REVIEW TOPIC 5

• Capital Market Theory: Capital market theory is a generic term

for the analysis of securities. In terms of trade off between the
returns sought by investors and the inherent risks involved, the
capital market theory is a model that seeks to price assets, most
commonly, shares.
• Market efficiency: Market efficiency refers to the degree to
which market prices reflect all available, relevant information. If
markets are efficient, then all information is already incorporated
into prices, and so there is no way to "beat" the market because
there are no undervalued or overvalued securities available.
→perfectly (everyone receives the information), completely
(everyone receives the entire information), instantly (everyone
receives the information at once), and for no cost (everyone
receives the information for free).
→The Weak, Strong, and Semi-Strong Efficient Market
Hypotheses
 TOPIC 6

BOND YIELDS AND PRICES

 LEARNING OBJECTIVE

1. Discuss the general features, yields, prices, popular types

of corporate bonds.
2. Understand the key inputs and basic model used in the
valuation process
3. Basic valuation model to bonds and describe the impact
of required return and time to maturity on bond values.
4. Explain the yield to maturity (YTM), its calculation, and
the procedure used to value bonds that pay interest
semiannually.
BOND VALUATION

1.Interest rate and required return

2.Corporate bond
3.Bond valuation
INTEREST RATE AND RETURN
Interest rate

Usually applied to debt instruments such as bank loans

or bonds; the compensation paid by the borrower of
funds to the lender; from the borrower’s point of view, the
cost of borrowing funds

Required return

Usually applied to equity instruments such as common

stock; the cost of funds obtained by selling an
ownership interest.
INTEREST RATE AND RETURN

Inflation
A rising trend in the prices of most goods and services.

Liquidity preference
A general tendency for investors to prefer short-term (that is,
more liquid) securities
INTEREST RATE AND RETURN
NOMINAL OR ACTUAL RATE OF INTEREST

The nominal rate of interest is the actual rate of

interest charged by the supplier of funds and paid by the
demander.

Real rate of interest: The rate that creates equilibrium

between the supply of savings and the demand for
investment funds in a perfect world, without inflation,
where suppliers and demanders of funds have no
liquidity preferences and there is no risk
Ex:
Lan wants to buy a doll from a shop. The shop has just
displayed the doll and it has only one doll is priced 100,000
VND. However, Lan saved 70,000 VND. And after every
month, if no one has bought the doll, the price of the doll will
be reduced by 10% compared with its price the previous
month. If no one has bought the doll, how many months at
least will Lan have to wait to buy the doll with the money she
has saved?
What are Bonds?

• A bond is a debt instrument that provides a

periodic stream of interest payments to investors
while repaying the principal sum on a specified
maturity date.
• A bond’s terms and conditions are contained in a
legal contract between the buyer and the seller,
known as the indenture.
• The valuation of a bond depends on the size of its
coupon payments, the length of time remaining
until the bond matures and the current level of
interest rates.
What are Bonds?

•A bond is a formal contract to repay borrowed

money with interest at fixed intervals.

•A bond provides the borrower with external

funds to:
– finance long term investments (for corporations)
– finance current expenditures (for municipal, state
or national governments).
BOND CHARACTERISTICS
• Buyer of a newly issued coupon bond is lending
money to the issuer who agrees to repay principal
and interest
• Bonds are fixed-income securities
➢Buyer knows future cash flows
➢Known interest and principal payments
• If sold before maturity price will depend on interest
rates at that time

2-12
BOND CHARACTERISTICS

• Prices quoted as a % of par value

• Bond buyer must pay the price of the bond
plus accrued interest since last semiannual
interest payment
➢Prices quoted without accrued interest
• Premium: amount above par value
• Discount: amount below par value

