Chapter 5 :BOND PRICES AND INTEREST RATE RISK

Mr. Al Mannaei
Third Edition
 What is Bond ?
• Debt instrument issued by a government or a
corporation in order to finance projects or
activities.
• A form of loan.
– Issuer : lender :

• At maturity borrower will pay lender face value + interest.

• Negotiable instruments.
 What is Bond ?
Why issuing bonds?
•Governments : to finance infrastructure projects:
schools, roads, power stations..etc.

•Corporations : to finance commercial project,

expand the business, increase capital and reduce
tax.
 What is Bond ?
Mona bought a bond for $980 issued by ALBA with 3
years maturity , the coupon rate is 6% , paid annually
?
– Who are the borrower & the lender?
– What is the $980 ?
– How much mona will receive every year* ?
– Can Mona sell the bond before maturity ?
– How much mona will receive at maturity ?

Year 1 Year 2 Year 3

(Maturity)

* in other word , how much alba have to pay each year.

What is Bond ?
• What is the Maturity (Time) of bonds ?
Range : from to
• What is the frequency of payment ?

• Is payment guaranteed ?

• Risk & Return ?

• Why corporation pay higher interest than government

?

• Listed vs. over the counter (OTC) ?!

How to price a bond ?
• The price of a bond is the present value of the future
cash flows promised, discounted at the market rate of
interest.

C1 C2 CN + F N
PB = 1
+ 2
+ ... N
(1 + i) (1 + i) (1 + i)
How to price a bond ?

C1 C2 CN + F N
PB = 1
+ 2
+ ... N
(1 + i) (1 + i) (1 + i)

Where PB = price of bond or present value of promised payments;

Ct = coupon payment in period t, where t = 1, 2, 3,…, n;
Fn = par value (principal amount) due at maturity;
i = market interest rate (discount rate or market yield); and
n = number of periods to maturity.
 Coupon rate & Market Yield
What is the difference between coupon rate & Market
Yield ?!
Example :
•You buy 1 year government bond for $1030.
•The bond pays 7% coupon annually.
•What is your profit ?! In percentage (%) ?!

2 2
C1 + F N
0 0
1
PB = 1
1
4 5 (1 + i)
 Coupon rate & Market Yield
Example (Continue) :
if you sell the bond after 6 months for $1050.
Calculate the market yield ?!

2 2
0 0
1 1
4 5
How to price a bond ?
• Example 1 : Consider 3 Years Bond with
face value of $1000 and Coupon rate 8% ,
Current market rate is 10% , Calculate the
price of the Bond ?
C1 C2 CN + F N
PB = 1
+ 2
+ ... N
(1 + i) (1 + i) (1 + i)
How to price a bond ?
• Example 1 : Consider 3 Years Bond with
face value of $1000 and Coupon rate 8% ,
Current market rate is 10% , Calculate the
price of the Bond ?
How to price a bond ?
• Example 2 : Consider 3 Years Bond with
face value of $1000 and Coupon rate 5% ,
Current market rate is 5% , Calculate the
price of the Bond ?
C1 C2 CN + F N
PB = 1
+ 2
+ ... N
(1 + i) (1 + i) (1 + i)
How to price a bond ?
• Example 2 : Consider 3 Years Bond with
face value of $1000 and Coupon rate 5% ,
Current market rate is 5% , Calculate the
price of the Bond ?
How to price a bond ?
Example 3: Consider a 1 year bond with a
face value of $1000 and a coupon rate of 8%
compounded annually, current market yield
is 5% , calculate the price of the bonds ?
How to price a bond ?
Example 3: Consider a 1 year bond with a
face value of $1000 and a coupon rate of 8%
compounded annually, current market yield is
5% , calculate the price of the bonds ?
1.Press (CMPD) bottom press EXE
2.Press EXE on (Set) choose END press EXE
3.Press EXE on (n) entre 1 press EXE
4.Press EXE on (I) entre 5 press EXE
5.Ignore PV ( press down )
6.Press EXE on PMT ENTRE 80 press EXE
7.Go back for PV press SOLVE.
 How to price a bond ?
Example 3: Consider a 1 year bond with a face
value of $1000 and a coupon rate of 8%
compounded annually, current market yield is
5% , calculate the price of the bonds ?
n= 1
I=5
PV= ?
PMT=80
FV=1000
C/Y=1
Coupon rate & Market IR
How Does the Market IR & Coupon rate affect Bond
price ?
 Coupon rate & Market IR
How Does the Market IR & Coupon rate affect Bond
price ?
If :
Coupon rate Greater Market IR >>> bond price higher than par ( issued at
premium )

Coupon rate Lower Market IR >>> bond price lower than par ( issued at
discount)

Coupon rate = Market IR >>> bond price equal par (issued at par)
Market IR & Bond Price
Negative relationship between i & Bond Price
– Increasing i ; decrease Bond Price.
– Decreasing i ; increase Bond Price.

