for 3
years. Compute the holding period return if post investment the yield in the market:
a) Falls to 8%
b) Rises to 11%
 𝐹𝑉 = 𝑃𝑉(1 + 𝑟)3
FV=Value of coupons at the end of 3 years+ Bond Price at the end of 3𝑦𝑒𝑎𝑟𝑠
FV=32.46+103.57=136.03
136.03= 100 ∗ 1 + 𝑟 3 , 𝑟 = 10.8%

1 2 3 4 5
Coupon 10 10 10 10 10
Principal 100
Total 10 10 10 10 110
10/(1+8%)^1 110/(1+8%)^2
9.26 94.31
Price 103.57
FV 11.664 10.8 10
Value of coupons 32.464 136.03
Bond Price 103.57
Total 136.03
 𝐹𝑉 = 𝑃𝑉(1 + 𝑟)3
FV=Value of coupons at the end of 3 years+ Bond Price at the end of 3𝑦𝑒𝑎𝑟𝑠
FV=33.42+98.29=131.71
131.71= 100 ∗ 1 + 𝑟 3 , 𝑟 = 9.62%

1 2 3 4 5
Coupon 10 10 10 10 10
Principal 100
Total 10 10 10 10 110
10/(1+11%)^1 110/(1+11%)^2

9.01 89.28
Price 98.29
FV 12.321 11.1 10
Value of coupons 33.421

Bond Price 98.29

Total 131.71
 Investment period less than the maturity of the bond

‘A’ invested in a 10%, 5-year bond of Face value Rs.100 and plans to hold the bond for 3
years. Compute the holding period return if post investment the yield in the market:
a) Falls to 8%
b) Rises to 11%

Summary
0.08 0.11
Re-investment
FV of coupons 32.46 33.42 risk
Price of the bond 103.57 98.29 Price risk

Total 136.03 131.71

Return 10.80% 9.62%
 Inference
• If yields change after the purchase the coupons are re-invested at a different
rate, leading to change in expected returns. This is termed as re-investment risk.

• Yield change also would lead to change in price at which the bond can be sold,
leading to change in expected returns. This is termed as price risk.

• Re-investment risk and Price risk have opposite impact i.e if one is favorable the
other is unfavorable.

• Yield decrease leads to re-investment of coupons at a lesser rate (unfavorable)

but increase in the price at which bond is sold (favorable)

• Yield increase leads to re-investment of coupons at a higher rate (favorable) but

decrease in the price at which bond is sold (unfavorable)
 Attempt the Quiz titled “BONDS” in Socrative.

How?

1. Go to [Link]
2. Click on “Login” (top right)
3. Click on “Student Login”
4. Room Name: SAIMTA
5. Enter your correct enrolment no.
 Bond equivalent Yield

• Yield offered by a bond with period of compounding less than a year. Semi-annual
compounding will result in yield to be higher than when the compounding is annual

• For a 10% coupon bond with semi-annual coupon payments, the bond equivalent
yield is given as follows

=(1 + 5%)2 −1 = 10.25%

 Current Yield

• 𝐶𝑜𝑢𝑝𝑜𝑛 𝑖𝑛 𝑅𝑠.
Current Yield =
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒

• For a 8% coupon, 2year bond trading at Rs.900 (F.V.=Rs.1000) the current yield is
given as:
80
Current Yield = = 8.9%
900
 Bond Price within the coupon dates

A 10%, 3-year bond issued on 10th July-2019 is trading at a price of Rs.101 on 8th Mar-
2020. What is the final price at which the bond would be available to the buyer?

Coupon date Transaction date Coupon Date

10-Jan-2020 8-Mar-2020 10-Jul-2020

 Terms
• Clean Price: Price quoted in the market

• Accrued Interest: Interest to be received by the holder of the bond when selling
the bond before the coupon date.

