Fixed Income Chapter3
Fixed Income Chapter3
VALUATION
CHAPTER 3
• In the Text Book Chapter 1 to 5 and Chapter 7 are to be covered for Fixed
Income Curriculum.
• For examination purpose also cover these chapters thoroughly
• Rest of the chapters are to be treated as additional readings
TABLE OF CONTENTS
01 INTRODUCTION
02 BOND PRICES AND THE TIME VALUE OF MONEY
03 PRICES AND YIELDS: CONVENTIONS FOR QUOTES AND CALCULATIONS
04 THE MATURITY STRUCTURE OF INTEREST RATES
05 YIELD SPREADS
06 SUMMARY
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1. INTRODUCTION
• The fixed-income market is a key source of financing for
business and governments.
• Similarly, the fixed-income market represents a significant
investing opportunity for institutions and individuals.
• Understanding how to value fixed-income securities is
important to investors, issuers, and financial analysts.
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2. BOND PRICES AND
THE TIME VALUE OF MONEY
• Bond pricing is an application of discounted cash flow
analysis.
Bond price should be equal to the value of all discounted
future cash flows.
4
•
Formula for calculating the bond price given the market
discount rate:
where
b)
The bond price is 108.530 per 100 of par value.
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Premium, Par and Discount Bonds
The price of a fixed-rate bond, relative to par value, depends
on the relationship of the coupon rate to the market discount
rate.
If the bond price is • This happens when the coupon rate
higher than par value,
the bond is said to be
is greater than the market discount
traded at a premium. rate.
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PREMIUM, PAR AND DISCOUNT BONDS
• Another five-year bond has a coupon rate of 8% paid annually. If the market
discount rate is again 6%, the price of the bond is…
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EXAMPLE 1
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Yield-to-Maturity
• If the market price of a bond is known, the following equation can be used
to calculate its yield-to-maturity:
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•
Example. Suppose that a four-year, 5% annual coupon
paying bond is priced at 105 per 100 of par value. The yield-
to-maturity is the solution for the rate, r, in this equation:
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• The price of a fixed-rate bond will change whenever the
market discount rate changes.
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Relationships between Bond Prices and Bond
Characteristics
Discount Rates Discount Rates
Coupon Price at Go Down Go Up
Bond Maturity
Rate 20% Price at % Price at %
19% Change 21% Change
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EXAMPLE 3
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Constant Yield Trajectory
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Pricing Bonds with Spot Rates
•• Because the market discount rates for the cash flows with
different maturities are rarely the same, it is fundamentally
better to calculate the price of a bond by using a sequence of
market discount rates that correspond to the cash flow dates.
where Z1, Z2, and ZN are spot rates for period 1, 2, and N,
respectively.
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•
Example. Suppose that the one-year spot rate is 2%, the
two-year spot rate is 3%, and the three-year spot rate is 4%.
Calculate the price of a three-year 5% annual coupon paying
bond:
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3. PRICES AND YIELDS: CONVENTIONS FOR
QUOTES AND CALCULATIONS
The sum of flat price and accrued interest is the full (dirty)
price (Pf).
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•• When a bond is between coupon payment dates, its price
has two parts: the flat price (PVFlat) and the accrued interest
(AI). The sum of the parts is the full price (PVFull),
• Accrued interest is the proportional share of the next
coupon payment:
where t is the number of days from the last coupon payment to
the settlement date; T is the number of days in the coupon
period; t/T is the fraction of the coupon period that has gone by
since the last payment; and PMT is the coupon payment per
period.
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•• The full price of a fixed-rate bond between coupon
payments given the market discount rate per period (r) can
be calculated as:
21
•
Example. A 6% German corporate bond is priced for
settlement on 18 June 2015. The bond makes semiannual
coupon payments on 19 March and 19 September of each
year and matures on 19 September 2026. Using the 30/360
day-count convention, calculate the full price, the accrued
interest, and the flat price per EUR100 of par value if the
YTM is 5.80% (2.90% per six months):
• The value of the bond after the latest coupon (19 March) is
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•
Example (continued):
23
Matrix pricing
•
Example. An analyst is pricing a three-year, 4% semiannual
coupon corporate bond with no active market to derive the
appropriate YTM. He finds two bonds with a similar credit quality:
A two-year bond is traded at a YTM of 3.8035%, and a five-year
bond is traded at a YTM of 4.1885%. Using linear interpolation,
the estimated YTM of a three-year bond will be 3.9318%:
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Matrix pricing
Example 6
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Matrix pricing is also used in underwriting new bonds
to get an estimate of the required yield spread over
the benchmark rate.
• The benchmark rate is typically the yield-to-maturity on
a government bond having the same, or close to the
same, time-to-maturity.
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Yield Measures for Fixed-Rate Bonds
• Investors use standardized yield measures to allow for
comparison between bonds with varying maturities.
where APR is the annual percentage rate and m and n are the
number of payments/compounding periods per year, respectively.
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OTHER YIELD MEASURES
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YIELD MEASURES FOR FLOATING-RATE NOTES
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The required margin
The specified yield spread (i.e., discount margin) is
over the reference rate is the yield spread over, or
called the “quoted under, the reference rate
margin” on the FRN. such that the FRN is
priced at par value on a
rate reset date.
•
Simplified FRN pricing model:
95.50 …
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• There are several important differences in yield measures
between the money market and the bond market:
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•
Examples: Suppose that a 91-day US Treasury bill (T-bill) with a
face value of USD10 million is quoted at a discount rate of 2.25%
for an assumed 360-day year. Enter FV = 10,000,000, Days = 91,
Year = 360, and DR = 0.0225. Find the price of the T-bill:
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The discount rate is
calculated using the
formula:
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4. THE MATURITY STRUCTURE OF
INTEREST RATES
The term structure of interest rates is the factor that explains the
differences between yields. It involves the analysis of yield curves, which
are relationships between yields-to-maturity and times-to-maturity.
38
A par curve is a sequence of yields-to-maturity such that
each bond is priced at par value.
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•Although finance textbook authors use varying notation, the most
common market practice is to name forward rates as in this
example: “2y5y” — pronounced “the two-year into five-year rate.”
The first number (two) refers to the length of the forward period in
years from today, and the second number (five) refers to the tenor
(time-to-maturity) of the underlying bond.
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• A general formula for the relationship between the two spot
rates and the implied forward rate is
•
where A is the years from today when the security starts and
B – A is the tenor.
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EXAMPLE 11
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Application of Forward Rates
•Implied spot rates can be calculated as geometric averages of forward rates.
•Bonds can then be priced using implied spot rates.
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5. YIELD SPREADS
44
Yield-to-Maturity Building Blocks
Taxation
Credit Risk
Expected
Inflation Rate
“Risk-Free”
Benchmark Rate of
Return
Expected
Real Rate
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• The yield spread in basis points over an
G-spread actual or interpolated government bond
I-spread or
• The yield spread of a specific bond over the
interpolated
standard swap rate in that currency of the
spread to the same tenor
swap curve
• Calculated as a constant yield spread over
a government (or interest rate swap) spot
curve — as opposed to the G-spread and I-
A zero volatility spread, which use the same discount rate
spread (Z- for each cash flow
spread) of a
bond
• The Z-spread is also used to calculate the
option-adjusted spread (OAS) on a
callable bond.
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6. SUMMARY
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SUMMARY
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SUMMARY
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SUMMARY
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SUMMARY
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