Bond Valuation

Dr. C. Bulent Aybar

Professor of International Finance
 Valuation Fundamentals
• The (market) value of any investment asset is simply the
present value of expected cash flows.
• The “rate” that these cash flows are discounted at is called
the asset’s required rate of return.
• The required return is a function of the real interest rate,
expected rate of inflation and the perceived risk of the asset.
• Higher perceived risk results in a higher required return and
lower asset value.

© Dr. C. Bulent Aybar

 Default Risk

• When an investment made in a bond, issuer promises to pay

coupon interest in stated frequency and the face value of the
bond at the maturity; in that sense there is no uncertainty
about the magnitude of the bond cash flows
• However, the issuer of the bond may default on interest and
principal payments on the borrowing.
• Generally speaking, borrowers with higher default risk
should pay higher interest rates on their borrowing than
those with lower default risk.

© Dr. C. Bulent Aybar

 Default Risk and Investment Prospects
• In a bond investment, the coupons are fixed at the time of the issue and
these coupons represent the promised cash flow on the bond.
• The best case scenario for the bond investor is that the investor receives
the promised cash flows; the investor is not entitled to more than
promised cash flows regardless how successful the company is. In other
words, there is limited upside in a bond investment!
• All other scenarios contain varying degrees of bad news each
associated with the delivered cash flows being less than the promised
cash flows.
• Consequently, the expected return on bond is likely to reflect the
specific default risk of the entity issuing the bond.

© Dr. C. Bulent Aybar

 Determinants of Default Risk for Firms
• The default risk of a firm is a function of two variables.
– Firm’s capacity to generate cash flows from operations
– Firm’s financial obligations including interest and principal payments
• Firms that generate high cash flows relative to their financial obligations
should have lower default risk than firms generate low cash flows
relative to their financial obligations.
• In addition to relative size of cash flows, default risk is also affected by
the volatility of cash flows.
• Most models of default risk use financial ratios to measure the cash flow
coverage and control for industry effects to evaluate the cash flow
volatility.

© Dr. C. Bulent Aybar

 Bond Ratings
• Most widely used measure of a firm’s default risk is its bond rating
which is assigned by an independent rating agency such as S&P,
Moody’s or Fitch.
• Some key ratios used by rating agencies are:
– Pretax Interest Coverage
– EBITDA Interest Coverage
– Funds from Operations/Total Debt
– Pretax Return on Permanent Capital
– Operating Income/Sales
– Long Term Debt/Capital
– Total Debt/Capitalization

© Dr. C. Bulent Aybar

 Financial Ratios Used to Measure Default Risk

Financial Ratio AAA AA A BBB BB B CCC

EBIT interest cov. (x) 17.5 10.8 6.8 3.9 2.3 1.0 0.2
EBITDA interest cov. 21.8 14.6 9.6 6.1 3.8 2.0 1.4
Funds from Operations/Total debt 105.8 55.8 46.1 30.5 19.2 9.4 5.8
Free Cash Flows /Total Debt (%) 55.4 24.6 15.6 6.6 1.9 -4.5 -14.0
Return on Capital (%) 28.2 22.9 19.9 14.0 11.7 7.2 0.5
Oper.Income/Sales (%) 29.2 21.3 18.3 15.3 15.4 11.2 13.6
Long-term Debt/Capital (%) 15.2 26.4 32.5 41.0 55.8 70.7 80.3
Total Debt/ Capital (%) 26.9 35.6 40.1 47.4 61.3 74.6 89.4
Number of firms 10 34 150 234 276 240 23
• As the table in the previous slide clearly shows, firms that
generate income and cash flows significantly higher than
debt payments that are profitable and that have low debt
ratios are more likely to be highly rated.
• While ratios are critical in evaluating default risk, rating
agencies also incorporate qualitative measures and
subjective judgments into the final mix. On occasion such
factors lead to ratings that are not consistent with the
financial ratios.

