Campbell R Harvey Fuqua School of Business Duke University charveymaildukeedu httpwwwdukeeducharvey Definition of a Bond A bond is a security that obligates the issuer to make specified interest and principal payments to the holder on specified dates ID: 663727
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Slide1
Bond Valuation
Global Financial Management
Campbell R. Harvey
Fuqua School of Business
Duke University
charvey@mail.duke.edu
http://www.duke.edu/~charveySlide2
Definition of a Bond
A
bond
is a security that obligates the issuer to make specified interest and principal payments to the holder on specified dates.
Coupon rate
Face value (or par)
Maturity (or term)
Bonds are sometimes called
fixed
income securities
.Slide3
Types of Bonds
Pure Discount or Zero-Coupon Bonds
Pay no coupons prior to maturity.
Pay the bond
’
s face value at maturity.
Coupon Bonds
Pay a stated coupon at periodic intervals prior to maturity.
Pay the bond
’
s face value at maturity.
Perpetual Bonds (Consols)
No maturity date.
Pay a stated coupon at periodic intervals.Slide4
Types of Bonds
Self-Amortizing Bonds
Pay a regular fixed amount each payment period over the life of the bond.
Principal repaid over time rather than at maturity.Slide5
Bond Issuers
Federal Government and its Agencies
Local Municipalities
CorporationsSlide6
U.S. Government Bonds
Treasury Bills
No coupons (zero coupon security)
Face value paid at maturity
Maturities up to one year
Treasury Notes
Coupons paid semiannually
Face value paid at maturity
Maturities from 2-10 yearsSlide7
U.S. Government Bonds
Treasury Bonds
Coupons paid semiannually
Face value paid at maturity
Maturities over 10 years
The 30-year bond is called the
long bond
.
Treasury Strips
Zero-coupon bond
Created by
“
stripping
”
the coupons and principal from Treasury bonds and notes.Slide8
Agencies Bonds
Mortgage-Backed Bonds
Bonds issued by U.S. Government agencies that are backed by a pool of home mortgages.
Self-amortizing bonds.
Maturities up to 20 years.Slide9
U.S. Government Bonds
No default risk. Considered to be
riskfree
.
Exempt from state and local taxes.
Sold regularly through a network of primary dealers.
Traded regularly in the over-the-counter market.Slide10
Municipal Bonds
Maturities from one month to 40 years.
Exempt from federal, state, and local taxes.
Generally two types:
Revenue bonds
General Obligation bonds
Riskier than U.S. Government bonds.Slide11
Corporate Bonds
Secured Bonds (Asset-Backed)
Secured by real property
Ownership of the property reverts to the bondholders upon default.
Debentures
General creditors
Have priority over stockholders, but are subordinate to secured debt.Slide12
Common Features of Corporate Bonds
Senior versus subordinated bonds
Convertible bonds
Callable bonds
Putable bonds
Sinking fundsSlide13
Bond RatingsSlide14
Valuing Zero Coupon Bonds
What is the current market price of a U.S. Treasury strip that matures in exactly 5 years and has a face value of $1,000. The yield to maturity is r
d
=7.5%.
What is the yield to maturity on a U.S. Treasury strip that pays $1,000 in exactly 7 years and is currently selling for $591.11?
1000
1
075
56
5
.
$696
.
=
591
11
1000
1
7
.
=
+
r
dSlide15
Bond Yields and Prices
The case of zero coupon bonds
Consider three zero-coupon bonds, all with
face value of F=100
yield to maturity of r=10%, compounded annually.
We obtain the following table:Slide16
Suppose the yield would drop suddenly to 9%, or increase to 10%. How would prices respond?
Bond prices move up if the yield drops, decrease if yield rises
Prices respond more strongly for higher maturities
The Impact of Price ResponsesSlide17
What is the market price of a U.S. Treasury bond that has a coupon rate of 9%, a face value of $1,000 and matures exactly 10 years from today if the required yield to maturity is 10% compounded semiannually?
0 6 12 18 24 ... 120 Months
45 45 45 45 1045
Bond Valuation:
An ExampleSlide18
What is the market price of a U.S. Treasury bond that has a coupon rate of 9%, a face value of $1,000 and matures exactly 10 years from today if the required yield to maturity is 10% compounded semiannually?
0 1 2 3 4 ... n
C C C C C+F
Valuing Coupon Bonds
The General FormulaSlide19
Bond Yields and Prices
The case of coupon bonds
Suppose you purchase the U.S. Treasury bond described earlier and immediately thereafter interest rates fall so that the new yield to maturity on the bond is 8% compounded semiannually. What is the bond
’
s new market price?
Suppose the interest rises, so that the new yield is 12% compounded semiannually. What is the market price now?
Suppose the interest equals the coupon rate of 9%. What do you observe?
Note:
Coupon bonds can be regarded as portfolios of zero-coupon bonds (how?)
What implication does this have for price responses?Slide20
New Semiannual yield = 8%/2 = 4%
What is the price of the bond if the yield to maturity is 8% compounded semiannually?
Similarly:
If r=12%: B=$ 827.95
If r= 9%: B=$1,000.00
Valuing Coupon Bonds (cont.)Slide21
Relationship Between Bond Prices and Yields
Bond prices are
inversely
related to interest rates (or yields).
A bond sells at
par
only if its coupon rate
equals
the coupon rate
A bond sells at a
premium
if its coupon is
above
the coupon rate.
A bond sells a a
discount
if its coupon is
below
the coupon rate.Slide22
Volatility of Coupon Bonds
Consider two bonds with 10% annual coupons with maturities of 5 years and 10 years.
The yield is 8%
What are the responses to a 1% price change?
