\

/

FUNDAMENTALS OF FINANCE

Outline

I. Basics of Bond Pricing

2. Total Return Analysis

3. Price Volatility Measures

4. Effective Duration & Convexity

)

5. Yield Curves and Spot Rates

6. Option-Adjusted Spread (OAS) Analysis

\ Example 1:

J

Compute the price of a 50/0 coupon bond with 3 years to maturity and a par/face value of $10,000 if the required yield is 5%.

Steps:

1. Calculate the values of the cash flows and when they will be . received/paid.

2. Calculate the price (present value) of the cash flows discounting at the required yield.

C = [.05/2]$10,000 for 6 semiannual periods

= $250

)

F = $10,000 to be received/paid 6 semiannual periods from now

P = 250/(1.025) + 250/(1.025)2 + 250/(1.025)3 + 250/(1.025)4

+ 250/(1.025)5 + 250/(1.025)6 + 10,000/(1.025)6

- $10,000 Gul t tv\o\.L--

Bond Pricing

1. Overview

. Any security can be thought of as a package of cash flows. In particular, a complex security can be thought of as a package of cash flows with options attached.

Bond pricing involves determining the value of a stream of cash flows. Each cash flow can be valued independently with the total value equal to the sum of the individual-cash flow. values.

\ ,.

2. Consider first the value of securities without options, i.e., option-free securities. In this case, the terms are fixed such that the underlying security cannot be called, put, or ·converted to another type of security.

Price of an option-free bond:

p =

c + (l +i)l

c + .... + (l +i)2

_£+_f

(1 +it (1 +i)"

where

P

~~

1

N F

price ($)

semiannual coupon payment ($)

~eriodic Interest rate (required yield in decimals) number of periods from the present

face or maturity value

\

J Example 2:

Compute the price of the same bond assuming that the required yield is 4%.

1. The expected cash flows are the same $250 in coupon payments and $10,000 at maturity.

2. The discount rate declines to 2% semiannually.

P = $10,280.07

This bond is called a premium bond because it trades at a price above par or face value,

Why does. this bond trade at a premium?

)

Example 3:

Compute the price of the same bond assuming that the required yield is 6%.

1. The expected cash flows are the same $250 in coupon payments and $}O,OOO at maturity.

2. The discount rate rises to 3% semiannually.

P = $9,729.14

This bond is called a discount bond because it trades at a price below par or face value.

Why does this bond trade at a discount?

Price of a Zero .. Coupon Bond

1. With a zero-coupon bond the investor pays a price and receives one cash flow at maturity.

2. Because no interim cash flows exist, there is no reinvestment rate risk assumed by the investor.

P - F/(I+if

Example 4:

Compute the price of a zero-coupon bond that matures in 3 years if

) the maturity value is $10,000 and the required yield is 5%.

P - $10,000/(1.025)6 - $8,622.97

Example 5:

Compute the price of this zero-coupon bond if the required yield:

- declines to 4%

P = $10,000/(1.02)6 - $8,879.71

- rises to 6%

P = $10,000/(1.03)6 - $8,374.84

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Current Yield

Current yield = annual dollar coupon interest/price

Example with the 5% coupon, $10,000 3-year par bond:

Annual coupon = $500

Face value = $10,000

Price = $10,000

Current yield = 500/1 0,000 - 5%

Example with the 5% coupon, 3-year bond priced at a premium:

)

Current yield = 50011 0,280.07 = 4.864%

Example with the 5% coupon, 3-yeardiscount bond:

Current yield = 500/9,729.14 = 5.139%

Current yield considers only coupon interest and ignores the time value of money.

G

)

Yield to Maturity

'"

Yield to maturity equals the discount rate that equates the present value of the sum of all-cash flows- to the current price. It assumes that each cash flow is reinvested at the yield to maturity.

In each of the prior examples, i represents the yield to maturity.

Yield to Call

Yield to call equals the discount rate that equates the present value of the sum of all cash flows to the current price assuming that the security is called on the first call date. Note that the final cash flows will typically equal the last coupon payment plus the call price, which may differ from the face value of the security.

