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Bond pricing
Bond price
=Coupon (PVIFA r%,t) + Face value (PVIF r%,t)
If a bond has five years to maturity, an $80 annual coupon, and a $1000 face
value, its cash flows would look like this:
Time 0 1 2 3 4 5
Coupons $80 $80 $80 $80 $80
Face Value $ 1000
How much is this bond worth? It depends on the level of current market interest
rates. If the market rate on bonds like this one is 8%, then this bond is worth;
B = 80(PVIFA 8%,5) +1000(PVIF 8%,5)
=80*3.9927 + 1000*0.6806 = 319.4+680.6 =$1,000
What if market interest rate changes after issue? Suppose market rate
increases to 10% two years from issue.
B = 80(PVIFA 10%,3) +1000(PVIF 10%,3)
= 80(2.4869) +1000(0.7513) =198.95+751.3= 950.25
What if market interest rate decreases to 6% two years from issue?
B = 80(PVIFA 6%,3) +1000(PVIF 6%,3)
=80*2.6730 + 1000*0.8396 = 213.84 + 839.6 =$1,053.44
Yields
Coupon rate or coupon yield: a bond’s annual coupon divided by its par
value.
Current yield: a bond’s annual coupon divided by the bond price
Yield to maturity
The market interest rate for bonds with similar features. This is the discount
rate that equates a bond’s price with the present value of is future cash flows.
3. The yield to maturity (or “YTM”) is the interest rate required in the
market on a bond. In other words, YTM is the rate that makes the price of the bond
just equal to the present value of its future cash flows.
Suppose the current bond price is $930. Annual coupon rate is 7%, maturity
is 10 years from now, and face value is $1000. Find YTM.
$930 = $70(PVIFA r%, 10) + $1000(PVIF r%,10)
Given a bond value, coupon, time to maturity, and face value, it is possible to find
the implicit discount rate, or yield to maturity, by trial and error only. To do this,
try different discount rates until the calculated bond value equals the given bond
value. Remember that increasing the rate decreases the bond value.
Callable bonds
• Bonds that may be repurchased by the issuer at a specified call price during
the call period
• A call usually occurs after a fall in market interest rates that allows issuers to
refinance outstanding debt with new bonds.
• Generally, the call price is above the bond’s face value. The difference
between the call price and the face value is the call premium
• Bonds are not usually callable during the first few years of a bond’s life.
During this period the bond is said to be call-protected.
• Decreasing yields cause bond prices to rise, but long-term bonds increase
more than short-term. Similarly, increasing yields cause long-term bonds to
decrease in price more than short-term bonds.
Malkiel’s Theorems
Summarizes the relationship between bond prices, yields, coupons, and maturity:
all theorems are ceteris paribus:
1) Bond prices move inversely with interest rates.
2) The longer the maturity of a bond, the more sensitive is it’s price to a change in
interest rates.
3) The price sensitivity of any bond increases with it’s maturity, but the increase
occurs at a decreasing rate. A 10-year bond is much more sensitive to changes in
yield than a 1-year bond. However, a 30-year bond is only slightly more sensitive
than a 20-year bond .
4) The lower the coupon rate on a bond, the more sensitive is it’s price to a change
in interest rates.
• If two bonds with different coupon rates have the same maturity, then the
value of the one with the lower coupon is proportionately more dependent on
the face amount to be received at maturity.
• As a result, all other things being equal, the value of lower coupon bonds will
fluctuate more as interest rates change.
• Put another way, the bond with the higher coupon has a larger cash flow
early in its life, so its value is less sensitive to changes in the discount rate
5) For a given absolute change in a bond’s yield to maturity, the magnitude of the
price increase caused by a decrease in yield is greater than the price decrease
caused by an increase in yield
Duration
• Price sensitivity tends to increase with time to maturity
• Need to deal with the ambiguity of the “maturity” of a bond making many
payments.
• Duration measures a bond’s sensitivity to interest rate changes.
• More specifically, duration is a weighted average of individual maturities of
all the bond’s separate cash flows.
• The weight is the present value of the payment divided by the bond price.
YTM = 10.498%