• Dirty Price=Clean Price +Accrued Interest

𝐷𝑎𝑦𝑠 𝑠𝑖𝑛𝑐𝑒 𝑙𝑎𝑠𝑡 𝑐𝑜𝑢𝑝𝑜𝑛

Accrued Interest=Coupon (in Rs.) *𝑑𝑎𝑦𝑠 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑡𝑤𝑜 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑𝑠
 Bond Price within the coupon dates

A 10%, 3-year bond issued on 10th July-2019 is trading at a price of Rs.101 on 8th Mar-
2020. What is the final price at which the bond would be available to the buyer?

Last coupon Date 1/10/2020

Next Coupon Date 7/10/2020
Settlement Date 3/8/2020
Maturity Date 7/10/2022
AI=5*(58/182)=1.59
Days since last coupon 58
Days till next coupon 124
Price=101+1.59=102.59 total coupon days 182
 Bond Types
Zero coupon bonds:

• Issued at discount to face value and redeemed at face value.

• No coupon is paid.

• Price of ZCB’s is computed as follows:

𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒
𝑃𝑟𝑖𝑐𝑒 = , where r is the YTM and ‘n’ is year to maturity
(1+𝑟)𝑛
 Zero Coupon Bond

Sardar Sarovar Ltd issued a zero coupon bond (Face Value:Rs.1,10,000) on 1st Jan 1993,
maturing 14 years later at Rs.3500. What is the yield to maturity offered by the bond?

𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒
𝑃𝑟𝑖𝑐𝑒 = , where r is the YTM and ‘n’ is year to maturity
(1+𝑟)𝑛

1,10,000
3500= (1+𝑟)14
,

110000 ( 1 )
𝑟=( ) 14 −1
3500
‘r=28%
 Bond Types
Convertible Bonds:

• Usual bond with face value, coupon and maturity but on or before maturity allows
conversion in equity shares of the company.

• For example, 10%, 5-year bond (Face Value=Rs.100) convertible on maturity into
equity at price per share of Rs.20 at the option the bond holder.

• The bond holder will convert only if share is trading above Rs.20 and will receive 5
equity shares of the company.
 Bond Types
Why company issue convertible Bonds?

• To make the bond more attractive so that investors may participate.

• The conversion option is an added benefit as compared to a simple bond.

• Allows the company to reduce the coupon rate on the bonds.

• Usually is the last option in the order of raising finance.

Callable bonds:

• Can be repurchased before the maturity date at the specified call price.

• Usually done when the issuer expects the interest rate to fall in future.

• If the rate fall the company calls back the bond and pays the call price to the
investors

• For callable bonds if interest rate decrease then the maximum value the price
would be the call price since in case of call back by the company that is the
maximum price that would be paid to investors.

• Yield to call is the expected return that would be earned if the bond is redeemed
by the call date.
A 4-year maturity, 8% coupon bond paying coupons annually is
callable in 2 years at a call price of Rs. 1100. The bond currently sells
at par.

a) What is the yield to call?

b) What is the yield to maturity?
 a) 12.7%
b) 8%

1 2
Coupon 80 80
Principal 1100
Total 80 1180

PV 80/(1+r)^1 1180/(1+r)^2
What value of ‘r’ will maker
the total equal to present
bond value?
 Callable bond
Masters Corp issued two bonds with 20-year maturities. Both bonds are callable at
$1050. The first bond was issued at a deep discount with a coupon rate of 4% and a
price of $580 to yield 8.4%. The second was issued at par value with coupon rate of
8.75%.

a. If you expect rate to fall substantially in the next two years, which bond has the
higher expected rate of return?

b. What is the YTM of par bond? Why is it higher than the yield of the discount
bond?
 Callable bond
Masters Corp issued two bonds with 20-year maturities. Both bonds are callable at
$1050. The first bond was issued at a deep discount with a coupon rate of 4% and a
price of $580 to yield 8.4%. The second was issued at par value with coupon rate of
8.75%.

a. Par value bond has higher chances of being called back if the interest rates drop
unlike the discounted callable bond which is trading at much lower price. Hence
discounted callable bond will provide higher returns

b. 8.75%. Since it has higher chances of being called back.

 Bond Types

• Puttable bonds give the bondholder the option to retire at the specified
price.