TOTAL RETURN ANALYSIS

A. Overview

1. Not all securities are held to maturity. This necessitates a procedure to analyze the expected return from buying a securitiy and selling it prior to maturity.

" Yield to maturity assumes that the investor can reinvest all interim cash flows, such as coupon interest received, at the calculated yield to maturity. This is obviously an heroic assumption that is frequently wrong.

3. Many securities contain options (labeled embedded options} Yield to maturity and yield to call do not recognize the value of these options.

4. Total return analysis is an attempt to address these criticisms.

B. Some Quick Concepts

1. Every security can be viewed as a package of cash flows. Some cash flows

may have options (puts, calls, prepayment, etc.) attached. .

2. Future value of an annuity (FV):

Let A 1 n

=

amount of the annuity periodic interest rate

number of compounding periods

=

A [o+t)n.1]

This is used in calculating the future dollar value of coupon interest and reinvestment income from buying a security.

FV

=

)

11

) 3. Present value of an annuity (PV):

PV

A

=

1 -

This is used in calculating the price of a stream of expected cash flows.

C. An .investor can vary assumptions about how long a security will be held, what reinvestment rate interim cash flows can earn. and what the price of the underlying security will equal at sale prior to maturity.

1. An investor can then compare alternative returns or yields by calculating the realized compound yield (ReY) associated with each alternative.

") The RCY essentially calculates the future dollar value of any investment under different assumptions and calculate the periodic yield compared ' with the initial investment.

)

D. Realized Compound Yield 'Calculation

RCY =

( Total Future DOllars] lin Initial investment

I

where

Total Future Dollars includes:

1. coupon interests

2. reinvestment income

3. value at maturity or sale price prior to maturity

E. A Comparison of Yield to Maturity and Rey

1. RCY allows the assumed reinvestment rate to vary.

2. RCY allows for the sale of the security prior to final maturity.

3. RCY represents a periodic rate that can be earned under the scenario assumed.

Computation or the Total Return Icr a Seven-Year, 9 % Bond Selllng at Par and Held to Maturity:

Reinvestment Rate = 9%

12

Step 1. The total future amount for this bond includes:

(I) Coupon interest of S45 every six months for seven years,

(2) Interest earned from reinvesting the semiannual coupon interest payments at 4.5% (one-half the assumed annual reinvestment rate), and

(3) The par value of $1,000.

The coupon interest plus interest on interest can be found as follows: c = $45;

m = 2;

r = .045 (=.09/2); n = ]4 (= 7 x 2)

Coupon interest [( 1.045) 14 - 1]

. . plus = $45

.. ~5

Interest on Interest .

= $45 [ 1.85 19 - 1] .045

= $45 (18.9321)

= $851.94.

Total future amount:

Coupon interest plus interest on interest Par value

= $ 851.94 = 1,000.00

$1,851.94

Total

Step 2. Compute the following:

II ..

[$1,851.941 - 1

$1,OOO.OOJ

= (1.85 ]94)"°7143 - 1 = 1.0450 - 1

= .0450 or 4.50%

Step 3. Doubling 4.50% gives a total return of 9.0%.

Source: Fizld lncom« MQth~mQlics by Fran.lc Fabozzi. 1993

Computation of the Total Return for a Seven-Year, 9 % Bond Selling at Par and Held to Maturity:

Reinvestment Rate = 5%

13

Step 1. The total future amount from this_ bond includes:

(1) Coupon interest of $45 every six months for seven years,

(2) Interest earned from reinvesting the semiannual coupon interest payments at 2.5% (one-half the assumed annual reinvestment rate), and

(3) The par va lue of $1,000.

The coupon interest plus interest on interest can be found as follows:

c = S45; m = 2;

r = .025 (=.0512); n = 14 (= 7 x 2)

Coupon interest [(1.025)1.0 - 1]

. plus = $45

Interest on interest .025

)

= $45 [1.4130 - 1] .025

= $45 (16.5189)

= $743.35.

Total future amount:

Coupon interest plus interest on interest Par value

Total

= S 743.35 = 1.000.00

$1,743.35

Step 2. Compute the following:

[$1,743.35.1'1'· _ 1 St,DDa.DOJ

= (1.74335).tr7143 - 1 = 1.0405 - 1

= .0405 or 4.05%.

