CHAPTER 8

BOND VALUATION AND RISK

All Rights Reserved Dr David P Echevarria 1

 BOND VALUATION
The value of any debt claim is equal to the
sum of the discounted future cash flows. The
discount [interest] for future cash flows is a
function of the level of riskiness for a
particular bond and is termed the Yield to
Maturity (YTM).
Bond valuation model;
1. Vb = Coupon * PVIFA + Face Value * PVIF

All Rights Reserved Dr David P Echevarria 2

 BOND VALUATION
A. Valuation of Bonds with Annual, Semi-annual, or
quarterly Payments
1. Two cash streams are expect for each bond
a. Coupons
b. Face or maturity value
2. Coupons valued like an annuity
3. Face Value a single discounted future cash flow
B. Methods for computing Bond Market Values
1. Bond Tables
2. Financial Calculators (preferred)

All Rights Reserved Dr David P Echevarria 3

USING FINANCIAL CALCULATORS
TO COMPUTE BOND VALUES
A bond pays a coupon of $120 per year, paid semi-annually.
The bond matures in 20 years and has a face value of
$1,000. If the current YTM rates are 9 percent, how much
should this bond sell for?
1. ENTER 20 [2nd] [N], [N]: Display: N = 40.00
2. ENTER 9 [I/Y]: Display: I/Y = 9.00
3. ENTER 60 [PMT]: Display: PMT = 60.00
4. ENTER 1000 [FV]: Display: FV = 1,000.00
5. PRESS [CPT] [PV]: Display: PV = -1,276.02
USING FINANCIAL CALCULATORS
TO COMPUTE BOND VALUES
A. What If Examples
1. Suppose the YTM is 11 percent; "I/Y" = 11.
Enter 11, press [I/Y], then [CPT] , then [PV];
-1,080.23.
2. If the YTM is 12%; enter 12, press [I/Y], then
[CPT], [PV]; PV = 1,000.00 or $1,000.00.
3. If the YTM is 15%, the price [PV] is $811.08.
 Note as YTM increases, VB decreases
 Yield to First Call
A. Callable Bonds Pay Premiums
1. The premium results in a Yield-to-First-Call
different from the Coupon Rate.
2. Calling a 30-year bond 5% coupon bond four
years after issuance @ 107.50.
3. N = 4
4. PV = -1000
5. PMT = 50
6. FV = 1075.00
7. CPT I/Y = 6.70%
Dr. David P. Echevarria All Rights Reserved Slide 6
 BOND VALUATION
C. Impact of Interest Rate Movements on Bond Prices
1. Bond Prices move in the Opposite Direction to Interest
Rates.
2. Bonds will sell at discounts or premiums or equal to Face
values
3. Interest Rates move in the Same Direction as Inflationary
Expectations
4. Interest Rates move in the Same Direction as Perceived
Riskiness

All Rights Reserved Dr David P Echevarria 7

 BOND VALUATION
D. Factors Affecting Bond Price Interest Rate
Sensitivity
1. The time remaining to maturity; direct relationship
2. The size of the coupon payments
3. The frequency of coupon payments; i.e., annual, Semi-,
quarterly, monthly

All Rights Reserved Dr David P Echevarria 8

 BOND VALUATION
F. Determination of Bond Yields
1. Yield to Maturity (YTM)
2. Current Yield
3. Tax treatment of gains and loses
a. Premiums
b. Discounts
G. Using Expectations to Manage Total Returns on
Bond Portfolios
1. If you know were interest rates are going you know
where bond prices are going
2. Riding the yield curve or betting on the movement of
interest rates

All Rights Reserved Dr David P Echevarria 9

 Duration
A. Measuring Sensitivity to Interest Rate Movements:
Duration
1. As duration increases, the greater the sensitivity
to interest rate fluctuations
2. Sensitivity is also a function of coupon rates
a. The larger the coupon rate, the shorter the duration
b. Zero coupon bonds: duration = maturity
3. Importance of determining the investment
horizon
4. Key strategy for immunizing the yield on a bond
portfolio

