ANALYSIS AND

VALUATION OF BONDS
PRICING OF BONDS – MEASURING YIELDS – BOND
PRICE VOLATILITY – FACTORS AFFECTING BOND
YIELDS AND THE TERM STRUCTURE OF INTEREST
RATES.
ANALYSIS AND VALUATION OF BONDS

'Bond Valuation'
• A technique for determining the fair value of a particular bond.
• Bond valuation includes calculating the present value of the bond's
future interest payments, also known as its cash flow, and the bond's
value upon maturity, also known as its face value or par value.
• Bond valuation is only one of the factors investors consider in
determining whether to invest in a particular bond.
BOND VALUE THEOREMS

The five bond value theorems are as follows:

Theorem 1: If the bond’s market price increases then its yield declines and
vice versa.
Theorem 2: If the bond’s yield remains constant over its life, then the
discount or premium depends on the maturity period.
Theorem 3: If the yield remains constant over its life, the discount and
premium on bonds will decline at an increasing rate as its life gets shorter.
Theorem 4: A raise in the bond’s price for a decline in the bond’s yield is
greater than the fall in the bond’s price for a raise in the yield.
Theorem 5: The percentage change in the bond’s price owing to change in its
yield will be small if the coupon rate is high
BOND RETURN
There are several ways of describing a rate of return on bond. Some of them
are:
1. Holding period return
2. The current yield
3. Yield to maturity
• Holding Period Return
• It is a return in which an investor buys a bond and liquidates it in the
market after holding it for a
• definite period of time.
• The formula for calculating holding period of return is as follows:
Price gain + Coupon payment
Purchase price
• A Bond is issued for Rs.100, it carry a coupon rate of interest 10%. The
bond is issued for 5 years and it matures at Rs.110. calculate its
holding period return.
Price gain + Coupon payment
Purchase price

10+10
100
= 20%
CONT….
The Current Yield
• It is a measure through which the investors can easily figure out the rate of
cash flow on the investments made by them every year.
• It is calculated as: Annual Coupon Payment
Purchase Price

For example:
The market price for a 8.24% G-Sec 2018 is Rs.118.85. The current yield on
the security will be 0.0824 x 100 / 118.85 = 6.93 percent.

Ex 2: A bond is issued for Rs.100 which carries a coupon rate of interest 12%. Its
maturity period is 7 years and mature at Rs.120. calculate its holding period
return and current yield.
HPR = 10%
Currant Yield = 12%
• Ex 2: A bond is issued for Rs.100 which carries a coupon rate of
interest 12%. Its maturity period is 7 years and mature at Rs.120.
calculate its holding period return and current yield.

• HPR = 20+12/100 = 0.32: 32%

• Current Yield = 12/100 = 12%
INTRINSIC VALUE OF THE BOND
• The following applies to any financial asset:
V = Current value of the asset
Ct = Expected future cash flow in period (t)
k = Investor’s required rate of return
Note: When analyzing various assets (e.g., bonds, stocks), the formula below is simply modified
to fit the particular kind of asset being evaluated.
Present value of interest stream :

C1 C2 C3 C4 C𝑛
𝑉0 = + + + +….+
(1+𝐾)1 (1+𝐾)2 (1+𝐾)3 (1+𝐾)4 (1+𝐾)𝑛

Ct n
V=
t = 1 (1 + k )
t
VALUATION OF BOND
𝑉0 = Price of the bond
Ct = Interest payment in period (t)
(Coupon interest)
MVn = Principal payment at maturity (par value)
K = Bondholders’ required rate of return or
yield to maturity
Annual Discounting:
C1 C2 C3 C4 C5 C𝑛 MV𝑛
𝑉0 = 1 + 2 + 3 + 4 + 5 +……+ 𝑛 + 𝑛
(1+𝐾) (1+𝐾) (1+𝐾) (1+𝐾) (1+𝐾) (1+𝐾) (1+𝐾)
𝑛
C𝑡 𝑀𝑉𝑛
𝑉0 = ෍ +
(1 + 𝐾)𝑡 (1 + 𝐾)𝑛
𝑡=1
 CONT…..
• Calculate the present value of the bond from the data given below
• Face value of the bond = Rs. 100
• Rate of interest = 10%
• Maturity period = 5 years
• Required rate of return = 12 %

C1 C2 C3 C4 C5 C𝑛 MV𝑛
• 𝑉0 = + + + +
(1+𝐾)1 (1+𝐾)2 (1+𝐾)3 (1+𝐾)4 (1+𝐾)5
+……+ (1+𝐾)𝑛
+ (1+𝐾)𝑛

𝑛
C𝑡 𝑀𝑉𝑛
𝑉0 = ෍ +
(1 + 𝐾)𝑡 (1 + 𝐾)𝑛
𝑡=1

• INTEREST = 100x10/100= 10
10 10 10 10 10 100
• 𝑉0 = (1+0.12)1 + (1+0.12)2 + (1+0.12)3 + (1+0.12)4 + (1+0.12)5 + (1+0.12)5
• 𝑉0 = 36.45 + 56.7 = 93.15
CONT…..