Step 3. Doubling 4.05% gives a total return of 8.1 %.

Source: FiRd Income Mathemotlcs by Frank Flbozzi, 1993

Computation or the Total Return ror a 20. Year, 7'Yo Bond Selling for 5816 and Held to Maturiti:

Reinvestment Rate = 6'70

1

\

)

-

Strp J. The total future amount from 'his bond includes:

(I) Coupon interest or S35 every six months for 20 years,

(2) Interest earned fr_pm reinvesting the semiannual coupon interest payments at 3% (one·half the--·assumed annual reinvestment rau:),and

_.

(3) The par value of S 1.000.

The coupon interest plus interest on interest can be found as follows: c = S35;

m = 2;

r = .03 (= .06/2); n = 40 (= 20 x 2)

Coupon interest 1<1.03)40 - 1]

plus ~ $35

interest on interest .03

)

• SJ5 [3 .2~~~ - 1]

= S35 (74.4013) = S2,639.04.

Total future amount:

Coupon interest plus interest en interest Par value

Total

= S2.639.04 = 1.000.00

$3,639.04

Step 2. Compute the following:

'I,g

[S3,639.04] _ 1 $816

= (4.45961 ).Dl5 _ I = 1.0381 - 1

= .0381 or 3.81 %

Step J. Doubling J .819& gives a 10lal retum of 7.62%

Source: FlZ4d Inco,", Malh,,"atics by Frank Faboz:zi, 1993

\ J

Illustration 8·5. Suppose that an investor with a five-year investment horizon is consideri ng purchasing a seven-year, 9% coupon bond selling at par. The investor expects that the coupon interest payments can be reinvested at an annual interest rate of 9.4% and that at the end of the investment horizon two-year bonds will be se11ing to offer a yield to maturity of 11.2%. As shown in Exhibit , the total return for this bond is 8.54%. The yield to maturity for this bond is 9%.

1~

Exhibit

Computation of the Total Return for a Seven-Year, 9% Bond Selling at Par and Held for Five Years:

Reinvestment Rate = 9.40/0

Sup J. The total future amount from this bond includes:

(1) Coupon interest of $45 every six months for five years. (the investment horizon),

(2) r merest earned from reinvesting the semiannual coupon interest payments at 4.7% (one-half the assumed annual reinvestment rate) until the end of the investment horizon, and

)

(3) The expected price of the bond at the end of five years.

The coupon interest pJus interest on interest can be found as follows:

c = $45; m = 2;

r = .04 7 (= .094/2); n = 10 (= 5 x 2)

Coupon interest [( 1.047) 10 - 1]

plus = $45

interest on interest .047

= $45 [ 1.5830 - 1] .047

= $45 (12.4032)

= $558.14.

The expected price of the bond five years from now is determined as folJows:

) (a) Present value of coupon interest payments, assuming the required yield to ma-

turity at the end of the investment horizon is ] 1.2%:

c = $45; _

i = .056 (= .112/2);

n = 4 (= remaining years to maturity x 2)

1 - 1 I

(1.056)4

PV = $45

.056

= $45 ! 1 _ .8042]-

" .056

= $45 (3.4964) = $157.34

(b) Present value of the maturity value:

$1,000 = $804.16 ( 1.056)4

Expected price = $157.34 + $804.16 = $96.1.50

Total future amount:

Coupon interest plus interest on interest Expected price

Total

= $558.14 = 961.50

$1,519:64

Step 2. Compute the following:

)

I;

[$1,5]9.64]10 _" 1

$1,000.00

= (1.51964).1 0 - 1 = 1.0427 - 1

= .0427 or 4.27%

Step 3. Doubling 4.27% gives a total return of 8.54%.

17

Bond Price Volatility' Measures

\

) The empirical record suggests two facts about the

behavior of interest rates. First, short rates are more variable than long rates. Second, the variability of rates has increased over time. Accordingly, it is crucial that market participants' be able to accurately measure how sensitive a bond's price is to a change in interest rates.