Positive relationship between Coupon & Bond Price

– Increasing Coupon ; increase Bond Price.
– Decreasing Coupon ; decrease Bond Price.
Question
What is the price of a $1000 face value with
a 10% coupon if the market rate of return is
10%?
How to price a bond ?
• Example 4: Consider a 2 year bond with a
face value of $1000 and a coupon rate of
5% compounded Semi-annually, current
market yield is 6% , calculate the price of
the bonds ?
How to price a bond ?
• Example 4: Consider a 2 year bond with a
face value of $1000 and a coupon rate of
5% compounded Semi-annually, current
market yield is 6% , calculate the price of
the bonds ?
C1 / 2 C2 / 2 C4 / 2 + F N
PB = 1
+ 2
+ ... 4
(1 + i / 2 ) (1 + i / 2 ) (1 + i)
Risk related with Bonds

• Credit or default risk: chance that issuer may

be unable or unwilling to pay as agreed.
Risk related with Bonds
• Reinvestment risk: potential effect of variability
of market interest rates on return at which
payments can be reinvested when received.

• Price risk: Inverse relationship between bond

prices and interest rates.

C1 C2 CN + F N
PB = 1
+ 2
+ ... N
(1 + i) (1 + i) (1 + i)
Zero Coupon Bonds
• No periodic coupon payments.
• Issued at discount from par.
• Single payment of par value at maturity.

FV
PB = n
(1 + i)
Zero Coupon Bond
• How to price Zero Coupon Bonds ?
Semi-annual, Quarterly ,
Annual monthly, daily

FV FV
PB = n
PB = mn
(1 + i) i
(1 + )
m
PB is simply PV of FV represented by par value, discounted at market rate.
Example
• if you want to purchase a Company XYZ
zero-coupon bond that has a $1,000 face
value and matures in 3 years compounded
annually, and you would like to earn 10%
per year on the investment, what is the
price of the bond ?
FV
PB = n
(1 + i)
Example
• if you want to purchase a Company XYZ
zero-coupon bond that has a $1,000 face
value and matures in 3 years compounded
semi-annually, and you would like to earn
10% per year on the investment, what is
the price of the bond ?
FV
PB = mn
i
(1 + )
m
Example
• In the previous example if the
compounding frequency increase , Bond
price will :
– Decrease
– Increase
– No Change
Compounding Frequency increase

Yearly , semi-annually, monthly, daily.

Compounding Frequency decrease
Problem
Carol purchases a one-year discount bond
with a face value of $1,000 for $862.07.
What is the yield of the bond?

FV
PB = n
(1 + i)
 Zero bond
• Mariam bought a bond mature after 3 years
for 1000 BD. The coupon rate and market
yield = 8%.
• Marwa bought zero-bond mature after 3
years for 1000 BD. The market yield is 8%.
• What if both bond defaulted after year 2 ?!

Year 0 1 2 3
Bond Yields
• Market Yield (Interest Rate)
– Yield to Maturity
– Expected Yield
– Realized Yield

C1 C2 CN + F N
PB = 1
+ 2
+ ... N
(1 + i) (1 + i) (1 + i)
Yield to Maturity (YTM)
• YTM : Investor's expected yield if bond is
held to maturity and all payments are
reinvested at same yield.
C1 C2 CN + F N
PB = 1
+ 2
+ ... N
(1 + i) (1 + i) (1 + i)
• The longer until maturity, the less valid
the reinvestment assumption
• Example:
– Bond A mature after 30 years pay 8%.
– Bond B mature after 5 years pay 8%.
– Which bond most likely will change the coupon rate ?!
Yields calculation
• The Bond price , Coupon rate & maturity
will be given and the Yield (i) has to be
calculated .
• The Yields can be calculated through
– Trail & error.
– Financial calculator.
C1 C2 CN + F N
PB = 1
+ 2
+ ... N
(1 + i) (1 + i) (1 + i)
YTM Example
• Investor buys 5% percent coupon
(semiannual payments) bond for $951.90;
bond matures in 3 years. Solve the bond
pricing equation for the interest rate (i)
such that price paid for the bond equals PV
of remaining payments
C1 C 2 due C under
N + FN
the
bond. PB = 1
+ 2
+ ... N
(1 + i) (1 + i) (1 + i)
 YTM Example
• Investor buys 5% percent coupon
(semiannual payments) bond for $951.90;
bond matures in 3 years. Solve the bond
pricing equation for the interest rate (i)
such that price paid for the bond equals PV
of remaining payments due under the bond.
25 25 1,025
951.90 = 1
+ 2
+ ... 6
(1 + (i / 2) ) (1 + (i / 2) ) (1 + (i / 2) )
YTM Example
• Investor buys 5% percent coupon
(semiannual payments) bond for $951.90;
bond matures in 3 years. Solve the bond
pricing equation for the interest rate (i) such
that price paid for the bond equals PV of
remaining payments due under the bond.
I: n: FV: PV: PMT:
Answer :
Expected Yield
• Predicted yield for a given holding period
• Almost same as YTM but the expected
holding period is shorter .

