BITS Pilani

presentation
BITS Pilani Dr. Nivedita Sinha
Department of Economics & Finance
Hyderabad Campus
 BITS Pilani
Hyderabad Campus

ECONF315/FINF315
Financial Management
https://www.livemint.com/companies/news/funds-raised-by-
listed-firms-via-bonds-rights-issues-see-double-digit-growth-
11618413327637.html
BITS Pilani, Pilani Campus
 https://www.livemint.com/economy/decision-on-
issuance-of-green-bonds-next-month-rbi-
governor-shaktikanta-das-11644832558774.html

9/19/2020
BITS Pilani, Hyderabad Campus
Bonds
A bond is an instrument of debt issued by a business or government
unit to raise capital to finance certain investments (say such as
infrastructure development, etc.).

Bond issues are considered fixed income securities because they

impose fixed financial obligations on the issuers :-
1. Pay a fixed amount of interest periodically to the holder.
2. Repay a fixed amount of principal at the date of maturity.

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Bond Characteristics
Par value or Principal: It is the amount the entity borrows and
promises to repay at maturity.
Coupon rate (Nominal yield): A bond carries a specific interest rate
Coupon rate= Coupon paid/Par value of the bond
Coupon: It is the income the bondholder will receive every period over
the life (holding period) of the issue.
Time (term) to maturity: It is the date or the number of years before a
bond matures (or expires). Time at which the par is payable to bond-
holders.
Yield to maturity or Yield: The yield to maturity is the rate of return
anticipated on a bond if held until maturity.

Current yield : It is calculated as the annual coupon paid divided by

current market price of the bond
Credit rating :The "quality" of the say bond issue refers to the
probability that the bondholders will receive the amounts promised at
the due dates.
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Bond Valuation
Given following bond characteristics:

1. Face value of bond is F paid at maturity

2. Coupon of C paid per period
3. T periods to maturity
4. Yield of r per period
C C C C+F

0 1 2 3 .............................. T

Bond Value = Present Value of coupons + Present value of the

face amount
= C/r [1-1/(1+r)T] + F/(1+r)T

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Problem 1 on Bond Yields
Hacker Software has 6.2% coupon bonds on the market with 9 years to
maturity. The bonds make semi-annual payments and currently sell for
105% of par. What is the current yield on the bond? The YTM? And
what is the Effective annual yield?

C/2 C/2 C/2 C/2+F

0 1 2 3 .............................. T = 18

Current Yield = Annual Coupon/Current price = 6.2%/105% = 5.9%

Using Goal seek Find YTM
Putting the formula : Market price today = C/2r [1-1/(1+r)^18) +
F/(1+r)^18 = 105% of par
r per period = 2.74%. r expressed as APR = 2.74% *2 = 5.49%
compounded semi-annually
EAR = (1+ r per period)^2 – 1 = 5.56%
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How is a coupon rate determined say for a
government security? – through auction

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 Bond basics
Bonds usually sell at par or very close to par value at the time of issuance. Hence,
coupon rate is the best estimate of the interest rate prevailing in the market for a
similar bond which in turn is equal to yield (yield to maturity) since it is selling at par.
Once the coupon rate is set, it remains the same throughout the life of the bond.

With time, the interest rates of bonds in the market may change (say for eg. because
an estimate of future inflation changed) –i.e. Yield to maturity (or yield) may change

If the interest rates prevailing now is less than the coupon rate (already set), our bond
will be worth more because people will be willing to pay a premium for the extra
interest income (in the form of coupons) one will be receiving as compared to what is
now being available in the market.

Similarly, if the interest rates increase (and is more than a coupon rate which was set
at the time of issuance), our bond will be worth less. Why?

Price and yield to maturity (or yield) are related through the formula and are
determined simultaneously. Yield increase, price decreases and vice versa.

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Demand and Supply curve of bonds
 Bond supply curve models the behaviour
of those who issue bonds, or borrowers.
Higher bond prices mean lower interest
rates, which encourage borrowing, holding
other factors constant.
 So the bond supply curve slopes up with
respect to bond prices.