I n this section, we will examine several important bond price volatility measures including: (1) duration; (2) dollar value of a basis point; (3) yield value of price change; and (4) convexity. We will learn how to calculate each of these measures and detail how they are used in practice to control those risks associated with changing interest rates.

18

\~ j

Duration Analysis: The Basics

A. Objectives

1.

To introduce duration as a measure of price sensitivity

2.

To demonstrate how duration information can be used to evaluate interest rate risk inherent with Securities and the entire port! olio.

3.

To provide examples of duration applications

4.

To introduce other measures of price volatility

B.

Duration as a Price Elasticity M easure6lfl; 1 ~ a F Ii &S fv ( D pti ~ - Fundamental PDints R.egarding DuratiDn R!.e..e, ~l.A-viti-d

"

i

1. Duration measures how price sensitive a security or a portfolio is to a change in interest rates. It is measured in units of time.

2. The longer (shorter) is duration, the greater (lesser) is price CdUfaJlDllL 15 =:

sensitivity. &eVl' :'f1\JL ~~ ~

Duration is used to estimate how much a security or portfolio will change

in price when interest rates change. Managers thus compare different

securities or a bank's assets versus liabilities .to know which is more price

volatile.

3. Price-Yield Diagram

C. Zero coupon versus coupon securities

the lower is a security's coupon, the longer is its duration, ceteris paribus

zero coupon securities have a duration equal to final maturity

1 c

Background Information on Duration .

A. Duration as a Weighted Average of Time to Maturity

- .

Macaulay's duration measure (See next pages: "Duration of an Asset. ")

2 Example calculations for option-free securities

3 Relationship Between a Security's Price and Yield to Maturity

B Duration as an Elasticity Measure

1. Duration also indicates how price sensitive a security or a portfolio is 10 a change in interest rates [See: "The Economic Meaning of Duration"]

2. Related Duration Measures

a. Modified Duration

.1 p .. Duration x 6 R

(J)

P (J + R)

(2)

Macaulay's duration = modified duration (1 + R)

(3) Modified duration multiplied by a prospective change in rates provides an estimate of the percentage change in price.

b. Dollar Duration

L1 P • ( Duration x a. p) x a. R (1 + R)

(1)

(2) Dollar duration equals the above term in brackets.

(3) Dollar duration multiplied by the change in rates gives an estimate of the dollar value change in price.

Macaulay Duration (in periods)

\ /

(1) PVCF1 + (2) PVCF.2 + ... + (n) PVCFn_ PVTCF

PVCFt - The present value of the cash flow in period t

discounted at the appropriate yield.

(t)·

The period when the cash flow is expected. to be received (t = 1,2, ... n).

n

Number of periods until maturity.

k

Nwnber of periods per year

PVTCF

Total present value of the bond's cash flows i.e., the bond price.

)

Culculutlnn of Macaulay Duration and Modified Duration for a 10%, S-year Bond Selling to Yield 100/e

Coupon rate = J 0.00%; Maturity (years) = 5;

~ nitial yield = 10.00%

Present value
Period Cash Present value of cash flow
(I) flow * of$laI5% (PVCF) i x P\'CF
$5.00 0.952380 4.761905 .; 76 IlJ05
") 5.00 0.907029 4.535147 I.} U70~fi5
-
J 5.00 0.863837 4.3 ]9188 12.957563
4 5.00 0.822702 4.113512 J 0.454049
5 5.00 0'.783526 3.917631 19.588154
6 5.00 0.746215 3.731077 21.3H()46I
...., 5.00 0.7 JU6H 1 3.)53407 2~.873846
I
8 5.00 0.676839 3.384197 j"'" 0'7] -7'
) ';':. f_:J 4
9 5.0U 0.644608 3.223045 29.00740 I
10 105.00 0.613913 64.460892 644.608920
Total 100.000000 810.782168 • Cash flow per $100 of par va lue