• Catastrophe bonds:
– usual bond with an option of not paying future principal and/or coupon in
case any catastrophe occurs.
– They provide investors higher yield for bearing risk that are little
correlated with the rest of their portfolio
– Pandemic bonds issued by World bank in 2017
Factors Used by Rating Companies

• Coverage ratios
• Leverage ratios
• Liquidity ratios
• Profitability ratios
• Cash flow to debt
 Protection Against Default

• Subordination of future debt– restrict additional

borrowing
• Dividend restrictions– force firm to retain assets rather
than paying them out to shareholders
• Collateral – a particular asset bondholders receive if
the firm defaults
 Credit Default Swaps

• A credit default swap (CDS) acts like an insurance policy on

the default risk of a corporate bond or loan.
• CDS buyer pays annual premiums.
• CDS issuer agrees to buy the bond in a default or pay the
difference between par and market values to the CDS buyer.
 Credit Default Swaps

• Institutional bondholders, e.g. banks, used CDS to enhance

creditworthiness of their loan portfolios, to manufacture AAA
debt.
• CDS can also be used to speculate that bond prices will fall.
• This means there can be more CDS outstanding than there are
bonds to insure!
Credit Risk and Collateralized Debt Obligations
(CDOs)

• Major mechanism to reallocate credit risk in the fixed-

income markets
– Structured Investment Vehicle (SIV) often used to
create the CDO
– Loans are pooled together and split into tranches
with different levels of default risk.
– Mortgage-backed CDOs were an investment disaster
in 2007
Bond Portfolio Management
Goals for the Session

• Passive management strategies

• Dedication
• Bond Indexing
• Immunization

• Active management strategies.

 Passive management strategies

• Managing to achieve benchmark returns with minimal turnover of the portfolio

• Assumes bond prices as given and try to control the risk

 Dedication

• Matching cash-flow of assets with the liabilities.

• Achieved by buying zero coupon bonds

• Limitation is the availability of zero coupon bonds across different maturities

 Passive management strategies: Bond Indexing

• Buying a pool of bonds to replicate an index.

• Mirror the performance of bond index.

• Market value weighted index of total returns

 Bond Indexing: Issues

• Include thousand of securities so that makes replication difficult.

• Illiquid securities.

• Rebalancing issues

• Interest income needs to be continuously re-invested

 Bond Indexing: Solution

• Stratified sampling approach is used instead.

• Identify homogenous group of securities in terms of

• Maturity,
• Coupon,
• Creditrisk
 Passive management strategies: Immunization

• Insulating the portfolio from interest rate risk altogether.

• Banks interested in protecting the their net-worth against market fluctuations.

• Pension funds, Insurance companies concerned balancing their assets against their
liabilities.

• Liabilities may have different durations as compared to assets.

 Immunization

A insurance company takes Rs10,000 as one time premium and

plans to pay back 8% return for a maturity of 5 years when the
policy lapses So what amount will the company have to pay at the
end of 5 years?

10,000*(1.08)^5 =14,693.28

For fulfilling its promise the company invests the money in a

coupon bond of 8% maturing in 5 years.
The following table shows the future value of cash flow derived from the bond,
when interest rates remain constant at 8%

years to FV cash
Year maturity flows Amount
1 4 800*(1.08)^4 1088.39
2 3 800*(1.08)^3 1007.76
3 2 800*(1.08)^2 933.12
4 1 800*(1.08)^1 864
5 0 800*(1.08)^0 800
redemption 5 0 10,000 10,000

Total 14693.28
What if the interest rates fall to 7%?

The re-investment happens at the rate of 7% and the bonds are

redeemed at 10,000
years to FV of cash
maturity flows Amount
1 4 800*(1.07)^4 1048.63
2 3 800*(1.07)^3 980.03
3 2 800*(1.07)^2 915.92
4 1 800*(1.07)^1 856
5 0 800*(1.07)^0 800
redemption 5 0 10000 10000

Total 14600.60

GAP=14,693.28-14,600.60=92.70
What if the interest rates rise to 9%?