C1 C2 CN + F N
PB = 1
+ 2
+ ... N
(1 + i) (1 + i) (1 + i)
Realized Yield
• Realized Yield: actual rate of return, given
the cash flows actually received and their
timing.
C1 C2 CN + F N
PB = 1
+ 2
+ ... N
(1 + i) (1 + i) (1 + i)

• Differ from YTM & Expected yield , due to :

– Change in the amount of promised payments.

– Change in market interest rates.

Realized Yield
Investor pays $1,000 for 10-year 8% coupon
bond; sells bond 3 years later for $902.63.
Solve for i such that $1,000 (the original
investment) equals PV of 2 annual
payments of $80 followed by a 3rd annual
payment PB of= $982.63
C1
+
C2
+ ...
CN + F N
1 2 N
(1 + i) (1 + i) (1 + i)
Realized Yield
Investor pays $1,000 for 10-year 8% coupon
bond; sells bond 3 years later for $902.63.
Solve for i such that $1,000 (the original
investment) equals PV of 2 annual
payments of $80 followed by a 3rd annual
payment of $982.63
80 80 982.63
1000 = 1
+ 2
+ ... 3
(1 + i) (1 + i) (1 + i)
Realized Yield
Investor pays $1,000 for 10-year 8% coupon
bond; sells bond 3 years later for $902.63.
Solve for i such that $1,000 (the original
investment) equals PV of 2 annual
payments of $80 followed by a 3rd annual
payment of $982.63
I: n: FV: PV: PMT:
Answer :
Bond price volatility (price risk)
• Percentage change in price for given change in
interest rates

where %∆PB = percentage change in price

Pt = new price in period t
P t – 1 = bond’s price one period earlier
Bond price volatility (price risk)
Bond price volatility (price risk)
Bond price volatility (price risk)
Bond theorems
• Bond prices are inversely related to bond yields.

• The price volatility of a long-term bond is greater than

that of a short-term bond, holding the coupon rate
constant.

• The price volatility of a low-coupon bond is greater

than that of a high-coupon bond, holding maturity
constant
• Price Risk
• Reinvestment Risk

• Price risk and reinvestment risk work against each

other.
You bought one year bond at par, where interest rate and coupon
rate= 5%.

After three months the interest rate fall to 3% ?!

• Price risk and reinvestment risk work against each
other.
– if interest rates fall :
• Bond prices rise but >> Coupons are reinvested at lower
return.

– if interest rates rise :

• Bond prices fall but >> Coupons are reinvested at higher
return.
Duration
• A measure of the volatility of bond price to
a change in interest rates.
• Expressed as a number of years.
• It is NOT the length of time it takes to get
back the original investment ( Payback
Period ).
Bond : Duration will always be less than its time to
maturity. 

Zero-Bond : Duration is equal to its time to maturity. 

Zero Bond Regular Bond

Duration
• Duration nCFt * t

t  1 (1  i)
t

D  n
CFt

t  1 (1  i)
t

– CF : Coupons payment
– t: time of payment
– i: interest
– n: number of years
Duration Example
• Suppose we have a bond with a 3-year
term to maturity, an 8% coupon paid
annually, and a market yield of 10%.
Duration is:
 Duration
• If the yield increases to 15%:

What is the relationship between yield &

Duration ?
Duration

What is the relation between coupon rates and duration ?!

Duration equals term to maturity for zero coupon securities.

 Duration concepts
• Higher coupon rates mean shorter duration (less price
volatility).

Bond A has 5 coupon rate , IR 10% , 2 years

Bond B has 8 coupon rate , IR 10% , 2 years
Which of the above bonds has lower duration ?

• Duration equals term to maturity for zero coupon

securities.

What is the duration for 3 years zero bond ?

 Duration concepts

• Longer maturities mean longer durations (greater price

volatility).
Bond A has 8 coupon rate , IR 10% , 5 years
Bond B has 8 coupon rate , IR 10% , 2 years
Which of the above bonds has lower duration ?

• The higher the market rate of interest, the shorter the

duration.
Bond A has 8 coupon rate , IR 20% , 2 years
Bond B has 8 coupon rate , IR 10% , 2 years
Which of the above bonds has lower duration ?
Duration

where: wi = proportion of bond i in portfolio and

Di = duration of bond i.
Duration
Duration

Using the 3-year, 4% coupon bond in Exhibit 5.6 (previous

slide ) , If yield increases to 12%:
 i 
%PB   D    100
 (1  i ) 
 0.02 
 2.88   100  5.24%
 1 .10 
 Thank You

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