Chapter 8

Bond Valuation and Risk

Prepared by
Professor Dr. Mohammad Bayezid Ali
Department of Finance
Jagannath University, Dhaka.

Financial Markets and Institutions, 7e, Jeff Madura

Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

1
Chapter Outline
• Bond valuation process
• Relationships between coupon rate, required return, and
bond price
• Explaining bond price movements
• Sensitivity of bond prices to interest rate movements
• Bond investment strategies used by investors
• Return and risk of international bonds

2
 Bond Valuation Process
• Bonds:
• Are debt obligations with long-term maturities issued
by government or corporations to obtain long-term
funds
• Are commonly purchased by financial institutions that
wish to invest for long-term periods
• The appropriate bond price reflects the present value of
the cash flows generated by the bond (i.e., interest
payments and repayment of principal):

C C C  Par
PV of bond  1
 2
 .... n
(1  k ) (1  k ) (1  k )
3
 Computing the Current Price of A
Bond
A 2-year bond has a par value of $1,000 and a coupon rate of 5
percent. The prevailing annualized yield on other bonds with
similar characteristics is 7 percent. What is the appropriate
?market price of the bond

C C C  Par
PV of bond  1
 2
 ....
(1  k ) (1  k ) (1  k )n
50 1,050
 
1.07 1.07 2
 963 .84 4
 Bond Valuation Process (cont’d)
• Bond valuation with a present value table
• Present value interest factors in Exhibit 8A.3 can be
multiplied by coupon payments and the par value to
determine the present value of the bond
• Impact of the discount rate on bond valuation
• The appropriate discount rate for valuing any asset is the
yield that could be earned on alternative investments with
similar risk and maturity
• Investors use higher discount rates to discount the future
cash flows of riskier securities
• The value of a high-risk security will be lower than the value
of a low-risk security
5
 Computing the Current Price of A
Bond Using PVIFs
A 2-year bond has a par value of $1,000 and a coupon rate of 5
percent. The prevailing annualized yield on other bonds is 7
percent. What is the appropriate market price of the bond
?using PVIFs

PV of bond  $50(PVIFk 7%,n 1 )  $1,050(PVIFk 7%,n 2 )

 $50(.9346 )  $1,050(.8734 )
 $46.73  $917.07
 $963.80
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 Bond Valuation Process (cont’d)
• Impact of the timing of payments on bond valuation
• Funds received sooner can be reinvested to earn additional
returns
• A dollar to be received soon has a higher present value than
one to be received later
• Valuation of bonds with semiannual payments
• First, divide the annual coupon by two
• Second, divide the annual discount rate by two
• Third, double the number of years
C/2 C/2 C / 2  Par
PV of bond  1
 2
 .... 2n
(1  k / 2) (1  k / 2) (1  k / 2)
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 Computing the Current Price of A
Bond With Semiannual Coupons
A 2-year bond has a par value of $1,000 and a semiannual coupon
rate of 5 percent. The prevailing annualized yield on other
bonds with similar characteristics is 7 percent. What is the
?appropriate market price of the bond

C/2 C/2 C / 2  Par

PV of bond    ....
(1  k / 2)1 (1  k / 2)2 (1  k / 2)2n
25 25 25 1,025
 1
 2
 3

1.035 1.035 1.035 1.035 4
 963.27 8
 Bond Valuation Process (cont’d)
• Use the annuity tables for valuation
• A bond can be valued by separating its payments into two
components:
PV of bond = PV of coupon payments + PV of principal
• The bond’s coupon payments represent an annuity (an even
stream of payments over a given period of time)
• The present value can be computed using PVIFAs

9
Computing the Current Price of A
Bond Using PVIFs and PVIFAs
A 30-year bond has a par value of $1,000 and an annual coupon
rate of 10 percent. The prevailing annualized yield on other
bonds with similar characteristics is 9 percent. What is the
?appropriate market price of the bond

PV of coupon payments  C(PVIFA k 9%,n 30 )

 $100(10.274)  $1,027.40
PV of principal  $1,000(PVIFk 9%,n 30 )
 $1,000(.0754 )  $75.40
PV of bond  $1,027.40  $75.40  $1,102.80
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Relationship between Coupon Rate,
Required Return, and Price
If the coupon rate of a bond is below the investor’s
required rate of return, the present value of the bond
should be below par value (discount bond)
If the coupon rate equals the required rate of return, the
price of the bond should be equal to par value
If the coupon rate of a bond is above the required rate of
return, the price of the bond should be above par value

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Relationship between Coupon Rate,
Required Return, and Price

$1,800.00
$1,600.00
$1,400.00
Present Value

$1,200.00
5-Year Bond
$1,000.00
10-Year Bond
$800.00
20-Year Bond
$600.00
$400.00
$200.00
$0.00
0.05 0.08 0.1 0.12 0.15
Required Return

