CF Session 2

Corporate Finance
Session II: Bond valuation
Prof. Sudarshan Kumar

IIM Calcutta
January 1, 2023
Prof. Sudarshan Kumar IIM Calcutta Session II: Bond valuation January 1, 2023 1
Introduction
• Financial claims with fixed cash flow at the fixed date
• Source of financing for the corporates as well governments
• Monetary policy tools for the central bank
• Fixed income securities as an investment for the risk averse investors
• Hedging instruments
Type of bond
Zero Coupon Bond
100
t
1 2 3 4
P
Coupon bond
100+C
C C C
t
1 2 3 4
P
Floating rate bond
Coupon is benchmarked to some benchmark interest rate such as

government bond yield
100+f4
f1 f2 f3
t
1 2 3 4
P
Market Segments
• Government bond market
• Corporate bond market
• Money market: To manage short term liquidity: maturity period

overnight rate to 1 year, includes T- bills
Two forms of debt financing
Bank loan
Bond
Bank loan vs. Corporate bond
Demand side
• Limited retail participation
• Demand for corporate bonds is constrained by prudential norms for
investment for the insurance companies and mutual 4funds.
• Foreign investors are also constrained by investment limits.
• Banks also prefer loans to bonds, as loans can be carried to their
balance sheets without being marked to market
• Illiquid market for credit default swaps (CDS)
Supply side
• Ease of raising money
• Large corporates can raise debt from the overseas markets
• Yield advantage
• Regulation vs covenants
Bank loan vs bond
• https:
//m.rbi.org.in/Scripts/BS_ViewBulletin.aspx?Id=17995
• https://www.livemint.com/opinion/online-views/
bonds-overtake-banks-in-funding-for-corporates-116067539231
html
• https://www.livemint.com/mutual-fund/mf-news/
bond-street-tempts-cos-with-lower-rates-11661711530218.
html
What is P
100
t
1 2 3 4
P
What is P
100
t
1 2 3 4
P
Zero Coupon bond

• What would be the price of 4 year zero coupon bond with the interest
rate 6%
What is P
100
t
1 2 3 4
P
Zero Coupon bond

• What would be the price of 4 year zero coupon bond with the interest
rate 6%
100 100
P= =
(1 + r )4 1.064
Coupon Bond
100+C
C C C
t
1 2 3 4
P
C C C 100 + C
P= + 2
+ 3
+
(1 + r ) (1 + r ) (1 + r ) (1 + r )4
Semi-annual coupon bond
4 year 8% /y coupon bond paid semi annually. Discount rate is 6% EAR
104
4 4 4 4 4 4 4
t
1 2 3 4
Effective Annual Rate (EAR)
Equivalent annual compounding rate for the m freq compounding rate
• We Should get equal future value for
◦ P$ invested for t years on annual compounding rate rEAR
◦ P$ invested for t years on m frequency compounding rate rm
rEAR ←→ r
mt
Solve P(1 + rEAR )t = P 1 + rmm
m
=⇒ rEAR = 1 + rmm −1

1
Also, =⇒ rm = m (1 + rEAR ) m − 1 =
rEAR ←→ rc
Solve P(1 + rEAR )t = Pe rc t
=⇒ rEAR = e rc − 1
Also =⇒ rc = ln(1 + rEAR )
4 year 8% /y coupon bond paid semi annually. Discount rate is 6% EAR
104
4 4 4 4 4 4 4
t
1 2 3 4
Price
Semi-annual compounding semi-annual rate= 2.9563%
PV= PV(7 period annuity of 4 with rate 2.9563%) + PV( 104 received at
8th period)
Other way round
4 year 8% /y coupon bond paid semi annually is trading at 106.57
104
4 4 4 4 4 4 4
t
1 2 3 4
P=106.57
Yield to maturity: YTM

YTM : Discount rate (r) at which present value of the cash flow = price
(P)
Price vs. Yield
Price vs. Yield
• Price and Yield are negatively related
• If Coupon rate < YTM =⇒ Price < Face value =⇒ bond is trading
at discount
• If Coupon rate > YTM =⇒ Price > Face value =⇒ bond is trading
at premium
• If Coupon rate = YTM =⇒ Price = Face value =⇒ bond is trading
at par
4 year 8% /y coupon bond paid semi annually. Discount rate is 6%/y

annual compounding
104
4 4 4 4 4 4 4
t
1 2 3 4
Price
Semi-annual compounding semi-annual rate= 2.9563%
PV= PV(7 period annuity of 4 with rate 2.9563%) + PV( 104 received at
8th period)
Some real example
8.15% GS 2026 24 Nov 26
104.075
4.075 4.075 4.075 4.075 4.075 4.075 4.075 4.075 4.075 4.075 4.075 4.075
t
17-09-20
24-11-20
24-11-21
24-11-22
24-11-23
24-11-24
24-11-25
24-11-26
N−1
!
1 X C /2 100
P= j
+
(1 + r /2)D/180 i=0
(1 + r /2) (1 + r /2)(N−1)
Day count convention
• Convention to calculate time period between two dates

