CFA Level I

Study Session 16 Reading 56

Reading 57
Reading 58
Reading 59
Introduction to the Valuation of Debt Securities
Yield Measures, Spot Rates, and Forward Rates
Introduction to the Measurement of Interest Rate Risk
Fundamentals of Credit Analysis
 CFA Level I: Fixed Income
LOS 56:
Introduction to valuation of debt securities
• explain the steps in the bond valuation process
• identify the types of bonds for which estimating the expected cash flows is difficult,
and explain the problems encountered when estimating the cash flows of these
bonds
• calculate the value of a bond and the change in value that is attributable to a change
in discount rate.
• explain how the price of a bond changes as the bond approaches its maturity date,
and calculate the change in value that is attributable to the passage of time
• calculate the value of a zero-coupon bond
• explain the arbitrage-free valuation approach and the market process that forces
the price of a bond toward its arbitrage-free value, and explain how a dealer can
generate an arbitrage profit if a bond is mispriced.
Bond valuation

Bond valuation is 3 step process:

Step 1: Estimate the expected cash flows.

Step 2: Determine the appropriate interest rate or interest rates that should be used to discount the cash flows.
Step 3 : Calculate the present value of the expected cash flows found in step 1 using the interest rate or interest rates
determined in step 2.

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Estimating cash flows
Cash flows are the interest and principal payments.

Investors will find it difficult to estimate the cash flows when they purchase a fixed income security.
1. the issuer or the investor has the option to change the contractual due date for the payment of the principal
(MBS, ABS)
2. the coupon payment is reset periodically ( floating rate security)
3. the investor has the choice to convert or exchange the security into common stock. (convertible bonds)

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Bond value
Ex: Bond XYZ matures in five years with a coupon rate of 7% and a maturity value of $1,000. The bond pays annually
and the discount rate is 5%.

Solu: The cash flow for each of the years is:

Year one = $70 Year Two = $70 Year Three = $70, Year Four is $70 and Year Five is $1,070.

PV of the cash flows is:

Year one = 70 / (1.05)1 = $66.67
Year two = 70 / (1.05)2 = $ 63.49
Year three = 70 / (1.05)3 = $ 60.47
Year four = 70 / (1.05)4 = $ 57.59
Year five = 1070 / (1.05)5 = $ 838.37

Now to find the value of the bond:

Value = 66.67 + 63.49 + 60.47 + 57.59 + 838.37
Value = 1, 086.59

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Bond value

As a bond moves closer to its maturity date, its price will move closer to par.

1. If a bond is at a premium, the price will decline over time towards its par value.
2. If a bond is at a discount, the price will increase over time towards its par value.
3. If a bond is at par, its price will remain the same.

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Zero – coupon bond

• Value of a zero coupon bond that matures N years from now is:
maturity value
(1 + i)N*2
• i = semi annual coupon rate

Question: what is the value of a zero coupon with a maturity of three years and a maturity value of $ 2000
discounted at 6%.

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Arbitrage-free valuation approach

Under the arbitrage-free valuation approach, present value of the cash flows of the zero-coupon bonds calculated at
the spot rates gives the arbitrage free value.

Dealers separate coupon treasury securities into different cash flows.

If the total value of these cash flows is greater than the market price of the bond, then the security is over valued
otherwise undervalued and there is an opportunity for arbitrage.

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Arbitrage process

A dealer has the ability to strip a security or to take apart the cash flows that make up the bond.

• if the market price of a Treasury security is less than the value using the arbitrage-free valuation, a dealer will buy
the security, strip the bond and then sell the Treasury strips at a higher amount than the purchase price for the
whole bond.

• if the market price is more than the value using the arbitrage-free valuation, the dealer will buy the strips, make
the bond "whole" and sell it at a higher price than that of the purchased strips.

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