Prepared By: Mr Njapau Noah [BEcon&Fin,M.

Econ(acc)]

UNIT 4. DESCRIBING FIXED INCOME

SECURITIES(BONDS) AND EXPLAINING
DERIVATIVES

Introduction
In this unit, we review some basic features of bonds and examine the structure
of the bond market and bond markets and management. The bulk of the unit
involves an in-depth discussion of the major fixed-income investments and valuations.
The chapter ends with a brief review of the price information sources for bond investors.
Aim
The aim of this unit is to equip you with knowledge of bonds. The unit will
further discuss how bond price and bond yields are calculated.

4.2 Bonds as Fixed Income Debt Securities

Bonds are long-term, fixed-obligation debt securities packaged in convenient, affordable
denominations for sale to individuals and financial institutions.
Bonds differ from other types of debt securities because they impose fixed financial
obligations on the issuers. Specifically, the issuer of a bond agrees to:
1. Pay a fixed amount of interest periodically to the holder of record
2. Repay a fixed amount of principal at the date of maturity
In most cases interest on bonds is paid every six months. However some bond issuers
issue payment in intervals as short as a month or as long as a year. The principal is due
at maturity; this par value of the issue is rarely less than ZMW 100. Par value is the face
value of a bond or any fixed-income security. The public debt market is divided into 3
categories which are long term intermediate and short term. This is discussed in unit 1
under investment alternatives.
Bond characteristics
The main intrinsic features of a bond are: Coupon. Maturity, principle value and the type
of ownership.
Coupon of the bond is the income the bond holder is expected to receive in intervals
during the life of a bond or the holding period.
Coupon rate is the interest charged on the bond that translates to the coupon payment
as a percentage of the face value of a bond.
Maturity or Term to Maturity indicates the time or number of years before the bond
matures. There are different types of maturities like serial maturity, term maturity etc.
(refer to the recommended books).
Principle or Par value refers to the original debt obligation by the issuer. Principal value
is not the same as the bond’s market value. The market price fall or rise depending on
the coupon rate and the market rate of return which is the yield of the bond. This is
illustrated further as we calculate bond price and Yield to Maturity (YTD).

4.3 Types of bond issuers

In relation to common stocks and public debt instruments, companies and corporations
can have have different types of bonds issues outstanding at a given time. Bonds can
have different types of collateral according to the type of bond it is (Refer to the
recommended books). These can be either senior, unsecured, or subordinated (junior)
securities.
Features Affecting a Bond’s Maturity Investors should be aware of the three alternative
call option features that can affect the life (maturity) of a bond. One extreme is a freely
callable provision that allows the issuer to retire the bond at any time with a typical
notification period of 30 to 60 days. The other extreme is a noncallable provision wherein
the issuer cannot retire the bond prior to its maturity.1 Intermediate between these is a
deferred call provision, which means the issue cannot be called for a certain period of
time after the date of issue.
Bonds can be valued in kwacha or dollar form depending on the issuer. The rates and
return are dependent market the issuer is situated in. We describe both the present
value model, which computes a specific value for the bond using a single discount value,
and the yield model, which computes the promised rate of return based on the bond’s
current price and a set of assumptions.

4.4 Calculating Interest Yields (Current yield)

An investor who wishes to put funds on deposit will generally look at interest rates offered
on deposits in the market place and will place his funds with the institution that offers
the highest interest rate for the particular period chosen. The deposit that offers the
highest rate of interest clearly is the one that offers the ‘best value’ to the prospective
investor. It is important to define the various interest rates or yields that apply to a fixed-
interest bond.

Coupon rate; This is the annual interest paid divided by the par value of the bond,
expressed as a percentage.
This term has several other names:
➢ Flat yield: This is the actual annual coupon payable divided by the current market
value of the bond, which usually differs from the par value expressed as a
percentage.
➢ Current yield
➢ or running yield
The current yield is the most basic measure of the yield of a bond. It is the coupon
payment over the current price of the bond.