Macaulay duration 810.782168 =811
(in half years) =
100.000000 .
Macaulay duration 8.11 = 4.05
=
(in years) 2
Modified du ration 4.05 = 3.86
= -_ ..
(in years) 1.0500
\
f \
/
Calculating Duration: Some Examples
A. 3-Year, 9.4% Coupon Bond, $10,000 Par Value,
Interest Paid Semiannually
l. Assume that the current yield to maturity is 9.4% (4.7% semiannually).
CF Weight =
t cr, CF I Price Weight x t
(I +i)1 (1 + i)'
$470 $448.90 .04489 .0449
2 470 428.75 .04288 .0858
... 470 409.50 .04095 .1229
.)
4 470 391.12 .03911 .1564
5 470 373.56 .03735 .1868
6 10,470 7,948.17 .79482 4.7689
10,000 1.0 5.3639
2. Thus, duration equals 5.3639 semiannual periods, or 2,682 years.
B. 3 - Year, Zero Coupon Bond that pays S 1 0, 000 at maturity I. At any yield to maturity i; with semiannual compounding;

cr, CF Weight = CF I Price Weight x t
t
(1 +i) l (1 +i)'
6 $10,000 10,000 10,000 / 10,000 = 1.0 6
(l ... j)6 (I + i)6 (1 + i)6 \

/

2. Thus, duration equals 6 semiannual periods, or 3 years.

3. Duration of a zero coupon instrument equals maturity.

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+ + I • Five properties of a bond's duration

\ )

(1) For zero coupon bonds, duration is equal to maturity.

(2) For coupon bonds, duration is less than maturity.

(3) Holding maturity constant, duration is higher

) when the coupon rate is lower.

(4) Holding the. coupon rate constant, duration increases with time to maturity.

(5) Holding other factors constant, duration is higher when the bond's yield to maturity is lower.

Other Important Volatility Measures

\ j

Dollar value of a basis point (DVOl)

The dollar value of a basis point is the change in the bond's price if the yield changes by one basis point.

DVOI is expressed as the absolute value of the price change.

Computing DVOI (M=100)

.Price
Bond Term
Coupon (years) , 10.00% 10.01 % DV01
8.00% 5 92.2783 92.2415 .0367
8.00% 15 84.6275 84.5595 .0681
8.00% 30 81.0707 80.9920 .0787 Cornputatlcn of the Price Value of a Basis Point
\,
! Bond Term Price Price value of
Coupon (years) @JO.OO% @10.01% a basis points
.00% 5 . 61.3913 61.3621 .0292
.00% 15 23.1 377 23.1047 .0330
.00% 30 5.3536 5.3383 .0153
8.00% 5 92.2783 92.2415 .0367
- 8.00% 15 84.6275 84.5595 .0681
8.00% 30 81.0707 80.9920 .0787
10.00% 5 ]00.0000 99.9614 .0386
10.00% 15 100.0000 " 99.9232 .0768
10.00% 30 100.0000 99.9054 .0946
14.00% 5' 115.4435 115.4011 .0423
14.00% 15 '. 130.i440 130.6506 .0943
) __ 14.00% 30 137.8586 J3/.7~:?1 " .1263
Bond Term Price Price value of
Coupon (years) @/O.OO% @9.99% a basis point
.00% 5 61.3913 61.4206 .0292
.00% 15 23.1377 23.1708 .0331
.00% 30 5.3536 5.3689 .0153
8.00% 5 92.2783 92.3150 .0367
8.00% 15 84.6275 84.6957 .0.681
8.00% 30 81.0707 81.1496 .0788
10.00% 5 100.0000 100.0386 .0386
10.00% 15 100.0000 100.0769 .0769
10.00% 30 100.0000 100.0947 .0947
14.00% 5 115.4435 115.4858 .0424
]4".00% 15 130.7449 130.8393 .0944
:4.00% 30 137.8586 137.9851 .1265 • Absolute value per $100 of par value

3

Yield Value of a Price Change

\

j

The change in yield for a specified price change.

How do we calculate YV of 1/32?

( 1 ) Calculate the bond's yield if the bond's price increases/decreases by 1/32.

(2) Calculate the difference between the initial yield and the new yield.