Bond demand is based on the behaviour of

those who buy bonds, or lenders/savers.
As the bond price rises, both the yield to
maturity and the expected return fall. As the
expected return falls, the quantity demanded
of the bond will fall.
 At higher prices P, the quantity demanded
of bonds is lower—buyers are discouraged

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Common Types of Bonds
Bonds based on the type of future income streams. The most
common are :

 Pure Discount Bonds (zero coupon) : Bonds where issuer

promises to pay a single payment at a future date.

 Coupon bonds: Bonds where issuer promises to make payments

of a stream of interests (par value x coupon rate) along with a
principal payment at the end of maturity

 Perpetual bonds : Bonds where issuer promises to pay fixed cash

flow streams (steady stream of interests) forever. They are not
redeemable.

Most of the bonds in the market are similar or a combination of the

above bonds
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Bond Valuation
Given following bond characteristics:

1. Face value of bond is F paid at maturity

2. Coupon of C paid per period
3. T periods to maturity
4. Yield of r per period
C C C C+F

0 1 2 3 .............................. T

Bond Value today (coupon bond) = Present Value of coupons +

Present value of the face amount
= C/r [1-1/(1+r)T] + F/(1+r)T

Bond value of a zero coupon bond = F/(1+r)T

Bond value of a perpetual bond = C/r
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Bond price theorems

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 1. Relation between Yield to maturity and
Price of bond
Given following bond characteristics:

1. Face value of bond is F paid at maturity

2. Coupon of C paid per period
3. T periods to maturity
4. Yield of r per period

P0 = C/r [1-1/(1+r)T] + F/(1+r)T

When the Yield is equal to the coupon rate of interest , the price of the bond is equal to its par value.
When the Yield is greater than the coupon rate of interest , the price of the bond is less than its par value; it
is said to be trading at a discount.
When the Yield is less than the coupon rate of interest , the price of the bond is greater than its par value ;
it is said to be trading at a premium
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Relation between Yield and Price of bond:
Bond's price and its yield are inversely
related. When the YTM < coupon rate, the bond
1300 trades at a premium.
Bond Value

1200

1100
When the YTM = coupon rate, the bond
trades at par.

1000

800
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
6 3/8 Yield to maturity
When the YTM > coupon
rate, the bond trades at a
discount.
Relation between Yield and Price of bond
Interest rates are determined in the marketplace – demand and supply for
bonds

Interest rates change in the marketplace with changing macro-economic

variables – because of a shift in the demand and supply curves for bonds

When interest rates rise, the Present Value of bond’s remaining cash
flows declines and the bond is worth less (investors will be willing to lend
something less than the promised repayment to compensate for the less
coupon rate they will be receiving) – Bonds will be selling at discount

When interest rates fall, the bond is worth more (investors will be willing
to pay something more than the promised repayment to get this extra
coupon amount they will be receiving) – Bonds will be selling at premium

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Problem 2 on Holding Period yield
HPY: Return you receive from holding an asset over a period of time.
YTM on the bond is the interest rate you earn on your investment if
interest rates do not change and you hold the bond till maturity. If you
actually sell the bond before it matures, your realized return is HPY.
a) Suppose you buy a 5.6% annual coupon bond for $930. The bond
has 10 years to maturity. What rate of return you expect to earn on
your investment?
b) Two years from now, the YTM on your bond has declined by 1%
and you decide to sell. What price will your bond sell for? What is
the HPY on your investment?

Using Goal seek in excel find YTM

YTM = 6.58% (annual rate)
Now find the price of the bond two years from now when YTM has
declined by 1% =$1001.44
Calculate HPY for holding the bond for 2 years = 9.68%.
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2. Relation between Price of bond and
maturity date
The price of a bond approaches its par value as it nears its’ maturity
date – Pull to par

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Problem 3 on Bond price movements
Miller Corp. has a premium bond making semi-annual payments. The
bond pays an 8% coupon, has a YTM of 6% and has 13 years to
maturity.
Modigliani co. has a discount bond making semi-annual payments.
This bond pays 6% coupon, has a YTM of 8% and also has 13 years to
maturity. If interest rates remain unchanged, what do you expect the
price of the bonds to be one year from now? In 3 years? In 8 years? In
12 years? In 13 years? What’s going on here. Illustrate your answers by
graphing bond prices versus time to maturity.

