Bonds

• Debt Certificates
• Price (P)
– Redemption value (C)
– Coupon (c)
– Number of coupon payments (n)
– Yield rate (i reflected in the Price)

Bonds and Yield Curve

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 Bond issuer
• Government Bonds
– Federal Government
• US Treasury
– Treasury Bills (less than 1Y)
– Treasury Notes (1Y to 7Y)
– Treasury Bonds (more than 7Y)
• Mexican Government
– CETES (up to 1Y). Since 1978
– Bonos (from 3Y up to 30Y). Since 2000
– Regional Government
• Corporate Bonds

Bonds and Yield Curve

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 Credit Risk
– Different Risk Levels
• Default Risk
• Rating agencies
– Moody’s
– Standard & Poor’s
– Fitch
• Ratings
– Obtained from public information regarding the issuer of the Bond
– Different rating agencies may disagree on a particular rating
– Ratings change over time

Bonds and Yield Curve

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 Bond ratings

Probabilidad de quiebra

Bonds and Yield Curve

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 Bond ratings

• Class is divided in 4 groups

• Choose a person to write
• Choose a person to present
• Using the internet, look for the
ratings given to the debt of the
following countries:
 Group 1: Mexico and France
 Group 2: USA and Argentina
 Group 3: Germany and China
 Group 4: Brazil and Australia

Bonds and Yield Curve

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 Interest Rate Risk
• Interest Rate (IR) Risk
– At issue date the coupon rate reflects current IRs
– IRs move
• Valuing the bond at a new IR will change its value

• Get in teams
• Build a table that shows the price of a
particular bond for different IRs
 Annual coupons
 Coupon rate is 5%
 Face amount is 100
 Bond matures at par in 3Y
• Show results in a graph
• What happens to the price of the bond as the
IR changes?
Bonds and Yield Curve
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 IR Risk
– IR Risk is greater for bonds that have small fixed coupons

• Get in teams
• Make a copy of previous table
 Annual coupons
 Coupon rate is 45%
 Face amount is 100
 Bond matures at par in 3Y
• Show new results in a graph
• What happens to the price of the bond
when there is a change in the coupon rate?

– Variable Coupons
Bonds and Yield Curve
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 IR Risk
– IR Risk is greater for longer maturity bonds

• Get in teams of 2 or 3
• Make a copy of first table
 Annual coupons
 Coupon rate is 5%
 Face amount is 100
 Bond matures at par in 20Y
• Show new results in graph
• What happens to the price of the
bond when there is a change in
maturity?

Maturity determines price volatility

Bonds and Yield Curve
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 IR Risk
• Every bond is a combination of zero-coupon bonds

• What is the average maturity?

• For a zero coupon bond, duration is the same as maturity

Bonds and Yield Curve

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 IR Risk
• Considering compound interest

Bonds and Yield Curve

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 IR Risk
• Considering continuous IR

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 IR Risk
– Considering any type or IR (i.e. continuous or compound)
• Macaulay Duration

• Modified Duration

Bonds and Yield Curve

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 IR Risk
– For a portfolio of bonds, consider Modified Duration

Bonds and Yield Curve

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 IR Risk
• Get in teams
• Consider the following portfolio of bonds:
Bond PV Duration

1 13m 2
2 27m 7
3 60m 8
4 40m 14

• Find the portfolio's duration

• If the interest rate changes by 50bps, what is the
approximate percentage change in the value of the
portfolio?

Bonds and Yield Curve

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 IR Risk
– Duration and Convexity
• Taylor Series Approximation

Bonds and Yield Curve

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 IR Risk
– Convexity (Macaulay and modified)
• Duration is a linear measure, the first derivative
• Duration is good for small changes in IR
• For big changes in IR, Duration is not a good approximation
• Convexity considers the second derivative of the Price of a Bond,
w.r.t. IR

Bonds and Yield Curve

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 IR Risk
• Effective Duration

• Effective Convexity

Bonds and Yield Curve

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 IR Risk
• Considering compound interest

• Considering continuous interest

where =c for t=1,2,…,n-1 and

Bonds and Yield Curve

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 IR Risk

• Get in teams
• Consider an annual IR of 4.5% and the following bond:
• Annual coupon rate of 3%
• Maturity is 5Y
• Matures at par
• Face value is 100
• Considering compound interest, find:
• Price
• Duration (both Modified and Macaulay)
• Convexity