© Dr. C. Bulent Aybar

 Interest Rates (discount rates) and Yield (Default) Spread

• The interest rate on a corporate bond should be a function of

its default risk, which is measured by its rating.
• If the rating is a good measure of the default risk, higher
rated bonds should be priced to yield lower interest rates
than would lower rated bonds.
• The difference between the interest rate on a bond wit
default risk and a default-free government bond is referred to
as default spread.
• Default spread vary by maturity of the bond and can also
change from period to period, depending on economic
conditions.
© Dr. C. Bulent Aybar
Yield Spreads by Industry and Rating Class
 Generic Valuation Model

CF1 CF2 CF3 CFN

V0     ........ 
(1  r1 ) (1  r2 ) (1  r3 ) (1  rN )

• V0= Value of the asset at time zero

• CFt= Cash flow expected at the end of the year t
• r= required rate of return (discount rate
• N= maturity

V0  [CF1  PVIFAr ,1 ]  [CF2  PVIFAr ,2 ]  ...  [CFN  PVIFAr , N ]

 Bond Valuation: Bond Fundamentals
• Bonds are long-term debt instruments used by businesses
and government to raise large sums of money, typically from
a diverse group of lenders.
• Most bonds pay interest semiannually at a stated coupon
interest rate, have an initial maturity of 10 to 30 years, and
have a par value of $1,000 that must be repaid at maturity.

© Dr. C. Bulent Aybar

 Inputs for Bond Valuation

• We need the following parameters to value a bond:

– Coupon Interest Rate (expressed as a percentage)
– Par Value (amount stated in dollars, usually $1,000)
– Frequency of Coupon Payments (Annual, Semi-annual etc)
– Maturity Date or Time to Maturity
– Required Rate of Return (or Yield to Maturity)

© Dr. C. Bulent Aybar

 Simple Example

• Mills Company, on January 1st, 2007, issued a 10% coupon

interest rate, 10-year bond with a $1,000 par value that pays
interest annually. Assuming 7% interest rate (=required rate
of return) , calculate the Bond value at the issue date.
• Inputs:
– Coupon Interest=10%
– Par Value=$1,000
– Time to Maturity= 10yrs
– Frequency of Coupon Payments: Annual
– Required Rate of Return =7%

© Dr. C. Bulent Aybar

 Cash Flows: 10 Year 10% Coupon Bond
$100 $100 $100 $100 $100+1,000

$100 $100 $100 $100 $100

The value of the bond is equal to the present value of all the
cash flows discounted at the required rate of return:

100 100 100 100 100 1, 000

B0     .......   
(1  0.07) (1  0.07) 2 (1  0.07) 3 (1  0.07) 9 (1  0.07)10 (1  0.07)10
 PV of Bond Cash Flows
• We can treat Coupon Interest payments as ordinary annuities. There are 10
equal payments during the life of the bond. Present value of the coupon
payments can be calculated with PVA formula.
 10 
 ( 1  0.07 ) 1 
PVA  100
0  10   702.36
(
 0.07 1 0.07
 ) 
 

• The last payment also includes the par value of the bond. We should add
the present value of the Par Value to the present value of coupon payments.

 
 1,000   508.35
PV   
( 1  0.07 )
10
 
• By combining these two components we get: P=702.36 +508.35=1,210.71

© Dr. C. Bulent Aybar

 Bond Valuation: Generalization

 (1  r ) N  1   1 
B0  I   N 
 M  N 
 r  (1  r )   (1  r ) 

• B0=Bond Value at time 0

• I = Annual Interest Paid in Dollars or Coupon Interest
(=Coupon Interest Rate x Par Value)
• r= required rate of return
• N=Number of years to Maturity
• M=Par value of the bond
 Bond Valuation Model
Since bonds typically pay a stream of coupons until maturity and the face value of the
bond at the maturity, we can value a bond as a package of an annuity, and a single
payment (the repayment of the face value).