All Rights Reserved Dr David P Echevarria 10

 BOND PORTFOLIO MANAGEMENT
B. Use of Duration as an Immunization Strategy
"A portfolio of bonds is immunized from interest
rate risk if the duration of the portfolio equals the
desired investment horizon" Fisher and Weil
1. Requires a known investment horizon; when do you need
the cash?
2. Involves periodic adjustment in portfolio composition;
see #3 below
3. Increase in YTM after the position is set results in a
decrease in duration and vice-versa (Reinvestment of
cash flows at higher rates than original YTM)
4. Duration affected by calls, serial redemptions, and
sinking fund provisions

All Rights Reserved Dr David P Echevarria 11

 Managing Bond Risk: Duration
YTM = 10.00% YTM = 4.00%
Par Value $ 1,000.00 Par Value $ 1,000.00
Price ($1,000.00) Price ($1,000.00)
Coupon 10.00% Coupon 4.00%

t CP PV(CP) t PV(CP) t CP PV(CP) t PV(CP)

1 $100.00 $ 90.91 $ 90.91 1 $40.00 $ 38.46 $ 38.46
2 $100.00 $ 82.64 $ 165.29 2 $40.00 $ 36.98 $ 73.96
3 $100.00 $ 75.13 $ 225.39 3 $40.00 $ 35.56 $ 106.68
4 $100.00 $ 68.30 $ 273.21 4 $40.00 $ 34.19 $ 136.77
5 $100.00 $ 62.09 $ 310.46 5 $40.00 $ 32.88 $ 164.39
6 $100.00 $ 56.45 $ 338.68 6 $40.00 $ 31.61 $ 189.68
7 $100.00 $ 51.32 $ 359.21 7 $40.00 $ 30.40 $ 212.78
8 $100.00 $ 46.65 $ 373.21 8 $40.00 $ 29.23 $ 233.82
9 $100.00 $ 42.41 $ 381.69 9 $40.00 $ 28.10 $ 252.93
10 $1,100.00 $ 424.10 $ 4,240.98 10 $1,040.00 $ 702.59 $ 7,025.87
$ 1,000.00 $ 6,759.02 $ 1,000.00 $ 8,435.33
Dur = 6.7590238 Dur = 8.43533161

All Rights Reserved Dr David P Echevarria 12

 Duration for a Zero Coupon
Bond
YTM = 10.00%
Par Value $ 1,000.00 Effects of Coupon Rates on
Price ($385.54) Duration:
Coupon 0.00%
As coupon rates increase,
t CP PV(CP) t PV(CP) duration decreases and vice-
1 $0.00 $ - $ -
2 $0.00 $ - $ -
versa.
3 $0.00 $ - $ - As YTM decrease, duration
4 $0.00 $ - $ - increases and vice versa.
5 $0.00 $ - $ -
6 $0.00 $ - $ - The duration for a zero-
7 $0.00 $ - $ - coupon bond is equal to its
8 $0.00 $ - $ -
9 $0.00 $ - $ -
maturity.
10 $1,000.00 $ 385.54 $ 3,855.43
$ 385.54 $ 3,855.43
Dur = 10

All Rights Reserved Dr David P Echevarria 13

 BOND PORTFOLIO MANAGEMENT

B. Use of Derivative Securities as Hedges

1. Interest rate futures, as well as options on futures
2. May also involve currency hedges
3. SWAP agreements may also be used

All Rights Reserved Dr David P Echevarria 14

 Interest Rates, Economic Activity
and Long Term Cycles

All Rights Reserved Dr David P Echevarria 15

 The Kondratieff Cycle
Where is the US (and Everyone one else)
Headed?

All Rights Reserved Dr David P Echevarria 16

All Rights Reserved Dr David P Echevarria 17
 CHAPEL HILL, N.C. (MarketWatch) — There are eerie parallels
between the stock market’s recent behavior and how it behaved right
before the 1929 crash.

All Rights Reserved Dr David P Echevarria 18

 HOMEWORK QUESTIONS
A. What 2 cash flows are associated with bond investments?
B. What effects do interest rate increases (decreases) have on;
1. Market values of bonds?
2. Current yields?
3. Yields to maturity?
C. What does it mean when a bond sells at par, at a discount, at
a premium?
D. What information is necessary in order to make good bond
investments?

All Rights Reserved Dr David P Echevarria 19