◦ 30/360
◦ actual/365
◦ actual/360
◦ actual/actual
• Indian Bond market follows 30/360 convention
• Indian Money market follows actual/365 convention
• Day count (D) = (Y2-Y1)*360 + (M2-M1)* 30+ (D2-D1)
Accrued Interest
• Coupon interest earned but not paid out: Accrued interest:
C Days after last coupon payment
×
2 180
• Clean price = Dirty price -accrued interest
• Clean price is quoted price and Dirty price is the actual price buyer pays
for the security
Other return measure
• Holding period return
Coupon payment+ final price - intial price

HPR =
initial price
Risk: Debt investment
If you invest in 2 year 8% coupon bond with YTM 6%
• Price risk
• Reinvestment risk
Investment horizon 1 year
Interest rate reduces to 5% after one year

• Bond has maturity of 1 year now
108
• Total money you would receive is 8 + 1.05
• Return on the investment would be 7%
Interest rate increases to 7% after one year

• Bond has maturity of 1 year now
108
• Total money you would receive is 8 + 1.07
• Return on the investment would be 5.08%
Measure of interest rates risk: Price vs. Yield
• How much price of the bond will change with change in interest rate
• Long term bonds are more sensitive to short term bonds
• What is long term bond:::: 7% coupon 10 year bond and 1% coupon 9
year bond
Duration
100+C
C C C
t
1 2 3 4
P
C C C 100 + C
P= + + +
(1 + r ) (1 + r )2 (1 + r )3 (1 + r )4
C C C 100+C
1× (1+r ) +2× (1+r )2
+3× (1+r )3
+4× (1+r )4
D= C C C
(1+r ) + (1+r )2
+ (1+r )3
+ 100+C
(1+r )4
C C C 100+C
1× (1+r ) +2× (1+r )2
+ 3 × (1+r )3 + 4 × (1+r )4
=
P
Interpretations
C C C 100+C
1× (1+r ) +2× (1+r )2
+3× (1+r )3
+4× (1+r )4
D=
P
• Weighted average of the timing of the cash flow, with weights being
discounted cash flow
• Average time it takes to recover your investment
Sensitivity of the price to interest rate
N X ti × CiN
X Ci δP D
P= =⇒ = − = P
(1 + r )ti δr (1 + r )ti +1 1+r
i=1 i=1
• Modified Duration (MD) =

δP
D
= P
1+r δr
• % Change in price for change in yield percentage points
• % Change in price ≈ −MD × ∆r
Bond is trading at 105 rupees and has modified duration of 8 what would
be the approximate price if interest rate changes by 1%
Sensitivity of the price to interest rate
N N
X ti × Ci
X Ci δP D
P= =⇒ = − = P
(1 + r )ti δr (1 + r )ti +1 1+r
i=1 i=1
• Modified Duration (MD) =

δP
D
= P
1+r δr
• % Change in price for change in yield percentage points
• % Change in price ≈ −MD × ∆r
Bond is trading at 105 rupees and has modified duration of 8 what would
be the approximate price if interest rate changes by 1%
Prof. Sudarshan Kumar IIM Calcutta ∆P Session

= 105 × 8valuation
II: Bond × 1% January 1, 2023 27
The second order effect
Convexity adjustments
• Duration adjustment works well for small changes in yield
• Convexity:
1 δ2p
C=
P δr 2
• % Change in price ≈ −MD × ∆r + 0.5 × C × ∆r 2
Determinants of the yield
• Expectation about the risk free interest rate: Central bank decisions
• Bankruptcy risk:Credit Rating:Moody, Fitch, S& P

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Corporate Finance

Session II: Bond valuation

Prof. Sudarshan Kumar

• Financial claims with fixed cash flow at the fixed date

• Source of financing for the corporates as well governments

• Monetary policy tools for the central bank

• Fixed income securities as an investment for the risk averse investors

Coupon is benchmarked to some benchmark interest rate such as

• Government bond market

• Corporate bond market

• Money market: To manage short term liquidity: maturity period

Zero Coupon bond

Zero Coupon bond

4 year 8% /y coupon bond paid semi annually. Discount rate is 6% EAR

4 year 8% /y coupon bond paid semi annually. Discount rate is 6% EAR

4 year 8% /y coupon bond paid semi annually is trading at 106.57

Yield to maturity: YTM

• Price and Yield are negatively related

4 year 8% /y coupon bond paid semi annually. Discount rate is 6%/y

8.15% GS 2026 24 Nov 26

• Convention to calculate time period between two dates

• Indian Money market follows actual/365 convention

• Day count (D) = (Y2-Y1)*360 + (M2-M1)* 30+ (D2-D1)

• Holding period return

Coupon payment+ final price - intial price

If you invest in 2 year 8% coupon bond with YTM 6%

Interest rate reduces to 5% after one year

Interest rate increases to 7% after one year

• Modified Duration (MD) =

• % Change in price ≈ −MD × ∆r

• Modified Duration (MD) =

• % Change in price ≈ −MD × ∆r

Prof. Sudarshan Kumar IIM Calcutta ∆P Session

• Duration adjustment works well for small changes in yield

• % Change in price ≈ −MD × ∆r + 0.5 × C × ∆r 2

• Bankruptcy risk:Credit Rating:Moody, Fitch, S& P

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• Day count (D) = (Y2-Y1)360 + (M2-M1) 30+ (D2-D1)