FINM3093: Investments

Lecture 6

Dr Sherry Zhou
United International College, Zhuhai

1
Outline
• Fixed Income Securities (Bonds)
• Bond Features & Pricing (Textbook Chapter 14)
• Term Structure of Interest Rates (Textbook Chapter 15)
• Risks of Bond Investment (Textbook Chapter 16)

2
Bond Characteristics (Textbook Chapter 14)
• A bond is a security that is issued in connecting with a borrowing
arrangement
• Issuer agrees to make specified payments to the bondholder on specified
dates
• Par value (i.e., face value) is the payment to the bondholder on the
bond’s maturity date
• Coupon rate is a bond’s interest payments per dollar of par value
• Bond indenture is the contract between the issuer and the
bondholder

3
Getting back to the basics...
• Time Value of Money: the notion that money has a higher value in
future due to potential earning capacity.
• Future Value (FV): the value of an asset at a specific future date.
• Present Value (PV): the current value of a future cash flow or a sum
of future cash flows discounted at a specific rate.

𝐹𝑉 = 𝑃𝑉(1 + 𝑟)𝑛

1
𝑃𝑉 = 𝐹𝑉
(1 + 𝑟)𝑛
4
FV & PV of an Annuity
• Annuity: A stream of cash flows at fixed amount being paid or
received on a monthly/semi-annual/regular basis.

(1 + 𝑟)𝑇 −1
𝑃𝑇 = 𝐴
𝑟

1
1−
(1 + 𝑟)𝑇
𝑃0 = 𝐴 = 𝐴 × Annuity factor(𝑟, 𝑇)
𝑟

5
Bond Pricing
𝑇
Coupon Par Value
Bond value = ෍ 𝑡
+
(1 + 𝑟) (1 + 𝑟)𝑇
𝑡=1

= Coupon × Annuity factor(r,T) + Par value ×PV factor(r,T)

6
Example: Bond Pricing
• An 8% coupon, 30-year maturity with par value of $1,000 pays 60
semiannual coupon payments of $40 each. Suppose that the interest
rate is 8% annually, or r = 4% per six-month period. Then the value of
the bond is

If the interest rate rises to 10% (5% per six months), the bond’s price is

7
Bond Prices and Yields
• Inverse relationship between price and yield is a central feature of
fixed-income securities
• Interest rate fluctuations represent the main source of risk in the
fixed-income market
• The price curve is convex and becomes flatter at higher interest rates
• The longer the maturity of the bond, the more sensitive the bond’s
price to changes in market interest rates

8
The Inverse Relationship Between Bond Prices and
Yields

9
Bond Prices at Different Interest Rates

10
Bond Yields: Yield to Maturity
• Yield to maturity (YTM) is the interest rate that makes the present
value of a bond’s payments equal to its price
• Interpreted as a measure of the average rate of return that will be earned on
a bond if it is bought now and held until maturity
• To calculate YTM, solve the bond price equation for the interest rate
given the bond’s price

11
Yield to Maturity Example
• Suppose an 8% coupon, 30-year bond is selling for $1,276.76. What is
the YTM?

$1276.76 = 
60
$40 1000
+
t =1 (1+ r ) (1+ r )
t 60

• r = 3% per half year

• Bond equivalent yield (APR) = 6%
• EAR = (1.03)2 - 1 = 6.09%

12
Spreadsheet Calculation
• Bond pricing
• = PRICE(settlement date, maturity date, annual coupon rate, yield to maturity,
redemption value as percent of par value, number of coupon payments per year)

13
Spreadsheet Calculation
• Find yield to maturity
• = YIELD(settlement date, maturity date, annual coupon rate, bond price,
redemption value as percent of par value, number of coupon payments per year)