YV of 1/32 (M = $100)
Decrease price by 1/32
Initial price Yield at Initial Yv .
Bond minus 1/32 . Yield of 1/32
new pnce
10%, 5-year 99.96875 .1000810 .10 .0000810
10%, IS-year 99.96875 .1000407 .10 .0000407
10%, 3D-year 99.96875 .1000330 .10 .0000330 0..
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3

- Convexity is a measure of the curvature of the

) price/yield relationship.

How do we calculate convexity?

Convexity (in periods)

1 (2)PVCF1 + (2) (3) PVCF2 + ... + n(n+ 1) P\lCFn (1 +y)~ x 'PVTCF

preseIit value of the cash flow in perio t discounted at the appropriate yield

. t

period when the expected cash flow is to -be received

n

number of periods until maturity

PVTCF

total present value of the bond ~ s cas: flows

) How do we use it?

Modified duration provides the first approximation of the bond's sensitivity to a change in yield.

Convexity gives a finer second approximation.

Approximate percentage change in price due to convexity

= (.5) x Convexity x (Yield change)?

)

') Example

15 year bond, 8% coupon, M = $100, and y = 10%·

Convexity = 94.36

If the yield increases from 10% to 13 %, what is the percentage change in price due to convexity?

) (.5) x 94.36 x (.O_~)2 = .0425

Percentage price change due to convexity is 4.25 %

This is the error due to using duration alone .

. Let's put duration and convexity together.

Same bond-

Duration (Modified) 8.05

Convexity 94.36

Percentage change in the bond's price using duration

= - Modified duration x Yield change = -8.05 x .03

= - 0.2415

The approximate percentage change in price resulting from both duration and convexity is the sum

Price change based on Duration Convexity

Approximate % 12ri ce change

- 24.15

+ 4.25

Total

-19.90

DURA TION AND CONVEXITY

)

Duratiog: Present value-weichted averaee maturity of all future cash flows. Gives the prlc« volatili" of bonds and other financial assets.

For the mathematically minded (math nuts):

..

LI* CF, /(1 + r)'

,.1

Duration (D)

-

-

tI

LeF, 1(1 + r)'

,.1

where t = time cash flow received eF. = cash now, time t

(1 + r)' = discount at time t

Price volatility is 8 function of D:

Price Vol., aP = -D(ar /(1 + r»*P

)

For example, here are durations for different maturities of recent U. S. Treasury coupon securities:

13.71

Five

Ten

Thirty

4.43

7.67

D

A measure of price volatility for a ten-year Treasury is 7.67°A. (about three times more volatile tbanthe three-year). A one percent shift in interest rates cbau£es its value by roughly 7.67%. A one percent increase drives a par (100) value bond to about 92.33 (100.00 - 7.76).

dP

f-price curve tor asset

f- Duratioa at poiat of.taDleDcy . with price curve

Ar

37

- Convexity measures the error between price estimated by duration and the actual price curve.

,.

ret + (1). CF, 1(1 +r)'

,·1

--------------

,.

LeF, 1(I+r)'

,.1

Find D and Dl for a 5-year bond with 6.87% coupon payable semiannually. Selling for 100.

)

"t (J.B.l. Clsb Elow Elr" " .. ~ ."" "~.I\V"'w.~ '" . '~'Jj.\t~(t, ~rl.t
_.... .
~J~.j!W",,~ ... ~ .. ~. ::.,;,~ ..... :;.~ . "-'II ,: ..... \: ... ;.:~ :!.~-:-1. - '_ '. -!"" ... -~,
.110 •• .t .• - '. • ......... ..,.,
1 S3.435 3.32 3.31 6.64
2 53.435 3.11 6.42 19.26
3 S3.435 3.10 9.30 37.20
4 S3.435 3.00 11.00 60.00
5 53.435 1.90 14.50 87.00
6 S3.435 2.80 16.80 117.60
7 S3.435 2.71 18~97 151.76
8 S3.435 2.62 " '20.96 188.64
9 53.435 2.53 22.77 227.70
10 5103.435 23.65 73fi.50 8101.50
I = 100.00 861.54 8997.24 D = 861.54 100.00

8997.24 100.00

= 8.615 periods or

- 89.97

4.31 years

The price "olatility corollary for Dl is:

·The price change due to duration and convexity is:

(N) (Ar)2

~p = [-D + ~ D2 ] .. p

(J+r) (1+r)~

)

Assume interest rates rise from 6.870/0 to 8.00%. For the 6.87 coupon bond:

Ap [4 31 ~Ol ! .. 89 97·" .0001 ] .. p

~ = -. 1.0687 + 2 • 1.1421

= -4.706 + 0.134

= - 4.572 (aetual = 4.59)

Effective Duration and Convexity

...

