Intermediate Finance

Session 9
Chapter 18
Present Value Model
Price Yield Curve
 Price Yield Curve
• When the yield is below the coupon rate, the bond
will be priced at a premium to its par value.
• When the yield is above the coupon rate, the bond
will be priced at a discount to its par value.
• The price-yield relationship is not a straight line;
rather, it is convex. As yields decline, the price
increases at an increasing rate; and, as yields
increase, the price declines at a declining rate. This
concept of a convex price-yield curve is referred to as
convexity
Present Value Model
 Yield Model
• Instead of determining the value of a bond
in dollar terms, investors often price bonds
in terms of yields—the promised rates of
return on bonds under certain assumptions
Yield Model
Computing Bond Yields
 Nominal Yield
• Nominal yield is the coupon rate of a
particular issue.
• A bond with an 8 percent coupon has an 8
percent nominal yield.
 Current Yield
• Measures the current income from the bond
as a percentage of its price, it is important
to income-oriented investors (e.g., retirees)
who want current cash flow from their
investment portfolios.
 Promised Yield to Maturity
• Most widely used bond yield figure because it
indicates the fully compounded rate of
return promised to an investor who buys
the bond at prevailing prices. We are
assuming that:
Promised Yield to Maturity
 Promised Yield to Call
• Bond with a call feature is selling for a price
above par (that is, at a premium) equal to or
greater than its call price, a bond investor
should consider valuing the bond in terms of
YTC rather than YTM.
Promised Yield to Call
 Realized Horizon Yield
• Measures the expected rate of return of a bond
that you anticipate selling prior to its maturity
Future Bond Prices
 Realized (Horizon) Yield with
Differential Reinvestment Rates
Bond Valuation Using Spot Rates
WHAT DETERMINES
INTEREST RATE?
What Determines Interest Rates
What Determines Interest Rates