N 1   1 
B0  I    t 
 M  N 
 t 1 (1  r )   (1  r ) 
 (1  r ) N  1   1 
B0  I   N 
 M   (1  r ) N 
 r  (1  r )   
B0  I  ( PVIFAr , N )  M  ( PVIFr , N )

• B0=Bond Value at time 0

• I = Annual Interest Paid in Dollars or Coupon Interest (Coupon Interest
Rate x Par Value)
• r= required rate of return
• N=Number of years to Maturity
• M=Par value of the bond
Bond Valuation with Financial Calculator and Excel

10

7
-100
-1,000

1,210.71

Use Excel Function PV with the following arguments:

@PV(rate, # periods, -payment, -FV, Type)
@PV(7% ,10, -100, -1000, 0) =1210.71
 20 Year Maturity 10% Coupon Bond

• 20 Year Maturity 10% Coupon Bond with par value of

$1,000 makes annual payments. If an investor targets 6%
return and intends to hold the bond to maturity, what should
be the price investor should pay for this bond?

 N  20 1   1 
B0  100    t 
 1, 000   20 
 1, 458.80
 t 1 (1  0.06 )   (1  0.06 ) 

© Dr. C. Bulent Aybar

 Bond Investment Problem

• Assume that you have 1 year investment horizon and trying

to choose among three bonds. All have the same degree of
default risk and mature in 10 years.
– The first is a zero coupon bond that pays $1,000 at maturity.
– The second is has an 8% coupon rate and pays the $80 coupon once
per year.
– The third is a 10% coupon rate and pays the $100 coupon once a
year
• If all bonds priced to yield 8% to maturity what are their
prices
a) at the time of purchase t=0
b) at the beginning of year t=1
© Dr. C. Bulent Aybar
 Bond Prices @ 8% YTM at the Purchase

• Zero Coupon Bond:

 1, 000 
B0   10 
 463.19
 (1  0.08 ) 

• 8% Coupon Bond:

 N 10 1   1 
B0  80    t 
 1, 000   10 
 1, 000
 t 1 (1  0.08 )   (1  0.08 ) 

• 10% Coupon Bond:

 N 10 1   1 
B0  100    t 
 1, 000   10 
 $1,134.20
 t 1 (1  0.08 )   (1  0.08 ) 
© Dr. C. Bulent Aybar
 Bond Prices @ 8% YTM at the beginning of the next year

• Zero Coupon Bond:

 1, 000 
B0   9
 500.25
 (1  0.08 ) 

• 8% Coupon Bond:

 N 9 1   1 
B0  80    t 
 1, 000   9
 1, 000
 t 1 (1  0.08 )   (1  0.08 ) 

• 10% Coupon Bond:

 N 9 1   1 
B0  100    t 
 1, 000   9
 $1,124.94
 t 1 (1  0.08 )   (1  0.08 ) 
© Dr. C. Bulent Aybar
 What is the holding period return?
• Assuming that bonds are sold at the prices calculated in the previous slide, what
would be the pre-tax and after tax return for each bond. Assume 30% ordinary
income tax and 20% capital gains tax:
– Zero Coupon
• (500.24/463.20)-1=8% after tax  0.08 x (1-0.3)=5.6%
– 8% Coupon Bond:
• 80/1,000=8% after tax  0.08 x (1-0.3)=5.6%
– 10% Coupon
• Capital Gains/Loss=(1,124.94-1,134.20)=-9.26
• Tax Credit on loss=9.26 x 0.2=1.852
• Interest Income=$100 Ordinary income tax =100 x 0.3=30
• Net Taxes =28.14  Net Income=100-9.20-28.14=62.59
• After Tax Return=62.59/1,134.20=5.52%

© Dr. C. Bulent Aybar

 Example: Yield to Maturity

Consider a bond with 10 year maturity. Bond is traded at

$932.90 and pays annual coupon rate of 7%. What is the
bond’s YTM?
N=10, Coupon = 7% Price = $950

70
10
1,000
932.90=  + 10
(1+r)
t
(1+r)
t=1

Solve for r = 8%  YTM=8%.

 Example: Yield to Maturity/Semiannual Coupon

Consider a bond with 10 year maturity. Bond is traded at

$950 and pays 7% semiannually. What is the bond’s
YTM?
N=10, Coupon = 7% Price = $950

35 1000
20

950=  + T

(1+r) (1+r)
t
t=1

Solve for r = 3.8635%. Note that r is semiannual yield.

