CHAPTER

18
Valuation of Debt Contracts
and Their Price Volatility
Characteristics
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Learning Objectives
The cash flow characteristics of a bond
How the price of a bond is determined
Why the yield to maturity is used as a
measure of a bonds return
The importance of the reinvestment rate
in realizing the yield to maturity
Why the price of a bond changes
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Learning Objectives
(continued)

That the price/yield curve of an optionfree bond is convex

That the two characteristics of a bond that
affect its price volatility are its coupon
and its maturity
What duration is and how it is calculated

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Learning Objectives
(continued)

The limitations of duration as a measure

of price volatility of a bond when interest
rates change
What the convexity of a bond is and how
it is related to bond price volatility

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Features of Debt
Contracts
Bullet maturity means that the entire
principal is due at the maturity date
When the principal is paid variously
throughout the life of the loan, then the
last remaining payment at maturity is the
balloon payment

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Features of Debt
Contracts (continued)
A special type of debt contract is a bond,
and the amount paid at maturity is called
par value, maturity value, or face value
A debt contracts coupon is the periodic
interest payment made to owners during
the life of the contract
The coupon is coupon rate or the rate of
interest
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Features of Debt
Contracts (continued)
When both the principal and interest are
paid at maturity, the debt is call zerocoupon instruments
Typically, but not universally, for bonds
issued in the United States the coupon
payments are made every 6 months
The price of most debt contracts are
quoted as percentages of par value
Copyright 2009 Pearson Education, Inc.

Basic Valuation
Principles
The cash flow from a bond consists of
each period coupon payments and the
repayment of the principal
The price of a debt instrument must equal
the sum of the stream of discounted
payments the debtor is required to make
until maturity. The discounted value of the
debt is
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Basic Valuation
Principles (continued)

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Return from a Bond:

Yield to Maturity
Measure
yield to maturity
A measure that will permit a comparison of
the rate of return of instruments having
different cash flows and different maturities
is needed
It is defined as that interest rate which makes
the present value of the cash flows equal to
the market value (price) of the instrument
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Return from a Bond:

Yield to Maturity
Measure
(continued)
yield to maturity

where P is the par value, C the coupon

payment, M the maturity value, n the
number of periods, and y is the yield to
maturity
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Return from a Bond:

Yield to Maturity
Measure
The ratio of the(continued)
par value to the maturity
value P/M is the par value relation,
usually expressed as a percentage. If it is
equal to one, the bond sells "at par": If
this is larger than one, it sells at a
"premium"; and if less than one, it sells at
a "discount"

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12

Price of an Option-Free
Bond
The yield to maturity calculation for a
bond that pays interest semiannually
results in the calculation of a semiannual
interest rate
The resulting yield to maturity is said to
be calculated on a bond-equivalent or
coupon-equivalent yield basis

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Price of an Option-Free
Bond (continued)

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Price of an Option-Free
Bond (continued)
The yield to maturity computed using this
conventiondoubling the semiannual
yieldis called the bond equivalent
yield

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Reasons for Changes in

Bond Prices
The price of a bond can change over time
for any one of the following reasons
A change in the level of interest rates in the
economy
A change in the price of a bond selling at a
price other than par as it moves towards
maturity without any change in the required
yield
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Reasons for Changes in

Bond Prices (continued)
For a non-Treasury security, a change in the
required yield due to a change in the yield
spread between non-Treasury and Treasury
securities
A change in the perceived credit quality of
the issuer

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17

What Determines the

Premium-Par Yield
When a bond is selling at par, its yield to
maturity is equal to its coupon rate
The coupon rate of an n-period bond
selling at par is called the n-period par
yield
This occurs when the following equation
holds true
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What Determines the

Premium-Par Yield
(continued)

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Reinvestment of Cash
Flow and Yield
An investor will only realize the yield to
maturity that is calculated at the time of
purchase if
all the coupon payments can be reinvested
at the promised yield to maturity
the bond is held to maturity