𝑐𝑜𝑢𝑝𝑜𝑛 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝐶
Current Yield = 𝑇ℎ𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑐𝑙𝑒𝑎𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑏𝑜𝑛𝑑 = 𝑌 = 𝑃𝑏x100
Equation 1.3

Example 2
Consider a bond with an annual coupon payment of $7 with a current market price of
$92.78. Calculate the current yield.

𝐶 $7
𝑌 = 𝑃𝑏x100 == 92.78 𝑥100 = $7.54

Example 3
The Irish Government issues a 4.6% Treasury, 18th April, 2016 at a price of 84.35 Euros.
Calculate the flat yield/running yield of this security.

Example 4: The future value (FV) of a deposit

K1,000 (one thousand Kwacha) is deposited by a customer at FNB (First National Bank)
at a fixed annual rate of interest of 5% with interest credited once a year. The deposit is
to last for a term of 10 years. The value of deposit after one year is calculated as:

K1,000 x (1+r),
where r = rate of interest expressed as a decimal

K1,000 x (1+0.05) = K1,050

The value of deposit after 10 years is calculated as:

K1,000 x (1+r)^n
where n = term of deposit in years

10
= 𝑘1000𝑥(1 + 0.05) = 𝑘 1, 629
The process whereby money grows at a compound rate of interest to reach a future value
as we move forward in time can be reversed if we examine what happens as we move
forward in time.

Example 5: The present value (PV) of a sum to be received in the future

A payment of K1,000 is to be received in exactly one year. The rate of interest or discount
rate is 5%. The payment in today’s money (the present value) may be calculated using
the formula: K1,000/ (1+ r), where r = the rate of interest or the expected rate of return,
commonly referred to as the discount rate. Therefore, the PV of this expected receipt is
K1,000/1.05 = K952.
If this payment were to be received in 10 years’ time, the PV may be calculated using the
𝑘1000
formula: = (1+𝑟)𝑛

where n = the number of years to wait before payment is received. Now the PV of this
𝑘100
expected receipt becomes = (1.05)10 = k614 . This example illustrates that the PV of a

future payment is calculated by dividing the expected payment by one plus the rate of
interest to the power of the number of years to wait for the payment.

4.5 Calculating the Bond Price

Determining the price of Government bonds
A government bond provides a stream of income payments known as coupon payments
(most coupon payments are paid twice yearly), and a payment upon maturity of the bond
that is equal to the face value of the bond. As earlier discussed government bonds have
high degree of liquidity, low transaction costs and it is worth mentioning that these are
traded by licensed institutions such as commercial banks and Investment Banks.
Government bonds have the advantage of being risk free in the sense that the purchaser
of the bond can be sure that the government will pay the coupon payments and maturity
value. The basic principle underlying the price of any financial asset is that it should be
determined by the present value of the asset’s expected cash flow i.e. the expected
stream of cash payments over the life of the asset.

The Present Value Model of calculating bond price

Where:
P𝑚 = 𝑡ℎ𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑
𝐶𝑖 = the annual coupon payment for a bond
𝑖 = 𝑦𝑖𝑒𝑙𝑑 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑
N= number of years to maturity

Example 1: Consider the following bond information:

Par Value of the Bond k1000
Coupon (10% of k1000) k100
Maturity (Number of years) 5
Interest/ Yield 8%
You are required to calculate the bond price.
100 100 100 100 100 1000
𝑝= + 2
+ 3
+ 4
+ 5
+ =
1 + 0.08 (1 + 0.08) (1 + 0.08) (1 + 0.08) (1 + 0.08) (1 + 0.08)5

P= 92.6 + 85.7 + 79.4 + 73.5 + 68.02 + 680.58

P= k 1079.9
The effect of higher interest rates is to lower the price of the bond.
Bonds for the first time are sold on the primary market and the government invites
investors to bid on the price. For you to decide on the price you will need to determine
what the future value of the coupon payment of the bond are in today’s monetary value
using above equation. This means finding the PV of the interest payments which are the
coupon payment and as well as the final redemption amount.
Example 6: Calculating the present value of a Government Bond, 4% Treasury 2014 An
investor has decided on 15th January, 2011 to invest in a government bond 4% Treasury
2014. The expected return is 3% and the redemption amount is $100. Calculate the
present value of the cash flows that will be generated by this bond.
Year 2015 2016 2017 P(B)
Cash flow 4 4 104
Present Value(PV) 4/1.03 4 104
= =
(1.03)2 (1.03)3
PV of redemption 3.88 3.77 95.18 102.83
payment

The principal is the face value of the bond.