\ )

Effective = duration

E. - P +_ (P o)(y + - y_)

Notation

P _ price if yield is decreased by x basis points

p + = price if yield is increased by x basis )p6ints

Po = initial price (per $100 of par value)

y + initial yield plus x basis points"

y_ initial yield minus x basis points

This approximation formula is critical when examining bonds whose cash flows change when

" "

yields change - (e. g., bonds with options

attached) .

40

') Example.

_.

Consider a.20 year 8 % coupon bond selling at $90. 80 yielding 9 %

Let's evaluate the price changes for. a lO-basispoint change up and down.

) P, 91.66

p , 89.95

"T'

Po 90.80

y + - .091 y_ .089

Effective = 91.66 - 89.95 = 9.42

duration (90.80)(.091 - .089)

Source: Fiud InCD"'~ MQlh'~mQIiCJ

Effective = -- P, + p. - 2(PoL

convexity (Po)[O.5 (y + - Yw)]2

Effective = 89.95 + 91.66 - 2(90.80) convexity (90.80)[0.5(.091 - .089)]2

)

Effective = 110.132 convexity

As noted, effective convexity like effective duration allows the cash flow to change as yields change.

)

Par curve

\

j Par rate - - the discount rate at which the bond's price

equals its par value.

M=

c + (1 +y)l

c + ... + (1 +y)2

c + M

(1 +y)n (1 +y)n

To Create a par Yield Curve

1 period
M - C + M
) (1 +y)l (1 ~y)l
2 periods'
M - C + C + M
(1 +v)' (1 +y)2 (1 +y)2 n periods

M=

c + (1 +y)l

c + ... + (1 +y)2

c + M

(1 +y)D (1 +y)n

Spot Rate Curve

,

.....

)

A spot rate is the interest rate used to discount a single expected future cash flow. .

Treasury spot rate curve - - the. theoretical relationship between the yield on zero-coupon Treasury securities and term to . maturity .

Maturity and . Yield to Maturity for five hypothetical ) securities:

Yield to .
Maturity Coupon Maturity Price
0.50 .0000 .080 96.15
1.00 .0000 .083 92.19
1.50 .0850 .089 99.45
2.00 .0900 .092 99.64
2.50 .1100 .094 103.49 )

/

What is the 6 month spot rate?

I : .. -

.)

6-month spot rate = 8 %

What is the 1 year spot rate

1 year spot rate = 8.3%

What is the 1 1/2 year spot rate?

Given the two spot rates we already have, we can calculate it.

) 99.45 4.25 + 4~25 + 104.25
(1 +Yl)l (1 +Y2)2 (1 +Y3)3
Yl one half the 6-month spot rate
Y2· - .one half the 1 year spot rate
-
Y3 one half the 1 1/2 year spot rate Yl .04

Y2 .0415

99.45 -

4.25 (1.04)1

+ 4.25 + (1.0415)2

104.25 (1 +Y3)3

99.45 = 4.08654 + 3.91805 + . 104.25 (1 +Y3)3

91.4451 = 104.25 (1 +Y3)3

Y3 = .04465

1 1/2 year spot rate = 8.93 %

, .... ..

What is the 2 year spot rate?

.04

Y2 .0415

Y3.. .04465

Two year Treasury bond

99.64 =

4.50 + 4;50 + 4.50 + 104.50

(1.04)1 (1.0415)2 (1.04465)3 (1 +Y4)4

) 99.64 =

4.32692 + 4.14853 + 3.9473 + 104.50

(1 +Y4)4

. 87.21725 - 104.50

(1 +Y4)4

1.198158

-

-

.0462

2 year spot rate = 9.25%

)

48

Forward Curve

\ J

Suppose an. investor has an anticipated holding period of 1 year.