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Bond Price Volatility

Review of Price/Yield Relationship
If the price/yield relationship for any option-free
bond is graphed, its shape is slightly convex
a fundamental characteristic of an option-free
bond is that its price changes in the opposite
direction from the change in yield. This behavior
follows from the fact that the price of a bond is
equal to the present value of its cash flow

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Bond Price Volatility

(continued)

Price Volatility Properties

The absolute dollar price change and the
absolute percentage price change are not the
same for an equal increase and decrease in the
yield, except for very small changes
In general, the dollar price increase and the
percentage price increase when the yield
declines are greater than the dollar price
decrease and percentage price decrease when the
yield increases
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Bond Price Volatility

(continued)

Characteristics of a Bond that Affect

Price Volatility
Two characteristics of a bond that are the
primary determinants of its price volatility
Coupon
Term to maturity

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Bond Price Volatility

(continued)

For a given term to maturity and initial

market yield, percentage price volatility is
greater the lower the coupon rate
For a given coupon rate and initial yield,
the longer the term to maturity, the greater
the price volatility, in terms of percentage
price change

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Bond Price Volatility

(continued)

Measure of Price Volatility: Duration

The sensitivity of prices to rate changes
can be estimated using a pricing model for
the security and small changes in market
rates. The following formula is useful for
measuring duration

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Bond Price Volatility

(continued)

Measure of Price Volatility: Duration

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Bond Price Volatility

(continued)

Measure of Price Volatility: Duration

The previous formula is an approximation
of the Macaulay duration
This measure of duration can be interpreted
as the number of years for the returns (as
reinvested) to equal the initial payout. The
higher the number of years, the greater is
the duration or price sensitivity
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Bond Price Volatility

(continued)

Measure of Price Volatility: Duration

Using duration to approximate the
percentage price change The relationship
between duration and the approximate price
change is as follows: Approximate Percentage
Price Change = Duration (y) 100
Interpretation of duration: Duration can be
interpreted as the approximate percentage price
change for a 100 basis point change in yields
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Bond Price Volatility

(continued)

Measure of Price Volatility: Duration

Dollar duration: If duration measures the
percentage price change, then dollar
duration of a bond measures the dollar price
change

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Bond Price Volatility

(continued)

Macaulay duration is a weighted average

term-to-maturity of the components of a
bond's cash flows, in which the time of
receipt of each payment is weighted by
the present value, of that component

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Bond Price Volatility

(continued)

D in equation (18.13) is called Macaulay

duration

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Bond Price Volatility

(continued)

Modified Macaulay Duration

Modified duration = Macaulay duration/
(1 + y)

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Bond Price Volatility

(continued)

Convexity
Duration is in fact a first approximation for a
small change in yield. The approximation
can be improved by using a second
approximation. This approximation is the
bonds convexity. The convexity measure of
a security is the approximate change in the
price that is not explained by the duration
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Bond Price Volatility

(continued)

A simple formula for estimating convexity is

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Bond Price Volatility

(continued)

Modified convexity and effective

convexity
If "Con" is calculated assuming that
expected cash flows change with rates it is
known as effective convexity or optionadjusted convexity

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Bond Price Volatility

(continued)

Modified convexity and effective

convexity
All option-free bonds exhibit positive
convexity
Bonds which contain options might
exhibit negative convexity at certain
points along their price/yield function
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Summary
The cash flow from a bond consists of
periodic coupon payments (semiannual
payments in the United States) and the
repayment of the principal
A bonds price changes over time for
several reasons

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Summary

(continued)

Two characteristics of a bond that affect its

price volatility and therefore its interest
rate risk exposure are maturity and coupon
rate
A measure of price volatility that relates
coupon and maturity is duration. Duration
is interpreted as the approximate
percentage price change of a bond for a
100 basis point change in interest rates
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Summary

(continued)

The best way to think about duration is as

a measure of price sensitivity rather than
some weighted time measure
Convexity is another measure of price
volatility to be used in conjunction with
duration to improve the estimate for price
volatility for large changes in interest
rates.
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