The interest payment (coupon) is a specified percentage of the principal. This percentage
is represented by annual coupon rate.
The discount rate is the required annual compounded rate of return on similar bonds.
if we pay $102.83 for the bond, it will deliver to us a return of 3% per annum. If the bond
is priced lower than $102.83, it will deliver a return greater than 3% p.a. A price higher
than $102.83 implies a return of less than 3% p.a. in which case, we would not invest in
the bond.

4.5 Calculating Bond Yield

This is the rate of return that an investor will receive if they hold the security up to until
𝐹+𝑃
+𝐶
maturity date. 𝑌𝑇𝑀 = 𝑛
𝐹+𝑃
2

Example 2: A bond has 8% coupon, paid annually. The par value is k1000 and the bond
mtures in 6 years. If the bond currently sells for 911.37 what is its yield to maturity.
 1000 + 911.37
+ 40
𝑌𝑇𝑀 = 2 = 4.958%
1000 + 911.37
2

Current Yield Current Yield is found by taking the stated annual coupon payment and
dividing it by the current market price of the bond as illustrated under Unit 4.4.

Summary
This unit has been able to describe; what bonds are, types of bonds, pricing
of bonds and how bonds are priced and managed.

Activity
1. What is bond?
2. In the bond market, what do the following terms mean: par value, coupon rate,
maturity date and gross redemption yield.
3. Describe 10 types of bonds.
4. Explain 3 ways in which bonds are issued.
5. How does risk premia work?
UNIT 5. DESCRIBING DERIVATIVE
SECURITIES
Introduction
Welcome to Unit 5! This unit is going to look at derivative instruments as other
forms of investment.

Aim
The aim of this unit is to equip you with knowledge about derivative
instruments.

5.1 Derivative Markets

Individual Investors and institution investors can take advantage of future markets.
Investors can further reduce risk/volatility associated with the markets by diversifying
their investment to eliminate unsystematic risk.
The role derivatives play in reducing risk: A derivative instrument is one for which the
ultimate payoff to the investor depends directly on the value of another security or
commodity called the underlying asset. A call option, for example, gives its owner the
right to purchase an underlying security, such as a stock or a bond, at a fixed price within
a certain amount of time.
instruments that call for money to change hands at some future date, with the amount
to be determined by one or more reference items, such as interest rates, stock prices or
currency values (Brian O’Loughlin and Frank O’Brien - Fundamentals of investment an
Irish Perspective). Among derivatives we have two basic derivatives among many. These
are:
1) Forward and Future contracts:
2) Options Contracts:
3) Swaps:
4) Interest rate agreements:

5.2 Participants in Derivative Markets

Speculators are active players in derivatives markets, speculator are different from
investors in the sense that Speculators-These are attracted to risk, unlike hedgers and
arbitrageurs. Speculators seek exposure and take up positions, i.e. over-bought or
oversold, seeking not a small risk less profit, but the chance of a greater profit resulting
from the greater risk to which they are exposed while investors take calculative steps in
their investments. Other players on derivative markets are Arbitrageurs and Hedges,
all can be classified as investors.
Arbitrageurs buy cheaply and sell dearly. If all hedgers were selling, the arbitrageurs
would become buyers, causing prices to move upwards from the lower levels resulting
from the sales of the hedgers. The arbitrageurs would then try and sell in dearer markets,
moving prices downwards. They seek a risk-less profit.
Hedges wish to avoid risk by eliminating as much as is possible the likelihood of price
changes.