The re-investment happens at the rate of 9% and the bonds are

redeemed at 10,000

years to FV of cash
maturity flows Amount
1 4 800*(1.09)^4 1129.27
2 3 800*(1.09)^3 1036.02
3 2 800*(1.09)^2 950.48
4 1 800*(1.09)^1 872
5 0 800*(1.09)^0 800
redemption 5 0 10000 10000

Total 14787.76

GAP=14,787.76-14,693.28=94.48
What if instead of investing in 5 year bond the company invests in
a 6 year 8% bond?

If interest rates remain at 8%

years to FV cash
maturity flows Amount
1 4 800*(1.08)^4 1088.39
2 3 800*(1.08)^3 1007.77
3 2 800*(1.08)^2 933.12
4 1 800*(1.08)^1 864
5 0 800*(1.08)^0 800
sale of bond 5 0 10800/1.08 10000

Total 14693.28
What if the interest rates fall to 7%?

The re-investment happens at the rate of 7% and the bonds are

redeemed at 10,000

years to FV of cash
maturity flows Amount
1 4 8*(1.07)^4 1048.64
2 3 8*(1.07)^3 980.03
3 2 8*(1.07)^2 915.92
4 1 8*(1.07)^1 856
5 0 8*(1.07)^0 800
sale of bond 5 0 10800/1.07 10093.46

14694.04

Benefit=14,694.04-14,693.28=0.77
 What if the interest rates rise to 9%?

The re-investment happens at the rate of 9% and the bonds are

redeemed at 10,000
years to FV of cash
maturity flows Amount
1 4 8*(1.09)^4 1129.27
2 3 8*(1.09)^3 1036.02
3 2 8*(1.09)^2 950.48
4 1 8*(1.09)^1 872
5 0 8*(1.09)^0 800
sale of the bond 5 0 10800/1.09 9908.26

14696.03

Benefit=14,696.03-14,693.28=2.74
Thus for any change in interest rate the difference between the
return from the bond and the obligation to the insurance
holder is quite less.

What’s the duration of this 8%, 6 year bond?

4.99 years

Thus in the example we matched the duration of the

obligations to the duration of the investment so as to eliminate
the risk of any change in interest rate.
You are managing a portfolio of Rs 1mn. Your target duration is 10
years, and you can choose from two bonds, a zero coupon bond with
maturity of 5 years and a perpetuity each yielding 5%.

(a)How much of each bond will you hold in your portfolio?

(b)How will these fractions change next year if target duration is now
9 years?

(a)11/16 invested in the zero and 5/16 in the perpetuity.

(b)12/17 invested in the zero and 5/17 in the perpetuity.

A pension plan will pay Rs.10,000 once a year for a 5-year
period. The first payment would come in exactly five years. The
pension fund wants to immunize its position. The current rate of
interest is 10%
(a)What is the duration of the obligation?
(b)f the plan uses 5-year and 20-year zero coupon bonds to
construct the immunized portfolio, how much money ought
to be placed in each bond?
(c) No. of 5-year and 20-year bonds that need to be bought.
Assume FV=Rs.100
(a) 6.81
(b) 88% in 5 year
(c ) no. of 5yr bonds=367,no. of 20yr bonds=209
 Limitations of Immunization

• Duration is dependent on YTM. As the YTM changes the duration would change and
immunization would have to be done again.

• Duration is a function of maturity. After a year, for example, the duration of asset and
liability may not match, so immunization will have to be done again.

• Duration was computed using a single rate. In case the yield curve is not flat, term
structure would be used to compute duration.

• With non-flat yield curve, we are making an assumption of parallel shifts in yield curve
 Active Management:
Swapping Strategies
• Substitution swap: Involves identifying bonds that are identical in most of the
parameters like default risk, coupon, maturity which in usual circumstances
trade at similar prices.
• Intermarket swap: involves mispricing across sectors i.e. corporates bonds
usually trade at a range bound yield spread as compared to a government
security
• Rate anticipation swap: Involves interest rate forecasting. When investors
expect the rates to fall they would swap the short term bonds for long term
bonds and thus make higher profit on account of higher percentage increase in
price and vice versa.
• Pure yield pickup
• Tax swap
Term Structure of Interest Rates
Goals for the Session

• Yield Curve

• Strips

• Forward Rate

• Bootstrapping
 Yield Curve

• Is a plot between yield and time to maturity.