2-13
Types of bonds
• Corporate Bonds – Issued by Corporations to
expand or finance a project, usually taxable and
offer higher returns.
• Government Bonds – Treasury bonds carry the
lowest degree of risk and are the benchmark
against which all other types of bonds are
measured. Although their market values fluctuate,
they are considered the safest.
• Municipal Bonds – Issued by the local
government usually to finance specific projects.
• Other terminologies – Agency bonds,
Collateralized bonds, Commercial papers,
Convertible bonds, Covenant bonds, Credit
Rating, Debentures
 Corporate bond
A bond is a long-term debt instrument that pays the
bondholder a specified amount of periodic interest rate over a
specified period of time
The bond’s coupon
The bond’s maturity
The bond’s principal is the rate is the specified
date is the time at
amount borrowed by the interest rate (or $
which a bond
company and the amount amount) that must
becomes due and
owed to the bond holder on be periodically paid.
the principal must be
the maturity date.
repaid.
 Corporate bond
a) Face/Par Value
The face value (also known as the par value) of a bond is the
price at which the bond is sold to investors when first issued; it
is also the price at which the bond is redeemed at maturity. In
the U.S., the face value is usually $1,000 or a multiple of
$1,000.

b) Coupon Rate (coupon yield)

The periodic interest payments promised to bond holders are
computed as a fixed percentage of the bond’s face value; this
percentage is known as the coupon rate.

Annual coupon payments (CP)

Coupon rate =
Face value
 Corporate bond
c) Coupon
A bond’s coupon is the dollar value of the periodic interest
payment promised to bondholders; this equals the coupon rate
times the face value of the bond.
For example, if a bond issuer promises to pay an annual
coupon rate of 5% to bond holders and the face value of the
bond is $1,000, the bond holders are being promised a coupon
payment of (0.05)($1,000) = $50 per year.
d) Maturity
A bond’s maturity is the length of time until the principal is
scheduled to be repaid. Occasionally a bond is issued with a
much longer maturity. There have also been a few instances
of bonds with an infinite maturity; these bonds are known
as consols. With a consol, interest is paid forever, but the
principal is never repaid.
Corporate bond: Bond Yields

• A bond’s yield or rate of return is frequently used to

assess its performance over a given period, typically 1

year.

• The three most widely cited yields are:

➢ Current yield

➢ Yield to maturity (YTM)

➢ Yield to call (YTC)

Corporate bond - Bond Yields

The bond’s current yield is the annual interest (income)

divided by the current price of the security

The bond’s yield-to-maturity is the yield (expressed as a

compound rate of return) earned on a bond from the time it
is acquired until the maturity date of the bond

A yield curve graphically shows the relationship between

the time to maturity and yields for debt in a given risk class
 Corporate bond: Bond Prices

Because most corporate bonds are purchased and held by

institutional investors, bond trading and price data is not
readily available to individuals.

Although most corporate bonds are issued with a par or face

value of $1,000, all bonds are quoted as a percentage of par.

The price a dealer will pay to purchase a bond calling bid

price.
Corporate bond: Example
BOND RATINGS
• Rate relative probability of default
• Rating organizations
➢Standard and Poors Corporation (S&P)
➢Moody’s Investors Service Inc
• Rating firms perform the credit analysis for the
investor
• Emphasis on the issuer’s relative probability of
default
Corporate bond: Bond Rating
Corporate bond: Bond Rating
Corporate bond: Common types of bonds

• Zero- (or low-) coupon bonds

• Junk bonds
• Floating-rate Bond
• Extendible notes
• Putable bonds
Corporate bond: Common types of bonds
Zero- (or low-) coupon bonds
• Issued with no (zero) or a very low coupon (stated
interest) rate and sold at a large discount from
par.
• The price of a zero-coupon bond can be
calculated by using the following formula:

M P = price
P=
(1+r)n M = maturity value
r = investor's required annual yield
n = number of years until maturity
FOR EXAMPLE

• If you want to purchase a Company XYZ zero-

coupon bond that has a $1,000 face value and
matures in three years, and you would like to earn
10% per year, compounded semiannual on the
investment, How much you willing to pay for this
bond today?
Corporate bond: Common types of bonds
Junk bonds
• Debt rated Ba or lower by Moody’s or BB or lower
by Standard & Poor’s.
• High-risk bonds with high yields – often yielding
2% to 3% more than the best-quality corporate
debt
Corporate bond: Common types of bonds