14
Bond Yields: YTM vs. Current Yield
• Yield to maturity
• Bond’s internal rate of return
• Interpreted as compound rate of return over life of the bond assuming all
coupons can be reinvested at that yield
• Proxy for average return
• Current yield is the bond’s annual coupon payment divided by its price
• Premium bonds: bonds selling above par value
• Coupon rate > Current yield > YTM
• Discount bonds: bonds selling below par value
• Coupon rate < Current yield < YTM

15
Bond Yields: Yield to Call
• Some corporate bonds are issued with call provisions allowing the
issuer to repurchase the bond at a specified call price before the
maturity date.
• If a company issues a bond with a high coupon rate when market interest
rates are high and interest rates later fall, the firm might like to retire the
high-coupon debt and issue new bonds at a lower coupon rate to reduce
interest payments
• Callable bonds typically come with a period of call protection, an initial time
during which the bonds are not callable.

16
Bond Prices: Callable and Straight Debt
Consider a bond that has the same coupon rate and maturity date but is callable at
110% of par value, or $1,100.

17
Bond Yields: Yield to Call
• Low interest rates
• The price of the callable bond is flat since the risk of repurchase or call is high
• High interest rates
• The price of the callable bond converges to that of a normal bond since the
risk of call is negligible

18
Yield to Call: Example
• Suppose the 8% coupon, 30-year maturity bond sells for $1,150 and is
callable in 10 years at a call price of $1,100.

Yield to maturity is ________________________________.

Yield to call is ____________________________________.
19
Bond Prices over Time
• A bond will sell at par value when its coupon rate equals the market
interest rate. In this case, the coupon payments are sufficient to
provide fair compensation for the time value of money.
• When the coupon rate is lower than the market interest rate, the
coupon payments alone will not provide bond investors as high a
return as they could earn elsewhere.
• The bonds must sell below par value to provide a “built-in” capital gain on the
investment.

20
Fair Holding-Period Return
• Suppose a bond was issued several years ago when the interest rate was 7%. The
bond’s annual coupon rate was set at 7%. Suppose for simplicity that the bond
pays its coupon annually. Now, with three years left in the bond’s life, the market
interest rate is 8% per year. The bond’s market price is
$70 × Annuity factor 8%, 3 + $1,000 × PV factor 8%, 3 = $974.23
In another year, after the next coupon is paid and remaining maturity falls to two
years, the bond will sell at
$70 × Annuity factor 8%, 2 + $1,000 × PV factor 8%, 2 = $982.17
The capital gain is ___________________________. If an investor had purchased
the bond at $974.23, the total return over the year is ___________________.
The rate of return is thus _____________________.

21
Prices Path of Two 30-Year Maturity Bonds

22
Zero-Coupon Bonds
• Zero-coupon bond carries no coupons and provides all of its return in
the form of price appreciation on the maturity date of the bond.
Par Value
Bond value =
(1 + 𝑟)𝑇

• Consider a zero with 30 years until maturity and suppose the market interest
rate is 10% per year. The price of the bond today is $1,000/(1.10)30 = 57.31.
next year, with only 29 years until maturity, if the yield is still 10%, the price
will be ___________________.

23
Price of a 30-Year Zero-Coupon Bond Over Time

24
The Yield Curve (Textbook Chapter 15)
• Relationship between yield and maturity may be shown graphically in
a yield curve
• Yield curve is a plot of yield to maturity as a function of time to maturity
• Key concern of fixed-income investors
• Central to bond valuation
• Allows investors to gauge their expectations for future interest rates against
those of the market

25
Yield Curve of Chinese Government Security

26
Yield Curve: Bond Pricing
• Yields on different maturity bonds are not equal
• Consider cash flow of each bond as a stand-alone zero-coupon bond
• The value of the bond should be the sum of the values of its parts

27
Prices and Yields to Maturities on
Zero-Coupon Bonds ($1,000 Face Value)

28
Valuing Coupon Bonds
• Value a 3-year, 10% coupon bond using discount rates from previous
table:
$100 $100 $1100
Price = + 2
+
1.05 1.06 1.073