• A pure yield curve (called the term structure) is one which plots the relationship using
the yield of zero coupon bonds.

Yield Curve
12%

10%

8%

6%

4%

2%

0%
0 1 2 3 4 5 6
 Rising Yield Curve Constant Slope Yield curve
12% 8%

7%
10%
6%
8%
5%

6% 4%

3%
4%
2%
2%
1%

0% 0%
0 1 2 3 4 5 6 0 1 2 3 4 5 6

Inverted Yield Curve

12%

10%

8%

6%

4%

2%

0%
0 1 2 3 4 5 6
 Use of Yield Curve

• Is used to price a bond or any financial asset.

• Generally the interest rate for discounting 1-year cash-flow is different from the one
which is used to discount a 2-year cash-flow and so on.

• Shape of the yield curve provides the direction of future interest rates.

• On the run yield curve is for recently issued coupon bonds selling at par or near par.
 YTM Vs Yields from yield curve

• Yield curve provides YTM’s for a specific maturity. (Zero coupon bond)

• For a coupon bond (say a 3-year, 10% bond) provides different maturity cashflows so it
is not actually a specific maturity.

• It contains a one, two and three year cashflows.

• So YTM of a 3-yr coupon bond and YTM from the yield curve will not match.
 YTM Vs Yields from yield curve: Example

• Given a 3-year, 10% bond, Face Value:100

• Compute the bond price and the YTM of the bond, given the term structure below

Rising Yield Curve

12%

10%

8%

6%

4%

2%

0%
0 1 2 3 4 5 6
• Compute the bond price by discounting the cashflows using yields from the term
structure
10 10 110
Price=(1+7%)1 + (1+8%)2 + (1+9%)3 =102.86

• Find the YTM that equates the present value of cashflows to this price.
10 10 110
102.86=(1+𝑟)1 + (1+𝑟)2 + (1+𝑟)3 , solving r = 8.87%

7% 8% 9%
0 1 2 3
10 10 110
PV using YTM 10/(1+y)^1 10/(1+y)^2 110/(1+y)^3
PV using YC 10/(1+7%)^1 10/(1+8%)^2 110/(1+9%)^3
PV using YC 9.35 8.57 84.94
Price 102.86
 Inference

• YTM of a coupon bond is the some amalgamation of return on a portfolio of different

maturity zero coupon bonds.

• Investing in a coupon bond is same as investing in different maturity zero coupon

bonds.

• This is also called as bond stripping.

 Bond Stripping

• A 10% coupon bond of maturity 3-years has the following cash-flows:

• Rs.10 payable at the end of each year for 3 years

• Rs.100 payable at maturity

• This is a mix of three zero coupon bonds of 1,2,3 year maturity paying a face
value of Rs.10 and one zero coupon bond of 3-year maturity paying a FV of
Rs.100.

• Thus a coupon bond can be stripped in series of ZCB’s and yield curve can
be used to price the coupon bond. (is usually done for arbitrage)
 Yield Curve Under certainty

• Given 1-year rate at 8% while 2-yr rate at 9%, as per the yield curve. Under certainty
all rates should be same since there is no risk. Then why are they different?

• Consider an investor with a holding period of 2-yr. She can invest either in a 2-yr
instrument or in a 1-yr instrument now and then invest the proceeds after 1-yr again
in a 1-yr instrument

• By arbitrage principle the return earned should be same.

