UNIT 2

FIXED INCOME SECURITIES

Dr Suresha B
School of Business and Management

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Unit Outline
● Risks associated with investing in bonds
● Relationship between a bond’s coupon rate, price, par value
and yield required by the market;
● Impact of bond maturity, coupon, embedded options and yield
level on interest rate risk.
● Price of a callable bond, option-free bond and embedded call
option; interest rate risk of a floating rate security;
● Duration and dollar duration of a bond; yield-curve risk;
disadvantages of callable bonds; reinvestment risk; credit risk
and credit ratings; liquidity risk, exchange rate risk.

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Is Bond Investments Risk free?

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RISKS ASSOCIATED WITH INVESTING IN
BONDS
8
 Malkiel’s Bond Pricing Theorems
In 1961, Burton Malkiel published a paper where he proved
five important bond pricing theorems:
1. Bond prices move inversely to interest
rates.
2. Longer maturity bonds respond more
strongly to a given change in interest rates.
3. Price sensitivity increases with maturity at a
decreasing rate.
4. Lower coupon bonds respond more
strongly to a given change in interest rates.
5. Price changes are greater when rates fall
than they are when rates rise (asymmetry in
price changes)
*Note: Malkiel is also the author of “A Random Walk Down Wall Street.”
 Bond Pricing Theorem I
• Bond prices and market interest rates move in
opposite directions.
 Bond Pricing Theorem II
• When coupon rate = YTM, price = par value.

• When coupon rate > YTM, price > par value

(premium bond)

• When coupon rate < YTM, price < par value

(discount bond)
(Note:YTM is markey yield)
 Bond Pricing Theorem III
• A bond with longer maturity has higher relative (%) price change
than one with shorter maturity when interest rate (YTM)
changes. All other features are identical.
 Bond Pricing Theorem IV
• A lower coupon bond has a higher relative (%)
price change than a higher coupon bond when
interest rate (YTM) changes. All other features
are identical.
Coupon Rate and Bond Price Volatility
Bond Value
Consider two otherwise identical bonds.
The low-coupon bond will have much more
volatility with respect to changes in the
discount rate

High Coupon Bond

Discount Rate
Low Coupon Bond
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Option Free Bond v/s Embedded Bond

● An option free bond is a plain vanilla bond with no option embedded.
● With option embedded means that there is call feature that is the
issuer can call back the bond later before maturity or put option bond
the investor can sell before maturity of the bond at a predetermined
price.
● The disadvantage for an investor is that if issuer “call`s” the bond
the investor would have to invest its money again at the lower rate.
● In contrast to callable, puttable bond gives the investor an option to
sell the bond at a pre-specified price.
● If market rates go above coupon rate the investor will have a choice
of selling the bond back to issuer before the maturity date.
● Therefore the investor could have another opportunity to invest at
higher interest rates. If the put option is exercised the disadvantage
for the issuer is that issuer would need to issue a new bond with the
higher interest rate. Excellence and Service
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Price of callable bond

● A callable bond is a type of bond that allows the issuer of the bond
to retain the privilege of redeeming the bond at some point before
the bond reaches its date of maturity.
price of callable bond = price of straight bond – price of call option
● Price of a callable bond is always lower than the price of a
straight bond because the call option adds value to an issuer.
● Yield on a callable bond is higher than the yield on a straight bond.

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Duration and Dollar duration of a Bond

● Bond duration is a way of measuring how much
bond prices are likely to change if and when
interest rates move.
● In more technical terms, bond duration is
measurement of interest rate risk. Understanding
bond duration can help investors determine how
bonds fit in to a broader investment portfolio.
● Dollar duration is a bond analysis method that
helps an investor ascertain the sensitivity of bond
prices to interest rates changes.
● The method measures the change in the price of a
bond for every 100 bps (basis points) of change
in interest rates.

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End of Unit 2

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