• Price = $1,082.17 and YTM = 6.88%

• 6.88% is less than the 3-year rate of 7%

29
The Yield Curve under Certainty
• Consider two 2-year bond strategies:
1. Buy the 2-year zero offering a 2-year YTM of 6% and hold it until maturity
• Face value is $1,000, so it is purchased today for $1,000/(1.06)2 = $890 and matures in
two years to $1,000
• Total 2-year growth factor is $1,000/$890 = 1.1236
2. Invest the same $890 in a 1-year zero-coupon bond with a YTM of 5% and
upon maturity reinvest the proceeds in another 1-year bond

30
Two 2-Year Investment Programs

31
Spot Rates and Short Rates
• Spot rate
• The rate that prevails today for a time period corresponding to the zero’s
maturity

• Short rate
• Applies for a given time interval (e.g., one year)
• Refers to the interest rate for that interval available at different points in time

32
Short Rates versus Spot Rates

33
Forward Rates
(1 + 𝑦𝑛 )𝑛
(1 + 𝑟𝑛 ) =
(1 + 𝑦𝑛−1 )𝑛−1

• rn = short rate in year n

• yn = YTM of a zero-coupon bond with an n-period maturity

(1 + 𝑦𝑛 )𝑛 = (1 + 𝑦𝑛−1 )𝑛−1 × (1 + 𝑟𝑛 )

34
Forward Rates Continued
• The forward interest rate is a forecast of a future short rate
(1 + 𝑦𝑛 )𝑛
(1 + 𝑓𝑛 ) =
(1 + 𝑦𝑛−1 )𝑛−1

• Rate for 4-year maturity = 8%

• Rate for 3-year maturity = 7%

1+ f4 =
(1 + y4 )
4
=
1.084
= 1.1106
(1 + y3 )3 1.073

f 4 = 11.06%
35
Theories of Term Structure

Expectations Hypothesis Theory Liquidity Preference Theory

• Simplest theory of the term • Long-term bonds are more risky
structure • f2 > E(r2)
• States forward rate equals • The excess of f2 over E(r2) is the
market consensus expectation liquidity premium
of future short interest rate • Predicted to be positive
• f2 = E(r2) and liquidity premiums • Yield curve has an upward bias
are zero built into the long-term rates
because of the liquidity
premium

36
Interest Rate Sensitivity (Textbook Chapter 16)
1. Bond prices and yields are inversely related

2. An increase in a bond’s yield to maturity results in a smaller price

change than a decrease in yield of equal magnitude

3. Prices of long-term bonds tend to be more sensitive to interest rate

changes than prices of short-term bonds

37
Interest Rate Sensitivity
4. Interest rate risk is less than proportional to bond maturity

5. Interest rate risk is inversely related to the bond’s coupon rate

6. The sensitivity of a bond’s price to a change in its yield is inversely

related to the YTM at which the bond is currently selling

38
Change in Bond Price as a Function of Change
in Yield to Maturity

39
Prices of 8% Coupon Bond
(Coupons Paid Semiannually)

40
Prices of Zero-Coupon Bond
(Semiannual Compounding)

41
Interest Rate Sensitivity
• Higher-coupon-rate bonds have a higher fraction of value tied to
coupons rather than final payment of par value.
• So the “portfolio of payments” is more heavily weighted toward the earlier
short-maturity payments, which gives it lower “effective maturity”.

• A higher yield reduces the present value of all of the bond’s

payments, but more so for more-distant payments.
• At a higher yield, a higher proportion of the bond’s value is due to its
earlier payments, so effective maturity and interest rate sensitivity are
lower.