Three choices:

(1) Invest in a security having a maturity equal to the anticipated holding period.

(2) Invest in a series of shorter term" securities (i.e., rollover).

)

(3) Invest in a security having a "maturity greater than the anticipated holding period and selling at the appropriate time.

If these strategies have the same yield, an investor will be indifferent between the three.

1.9

\ J

A. Standard Pricing of Non-Treasury Securities

1. Cash Row Yield Spread Analysis

The traditional way to price non-Treasury securities is to calculate the difference between the yield to maturity on the non-Treasury security and the yield to maturity on a "matched" Treasury security. The matching is typically done according to Macaulay's duration or the weighted average life for a mortgage-backed security. The Treasury yield is that from the spot rate curve.

2. Weaknesses

There are two weaknesses. in this. First. yield to maturity ignores the shape of the term-structure of yields. Each cash flow should be valued as a separate security and priced off the corresponding spot rate for a zero-coupon Treasury. Second. many non-Treasury securities contain options. while Treasury securities do not. The expected yield on a security with embedded options should reflect the value of the options.

B. Static Spread

1. The static spread is the percentage yield premium that when added to the spot rate on corresponding zero-coupon Treasuries will make the present value of the cash flows from the non-Treasury security equal to the current price of the non-Treasury security.

2. The static spread measures the incremental yield over Treasury securities over the entire spot rate curve if the non-Treasury security is held to maturity ..

;0

C. Option Adjusted Spread (OAS)

1. Time paths of interest rates: The OAS calculation is based on estimated cash flows over a range of interest rate paths that represent possible future changes in rates on zero-coupon Treasuries.

2. The procedure to estimate the OAS consists of calculating a present value of the cash flows from a non-Treasury security under each rate path using the current spot rates plus some assumed yield spread. The OAS is the percentage yield premium that when added to the

Treasury spot rate makes the average present value of the cash flows from the non-Treasury security under all the various rate paths equal to the current price of the

non- Treasury security.

D. Steps in the OAS Calculation (from Fabozzi: CMOs: Structure and Analysis)

)

1. From the Treasury yield curve, estimate the term structure of of interest rates (spot rates) and the implied forward rates.

1. Select a probability distribution for the short-term Treasury rate.

The probability distribution should be selected so that it is consistent with (a) the current term structure of interest rates, and (b) the historical behavior of interest rates. This will prevent the possibility of. arbitrage along the yield curve.

3. Use the probability distribution and Monte Carlo simulation to determine randomly a large number of interest rate paths.

4. For each path found in (3), determine the cash flows according to some prepayment model.

5. For an assumed spead and the term structure along a path. calculate a present value for each path.

6. Calculate the average present value for all paths.

7. Compare the average present value to the market price of the mortgage-backed security. If they are equal. the assumed spread' used in (5) is the option-adjusted spread. If they are not, try another

spread and repeat (6) and (7). .

5"

\

)

To account for this additional risk, an additional risk premium is added to the entire sequence of simulated interest rates ..

PVj = CF.:u +

(1 + r1j + OAS)1

(1 + r2j + OAS)2

CF~

... + CFIl .

(1 + rTj + OAS)'

Average Present =

(1/J)[PV1 + PV2+ '0' + PVJ] Value

CFtj = expected cash flow at month t for path j

rtj = simulated Treasury rate for month t for path j

PVj = present value on path j

T = number of months until W AM

J = number of paths

) .

52

\

I

The OAS is the expected spread to. the Treasury yield curve.

Why is it the "option-adjusted" spread?

The OAS represents the additional return demanded by investors for holding a

) mortgage security over the Treasury yield after accounti·ng for the prepayment

option. _

Path-dependent discounting

. This method helps capture the embedded

option cost. -

53

) Limitations of the OAS Methodology

Several Wall Street firms publish optionadjusted spreads on a weekly basis.

Estimated spreads for the same security issue can differ significantly across firms.

) Why?

The OAS reflects both the security's cash flows and the assumptions of the underlying pricing model.

The GAS is sensitive to these assumptions.