Bonds in perpetuity
Perpetual bonds are the bonds which have infinitive maturity
I1 I2 I3 I∞
• 𝑉0 = (1+𝐾)1 + (1+𝐾)2 + (1+𝐾)3 +………..+ (1+𝐾) ∞

∞
I𝑡
𝑉0 = ෍
(1 + 𝐾)𝑡
𝑡=1

𝐼
𝑉0 =
𝑘
• Mr. A has a perpetual bond of the face value of Rs. 1000.
He receives an interest of Rs. 60 annually. What would be
its value if the required rate of return is 10%?
𝐼
𝑉0 =
𝑘
60
𝑉0 = = 600Rs
0.10
 Price Interest rate relationship:

The price of a government security is inversely related to the market interest rate. As
the interest rate increases price decreases and therefore, the yield increases.

• Therefore, if the market price is equal to face value of the government security, then
the current yield, coupon yield and Yield to maturity will all be equal to the coupon rate

Coupon rate = Yield to maturity if, Market price = Face value

• If Market Price is less than the face value of the bond, the current yield and yield to
maturity will be higher than the coupon yield.
Coupon rate < Yield to maturity if, Market price < Face value

• In cases where the market price of the bond is more than its face value, the current
yield and Yield to maturity will be lower than the coupon rate.
Coupon rate > Yield to maturity if, Market price > Face value
• Face value of the debenture = Rs. 1000
• Annual interest rate of the debenture = 12%
• Maturity period = 5 years
• What is the value of the debenture if
• 1) Required rate of return is 12 %
• 2) Required rate of return is 15 %
• 3) Required rate of return is 10 %

• Interest = 1000x12/100 = 120

C1 C2 C3 C4 C5 MV
• 𝑉0 = 1 + 2 + 3+ 4+ 5 +
(1+𝐾) (1+𝐾) (1+𝐾) (1+𝐾) (1+𝐾) (1+𝐾)5
120 120 120 120 120 1000
• 1. 𝑉0 = (1+0.12) 1 + (1+0.12) 2 + (1+0.12) 3 + (1+0.12)4 + (1+0.12)5 + (1+0.12)5
= 999.60 or 1000
120 120 120 120 120 1000
• 2. 𝑉0 = (1+0.15) 1 + (1+0.15) 2 + (1+0.15) 3 + (1+0.15)4 + (1+0.15)5 + (1+0.15)5
= 889.24
120 120 120 120 120 1000
• 3. 𝑉0 = (1+0.10) 1 + (1+0.10) 2 + (1+0.10) 3 + (1+0.10) 4 + (1+0.10) 5 + (1+0.10)5
= 1075.92 or 1076
• Face value of the debenture = Rs. 100
• Annual interest rate of the debenture = 10%
• Maturity period = 8 years
• What is the value of the debenture if
• 1) Required rate of return is 10 %
• 2) Required rate of return is 12 %
• 3) Required rate of return is 8 %
BOND VALUATION (CONTINUED)
• Semiannual Discounting:
• Divide the annual interest payment by 2
• Divide the annual required rate of return by 2
• Multiply the number of years by 2

2𝑛
I𝑡 /2 𝑀𝑉𝑛
𝑉0 = ෍ 𝑡
+
(1 + 𝐾/2) (1 + 𝐾/2)2𝑛
𝑡=1
PROBLEM…..

• An investor holds a debenture of Rs. 100 carrying a coupon rate of 12 %p.a. the interest is
payable half yearly on 30th June and 31st December. The maturity period of the debenture is 6
years and it is to be redeemed at a premium of 10%. The investors required rate of return is 14%
p.a. Calculate the value of the debenture.
• Interest = 100x12/100 = 12/-
• Maturity value = 110

2𝑛
I𝑡 /2 𝑀𝑉𝑛
𝑉0 = ෍ +
(1 + 𝐾/2)𝑡 (1 + 𝐾/2)2𝑛
𝑡=1

12/2 12/2 12/2 12/2 12/2

𝑉0 = + (1+0.14/2)2 + (1+0.14/2)3 + (1+0.14/2)4 + (1+0.14/2)5 +
(1+0.14/2)1
12/2 12/2 12/2 12/2 12/2 12/2 12/2
+ + + + + + +
(1+0.14/2)6 (1+0.14/2)7 (1+0.14/2)8 (1+0.14/2)9 (1+0.14/2)10 (1+0.14/2)11 (1+0.14/2)12
11 0
(1+0.14/2)12