42
Duration
• A measure of the average maturity of a bond’s promised cash flows
• Macaulay’s duration equals the weighted average of the times to
each coupon or principal payment
• Weight applied to each payment time is proportion of total value of bond
accounted for by that payment (i.e., the PV of the payment divided by the
bond price)

• Duration = Maturity for zero coupon bonds

• Duration < Maturity for coupon bonds

43
Duration Calculation
• Duration calculation: T
D =  t wt
t =1

(1 + y )
t
CFt
wt =
P
CFt = Cash Flow at Time t
P = Price of Bond
y = Yield to Maturity

44
Duration Calculation

Suppose the interest rate decreases to 9% as an annual percentage rate. What will happen
to the prices and durations of the two bonds?
45
Interest Rate Risk
• Duration as a measure of interest rate sensitivity
• Price change is proportional to duration

P   (1 + y ) 
= −D   
P  1+ y 
• D* = Modified duration = D/(1 + y)

P
= − D * y
P
46
Duration Rules
• Rule 1
• The duration of a zero-coupon bond equals its time to maturity
• Rule 2
• Holding maturity constant, a bond’s duration is lower when the coupon rate is
higher
• Rule 3
• Holding the coupon rate constant, a bond’s duration generally increases with
its time to maturity

47
Duration Rules
• Rule 4
• Holding other factors constant, the duration of a coupon bond is higher when
the bond’s yield to maturity is lower

• Rule 5
• The duration of a level perpetuity is equal to:
1+ y
y

48
Bond Duration versus Bond Maturity

49
Bond Durations

50
Bond Durations
(Yield to Maturity = 8% APR; Semiannual Coupons)

51
Self-Check Exercise
• What happens to duration when you increase the coupon rate? The
yield of maturity? The maturity?
• What happens to duration if the bond pays its coupons annually
rather than semiannually?

52
Convexity
• Relationship between bond prices and yields is not linear
• Duration rule is a good approximation for only small changes in bond
yields
• Bonds with higher convexity exhibit higher curvature in the price-
yield relationship
• Convexity is measured as the rate of change of the slope of the price-yield
curve, expressed as a fraction of the bond price
1 𝑑2 𝑃
Convexity = × 2
𝑃 𝑑𝑦

53
Bond Price Convexity
(30-Year Maturity; 8% Coupon; Initial YTM = 8%)

54
Convexity
𝑇
1 𝐶𝐹𝑡 2 + 𝑡)
𝐶𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 = ෍ (𝑡
𝑃 × (1 + 𝑦)2 (1 + 𝑦)𝑡
𝑡=1

• As we have learnt in Calculus class, the differentiation of a smooth

function can be approximated by a Taylor expansion:

𝑑𝑃 1 𝑑2 𝑃 2
𝑑𝑃 = 𝑑𝑦 + 2
𝑑𝑦 + 𝑒𝑟𝑟𝑜𝑟
𝑑𝑦 2 𝑑𝑦

55
Convexity
• Accounting for convexity changes the equation
Δ𝑃 1
= −𝐷 Δ𝑦 + [Convexity × (Δ𝑦)2 ]
∗
𝑃 2

• The first term on the RHS captures the price change based on
modified duration whereas the second term captures price change
due to convexity.

56
Why Do Investors Like Convexity?
• Bonds with greater curvature gain more in price when yields fall than
they lose when yields rise
• The more volatile interest rates, the more attractive this asymmetry

• Investors must pay higher prices and accept lower yields to maturity
on bonds with greater convexity

57
Convexity of Two Bonds

58
Summary
• Bond pricing
𝑇
Coupon Par Value
Bond value = ෍ 𝑡
+
(1 + 𝑟) (1 + 𝑟)𝑇
𝑡=1

• Inverse relationship between price and yield

• Price curve is convex and becomes flatter at higher interest rates
• A coupon bond is a bond that
a) pays interest on a regular basis (typically every six months).
b) does not pay interest on a regular basis but pays a lump sum at maturity.
c) can always be converted into a specific number of shares of common stock in the issuing
company.
d) always sells at par value.
e) None of the options are correct.
59
Summary
• Bond yields
• Yield to maturity (YTM)
• Interest rate that makes the present value of a bond’s payments equal to its price
• A measure of the average rate of return what will be earned on a bond if it is
bought now and held until maturity
• Current yield
• Bond’s annual coupon payment divided by its price
• Premium bonds: coupon rate > current yield > YTM
• Discount bonds: coupon rate < current yield < YTM