• What's the difference between economic

forces and issue characteristics?
• Any examples?
 Economic Factors
• Effect of economic factors
– real growth rate
– tightness or ease of capital market
– expected inflation
– or supply and demand of loanable funds
 Issue Characteristics
• The quality of the issue as determined by its
risk of default relative to other bonds
• The term to maturity of the issue, which can
affect price volatility
• Indenture provisions, including collateral, call
features, and sinking-fund provisions
• Foreign bond risk, including exchange rate
risk and country risk
Types of Yield Curves
Types of Yield Curves
Types of Yield Curves
Types of Yield Curves
 HOW DO YOU
EXPLAIN SHAPE OF
THE YIELD CURVE?
 Term Structure Theories
• Expectation Hypothesis (?)
• Liquidity Preference Hypothesis (?)
• Segmented Market Hypothesis (?)
 Expectation Hypothesis
• Shape of the yield curve results from the
interest rate expectations of market
participants.
• More specifically, it holds that any long-term
interest rate simply represents the
geometric mean of current and future one-
year interest rates expected to prevail over
the maturity of the issue
 LP Hypothesis
• Long-term securities should provide higher
returns than short-term obligations because
investors are willing to accept lower yields for
short-maturity obligations to avoid the
higher price volatility of long-maturity
bonds.
• Lenders prefer short-term loans, and to
induce them to invest in volatile long-term
bonds, it is necessary to offer higher yields.
 LP Hypothesis
• This theory in isolation argues that the yield
curve should generally slope upward and
that any other shape should be viewed as a
temporary aberration.
 SM Hypothesis
• Different institutional investors have different
maturity needs that lead them to confine their
security selections to specific maturity segments.
• Investors supposedly focus on short-,
intermediate-, or long-term securities.
• This theory contends that the shape of the yield
curve ultimately is a function of these unique
investment preferences of major financial
institutions.
Trading Implications
 Trading Implications
• Information on maturity yields can help you
formulate yield expectations by simply observing
the shape of the yield curve.
• If the yield curve is declining sharply, historical
evidence suggests that interest rates will probably
decline.
• Strong expectation theorists would suggest that you
need to examine only the prevailing yield curve to
predict the future direction of interest rates.
Yield Spreads
 Yield Spreads
• Different segments of the bond market may
have different yields.
• For example, pure government bonds will
have lower yields than government agency
bonds, and government bonds have much
lower yields than corporate bonds. (why?)
 Yield Spreads
• Bonds in different sectors of the same
market segment may have different yields.
• For example, prime-grade municipal bonds
will have lower yields than good-grade
municipal bonds, and you will find spreads
between AA utilities and BBB utilities, or
between AAA industrial bonds and AAA
public utility bonds.
 Yield Spreads
• Different coupons or seasoning within a
given market segment or sector may cause
yield spreads.
• Examples include current coupon government
bonds versus deep-discount governments or
recently issued AA industrials versus seasoned
AA industrials.
 Yield Spreads
• Different maturities within a given market
segment or sector also cause differences in
yields.
What determines…
PRICE VOLATILITY
FOR BONDS
 Price Volatility
1. Bond prices move inversely to bond yields
(interest rates).
2. For a given change in yields (interest rates),
longer maturity bonds experience larger
price changes; thus, bond price volatility is
directly related to term to maturity.
3. Bond price volatility increases at a
diminishing rate as term to maturity
increases.
 Yield Spreads
4. Bond price movements resulting from equal
absolute increases or decreases in yield are
not symmetrical. A decrease in yield raises
bond prices by more than an increase in yield
of the same amount lowers prices. (Why?)
5. Higher coupon issues show smaller
percentage price fluctuation for a given
change in yield; thus, bond price volatility is
inversely related to coupon.
Trading Strategies
 Trading Strategies
• What the are two major variables that
influence a bond’s interest rate sensitivity?
 Trading Strategies
• Knowing that coupon and maturity are the
major variables that influence a bond’s
interest rate sensitivity, we can develop some
strategies for maximizing rates of return when
interest rates change.
• Specifically, if you expect a major decline in
interest rates, you know that bond prices will
increase, what kind of portfolio of bonds
would you want to have?
 Trading Strategies
• Knowing that coupon and maturity are the major
variables that influence a bond’s interest rate
sensitivity, we can develop some strategies for
maximizing rates of return when interest rates change.
• Specifically, if you expect a major decline in interest
rates, you know that bond prices will increase, so
you want a portfolio of bonds with the maximum
interest rate sensitivity so that you will enjoy
maximum price changes (capital gains) from the
change in interest rates.
 Trading Strategies
• In contrast, if you expect an increase in
market interest rates, you know that bond
prices will decline, and you want a portfolio
with minimum interest rate sensitivity to
minimize the capital losses caused by the
increase in rates
 Duration Measures
• Because the price volatility (interest rate
sensitivity) of a bond varies inversely with its
coupon and positively with its term to maturity,
it is necessary to determine the best combination
of these two variables to achieve your objective.
• This effort would benefit from a composite
measure that considered both coupon and maturity.
• A composite measure of the interest rate
sensitivity of a bond is referred to as duration.
Macaulay Duration
 Macaulay Duration
• The duration of a zero coupon bond will
equal its term to maturity.
• The duration of a coupon bond always will
be less than its term to maturity.
• There is an inverse relationship between
coupon and duration.
 Macaulay Duration
• There is generally a positive relationship
between term to maturity and duration.
• Note that the duration of a coupon bond
increases at a decreasing rate with maturity and
the shape of the duration/maturity curve will
depend on the coupon and YTM of the bond.
• Also, the duration of a deep discount bond will
decline at very long maturities (over 20 years).
 Macaulay Duration
• There is an inverse relationship between
yield to maturity and duration.
• Sinking funds and call provisions can cause
a dramatic change in the duration of a
bond.
 Chapter 18
• Pages 623-634
• Pages 636-644
• Pages 650-660
• Mathematical derivations are not required