Floating-rate bonds
• Stated interest rate is adjusted periodically within stated
limits in response to changes in specified money market or
capital market rates. Popular when future inflation and
interest rates are uncertain.
• Ex: An investor buys a bond with an interest rate of 8% of
the adjustment period of 6 months while a government
bond has a fixed interest rate of 7.5%. After a period when
the government bond interest rate is increased to 8.5%,
after 6 months, the bond A owned will be adjusted the
interest rate at least to 9% to still ensure that A enjoys a
higher interest rate than 0, 5% compared to when
investing in government bonds → Floating-rate bonds
Corporate bond: Common types of bonds

Extendible notes
• Short maturities, typically 1 to 5 years, that can be
renewed for a similar period at the option of
holders.
• Similar to a floating-rate bond. An issue might be a
series of 3-year renewable notes over a period of
15 years; every 3 years, the notes could be
extended for another 3 years, at a new rate
competitive with market interest rates at the time
of renewal.
Corporate bond: Common types of bonds

Putable bonds
• Bonds that can be redeemed at par
(typically, $1,000) at the option of their
holder either at specific dates after the date
of issue and every 1 to 5 years thereafter or
when and if the firm takes specified actions,
such as being acquired, acquiring another
company, or issuing a large amount of
additional debt.
 VALUATION FUNDAMENTALS

❖ The (market) value of any investment asset is simply the

present value of expected cash flows.

❖ The interest rate that these cash flows are discounted at

is called the asset’s required return.

❖ The required return is a function of the expected rate of

inflation and the perceived risk of the asset.

❖ Higher perceived risk results in a higher required return

and lower asset market values.
Bond Valuation

BASIC BOND VALUATION

𝒏
𝟏 𝑴
𝑩𝟎 = 𝑰 ෍ +
𝒕=𝟏
(𝟏 + 𝒓𝒅 )𝒕 (𝟏 + 𝒓𝒅 )𝒏
Bond Valuation

BASIC BOND VALUATION

Tim Sanchez wishes to determine the current value

of the Mills Company bond. Assuming that interest
on the Mills Company bond issue is paid annually
and that the required return is equal to the bond’s
coupon interest rate, I = $100, rd= 10%, M =
$1,000, n = 10 years. Jan 1, 2013 issuing date.
 Bond Valuation

Bond Values for Various Required Returns (Mills Company’s 10%

Coupon Interest Rate, 10-Year Maturity, $1,000 Par, January 1, 2010,
Issue Paying annual Interest)
Bond Valuation
Bond values and Requires return
Discount: the amount by
which a bond sells at a
value that is less than its
par value

Premium: The amount by

which a bond sells at a
value that is greater than
its par value
Bond Valuation

Time to Maturity

and Bond values

 Yield to Maturity (YTM)
Bond Valuation
➢ The yield to maturity measures the compound annual
return to an investor and considers all bond cash flows. It is
essentially the bond’s IRR based on the current price.
➢ Note that the yield to maturity will only be equal if the bond
is selling for its face value ($1,000).
➢ And that rate will be the same as the bond’s coupon rate.
✓ For premium bonds, the current yield > YTM.
✓ For discount bonds, the current yield < YTM.
 Yield to Maturity (YTM)
Bond Valuation
The Mills Company bond, which currently sells for $1,080, has
a 10% coupon interest rate and $1,000 par value, pays interest
annually, and has 10 years to maturity. What is the bond’s
YTM?
𝐶𝐹 ≈ 𝐼 1 𝑀
𝐵0 = 𝑥 1− 𝑛
+
𝑌𝑇𝑀 (1 + 𝑌𝑇𝑀) (1 + 𝑌𝑇𝑀)𝑛