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 Explaining Bond Price Movements
• The price of a bond should reflect the present value of future
cash flows based on a required rate of return:
Pb  f ( k )  f ( Rf , RP )
- - -
• An increase in either the risk-free rate or the general level
of the risk premium results in a decrease in bond prices

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 Explaining Bond Price Movements
(cont’d)
• Factors that affect the risk-free rate
• Inflationary expectations
• Economic growth
• Money supply
• Budget deficit

Rf  f ( INF , ECON, MS, DEF )

  - 

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 Explaining Bond Price Movements
(cont’d)
• Factors that affect the risk-free rate (cont’d)
• Impact of inflationary expectations
• An increase in expected inflation will increase the
required rate of return on bonds
• Indicators of inflation are closely monitored
• Consumer price index
• Producer price index
• Oil prices
• A weak dollar

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 Explaining Bond Price Movements
(cont’d)
• Factors that affect the risk-free rate (cont’d)
• Impact of economic growth
• Strong economic growth places upward pressure on the
required rate of return
• Signals about future economic conditions affect bond
prices immediately
• Employment
• GDP
• Retail sales
• Industrial production
• Consumer confidence
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 Explaining Bond Price Movements
(cont’d)
• Factors that affect the risk-free rate (cont’d)
• Impact of money supply growth
• If there is no simultaneous increase in the demand for
loanable funds, an increase in money supply growth
should place downward pressure on interest rates
• In high inflation environments, an increased money
supply may increase the demand for loanable funds and
place upward pressure on interest rates
• Impact of budget deficit
• An increase in the budget deficit places upward pressure
on interest rates

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 Explaining Bond Price Movements
(cont’d)
• Factors that affect the credit (default) risk premium
• The general level of credit risk on corporate or municipal
bonds can change in response to a change in economic
growth:
RP  f ( ECON )
-
• Strong economic growth tends to improve a firm’s cash
flows and reduce the probability that the firm will default
on its debt payments

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 Explaining Bond Price Movements
(cont’d)
• Summary of factors affecting bond prices

Pb  f ( Rf , RP )

Rf  f ( INF , ECON, MS, DEF )
 ? - 

• Other factors are also changing, making the precise impact of

each factor on bond prices uncertain
• Impact of bond-specific characteristics
• Changes in the issuing firm’s capital structure and factors such
as call features can affect individual bond prices
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 Explaining Bond Price Movements
(cont’d)

• Bond market efficiency

• In an efficient market, bond prices should fully reflect all
available information
• In general bond prices should reflect information that is
publicly available
• Prices may not reflect information about firms that is
known only by managers of the firms

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Sensitivity of Bond Prices to Interest Rate
Movements
• A measurement of bond price sensitivity can indicate
the degree to which the market value of bond holdings
may decline in response to an increase in interest rates
• Two common methods for assessing bond’s price
sensitivity are bond price elasticity and duration.

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Sensitivity of Bond Prices to Interest Rate
Movements (cont’d)
• Bond price elasticity
• Measures the sensitivity of bond prices to changes in the
required rate of return:
e percent change in P
p 
percent change in k

• The price sensitivity is greater for declining interest rates than

rising interest rates
• Bond price elasticity is always negative
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 Sensitivity of Bond Prices to Interest Rate
Movements (cont’d)
• Bond price elasticity (cont’d)
• Influence of coupon rate on bond price sensitivity
• The relationship between bond price elasticity and coupon
rates is inverse
• Zero-coupon bonds have the greatest price sensitivity
• Bonds yielding only coupon payments are least sensitive
• Financial institutions may restructure their bond portfolios to
contain higher-coupon bonds when they are concerned
about a possible increase in interest rates
• Influence of maturity on bond price sensitivity
• As interest rates decrease, long-term bond prices increase by
a greater degree than short-term bond prices
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Computing Bond Price Elasticity
A 15-year bond has a yield to maturity of 7 percent and a coupon
rate of 10 percent. The current price of this bond is $1,273.24.
If the yield to maturity increases to 9 percent, the new price
of the bond is $1,080.61. What is this bond’s bond price
?elasticity

e percent change in P
p 
percent change in k
$1,080.61  $1,273.24
$1,273.24

9%  7%
7%
 0.53 24
 Sensitivity of Bond Prices to Interest Rate
Movements (cont’d)
• Duration
• Duration measures the life of a bond on a present value
basis
• The longer the bond’s duration, the greater its sensitivity to
interest rates
n
Ct ( t )
 (1  k ) t
DUR  t n1
Ct
t 1
 (1  k ) t