• The yields on these two bonds are not directly comparable.
The 8% yield is an annual yield, 3.8635% is a semi-annual
yield.
• In the bond markets there is one “yield measure” that is
reported to allow comparisons across bonds regardless their
compounding frequency. This measure is called “Bond
Equivalent Yield”.
• Bond Equivalent Yield is the yield the bond would offer as if
it were compounded semiannually regardless its actual
compounding frequency.

© Dr. C. Bulent Aybar

 Bond Equivalent Yield

m 2
 r  b
1    1  
 m  2

r/m in the left hand side is the periodic yield to maturity. b

on the left hand side is the “Bond Equivalent Yield” that
allows apples to apples comparisons among bonds.
 Example: Bond Equivalent Yield
In the previous two examples The 7% bond paying annual coupon
had 8% YTM and the bond paying semiannual coupon had 3.8635%
YTM. The bond equivalent yields for these bonds are:

2
 b
1  0.08  1    b  7.85%
 2
2
 b
1  0.038635
2
 1    b  7.727%
 2
 Two Yield Measures
• Bond Equivalent Yield
– 3.86% x 2 = 7.72%
– Note that this annualized yield is only comparable to bonds that pay
semi-annual coupon
• Effective Annual Yield
– (1.0386)2 - 1 = 7.88%
– Note that this yield is comparable to bonds that pay annual coupon
interest.

© Dr. C. Bulent Aybar

 Bond with Semi-annual Coupon Payments

Mills Company, on January 1st, 2007, issued a 10% coupon interest

rate, 10-year bond with a $1,000 par value that pays interest
semiannually. Assuming 7% bond equivalent yield , calculate the
Bond value!
 Bond with Semi-annual interest payments
• In this case, interest payments will be received in every six months.
Since the annual coupon rate is 10%, the semiannual interest will be half
of this.
• Since there are two payments annually per period interest will be :
• (Par Value x Coupon Interest)/2 or (1,000 x 0.1)/2=50
• There will be 10 x 2 =20 cash flows each $50 until the maturity plus the
par value of the bond which will be received at the end of the 20 th period.
• Note that we will calculate the PV of these 20 payments that will be
received in every 6 months over a 10 year period.
• This implies that we adjust the bond equivalent yield to match the
frequency of payments. The discount factor should be :
r/2=0.07/2=0.035

© Dr. C. Bulent Aybar

 Bond Value with Semi-annual Interest Payments

(100 / 2) (100 / 2) (100 / 2) (100 / 2) 1, 000

B0    .......   
(1  (0.07 / 2)) (1  (0.07 / 2)) 2
(1  (0.07 / 2))19
(1  (0.07 / 2)) 20
(1  (0.07 / 2)) 20
B0  1, 213.19

 (1  r / 2) Nx 2  1   1 
B0  ( I / 2)   Nx 2 
 M   (1  r / 2) Nx 2 
 ( r / 2)  (1  r / 2)   

 (1  0.07 / 2)10 x 2  1   1 
B0  (100 / 2)   10 x 2 
 1, 000   10 x 2 
 1, 213.18
 (0.07 / 2)  (1  0.07 / 2)   (1  0.07 / 2) 
Bond Price with Compounding Frequency k

   
I  N k 1   1 
B0      M  
r
k  t 1 (1  )t  r
 (1  ) N k 
 k   k 
 Example: Quarterly Compounding

ABC Company, on January 1st, 2010, issued a 10% coupon interest

rate, 10-year bond with a $1,000 par value that pays interest quarterly.
Assuming 7% bond equivalent yield , calculate the Bond value!
 Calculating required return from BEY

4 2
 r   0.07 
1    1    r  0.0694
 4  2 

   
100  104
1   1 
B0      1, 000     1, 219.33
4  t 1 (1  0.0694 0.0694
)t   (1  )10 
 4   4 
 Valuing a US Government with Bond-Semiannual Interest

• In July 2006 you purchase a 3 year US Government bond. The bond has
an annual coupon rate of 4%, paid semi-annually. If investors demand a
4.96% pa return, what is the price of the bond?