60
Summary
• Bond yields (cont’d)
• Yield to call
• Calculation is like YTM except that the time until
call replaces time until maturity and call price
replaces par value
• Low interest rates: price of callable bond is flat
• High interest rates: price of callable bond
converges to that of a normal bond
• Callable bonds should offer higher promised
YTM to compensate investors for the fact that
they will not realize full capital gains should the
interest rate fall and the bonds be called.
• Two bonds have identical times to maturity and
coupon rates. One is callable at 105, the other
at 110. Which should have the higher yield to
maturity? Why?

61
Summary
• Bond prices over time
• A bond will sell at par value when its coupon rate equals the market interest
rate.
• When the coupon rate is lower than the market interest rate, the bond must
sell ________ (below/above) par value.
• Consider a 5-year bond with a 10% coupon that has a present YTM of 8%. If
interest rates remain constant, one year from now the price of this bond will
be _________ (higher/lower/the same/par)
• Zero-coupon bonds
• Carries no coupons and pays par value on the maturity date of the bond.
Par Value
Bond value =
(1 + 𝑟)𝑇
62
Summary
• Yield curve
• A plot of yield to maturity as a function of time to maturity
• Yield curve under certainty
• All investments must provide equal total returns for any investment period
• Some rates
• Spot rate: the rate that prevails today for a time period corresponding to the
zero’s maturity
• Short rate: interest rate for a given time interval (e.g., one year) at different
points in time
• Forward rate: forecast of a future short rate
(1 + 𝑦𝑛 )𝑛
(1 + 𝑓𝑛 ) =
(1 + 𝑦𝑛−1 )𝑛−1
63
Summary
• Theories of term structure
• Expectation hypothesis theory
• f2 = E(r2) and liquidity premiums are zero
• Liquidity preference theory
• f2 > E(r2) and a positive liquidity premium can cause the yield curve to slope upward
• Which one of the following statements is true?
a. The expectation hypothesis predicts a flat yield curve if anticipated future short-term
rates exceed current short-term rates.
b. The expectation hypothesis contends that the long-term spot rate is equal to the
anticipated short-term rate.
c. The liquidity preference theory indicates that, all else being equal, longer maturity
bonds will have lower yields.
d. The liquidity preference theory contends that lenders prefer to buy securities at the
short end of the yield curve.

64
Summary
• Duration
• A measure of the average maturity of a bond’s promised cash flows
• Macaulay’s duration: weighted average of the times to each coupon or
principal payment
T
D =  t wt
t =1

• Duration as a measure of interest rate sensitivity

P
= − D * y D* = Modified duration = D/(1 + y)
P

65
Summary
• Duration rules: five rules
• You predict that interest rates are about to fall. Which bond will give you the highest
capital gain?
a. Low coupon, long maturity.
b. High coupon, short maturity.
c. High coupon, long maturity.
d. Zero coupon, long maturity.
• Holding other factors constant, the interest-rate risk of a coupon bond is higher
when the bond’s
a. term to maturity is higher.
b. coupon rate is higher.
c. yield to maturity is higher.
d. All of the options are correct.
e. None of the options are correct.

66
Summary
• Convexity
• Bonds with higher convexity exhibit higher curvature in the price-yield
relationship
1 𝑑2 𝑃
Convexity = × 2
𝑃 𝑑𝑦
Δ𝑃 ∗ 1
= −𝐷 Δ𝑦 + [Convexity × (Δ𝑦)2 ]
𝑃 2

• Bonds with greater curvature gain more in price when yields fall than they
lose when yields rise

67