25
Computing the Duration of A Bond
A bond has two years remaining to maturity, a $1,000 par value, a
9 percent coupon rate, and a 10 percent yield to maturity.
?What is the duration of this bond
n
Ct ( t )
 (1  k ) t
DUR  t n1
Ct
t 1
 (1  k ) t

$90 $1,090( 2)

(1.10 )1 (1.10 )2

$90 $1,090

(1.10)1 (1.10 )2
 1.92 years 26
 Sensitivity of Bond Prices to Interest Rate
Movements (cont’d)
• Duration (cont’d)
• Duration of a portfolio
• Bond portfolio managers commonly immunize their
portfolio from the effects of interest rate movements
• A bond portfolio’s duration is the weighted average of
bond durations, weighted according to relative market
value:
m
DUR p   w DUR
j 1
j j

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 Sensitivity of Bond Prices to Interest Rate
Movements (cont’d)
• Duration (cont’d)
• Modified duration
• Duration can be used to estimate the percentage change in
a bond’s price in response to a 1 percentage point change
in bond yields: DUR
DUR* 
(1  k )
• The estimate of modified duration should be applied such
that the bond price moves in the opposite direction from
the change in bond yields
• The percentage change in a bond’s price in response to a
change in yield is:
%P  -DUR *  y
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 Computing the Modified Duration of
A Bond
A bond has two years remaining to maturity, a $1,000 par value, a 9 percent
coupon rate, and a 10 percent yield to maturity. What is the modified
.duration of this bond? Interpret the modified duration for this bond

DUR
DUR* 
(1  k )
1.92
  1.75
1.10

A 1 percent increase in bond yields leads to a 1.75 percent decline in the price
.of the bond

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Computing the Price Change of A Bond in
Response to A Change in Yield

In the previous example, assume that bond yields rise

by 0.30%. What is an estimate of the percentage
?drop in the bond’s price
%P  -DUR *  y
 1.75  0.003
 .53%

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Sensitivity of Bond Prices to Interest Rate
Movements (cont’d)
• Duration (cont’d)
• Estimation errors from using modified duration
• If investors rely only on modified duration to estimate
percentage price changes in bonds, they will tend to
overestimate price declines and underestimate price
increases
• To accurately estimate the percentage change in price,
bond convexity must also be considered

31
 Sensitivity of Bond Prices to Interest Rate
Movements (cont’d)
• Duration (cont’d)
• Bond convexity
• Modified duration estimates assume a linear relationship
between bond prices and yields
• The actual relationship between bond prices and yields is
convex
• How the estimation errors from modified duration can vary
• For high-coupon, short-maturity bonds, price change
estimates based on modified duration will be very close to
actual price changes
• For low-coupon, long-maturity bonds, price change estimates
based on modified duration can give large estimation errors
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Bond Investment Strategies Used by
Investors
• Matching strategy
• The bond portfolio generates periodic income that can
match expected periodic expenses
• Involves estimating future cash outflows and developing a
bond portfolio that can generate sufficient payments to
cover those outflows
• Laddered strategy
• Funds are evenly allocated to bonds in each of several
different maturity classes
• Achieves diversified maturities and different sensitivities to
interest rate risk

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Bond Investment Strategies Used by
Investors (cont’d)
• Barbell strategy
• Funds are allocated to bonds with a short term to maturity
and bonds with a long term to maturity
• Allocates some funds to achieving relatively high
returns and other funds to cover liquidity needs
• Interest rate strategy
• Funds are allocated to capitalize on interest rate forecasts
• Requires frequent adjustment in the bond portfolio to
reflect current forecasts

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Return and Risk of International Bonds
• The value of an international bond is influenced by:
• Changes in the risk-free rate of the currency
denominating the bond
• Changes in the perceived credit risk of the bond
• Exchange rate risk

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 Return and Risk of International Bonds
(cont’d)
• Influence of foreign interest rate movements
• An increase in the risk-free rate of the foreign currency
results in a lower value for bonds denominated in that
currency
• Influence of credit risk
• An increase in risk causes a higher required rate of return on
the bond and lowers the present value of the bond
• Influence of exchange rate fluctuations
• The most attractive foreign bonds offer a high coupon rate
and are denominated in a currency that strengthens over the
investment horizon

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 Return and Risk of International Bonds
(cont’d)
• International bond diversification
• Reduction of interest rate risk
• International diversification of bonds reduces the sensitivity of
the overall bond portfolio to any single country’s interest rate
movements
• Reduction of credit risk
• Because economic cycles differ across countries, there is less
chance of a systematic increase in the credit risk of
internationally diversified bonds
• Reduction of exchange rate risk
• Financial institutions attempt to reduce their exchange rate risk
by diversifying among foreign securities denominated in various
foreign currencies

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