𝑉0 = 47.658 + 48.840 = 96.498

PROBLEM

• A bond is issued for Rs. 100 which carries a coupon rate of

interest 14%. The maturity period of the bond is 5 years.
The interest on the bond will be paid half yearly. If the
required rate of the bond is 16%, calculate the value of the
bond.
YIELD TO MATURITY (YTM)
• Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held
until it matures. Yield to maturity is considered a long-term bond yield but is
expressed as an annual rate.
• Yield to maturity is also referred to as "book yield" or "redemption yield.“
• YTM is essentially a bond's internal rate of return (IRR) if held to maturity.
• However, there is a trial-and-error method for finding YTM with the following
present value formula:
I1 I2 I3 I𝑛 FV
𝑉0 = 1 + 2 + 3 +⋯ … … . + 𝑛 + 𝑛
(1+𝐾) (1+𝐾) (1+𝐾) (1+𝐾) (1+𝐾)

𝑛
C𝑡 𝑀𝑉𝑛
𝑉0 = ෍ +
(1 + 𝐾)𝑡 (1 + 𝐾)𝑛
𝑡=1
CONT…

• Suppose the current value of a 8% bond of Rs. 1000 redeemable after 5 years at
par, is Rs. 924.28. calculate the yield to maturity of the bond.
I1 I2 I3 I𝑛 FV
• 𝑉0 = + + +⋯ … … . + +
(1+𝐾)1 (1+𝐾)2 (1+𝐾)3 (1+𝐾)𝑛 (1+𝐾)𝑛

• Interest = Rs.80
• V0 = 924.28
• FV = 1000
• Assume YTM=9%
80 80 80 80 80 1000
• 924.28= + + + + + =961.10
(1+0.09)1 (1+0.09)2 (1+0.09)3 (1+0.09)4 (1+0.09)5 (1+0.09)5

Assume YTM = 10%

80 80 80 80 80 1000
924.28= + + + + +
(1+0.10)1 (1+0.10)2 (1+0.10)3 (1+0.10)4 (1+0.10)5 (1+0.10)5
= 924.18

YTM = 10%
• Calculate YTM of the from the information given below
• Face value of the bond = 100
• Coupon rate of interest = 12%
• Duration of the bond = 7 years
• Present value of the bond = 85

• Assume YTM = 14%

12 12 12 12 12 12 12 100
• 85= + + + + + + + = 91.42
(1+0.14)1 (1+0.14)2 (1+0.14)3 (1+0.14)4 (1+0.14)5 (1+0.14)6 (1+0.14)7 (1+0.14)7

• Assume YTM = 16%

12 12 12 12 12 12 12 100
• 85= + + + + + + + = 83.84
(1+0.16)1 (1+0.16)2 (1+0.16)3 (1+0.16)4 (1+0.16)5 (1+0.16)6 (1+0.16)7 (1+0.16)7

• YTM is in between 14-16%

CONT….

Where:

C – Interest/coupon payment
FV – Face value of the security
PV – Present value/price of the security
t – How many years it takes the security to reach maturity
• Calculate YTM of the from the information given below
• Face value of the bond = 100
• Coupon rate of interest = 12%
• Duration of the bond = 7 years
• Present value of the bond = 85

100 − 85
• 12+
7
• YTM =
100 + 85
2
• YTM = 12+2.14/92.5 = 0.1528
• = 0.1528 X 100 = 15.28%
CALCULATING YIELD TO MATURITY

• Trial and Error: Keep guessing until you find the rate
whereby the present value of the interest and principal
payments is equal to the current price of the bond.
(necessary procedure without a financial calculator or
computer).
• Easiest Approach: Use a computer or financial
calculator. Note, however, that it is extremely important to
understand the mechanics that go into the calculations.
Duration of a Bond-

• Duration is the measure we use to estimate the average maturity of

a bond's cash flows. It represents the weighted average life of the
bond, where the weights are based on the present value of the
individual cash flows relative to the present value of the total cash
flows (current price of the bond).
• Duration measures the sensitivity of a bond’s price to changes in interest rates.
- A three year duration bond will approximately rise ( fall ) 3% if interest rates fall
(rise) by 100 Rs (1%)
- A six year duration bond will rise (fall) 6% if interest rates fall (rise) by 100 Rs
(1%)
CONT….
• It measures the time structure and interest rate risk of the bond
• The formula for calculating the duration is as follows:

𝑛
𝑃𝑣 (𝐶𝑡)
෍ xt
𝑃0
𝑡=1

Where D = Duration
C = Cashflow
R = Current yield to maturity
n = Number of years
Pv(ct) = Present value of the cash flow
P0 = Sum of the present value of cash flow
 MACAULAY DURATION

• Firstly, the face or par value of the bond is denoted by M.