5.3 Forwards and Futures

A forward contract is ‘physical’ in that the parties agree now on a price to be paid on a
mutually acceptable date.
Forward contracts have a number of distinct features:
➢ The amount can be tailored to suit the parties’ needs. Contracts are said to be
personalised.
➢ There is no secondary market-i.e. they are highly illiquid and the parties are
‘stuck’ with them.
➢ The only occasion when cash actually flows is on delivery.
 ➢ If one party cannot deliver from stock, then they must buy the commodity (or
currency) on the spot market in order to honour the forward contract.
➢ There is a risk of default, because the contract is often agreed on an OTC market
➢ Both parties expect their obligations to be

Futures, on the other hand, are very different from forwards on the obligation of the
parties and in that they:
➢ Have standard terms, which are not negotiable between the parties;
➢ Can be sold and bought in their own right in a secondary market.
➢ Are not usually intended to be delivered.
➢ Are usually offset before delivery.
➢ Are traded on a recognised investment exchange and traded for investment
purposes on an OTC market.
➢ Involve cash flows from outset, because of margining requirements.
➢ Have an element of gearing as a result of the need to deposit this margin.

5.4 Options
Options represent claims on an underlying ordinary share and are created by investors
and sold to other investors. The company whose stock underlies these claims has no
direct interest in the transactions.
The buyer of an option buys a right but not an obligation. At the end of the expiry period,
the buy has the following rights: exercise it, let it lapse or sell it.

The original seller of an option (the writer), has the following obligations:
➢ If the owner exercises the option, the writer must honour it.
➢ He does keep the price paid to him by the buyer.
Put options
These enable the buyer of the option the right (not the obligation) to sell the asset at the
exercise price, i.e. put the asset into the market. It too, has a changeable option price
(premium).
Equity options
These are options that are traded on the stock exchange market and LIFFE market.
Equity Options are available on many cash and derivative financial instruments-on equity
share prices, equity indices, cash markets, swaps, and even futures, to name but a few.
Call options
These allow the buyer of the option the right (not the obligation) to buy the asset at a
stated price, known as the exercise price, i.e. call the asset from the market. The exercise
price is also known as the strike price.
1) Swaps

5.5 Valuing options

The preceding discussion showed that positions in forward and option contracts can lead
to similar investment payoffs if the price of the underlying security moves in the
anticipated direction. This similarity in payoff structures suggests that these instruments
are connected. we will see that the values of five different securities can be linked: a risk-
free bond, an underlying asset, a forward contract for the future purchase or sale of that
asset, a call option, and a put option. These relationships, known as put-call parity, specify
how the put and call premiums should be set relative to one another. As such, put-call
parity represents a crucial first step in understanding how derivatives are valued in an
efficient capital market.

Suppose that at Date 0 an investor forms the following portfolio involving three securities
related
to Company WYZ:
 ➢ Long in a share of WYZ common stock at a purchase price of 𝑠𝑜
➢ Long in a put option to deliver one share of WYZ stock at an exercise price of X
on the Expiration Date T. This put could be purchased for the price of 𝑝𝑜,𝑇
➢ Short in a call option allowing the purchase of one share of WYZ stock at an
exercise price of X on the Expiration Date T. This call could be sold for the price of
𝐶𝑜,𝑇
Have the same expiration date and exercise price. However, the specific values of the
expiration date and exercise price do not matter in the analysis that follows. Further,
we will assume initially that WYZ stock does not pay a dividend during the life of the
options.
Panel A of Exhibit 20.16 lists the Date 0 investment necessary to acquire this portfolio
as (𝑠𝑜 + 𝑝𝑜,𝑇 − 𝐶𝑜,𝑇 ), which is the cost of the long positions in the stock and the put
option less

Net Portfolio Investment at Initiation (Date 0)

