FIS 5 - 11/01/2021

21 December 2021 19:28

Bond Pricing - Revising Concepts

• Bond is accounted in two parts
• Clean Price (Value) => Asset item goes to the B/S
• AI (income) => Income Statement
• When sold and purchased => it has to be broken into 2 parts but the final
money value has to be paid as Gross amount
• All library functions / Formulas only give the Clean part (Asset price)
• IN Excel => PRICE or YIELD Fn will give or use Clean Price
• Bond values are discussed in one of two ways:
• The price (quoted as a percentage of 100 FV in India and 1000 in US)
○ Indian Quotation in 4 Decimals (last 2 being 00, 25,50 and 75)

○ USA Quote is 32nd => 100-24 means 100+24/32 & 100-24+ means 100+

24/32+1/64
• The yield to maturity (% using the Clean price)
• These two methods are equivalent since a price implies a yield, and
vice-versa
• There are several ways that we can describe the rate of return on a
bond:
• Coupon rate
○ Fixed Coupons (6.10% till maturity GS 2031 Bond (12-Jul-2031))

• Most G-Secs would use fixed coupons

○ Floating Coupons (LIBOR + 1.00%) => based on an Index / Benchmark

• In India, we have FRBs linked to 182-Day T-Bills (Coupon fixation

linked to the index is average of 182-D cut off yields of last 3 Auctions)
• You can also use MIFOR (it is a combination of LIBOR and Forward

premia for Indian market => implied Terms Rate as Indian market does
not have established and liquid Term Money Market)
□ Suppose Archit wants to borrow USD100 to leverage Indian market

but does not want to take any risk of exchange rate

Borrow USD100 at LIBOR (assuming 3M LIBOR is 5% for 3M)
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  Borrow USD100 at LIBOR (assuming 3M LIBOR is 5% for 3M)
 To remove the EX Risk, Archit buys a Forward Cover which costs

3%.
 He would buy (100+1.25)USD 3M from now at = 73.90 + (73.90 *

0.03 *3/12) = 74.4543

 Now Archit converts 100USD at 73.90 to 7390 and he invests in

India at r% for 3 months. His total requirement of INR at maturity

= 101.25 * 74.4543 = 7,538.4979
 He must earn = 7538.4979 - 7390 = 148.4979 to break even which

converts into = 148.4979 / 7390 = 0.0201 => 0.0201*4 = 0.0804

=> he must invest at an implied rate of 8.04% to break even. If the
Indian 3M rate is higher than this, he would make money or he
would not borrow USD.
 This implied 8.04% rate is Called MIFOR.

○ Step-up Coupons => 2% (2 years), 5% (3 years) 15% (4 years)

○ If I hold the security till maturity, my income is guaranteed at the Coupon

rate
• Current yield
○ The concept was used in primitive times as we did not have sophisticated

computers and calculators => use approximation as most trading use to

happen till next coupon date and comparable yields were arrived at to find
out the relative attractiveness of the bonds in the portfolio.
• CY = CPN / Price

□ Holding cost => if CY is lower than the Coupon, positive holding cost

and vice versa

• Bonds which are held for trading as typically arranged in term so their

CY for buy / sell decision.

• Yield to maturity (YTM) => Yield Curve is generated => it converts price of
each and every bond of equal credit rating (viz. G-Secs) but with different
maturities into comparable yields to understand the behaviour of the risk
taking capabilities of the traders

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•

• The best fit line is like a No-Arbitrage Yield Curve

• Asymmetry of information gives the actual shape of the Yield Curve vis-
a-vis the No-arbitrage curve
• Assumption is that the bonds are held till maturity And all Future csh
flows (coupons when it will arrive, the investor would reinvest in the
same rate)
○ (a) Stay put till maturity on your investment
○ (b) All future receipts (future promised coupons) are reinvested at the same
rate
○ The (b) comes from the PV equation where we used the same Yld% to
discount all future cash flows.
• PV (Price) = CPN/(1+Y%)+CPN / (1+Y%)^2 +…..+CPN/(1+Y%)^n
+FV/(1+Y%)^n
□ Y% is same in all future cash flows for Discounting
□ When we use different Ys (like Y1, Y2, Y3 depending on the interest
rate applicable to that maturity), we call it a Spot Rate or Zero rate =>
Term Structure of interest rate using Time Value of Money
□ Both will give the same answer theoretically => which has given to
the growth of The STRIPS market globally as asymmetry drives to
the point where the sum is not equal to the combination of parts
□ The concept came because a 6.10% 2031 10 year Bond is a
combination of 21 cash flows (3.05 each half year till maturity and
100 at the end) coming at different maturities. STRIPING those cash
flows makes an investor to sell those maturities which are not in sync
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 flows makes an investor to sell those maturities which are not in sync
with its portfolio.
○ But the "time value of money" tells us the all reinvestment must be done at
the appropriate rate
• Modified yield to maturity
○ When we assume different interest rates to be applied at various Key break

points, we get the modified YTM

• Yield to call
○ Call is a right of the issuer to call back the bond when int rate drops

(refinance cost drops)

○ Call premia is to be paid for this (risk for the investor is when the investor

makes money, issuer calls back the bond and hence Risky investment)
• Realized Yield
○ Final return on the sale of the Bond

• The Coupon Rate

The coupon rate of a bond is the stated rate of interest that the bond
•

will pay during its life

Forward int rate
○

Mr. A has 100. (a) invest for 6 months and will pay 10% but
•

(b) invest for 3 months at 9% and agree to reinvest the money

after the maturity of 3 years and will get 10.76%.
Option a = 100 + 100*10%*6/12 = 105
•

Option b = 102.25 + 102.25*10.76%*3/12 = 105.0005

•

The coupon rate does not normally change during the life of the
•

bond, instead the price of the bond changes as the coupon rate
becomes more or less attractive relative to other interest rates
(present interest rate changes depending on the economic scenario
and coupon being fixed, we can determine its relative
attractiveness)
The coupon rate determines the dollar amount of the annual
•

interest payment:

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 •
• The Current Yield
• The current yield is a measure of the current income from owning
the bond
• It is calculated as:

• The Yield to Maturity

• The yield to maturity is the average annual rate of return that a
bondholder will earn under the following assumptions:
• The bond is held to maturity
• The interest payments are reinvested at the YTM
• PV Equation uses the same YTM for discounting all future cash
flows
• All Future cash flow are discounted at the same rate ignoring the time
value of money
• The yield to maturity is the same as the bond’s internal rate of
return (IRR)
• Calculation of YTM

•
• YTM = [(CPN/2)+(FV(MV) - CP)/(2*TIME
(YR))]/(0.4*FV+0.6*CP)
• PRICE = ((CPN(CASH)/YLD%)*(1-1/(1
+YLD%/2)^(2*TIME(YR))+100/(1+YLD%/2)^(2
*TIME(YR))
•

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