The sensitivity of a coupon bond increases with the maturity?Slide23
Bond Prices and Yields
Bond Price
F
c Yield
Longer term bonds are more
sensitive to changes in interest
rates than shorter term bonds.Slide24
Consider the following two bonds:
Both have a maturity of 5 years
Both have yield of 8%
First has 6% coupon, other has 10% coupon, compounded annually.
Then, what are the price sensitivities of these bonds to a 1% increase (decrease) in bond yields?
Why do we get different answers?
Bond Yields and Prices
The problemSlide25
Calculate the average maturity of a bond:
Coupon bond is like portfolio of zero coupon bonds
Compute average maturity of this portfolio
Give each zero coupon bond a weight equal to the proportion in the total value of the portfolio
Write value of the bond as:
The factor:
is the proportion of the t-th coupon payment in the total value of the bond.
Duration
Approximating the maturity of a bondSlide26
Duration is defined as a weighted average of the maturities of the individual payments:
This definition of duration is sometimes also referred to as
Macaulay Duration
.
The duration of a zero coupon bond is equal to its maturity.
Duration: A DefinitionSlide27
Calculate the duration of the 6% 5-year bond:
Calculate the duration of the 10% 5-year bond:
The duration of the bond with the
lower
coupon is
higher
Why?
Calculating DurationSlide28
Duration: An Exercise
What is the interest rate sensitivity of the
following two bonds. Assume coupons are
paid annually.
Bond A
Bond B
Coupon rate 10% 0%
Face value $1,000 $1,000
Maturity 5 years 10 years
YTM 10% 10%
Price $1,000 $385.54Slide29
Duration Exercise (cont.)Slide30
Duration Exercise (cont.)
Percentage change in bond price for a small increase in the interest rate:
Pct. Change = - [1/(1.10)][4.17] = - 3.79%
Bond A
Pct. Change = - [1/(1.10)][10.00] = - 9.09%
Bond BSlide31
For a zero-coupon bond with maturity
n
we have derived:
For a coupon-bond with maturity
n
we can show:
The right hand side is sometimes also called
modified duration
.
Hence, in order to analyze bond volatility,
duration,
and not maturity is the appropriate measure.
Duration and maturity are the same only for zero-coupon bonds!
Duration and VolatilitySlide32
Duration and Volatility
The example reconsidered
Compute the right hand side for the two 5-year bonds in the previous example:
6%-coupon bond:
D/(1+r)
= 4.44/1.08=4.11
10%-coupon bond:
D/(1+r)
= 4.20/1.08=3.89
But these are exactly the average price responses we found before!
Hence, differences in duration explain variation of price responses across bonds with the same maturity.Slide33
Is Duration always Exact?
Consider the two 5-year bonds (6% and 10%) from the example before, but interest rates can change by moving 3% up or down:
This is different from the duration calculation which gives:
6% coupon bond: 3*4.11%=12.33%<12.39%
10% coupon bond: 3*3.89%=11.67%<11.73%
Result is imprecise for larger interest rate movements
Relationship between bond price and yield is convex, but
Duration is a linear approximationSlide34
The Term Structure
of Interest Rates
The
term structure of interest rates
is the relationship between time to maturity and yield to maturity:
Yield
Maturity
1
2
3
5.00
5.75
6.00Slide35
Spot and Forward Rates
A
spot rate
is a rate agreed upon today, for a loan that is to be made today. (e.g. r
1
=5% indicates that the current rate for a one-year loan is 5%).
A
forward rate
is a rate agreed upon today, for a loan that is to be made in the future. (e.g.
2
f
1
=7% indicates that we could contract today to borrow money at7% for one year, starting two years from today).
r
1
=5.00%, r
2
=5.75%, r
3
=6.00%
We can either:
Invest $100 for three years , or:
Invest $100 for two years, and contract (today) at the one year rate, two years forwardSlide36
Forward Rates
A first look at arbitrage
Which investment strategy is optimal:
Invest $100 for three years:
$100*(1.06)
3
=
Invest $100 for two years, and invest the proceeds at the two-year forward rate:
$100*(1.0575)
2
(1+
2
f
1
)=
Hence the first strategy is optimal if
2
f
1
<6.50%, the second if
2
f
1
>6.50%.
Hence
2
f
1
=6.50% (Why?)
More generally: (1+r
n+t
)
n+t
=(1+r
n
)
n
(1+
n
f
t
)Slide37
When should you borrow?
Suppose you wish to borrow $20,000 in two years in order to borrow a car, and you know you can repay the loan in three years? You have two options:
I. 1. Borrow $17,884 now at 6%, repay $20,000*(1.06)
3
=$21,300.35 in three years .
2. Invest the proceeds from the loan for two years at 5.75% to have $17,884*(1.0575)
2
=$20,000 in two years.
II. Wait for two years, borrow at the prevailing one year loan rate in 1 year?
<forget about the cut the bank gets>
When would you follow strategy I (lock in the current rate) rather than wait (strategy II)?Slide38
When to borrow (cont.)
If you lock in the current rate, then you secure a borrowing rate of:
$ 21,300.35/$20,000=1.065, i. e. 6.5%
This is exactly the forward rate we calculated above
Why?
Hence, you would borrow and lock in rates now, if you expect that the one-year interest rate is going to be higher than 6.5% i 1999.
When would you set the cut-off rate for waiting higher? (lower?)
If everybody invests this way, then the forward rate equals the expected future spot rate.
Why?Slide39
Summary
Bonds can be valued by discounting future cash flows at the yield to maturity
Bond prices changes inverse with yield
Price response of bond to interest rates depends on term to maturity.
Works well for zero-coupon bond
Coupon bonds are like portfolios of zero-coupon bonds
Need duration as
“
average maturity
”
for coupon bonds
Only an approximation
The term structure implies terms for future borrowing:
Forward rates
Compare with expected future spot rates