20 20 20 20 20 1020
PV      
1.0248 1.02482 1.02483 1.02484 1.02485 1.02486

 $973.54
 Bond Values and Required Return: Discount , Par and Premium

ABC Bond has 10% Coupon Interest Rate, 10-Year to Maturity, $1,000 Par
Value and pays annual interest)

As you see in the table, when coupon and required return are equal, bond
Value is equal to its par value (or face value). If the required return is higher
than the coupon , bond is at a discount. If the required return is lower than the
coupon rate, the bond is at a premium.
Discount, Par and Premium Bonds

Premium Bond

Par Bond

Discount Bond
Interest Rate Decline - Premium and Discount Bond Values
PREMIUM BOND
Coupon 10% 10% 10% 10%
Yield 8% 6% 5% 4%
TTM 5 5 5 5
Par Value 1000 1000 1000 1000
Bond Value/Price $1,079.85 $1,168.49 $1,216.47 $1,267.11
% Change 8.21% 4.11% 4.16%
$ Change $88.64 $47.98 $50.64
DISCOUNT BOND
Coupon 2% 2% 2% 2%
Yield 8% 6% 5% 4%
TTM 5 5 5 5
FV 1000 1000 1000 1000
Bond Value $760.44 $831.51 $870.12 $910.96
% Change 9.35% 4.64% 4.69%
$ Change $71.07 $38.61 $40.85
 Premium and Discount Bond Responses to Interest Rate Change

Bond Price at Bond Price at Change in Bond Change as % of

10% YTM 5% YTM Price Value

10 Year 12% Coupon Bond 1,122.89 1,540.52 417.63 37%

15 Year 8% Coupon Bond 847.88 1,311.39 463.51 55%

Bond Price at Bond Price Change in Change as

10% YTM at 15% YTM Bond Price % of Value

10 Year 12% Coupon Bond 1,122.89 849.44 (273.45) -24%

15 Year 8% Coupon Bond 847.88 590.68 (257.19) -30%

 Yield to Maturity (YTM)
• Note that the yield to maturity and the coupon rate will be
equal only if the bond is selling at par (for its face value).
• For premium bonds, the current yield > YTM.
– 100/1134.2 =0.08816 > YTM=8%
– Coupon Interest>Current Yield>YTM
• For discount bonds, the current yield < YTM.
– 100/887=0.11274 <YTM=12%
– Coupon Interest <Current Yield<YTM

© Dr. C. Bulent Aybar

 Yield to Maturity (YTM)

• The Mills Company bond, which currently sells for $1,080,

has a 10% coupon interest rate and $1,000 par value, pays
interest annually, and has 10 years to maturity. What is the
bond’s YTM?

© Dr. C. Bulent Aybar

 Calculator and Excel Solutions

100 100 100 100 100 1, 000

1, 080     .......   
(1  r ) (1  r ) 2 (1  r )3 (1  r ) 9 (1  r )10 (1  r )10

Can we solve for r ? No simple solution! Use trial and error!

We know that r <10 (?), we can use two arbitrary numbers one
close to 10% and one from 10% eg 9 and 8% . We can
extrapolate the r

Use calculator: Plug -PMT, N, -FV, PV and solve it for I

Use Excel function @Yield (Settlement day, Maturity, Coupon

Interest, Price, Face Value, Frequency)
@YIELD Function
Goal Seek Solution
Goal Seek Solution
 Sweat & Tears Solution

• $1,080 = $100 x (PVIFAr,10yrs) + $1,000 x (PVIFr,10yrs)

• We need to solve this for r

1,080=100/(1+r) +100/(1+r)2+ 100/(1+r)3+……….+(1,000+100)/(1+r)10

• Choose two rates that would result in values above and below 1,080. For
instance if we take 9% and 8%.
• 1,063.80=100/(1+0.09) +100/(1+0.09)2+ +……….+(1,000+100)/(1+0.09)10
• 1,134.00=100/(1+0.08) +100/(1+0.08)2+ +……….+(1,000+100)/(1+0.08)10
• We can extrapolate the rate corresponding to 1,080.