Bonds and Yield Curve

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 IR Risk
• Minimizing IR Risk
Hedging
– Rudimentary Tools
• Matching Liabilities with Assets
• Eliminate risk by constructing a portfolio such that
duration is zero
– Duration for “long” positions is the same as duration for
“short” positions

Long Bond: I buy a bond

Short Bond: I sell a bond

Bonds and Yield Curve

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 IR Risk
– Immunization
• Build a portfolio:
– PV of Assets is the same as PV of liabilities

– Portfolio´s PV will have a local minimum if:

 Assets' duration is the same as liabilities' duration

 Assets' convexity is greater tan liabilities' convexity

– If portfolio´s PV has a local minimum :
» Small IR changes will increase the value of the portfolio!

Bonds and Yield Curve

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 IR Risk
• Weaknesses
– Only works for small changes in IR
– Requires frequent portfolio rebalancing
» Common within hedging strategies
– Assumes a unique IR
– In some cases it is not easy to determine cash flows
» Mortgage pre-payment

Bonds and Yield Curve

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 IR Risk
– Full Immunization
• Works for greater changes in IR
• Build a portfolio:
– Liability to pay at time is
– Find two assets:
» Cash flow A at time
» Cash flow B at time
– Assume that 2 out of 4 constants are known
– At time

Bonds and Yield Curve

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 Bond Prices
• Clean Price vs. Dirty Price
– Dirty Price

– Clean Price

• Bid Price vs. Ask Price

– Bid-ask spread: reflects liquidity

Bonds and Yield Curve

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 Types of Bonds
• Go to Bb, “Material del Curso”, Bonds
• Go to Readings and read: Bonds Kellison
• Go to the “Types of bonds” wiki and write a
sentence or two in order to define one of the
following bonds:
 Zero coupon bond
 Callable bond
 Puttable bond
 Convertible bond
 Serial Bonds
 STRIPS
• If you are the first to comment on that type of
bond and your comment is accurate, you can get
an extra point!
Bonds and Yield Curve
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 Types of Bonds
• Zero coupon bond
• Serial Bonds
• STRIPS
• Callable Bond
• Puttable Bond
• Convertible Bond
– CoCo Bonds
• Inflation-linked
– Real Rates (r) vs. Nominal Rates (R)

• MBS

Bonds and Yield Curve

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 Term Structure of IR
• Treasury Yield Curve
– Yields on zero-coupon bonds

Bonds and Yield Curve

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 Term Structure of IR

Bonds and Yield Curve

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 Term Structure of IR
• How to price bonds knowing that there is a Term
Structure of IR?
• Get in teams
• Consider the following two Par Bonds with F=100
• Bond 1, annual coupon rate of 5%, maturity is 3Y
• Bond 2, annual coupon rate of 10%, maturity is 5Y
• Assume the following Term Structure of IR:
Maturity IR

1 4%
2 4.25%
3 4.5%
4 4.25%
• For each bond, find: 5 4.2%
• Price
• Duration (both Modified and Macaulay)
• Convexity
Bonds and Yield Curve
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 Term Structure of IR
• Get in teams
• Choose a person to write
• Choose a person to present
• Read the file Term Structure
• As a team, fill the gaps in the notes.
See next slide

Bonds and Yield Curve

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 Theories that explain the shape of the Term
Structure of IR
• Expectations Theories
– Pure Expectation Theory
• According to this theory, _______________________________
• The main flaw of this theory is __________________________
– Liquidity theory
• This theory states that forward rates should reflect __________
– Preferred Habitat theory
• This theory is similar to the previous one, but rejects the
assentation that ______________. This is because __________
• Market Segmentation Theory
– This theory proposes ____________________________
Bonds and Yield Curve
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 Spot Rates
– Yield curves are built based on prices of zero-
coupon bonds
• The annual yield that is assumed in order to get that
particular price is known as spot rate

Bonds and Yield Curve

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 Spot Rates vs. Forward Rates
– From bond prices and spot rates we can derive
s2
forward rates

t0=0 t1 t2 tm-1 tm

f0 f1 fm-1

Bonds and Yield Curve

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