$100 $100 $1000

≈ 1080 = − 10
+
𝑌𝑇𝑀 𝑌𝑇𝑀(1 + 𝑌𝑇𝑀) (1 + 𝑌𝑇𝑀)10
Rd = 3%/year
YTM formula

M − B0
I+
YTM = n
M + B0
2
 Simple yield calculation - example
▪ Question:
A four-year bond has exactly four years till maturity
and the last coupon has just been paid. The coupon is
annual and equal to 5.5 percent. The bond price is 96
percent.
Calculate its simple yield.
 Simple yield calculation - example
▪ Question:
A four-year bond has exactly four years till maturity
and the last coupon has just been paid. The coupon is
annual and equal to 5.5 percent. The bond price is 96
percent.
Calculate its simple yield.
DURATION
• In simple terms, modified duration gives an idea of
how the price of a bond will be affected should
interest rates change. A higher duration implies
greater price sensitivity upwards (downwards)
should rates move down (up).
• Duration is quoted as the percentage change in
price for each given percent change in interest
rates. For example, the price of a bond with a
duration of 2 would be expected to increase
(decline) by about 2.00% for each 1.00% move
down (up) in rates.
DURATION
• The duration of a bond is primarily affected by its coupon
rate, yield, and remaining time to maturity. The duration of
a bond will be higher the lower its coupon, lower its yield,
and longer the time left to maturity. The following scenarios
of comparing two bonds should help clarify how these
three traits affect a bond’s duration:
✓If the coupon and yield are the same, duration increases
with time left to maturity
✓If the maturity and yield are the same, duration increases
with a lower coupon
✓If the coupon and maturity are the same, duration
increases with a lower yield
Example:

• 5.00% Coupon Bond at Par: Price Change for a Given

Rise in Rates

If Rates 2-Year 10-Year 30-Year

Move Up ... Bond Bond Bond

1.00% -1.0% -6.9% -13.7%

2.00% -1.9% -13.2% -24.7%

3.00% -2.8% -19.0% -33.6%

Exercise 1
a. What is the price of a 5-year bond with a
nominal value of $100, a yield to maturity of
7% (with annual compounding frequency), a
10% coupon rate and an annual coupon
frequency?
b. Same question for a yield to maturity of
8%, 9% and 10%. Conclude.
Exercise 2

The U.S. Treasury offers to sell you a bond for

$613.81. No payments will be made until the bond
matures 10 years from now, at which time it will be
redeemed for $1,000. What interest rate would you
earn if you bought this bond at the offer price?
Exercise 3

• Suppose a bond has a $1,000 face value, 20

years to maturity, an 8 percent coupon rate,
and a yield of 9 percent. What’s the price of
semiannual coupons bond?

• The meaning of 10% semiannual coupons?

→ Means that the bond pays coupon at 10% of
face value per year compounded semiannually.
So the rate is 5% per semiannual period which is
used to pay coupon at end of each half year.
Exercise 4

• What is the price of a 5-year bond with a

nominal value of $100, a yield to maturity of
7% (with annual compounding frequency), a
10% coupon rate and an annual coupon
frequency?
Exercise 5
• We consider the following zero-coupon curve:

Maturity (years) Zero-Coupon Rate (%)

1 4.00
2 4.50
3 4.75
4 4.90
5 5.00

1. What is the price of a 5-year bond with a $100

face value, which delivers a 5% annual coupon rate?
2. What is the yield to maturity of this bond?
Exercise 6
• We consider 2 bonds with following features:

Bond Maturity (years) Coupon Rate (%) Price YTM (%)

Bond 1 10 10 1,352.2 5.359
Bond 2 10 5 964.3 5.473

• These two bonds have a $1,000 face value, and

an annual coupon frequency. An investor buys
these two bonds and holds them until maturity.
Compute the annual return rate over the period,
supposing that the yield curve becomes
instantaneously flat at a 5.4% level and remains
stable at this level during 10 years
Exercise 7
• We are now in 31/12/2015 and you have information on
some government bonds. Their face value is EUR100 and
they all pay coupons on December 31st each year. They
already paid the coupon this year.