© Dr. C. Bulent Aybar

 Extrapolation of the Yield

• (1,134-1,063.80)/(8-9)=(1,080-1,063.80)/(X-9)
• Solve the equation for X
• (X-9) *(- 70.2)=16.2
• -70.2X=-615.6
• X=(615.6/70.2)=8.77 or 8.77%

© Dr. C. Bulent Aybar

 Current Yield, Capital Gains Yield and YTM
• Current Yield is the coupon payment as a percentage of the bond’s
current value.
• Current Yield=Coupon/Bond Price
• The yield to maturity measures the compound annual return to an
investor and considers all bond cash flows. It is essentially the rate that
equates the present value of the bond’s cash flows to bond’s price. This
is also referred as bond’s IRR based on the current price.
• Capital gains yield, is the return attributed to bond based on the
expected price in one year. A premium bond has a negative capital gains
yield as future expected price should be lower than current price.

© Dr. C. Bulent Aybar

 YTM, Capital Gains Yield and Current Yield
YTM=Current Yield + Capital Gains Yield
For Premium Bonds : YTM ≤ Current Yield ≤ Coupon
For Discount Bonds : Coupon Rate ≤Current Yield ≤ YTM

Par bond Premium Discount

Par 1,000 1,000 1,000
Maturity 10 10 10
Coup rate 10% 11% 9%
YTM 10.00% 10.00% 10.00%
Ann coup $100.00 $110.00 $90.00
Price $1,000.00 $1,061.45 $938.55
Cur Yield 10.00% 10.36% 9.59%
Cap gain 0.00% -0.36% 0.41%

Par Bond  YTM=Current Yield=10%

Premium Bond  YTM=Current Yield+Capital Gains Yield=10.36%-0.36%=10%
Discount Bond  YTM=Current Yield+Capital Gains Yield=9.59%+0.41%=10%
© Dr. C. Bulent Aybar
 Interest Rate Sensitivity of Bonds

• The sensitivity of the bond price to changes in interest rates

depends on:
– length of time to maturity
– coupon interest
– YTM

© Dr. C. Bulent Aybar

• The longer the term to maturity, the greater is a bond’s
volatility
• The amount of coupon interest also impacts a bond’s price
volatility. Specifically, the lower the coupon, the greater
will be the bond’s volatility, because it will be longer before
the investor receives a significant portion of the cash flow
from his or her investment.
• The bond price is less sensitive to changes in interest rates
when the YTM is low. The sensitivity increases with the
YTM.

© Dr. C. Bulent Aybar

 Duration: A Measure of Bond Price Volatility

• Duration combines the length of time to maturity and bond

cash flows and measures the sensitivity of bond value to
changes in the interest rates.
• The higher the duration of a bond, higher the sensitivity of
the bond value to the interest rate changes.

© Dr. C. Bulent Aybar

• Duration is defined as the weighted average of the times
until each payment is received, with the weights proportional
to the present value of the payment.
CFn
N N
(1  r ) n
D   n  wn   n 
n 1 n 1 B0
• Duration is shorter than maturity for all bonds except zero
coupon bonds
• Duration is equal to maturity for zero coupon bonds

© Dr. C. Bulent Aybar

 Duration as a Slope

Bond Price vs Bond Yield

1700.00

1500.00

1300.00

1100.00

900.00

700.00

500.00
0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1

Duration is essentially the slope of the bond price-yield curve at any

given interest rate.
Calculating the Duration of Two Bonds
 Duration/Price Relationship

• While duration measures the effective maturity of a bond it also captures

the sensitivity of bond price to changes in the required return or bond
yield.
• Price change is proportional to duration:

P   (1  r ) 
 D 
P  1  r 
• A more commonly used measure is “Modified Duration which is:
D* = modified duration=D/(1+r)
• With Modified Duration Bond Price –Bond Yield Relationship can
written as:
P
  D * r
P
© Dr. C. Bulent Aybar
 Example
• ABC Inc. has an outstanding bond with 10% coupon and 10 years to
maturity. The YTM of ABC Inc. bonds is 6%. The bond has McCauley
duration of 7.16 and the current price of the bond is $1294.40 .
Calculate the change in the bond price if the required rate of return on
ABC bonds go up to 8%.
• Solution:
• Since we have the MC Duration, we can easily calculate the change in
the value of bond by using bond price duration relationship which is
given as:
P   (1  r ) 
 D 
P  1  r 
• Modified Duration=-7.16 /(1+0.06) =-6.754
• Change in Bond Price= -(MD) x (Change in Yield) x Bond Price
• =-6.754 x (0.02) x 1294.40=$174.87
© Dr. C. Bulent Aybar
 Duration Approximation to Bond Price Change