Find PV of the bonds at different t and graph the plot versus time to
maturity

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3. Interest rate risk : How sensitive is the
price to changes in the interest rates
Price sensitivity to interest rate changes depends on two factors:-

I. Coupon rate

All other things being equal, the lower the coupon rate, the greater is the
interest rate risk (greater is the % change in price for a given change
in interest rate)

II. Time to Maturity

All other things being equal, the longer the time to maturity, the greater is
the interest rate risk (greater is the % change in price for a given
change in interest rate)

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 Interest rate risk and Term to maturity

Long term
Bond Value

bond Consider
(30 year two otherwise identical bonds.
bond)
The long-maturity bond will have much
more interest rate risk

Short term
bond (1 year
Par bond)

Short Maturity Bond

Long Maturity
Coupon Discount
Bond Rate (Interest rate%)
Problem 4 on Interest rate risk
The Faulk Corp. has a 6 percent coupon bond outstanding. The Gonas
Company has a 14 percent bond outstanding. Both bonds have 12 years
to maturity, make semi annual payments, and have a YTM of 10
percent. If interest rates suddenly rise by 2 percent, what is the
percentage change in the price of these bonds? What if interest rates
suddenly fall by 2 percent instead ? What does this problem tell you
about the interest rate risk of lower coupon bonds ?
Lower coupon bonds have higher interest rate risk. The % change in
price for a given change in interest rate will be more for a lower coupon
bond.
Faulk Corp. Gonas Corp.
Lower coupon Higher coupon
2% rise in Interest rate
% Change in Price -13.89% -11.79%

2% fall in interest rate

% Change in Price 17.06% 14.22%
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 Credit Rating

Confidence in the ability and the intention of a person or institution to

pay based on its solvency and probity, thereby entitling it to be trusted
in borrowing or buying.

Credit quality : The "quality" of the say bond issue refers to the
probability that the bondholders will receive the amounts promised at
the due dates.

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Inflation and Interest Rates

• Real rate of interest – % change in purchasing power (how much you

can buy with your rupees)

• Nominal rate of interest – quoted rate of interest, % change in the

number of rupees you have

• The ex ante nominal rate of interest includes our desired real rate of
return plus an adjustment for expected inflation.
Real versus Nominal Rates

• (1 + R) = (1 + r)(1 + h), where

– R = nominal rate
– r = real rate
– h = expected inflation rate

• Approximation
– R=r+h
Inflation-Linked Bonds

• Inflation can erode the real value of payments

• Inflation linked bonds are those that eliminate inflation risk – promise
of payments in real terms and not in nominal terms.
• Eg . TIPS (Treasury Inflation-Protected Securities) issued by U.S.
government.
The Fisher Effect
A rise in the rate of inflation causes the nominal rate to rise just enough so
that the real rate of interest is unaffected. In other words, real rate is
invariant to the rate of inflation.

(1 + R) = (1 + r)(1 + h), where

R = nominal rate
r = real rate
h = expected inflation rate
The Fisher Effect
Determinants of Bond Yields:
The Term Structure of Interest Rates
• Term structure of interest rates is the plot of interest rates against time
to maturity.
• The relationship between the short term and long term interest rates is
the term structure of interest rates
• It is important to recognize that we pull out the effect of default risk,
different coupons.
• Interest rates tell us the nominal interest rates on default free, pure
discount bonds.
• Graphical representation of the term structure
– Normal – upward-sloping, long-term rates are higher than short-
term rates
– Inverted – downward-sloping, long-term rates are lower than short-
term rates
– Flat : Short term rates and long term rates are quite similar
Determinants of Term structure of Interest
rates
3 components:-
1. Real rate of interest
2. Inflation premium
3. Interest rate risk premium
Determinants of Term structure of Interest
rates
Determinants of Yield curve
 Term structure of interest rates is for default free, pure
discount bonds
 Yield curve is for coupon paying bonds

Determinants of Yield curve are:-

1. Real rate of interest
2. Inflation premium
3. Interest rate risk premium
4. Default risk premium
5. Taxability premium
6. Liquidity premium
Thank you!

9/19/2020
BITS Pilani, Hyderabad Campus