Bond Maturity Coupon rate

A 31/12/2016 15%
B 31/12/2018 8%
C 31/12/2020 9%

• The following spot rate: r01=6.5%; r02=6.6%; r03=6.7%;

r04=6.8%; r05= 7%
Calculate: value of bonds; YTM of three bonds
Exercise 8

1. What is the price of a 5-year bond with a

nominal value of $100, a yield to maturity of 7%
(with annual compounding frequency), a 10%
coupon rate and an annual coupon frequency?
2. Same question for a yield to maturity of 8%,
9% and 10%. Conclude.
Exercise 9
• We consider the following zero-coupon curve:

Maturity (years) Zero-Coupon Rate (%)

1 4.00
2 4.50
3 4.75
4 4.90
5 5.00

1. What is the price of a 5-year bond with a $100 face value, which
delivers a 5% annual coupon rate?
2. What is the yield to maturity of this bond?
3. We suppose that the zero-coupon curve increases instantaneously
and uniformly by 0.5%. What is the new price and the new yield to
maturity of the bond? What is the impact of this rate increase for the
bondholder?
Major Differences Among Bond Markets
▪ Quotation
▪ Bonds are quoted in the form of a clean price net of
accrued interest.
▪ The full price (or value) of a bond is the sum of its
clean price plus accrued interest. Or,
P = Q +AI
➢ Where P = full price, Q = quoted price and AI
= accrued interest
▪ Accrued interest = Coupon * (days since last
coupon date/days in coupon period).
Full Price and Clean Price – An example

▪ Question: The clean price of a Eurobond is quoted at

Q=96%. The annual coupon is 5 percent, and we are
exactly four months from the past coupon payment.
What is the full price of the bond?
Major Differences Among Bond Markets

▪ Yield to Maturity:
▪ The yield to maturity (YTM) – (lãi suất đáo hạn) is the
average promised yield over the life of the bond.
▪ The convention used to calculate YTM varies across
markets.
▪ In the U.S, YTM is calculated at a semiannual rate and the
result is multiplied by 2 to report an annualized rate.
▪ Most Europeans calculate an annual, actuarial YTM.
▪ The simple interest yield approach is also used in Japan.
 Return on Foreign Bond Investments
▪ The return from investing in a foreign bond has three
components:
▪ During the investment period, the bondholder receives the
foreign yield.
▪ A change in the foreign yield (Δforeign) induces a
percentage capital gain/loss on the price of the bond.
▪ A currency movement induces a currency gain or loss on the
position.
Return = Foreign yield – D * (Δforeign yield) + % currency
movement
Currency-Hedging Strategies

▪ Foreign investments can be hedged against currency risk

by selling forward currency contracts for an amount equal
to the capital invested.

Hedged Return = Foreign yield – D * (Δforeign yield) +

Domestic cash rate – Foreign cash rate
 Currency-Hedging Strategies - Example
▪ You are British and hold a U.S. Treasury bond with a full
price of 100 and duration of 15. Its yield is 6 percent. The
dollar cash rate is 3 percent, and the pound cash rate is 4
percent. You expect U.S. yields to move down by 15
basis points over the year. Give a rough estimate of your
expected return if you decide to hedge the currency risk.
A Swiss investor has purchased a US. Treasury bond priced at 100. Its yield is
4.5 percent, and the investor expects the U.S. yields to move down by 15 basis
points over the year. The duration of the bond is 6. The Swiss franc cash rate is
1 percent and the dollar cash rate is 2 percent. The one-year forward exchange
rate is USD/SFr = 1.4600

a. The Swiss investor has come up with his own model to forecast the USD/SFr
exchange rate one year ahead. This model forecasts the one-year ahead
exchange rate to be USD/SFr = 1.3500. Based on this forecast, should the
Swiss investor hedge the currency risk of his investment using a forward
contract?
b. If the Swiss investor decides to hedge using a forward contract, give a rough
estimate of his expected return.
c. Verify for the hedged investment that the risk premium in Swiss francs is the
same as the risk premium on the same U.S. Treasury bond for a US. investor.
Ex

• A government bond has a yield of 8% and an expected market

return is 15%, the beta of the portfolio with the same risk level is
0.8.
a) Apply CAPM model to calculate the expected return of
investors.
b) Investors intend to buy the bonds of Retec company in the
market with the following information: the bond has par value
of 100,000 GBP; and has coupon rate of 9% per anual. The
number of years to maturity are 15 years. Calculate the
maximum price of this bond that investors can invest in?