Actual Change in Bond

Actual Change in Price/Duration
Bond Price vs Bond Yield
Yield Bond Price Bond Price Appoximation 1700.00
1294.40
1600.00
2.00% 1718.61 424.20 350.20
3.00% 1597.11 302.71 262.65 1500.00

4.00% 1486.65 192.25 175.10 1400.00

5.00% 1386.09 91.68 87.55
1300.00
6.00% 1294.40 0.00 0.00
1200.00
7.00% 1210.71 -83.70 -87.55
8.00% 1134.20 -160.20 -175.10 1100.00

9.00% 1064.18 -230.23 -262.65 1000.00

2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00%
10.00% 1000.00 -294.40 -350.20

As you see in the table, actual bond price change and the change approximated by
duration are not exactly the same. This happens because bond price yield relationship is
a convex relationship, and duration is a linear approximation. We miss the convexity in
linear approximation. We can make up for this by including another term to the
approximation called convexity.
 Rules for Duration

• Rule 1 : The duration of a zero-coupon bond equals its time to

maturity
• Rule 2: Holding maturity constant, a bond’s duration is higher
when the coupon rate is lower
• Rule 3: Holding the coupon rate constant, a bond’s duration
generally increases with its time to maturity
• Rule 4: Holding other factors constant, the duration of a coupon
bond is higher when the bond’s yield to maturity is lower
• Rules 5: The duration of a level perpetuity is equal to: (1+r) / r

© Dr. C. Bulent Aybar

 Bond Duration versus Bond Maturity

Bond Duration versus Bond Maturity

Note that lower the coupon rate, more linear the relationship is.
Bond Durations (Yield to Maturity = 8% APR; Semiannual Coupons )

Bond durations
(yield to
maturity=8%
APR,
semiannual
coupons

CONFIRMING THE RULES 2 &3:

Rule 2: Holding maturity constant, a bond’s duration is higher when the
coupon rate is lower
Rule 3: Holding the coupon rate constant, a bond’s duration generally
increases with its time to maturity
 Term Structure of Interest Rates

• The term structure of interest rates relates the

interest rate to the time to maturity for securities
with a common default risk profile.
• Typically, treasury securities are used to construct
yield curves since all have zero risk of default.
• However, yield curves could also be constructed
with AAA or BBB corporate bonds or other types of
similar risk securities.

© Dr. C. Bulent Aybar

Term Structure of Interest Rates

© Dr. C. Bulent Aybar

Current Yield Curve (10/25/08)
US Yield Curve (02/26/10)
 US Treasury Yield Curve
US Treasury Yield Curve
6

0
1 2 3 4 5 6 7 8 9 10 11

Oct-07 Oct-08 Oct-09 Oct-10

 Yield Curves-Japan & Eurozone

Japan Eurozone
 Theories of Term Structure: Expectations Theory

• This theory suggest that the shape of the yield curve

reflects investors expectations about the future
direction of inflation and interest rates.
• Therefore, an upward-sloping yield curve reflects
expectations of higher future inflation and interest
rates.
• In general, the very strong relationship between
inflation and interest rates supports this theory.

© Dr. C. Bulent Aybar

 Theories of Term Structure: Liquidity Preference Theory

• This theory contends that long term interest rates

tend to be higher than short term rates for two
reasons:
– long-term securities are perceived to be riskier than
short-term securities
– borrowers are generally willing to pay more for long-
term funds because they can lock in at a rate for a longer
period of time and avoid the need to roll over the debt.

© Dr. C. Bulent Aybar

 Theories of Term Structure: Market Segmentation Theory
• This theory suggests that the market for debt at any point in
time is segmented on the basis of maturity.
• As a result, the shape of the yield curve will depend on the
supply and demand for a given maturity at a given point in
time.

© Dr. C. Bulent Aybar

Components of Risk Premium