Lecture 3: Loans & Bonds Analysis

Lecturer: Phạm Thị Hồng Thắm

Foundations of Mathematical Finance

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Table of Contents

1 Loan Balance

2 Loan Amortization

3 Bond Analysis

4 Bond Amortization Schedule

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 Loan Balance

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Loan Balance

We consider a loan with fixed term of maturity, which is to be repaid

by a series of payments.
If the repayments prior to maturity are only to offset the interests,
followed by a final payment to redeem the principal upon maturity,
the loan is called an interest-only loan.
If the repayments include both payment of interest and partial
redemption of the principal, the loan is called a repayment loan.
We consider two approaches to compute the balance of the loan: the
prospective method and the retrospective method.

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The Prospective Method
Let the loan amount be L, and the rate of interest per payment
period be i.
If the loan is to be paid back in n installments of an
annuity-immediate, the installment amount A is given by
L
A= .
an

Let Bk be the outstanding balance right after the k th installment is

made.
Then we can calculate Bk by equating it with the present value of the
(k + 1)th , ..., nth installments

La n−k
Bk = Aa n−k =
an

This is called the prospective method.

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The Retrospective Method

On the other hand we can equate Bk with the difference of the

accumulated value at time k of the original loan L and the
accumulated values of the 1st , 2nd , ..., k th installments.

Bk = L(1 + i)k − As k .

This is called the retrospective method.

We can show that the two expressions for Bk are equivalent as follows.

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Equivalence

Ls k
L(1 + i)k − As k = L(1 + i)k −
an
L  
= (1 + i)k a n − s k
an
L (1 + i)k (1 − v n ) (1 + i)k − 1
 
= −
an i i
k n
 
L 1 − (1 + i) v
=
an i
n−k
 
L 1−v
=
an i
La n−k
= .
an

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Example
A housing loan of $400,000 was to be repaid over 20 years by monthly
installments of an annuity-immediate at the nominal rate of 5% per year.
After the 24th payment was made, the bank increased the interest rate to
5.5%.
a) If the lender was required to repay the loan within the same period,
how much would be the increase in the monthly installment ?
b) If the installment remained unchanged, how much longer would it
take to pay back the loan?

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Example
A housing loan is to be repaid with a 15-year monthly annuity immediate
of $2,000 at a nominal rate of 6% per year. After 20 payments, the
borrower requests for the installments to be stopped for 12 months.
a) Calculate the revised installment when the borrower starts to pay
back again, so that the loan period remains unchanged.
b) What is the difference in the interest paid due to the temporary
stoppage of installments?

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Example
A man borrows a housing loan of $500,000 from Bank A to be repaid by
monthly installments over 20 years at nominal rate of interest of 4% per
year. After 24 installments Bank B offers the man a loan at rate of interest
of 3.5% to be repaid over the same period. However, if the man wants to
re-finance the loan he has to pay Bank A a penalty equal to 1.5% of the
outstanding balance. If there are no other re-financing costs, should the
man re-finance the loan?

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 Loan Amortization

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Amortization

If a loan is repaid by the amortization method, each installment is

first used to offset the interest incurred since the last payment.
The remaining part of the installment is then used to reduce the
principal.
Consider a loan to be repaid by a n-payment unit annuity-immediate.
The principal is a n .
The interest incurred in the first payment period is

i an = 1 − v n .

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Amortization

Thus, out of the $1 payment, 1 − v n goes to paying the interest and

v n goes to reduce the principal.
The principal after the first installment is then reduced to
1 − vn
an − v n = − vn
i
1 − (1 + i)v n
=
i
1−v n−1
= = a n−1 .
i
By induction, we can show that the outstanding balance after the k th
installment is a n−k .

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Amortization Table

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Example
Construct an amortization schedule of a loan of $5,000 to be repaid over 6
years with a 6-payment annuity-immediate at effective rate of interest of
6% per year.

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Example
The following shows an amortization schedule for a loan which calls for
level semi-annual payments over 2 years. Fill in the missing values in the
amortization schedule and calculate the effective rate of interest.

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 Bond Analysis

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Basic Concepts

A bond is a contract/certificate of debt for which the issuer promises

to pay the holder a sequence of interest payments over a specified
period of time, and to repay the principal at a specified terminal date
(called the maturity or redemption date).
Many entities issue bonds. For e.g. national/provincial governments,
large corporations ...
Governments issue bonds to fund public programs, infrastructure
projects or general government expenditures.
Corporations issue bonds for expansion, acquisitions, investments, etc.

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Basic Features of Bonds

Face Value: Face value, denoted by F , also known as par or principal

value, is the amount printed on the bond.
Redemption Value: A bond’s redemption value or maturity value,
denoted by C , is the amount that the issuer promises to pay on the
redemption date. In most cases the redemption value is the same as
the face value.
Time to Maturity: Time to Maturity refers to the length of time
before the redemption value is repaid to the investor.
Coupon Rate: The coupon rate, denoted by r , is the rate at which the
bond pays interest on its face value at regular time intervals until the
redemption date.