The mathematical way of understanding is that a two year interest rate is a product of two single year
interest rates assuming no arbitrage exists i.e.
1 + 𝑟1 ∗ 1 + 𝑓1 = (1 + 𝑟2 )2
Where 𝑟1: is 1-year interest rate
𝑓1 : is 1-year rate 1-year after also called as forward rate
𝑟2: is 2-year interest rate
Given 𝑟1 = 8%, 𝑟2 = 9% 𝑓1 can be arrived as

1 + 𝑟1 ∗ 1 + 𝑓1 = 1 + 𝑟2 2

1 + 8% ∗ 1 + 𝑓1 = (1 + 9%)2
(1 + 9%)2
1 + 𝑓1 =
1 + 8%

𝑓1 = 10%
 Inference

• A 2-yr rate is a combination on 1-yr rate and 1-yr rate after one year. Higher interest
rate for 2-year bonds imply that interest rates for 1-yr maturing instruments are
expected to change from one year to the next.
 Forward Rates

Forward Rate: Implied future rate from the term structure

Future short rate: expected short term interest rate in future i.e. 1-yr rate 1-yr after or 1-yr
rate 2-yr after.

As per expectations hypothesis forward rate equals the market consensus expectation of the
future short interest rate.

(1  rn ) n
(1  f n ) 
(1  rn 1 ) n 1
A upward sloping yield curve indicates that the market
expects the future short term rate to be higher than the
current short term rate.
12

10

8
Rate

0
0 5 10 15 20 25
Year
A downward sloping yield curve indicates that the market
expects the future short term rate to be lower than the
current short term rate.
12%

10%

8%

6% Series1

4%

2%

0%
0 2 4 6 8 10 12 14
A flat yield curve indicates that the market expects the future
short term rate to be equal to the current short term rate.

9%

8%

7%

6%

5%

4%

3%

2%

1%

0%
0 2 4 6 8 10 12 14 16 18
 Attempt the Quiz titled “Term Structure” in Socrative.

How?

1. Go to [Link]
2. Click on “Login” (top right)
3. Click on “Student Login”
4. Room Name: SAIMTA
5. Enter your correct enrolment no.
Given the price of zero coupon bonds of 1,2,3 and 4 year maturity.
(a) Calculate the YTMs.

Maturity Price
1 943.4
2 898.47
3 847.62
4 792.16
 Computing the YTM’s

Bond 0 1 2 3 4
1 943.4 1000
2 898.47 1000
3 847.62 1000
4 792.16 1000

1000
943.4= , 𝑔𝑖𝑣𝑒𝑠 𝑟1 = 6%
1+𝑟1 1

898.47= 1000/(1 + 𝑟2 ) 2 , 𝑔𝑖𝑣𝑒𝑠 𝑟2 = 5.5%

847.62= 1000/(1 + 𝑟3 ) 3 , 𝑔𝑖𝑣𝑒𝑠 𝑟3 = 5.67%

792.16= 1000/(1 + 𝑟4 ) 4 , 𝑔𝑖𝑣𝑒𝑠 𝑟4 = 6%

Given the price of zero coupon bonds of 1,2,3 and 4 year maturity.
(a) Calculate the YTMs.
(b) The implied forward rates.

Maturity Price
1 943.4
2 898.47
3 847.62
4 792.16
 Computing the Forward Rates

Bond YTM
1 6% 1 + 6% ∗ 1 + 𝑓1 = (1 + 5.5%)2
2 5.5% 𝑓1 =5%
3 5.67%
4 6% (1 + 5.5%)2 ∗ 1 + 𝑓2 = (1 + 5.67%)3

𝑓2 = 6%

(1 + 5.67%)3 ∗ 1 + 𝑓3 = 1 + 6% 4

𝑓3 =7%
1-year rate today 6%
1-year rate 1-year after 5%
1-year rate 2-yr after 6%
1-year rate 3-yr after 7%
Given the price of zero coupon bonds of 1,2,3 and 4 year maturity.
(a) Calculate the YTMs.
(b) The implied forward rates.
(c) The expected price path of 4-year bond as time passes.