Portfolio
Long 1 WYZ stock S0
Long 1 put option P0,T
Short 1 call option C0,T
Net investment: S0 + P0,T − C0,T
Illustration 1
Portfolio Value at Option Expiration (Date T )
Portfolio (1) If ST ≤ X: (2) If
ST > X:
Long 1 WYZ stock ST ST
Long 1 put option (X − ST) 0
Short 1 call option 0− (ST
− X)
Net position: X X
Illustration 2
the proceeds generated by the sale of the call option Consider also the value that this
portfolio will have at the expiration date of the two options. Given that the stock’s value
at Date T (i.e.,𝑠𝑇 ) is unknown when the investment is made at Date 0, two general
outcomes are possible:(1) ST ≤ X and (2) ST > X. Illustration 2 shows the value of each
position as well as the net value of the whole portfolio at Date T. Whenever the Date T
value of WYZ stock is less than the exercise price common to the put and call options,
the investor will exercise the long position in the put and sell the WYZ share for X instead
of its lower market value. In that case, it will not be rational for the holder of the call to
pay X for a share that is worth less so the call will expire out of the money. On the other
hand, when ST exceeds X, the holder of the call will exercise the option to purchase WYZ
stock for X while the put would be out of the money. In either scenario, the net expiration
date value of the portfolio is X because the combination of options guarantees that the
investor will sell the share of WYZ stock at Date T for the fixed price X. The investor has,
in effect, a guaranteed contract to sell the share of stock when the long put and short
call positions are held jointly. The consequence of this result is that when the investor
commits.:S0 + P0,T − C0,T to acquire the position at Date 0, he knows that it will be
worth X at Date T. Thus, this particular portfolio has a comparable payoff structure to a
U.S. Treasury bill, another risk-free, zero coupon security that can have a face value of X
and a maturity date T. In an arbitrage-free capital market, this means that the Date 0
value of the portfolio must be equal to that of the T-bill, which is just the face value X
discounted to the present using the risk-free rate. This “no arbitrage” condition can be
formalized as follows.
𝑋
S0 + P0, T − C0, T =
(1 + 𝑅𝐹𝑅)𝑇

Equation 1.2
Where:
RFR = the annualized risk-free rate
T = the time to maturity (expressed in years)
Defining [𝑋 (1 + 𝑅𝐹𝑅)−𝑇 ] as the present value of a T-bill, this equation can be expressed
on
Date 0 in financial arithmetic terms as:
(Long Stock) + (Long Put) + (Short Call) = (Long T-Bill)
Example:
Suppose that WYZ stock is currently valued at $53 and that call and put options on WYZ
stock with an exercise price of $50 sell for $6.74 and $2.51, respectively. If both options
can only be exercised in exactly six months, Equation 1.2 suggests that we can create a
synthetic T-bill by purchasing the stock, purchasing the put, and selling the call for a net
price of $48.77 (= 53.00 + 2.51 − 6.74). On the options’ expiration date, this portfolio
would have a terminal value of $50. Thus, the risk-free rate implied by this investment
can be established by solving the following equation for RFR:
48.77 = 50 (1 + 𝑅𝐹𝑅)−0.5
𝑅𝐹𝑅 = [(50 ÷ 48.77)2 − 1] = 5.11%

Taking Long and short positions

Summary
Financial derivatives are essentially instruments that call for money to change
hands at some future date, with the amount to be determined by one or more reference
items, such as interest rates, stock prices or currency values.
Derivatives were primarily invented to reduce risk and not to fuel speculative activity.
The risk profile of the futures contract is identical to the risk profile of an equivalent
quantity of the relevant underlying security.
Financial futures can be divided into four (4) categories; stock index futures, interest rate
futures, long-term interest rate (bond) futures and currency futures.
Derivatives are classified into four main categories; futures, options, swaps and interest
rate agreements.
A call option gives the holder the right to buy (call away) shares of a particular company,
at a specified price, at any time up to a specified expiration date. A put option gives the
buyer the right to sell (put away) shares of a particular company, at a specified price, at
any time up to a specified expiration date.
The intrinsic value of an option is the difference between the current market price of the
underlying share and the strike price.
Over-the-Counter (OTC) derivatives are contracts where the buyer and the seller come
together directly and agree the terms of the contract between themselves.

Activity
1. What is a derivative?
2. In the derivative market, what do the following terms mean: underlying asset,
speculation, call and put options.
3. Describe 10 types of bonds?
4. Explain 3 ways in which derivatives can be used?
5. How does risk premia work?