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Diagram of a coupon-paying bond

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Basic Bond Price Formula

Proposition
Assume that the term structure is flat, so that cash flows at all times are
discounted at the same yield rate i. Thus, the fair price P of the bond is
given by
P = (Fr )a n + Cv n ,
where the discount factor v and the annuity function a n are calculated at
the yield rate i.

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Example
The following shows the results of a government bond auction:

Type of Bond Government bond

Issue Date February 15, 2010
Maturity Date February 15, 2040
Coupon Rate 4.500% payable semiannually
Yield Rate 4.530% convertible semiannually

Assume that the redemption value of the bond is the same as the face
value, which is $100. Find the price of the bond.

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Example
The following shows the information of a government bond traded in the
secondary market:

Type of Bond Government bond

Issue Date June 15, 2005
Date of Purchase June 15, 2009
Maturity Date June 15, 2020
Coupon Rate 4.2% payable semiannually
Yield Rate 4.0% convertible semiannually

Assume that the redemption value of the bond is the same as the face
value, which is $100. Find the purchase price of the bond immediately
after its 8th coupon payment on June 15, 2009.

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Example
Find the coupon rate of a 5-year $100 par semi-annual coupon bond
redeemable at par, yielding 5.7% convertible semi-annually, if its price is
the same as that of a zero-coupon bond with face value $100 maturing in
5 years and yielding 3.5% compounded annually.

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Makeham’s Formula

Proposition
Let K = Cv n be the present value of the redemption payment and
g = Fr /C be the modified coupon rate. Then the fair price P of the bond
is given by
g
P = K + (C − K ).
i

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Usually the face value F and the redemption value C are the same.
Thus, the modified coupon rate is the same as the coupon rate.
It should be noted that g is the coupon interest per unit amount of
the redemption value, while r is the coupon interest per unit amount
of the face value.
If g = i then
g
P=K+ (C − K ) = K + (C − K ) = C .
i
If g > i then
g
P=K+ (C − K ) > K + (C − K ) = C .
i
If g < i then
g
P=K+ (C − K ) < K + (C − K ) = C .
i

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 Bond Amortization Schedule

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The Discount/Premium Formula

Proposition
Let P be the fair price of an n-period coupon-paying bond whose face
value is F , redemption value is C , coupon and yield rates are r and i
respectively. The bond premium/discount is defined as P − C and is given
by
P − C = (Fr − Ci)a n = C (g − i)a n ,
where g = Fr /C is the modified coupon rate.

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Bond Premium/Discount

If the selling price of a bond P is larger than its redemption value C ,

the bond is said to be traded at a premium of value

P − C = C (g − i)a n .

On the other hand, if the selling price P is less than its redemption
value C , the bond is said to be traded at a discount of amount

C − P = C (i − g )a n .

Therefore,
Traded Amount Condition
Premium P − C = C (g − i)a n g >i
Par P −C =0 g =i
Discount C − P = C (i − g )a n i >g

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In the bond premium situation the bondholder pays more than the
redemption value.
The premium represents an amount that the investor will not receive
at maturity.
This paid-in-advance premium (which is an asset for the bondholder)
will be refunded (amortized) periodically from the coupon payments
over the life of the bond.

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Example: Bond Premium

Consider a $1,000 face value (same as the redemption value) 3-year

bond with semi-annual coupons at the rate of 5% per annum.
The current required rate of return for the bond is 4% convertible
semi-annually.
The price of the bond is

P = Fr a n + Cv n
1 − 1.02−6
= (1000 × 0.025) × + 1000 × 1.02−6
0.04
= 1028.01.

Therefore, the bond is traded at a premium of $28.01.

The amortization schedule of the bond premium is as follows.

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A bond premium amortization schedule

Half Coupon Effective Amortized amount Book

year payment interest earned of premium value
0 1028.0072
1 25 20.5601 4.4399 1023.5673
2 25 20.4713 4.5287 1019.0386
3 25 20.3808 4.6192 1014.4194
4 25 20.2884 4.7116 1009.7078
5 25 20.1942 4.8058 1004.9020
6 25 20.0980 4.9020 1000.0000
Total 150 121.9928 28.0072

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Formulas for a general bond amortization schedule

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Example
Fill in the missing values of the following bond amortization schedule for a
$100 par value 2-year bond with semi-annual coupons:

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Homework

Textbook questions:
Chapter 5: 2,3,4,7,8,12,14,17,22,23,37,54,55,60.
Chapter 6: 4,5,6,9,10,11,12,14,18,23,29.

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