Maturity Price
1 943.4
2 898.47
3 847.62
4 792.16
 The expected price path of 4-year bond as time passes

Forward
rates 6% 5% 6% 7%
Bond 0 1 2 3 4

1000/(1+7%)*(1+6%)*(1+5%) 1000/(1+7%)*(1+6%) 1000/(1+7%)

Price 792.16 839.69 881.68 934.58 1000

 Maturity YTM F
1 6.00% 6.00%
2 5.50% 5.00%
3 5.67% 6.00%
4 6.00% 7.00%

Maturity Price YTM F Price

1 943.4 6.00% 6.00% 792.16
2 898.47 5.50% 5.00% 839.6862
3 847.62 5.67% 6.00% 881.6766
4 792.16 6.00% 7.00% 934.5697
Prices of zero-coupon bonds reveal the following pattern of forward
rates: Year forward rate(%)
1-yr rate today 5
1-yr rate after 1 yr 7
1-yr rate after 2 yr 8

In addition to the zero-coupon bond, investors also may purchase a 3-

year bond making annual payments of $60 with par value Rs.1000.

What is the price of the coupon bond?

 0 1 2 3
60 60 1060
Present Value 60/1.05 60/(1.07)*(1.05) 1060/(1.08)*(1.07)*(1.05)
984.14 57.14 53.40 873.59
 Term structure in an uncertain world

• A short term investor wishing to invest in 1-yr security can’t be

persuaded to invest in 2-yr since the 1-yr interest rate after 1-yr
may not be as expected. There is a risk.

• If the 1-yr rate after 1-yr is more than the expectation, then his
yield would be less than what he could have earned by investing
in a simple 1-yr instrument.

• The investor thus wants a higher return to bear this risk. This is
called as the liquidity premium.

• Since the coupon is fixed, his return is higher only if the purchase
price is lesser than estimated by the equilibrium relationship.
 Theory of term structure

Liquidity Premium Theory

• Long term bonds are more risky than the short term bonds
• Investors demand a premium for bearing the risk of holding a long term bond.

According to this theory the future short term rate would exceed the current short term
rate due to the presence of additional premium.

Forward rate =liquidity premium + future short rate.

1-year zero coupon bond is trading at a yield of 10% while a two year is trading at
10.5%. If the short term rates remain constant (expected short term rate one year
hence =10%) then how much premium is the investor demanding to hold a two year
bond?

(1  10%) * (1  r )  (1  10.5%) 2

r  11% Implied forward rate

The investor is asking for 1% premium to hold the 2-year zero coupon bond. The 1% is
the difference between the implied forward rate and the expected short term rate.
 Interpreting the term structure

Given an upward sloping yield curve:

Can we assume that interest rates are going to rise?

Not necessary. The upward slope can be on account of liquidity

premium.
 Bootstrapping: Inferring Zero coupon yields from Coupon Bonds

Using the following data on coupon bonds, construct the term structure of interest rates
after computing the zero-coupon yields for various maturities.

Coupon Rate (%) Maturity (in years) Current Price

2 1 100
3 2 100.5
4 3 101
5 4 102
6 5 103
7 6 104
8 7 105
8.5 8 106
9 9 107
9.5 10 110
10 11 109.5
10.5 12 111
Assuming annual coupons, we can infer that 1-yr rate to be 2%.
For 2-yr maturity bond we can write the following:
3 103
100.5 = 1
+ 2
, 𝑔𝑖𝑣𝑒𝑛 𝑟1 = 2%, 𝑤𝑒 𝑐𝑎𝑛 𝑐𝑜𝑚𝑝𝑢𝑡𝑒 𝑟2 = 2.75%
(1 + 𝑟1 ) (1 + 𝑟2 )
For 3-yr maturity bond we can write the following:

4 4 104
101 = 1
+ 2
+ 3
, 𝑔𝑖𝑣𝑒𝑛 𝑟1 = 2%, 𝑟2 = 2.75%,
(1 + 𝑟1 ) (1 + 𝑟2 ) (1 + 𝑟3 )

𝑤𝑒 𝑐𝑎𝑛 𝑐𝑜𝑚𝑝𝑢𝑡𝑒 𝑟3 = 3.69%

Coupon (%) Maturity Date Price Yield
2 1 100
2.00%
3 2 100.5
2.75%
4 3 101
3.69%
5 4 102
4.55%
6 5 103
5.52%
7 6 104
6.58%
8 7 105
7.73%
8.5 8 106
8.25%
9 9 107
8.83%
9.5 10 110
8.98%