• Now, the coupon payment of the bond is calculated based on the effective
periodic rate of the interest.
• Then the frequency of the coupon payment is also determined.
• The coupon payment is denoted by C, and the effective periodic rate of interest
is denoted by r.
• Now, the total number of periods till maturity is computed by multiplying the
number of years till maturity and the frequency of the coupon payments in a
year. The number of periods till maturity is denoted by n. Also, the time of the
periodic payment is noted, which is denoted by i.
CONT….

• The Macaulay duration is calculated by multiplying the time period by

the periodic coupon payment and dividing the resulting value by 1 plus
the periodic yield raised to the time to maturity.
• For example, assume the Macaulay duration of a five-year bond with a
maturity value of Rs.5,000 and a coupon rate of 6%. Required rate of
return 12%.
𝑃 (𝐶𝑡) 𝑛 (𝑀)/ 1+𝐾 𝑛
σ𝑇𝑡=1 𝑣 x t +
𝑃
0 𝑃0

Interest = 5000x6/100 = 300

THE MODIFIED DURATION
Macauley Duration
• Modified Duration= 𝑌𝑇𝑀
1+ 𝑛

where:
• YTM=yield to maturity
• n=number of coupon periods per year
• The modified duration is an adjusted version of the Macaulay duration,
which accounts for changing yield to maturities
• For example, assume a six-year bond has a par value of Rs.1,000 and an
annual coupon rate of 8%. The Macaulay duration is calculated to be 4.99
years
4.99 4.99
• Modified Duration= 0.08 = = 4.924 years
1+ 6 1.01333
CONT….

• 14785.86/1000=14.785
0.12
• 1+ = 1.024
5
• 14.785/1.024= 14.438

• Ex: calculate the McCauley's duration and Modified duration of the bond from
the data given below
• Face value of the bond= 100
• Coupon rate = 12%
• Maturity period = 6 yrs
• Required rate of return = 14%
BOND PRICE VOLATILITY

• A bond’s volatility depends on two factors: its coupon rate and when it will
be retired (at maturity or call date).
• The longer the time until retirement, the greater the price volatility.
• The lower the coupon rate, the greater the price volatility.
• But how do we compare the volatility of two bonds with different coupon
rates and maturities? We use duration.
• the duration number can estimate how much a bond’s price will change in
response to changing interest rates.
• If you multiply the “modified duration” by the assumed change in interest
rates, you can approximate the percentage change that will occur in the
bond’s price.
WHAT AFFECTS DURATION?
• Bond price - As the bond price decreases, its duration increases.
• Coupon - As the coupon rate increases, it produces more income early on and
hence has a shorter duration.
• Maturity - As the bond maturity increases, its duration increases.
• Yield to Maturity - As the YTM increases, the duration decreases since the
present value of distant cash flows is weighted less.
• Sinking Fund - A sinking fund is a scheduled prepayment of the bond before it
matures. This lowers a bond's duration because of the extra cash flow in the
earlier years.
• Call Provision - A callable bond tends to have a shorter duration, because the
principal is potentially repaid earlier at the call date.
• P0 − P+ /P0 ∆y .
FIRSTLY, BOND YIELDS HAVE AN INVERSE
RELATIONSHIP WITH THE PRICE OF BONDS.

if demand for bond rises, the price of bonds goes up and the yield goes down.
If demand for buying bond falls, the price of bonds falls, causing higher interest rates
and yields
TERM STRUCTURE OF INTEREST RATES

• The term structure of interest rates, commonly known as the yield curve, depicts
the interest rates of similar quality bonds at different maturities.
• Essentially, term structure of interest rates is the relationship between interest
rates or bond yields and different terms or maturities.
• The term of the structure of interest rates has three primary shapes.
• Upward sloping—long-term yields are higher than short-term yields. This is
considered to be the "normal" slope of the yield curve and signals that the
economy is in an expansionary mode.
• Downward sloping—short-term yields are higher than long-term yields. Dubbed as
an "inverted" yield curve and signifies that the economy is in, or about to enter, a
recessive period.
• Flat—very little variation between short and long-term yields. This signals that the
market is unsure about the future direction of the economy.
CONT….

• Three other factors that can be important are:

• i) Saving by individuals,
• ii) International capital flows, and
• iii) Amount of premium required by investors to
compensate
• for interest rate risk.