S&PM PPT ch 10

PowerPoint Presentation: 

Bond Return and Valuation Chapter 10

Chapter Objectives: 

Chapter Objectives To understand the basics of bond To know the concept of bond return and valuation To learn about the types of bond risk To understand the bond value theorems To understand the concept of duration and immunisation

Concept of Bond: 

Concept of Bond It is a contract between a borrower and a lender in which the borrower is required to pay a certain amount of interest income to the lender. In general, bonds carry a fixed payment of interest till the maturity date. The rate of interest is also known as coupon rate.

Bond Risk: 

Bond Risk Bonds are considered to be quite safe but they also carry a certain amount of risk. Types of bond risk: Interest rate risk : The value of bonds changes due to variability of the market interest rates. Default risk : The borrower fails to pay the agreed value of debt instrument on time. Marketability risk : There is difficulty in liquidating the bonds in the market. Callability risk : There is an uncertainty created in the returns of the investor by the issuer’s right to call the bond any time.

Bond Return: 

Bond Return There are several ways of describing a rate of return on bond. Some of them are: Holding period return The current yield Yield to maturity

Holding Period Return: 

Holding Period Return It is a return in which an investor buys a bond and liquidates it in the market after holding it for a definite period of time. The formula for calculating holding period of return is as follows: It can be calculated on a daily, monthly or annual basis.

The Current Yield: 

The Current Yield It is a measure through which the investors can easily figure out the rate of cash flow on the investments made by them every year. It is calculated as:

Yield to Maturity: 

Yield to Maturity It is the single discount factor that makes the present value of future cashflows from a bond equivalent to the current price of the bond. The following assumptions are used to calculate yield to maturity: There should not be any default. The interest payments are reinvested at yield to maturity. The investor has to hold the bond till its maturity. It is calculated as:

Bond Value Theorems: 

Bond Value Theorems These are evolved on the basis of three factors: (i) coupon rate (ii) years to maturity (iii) expected rate of return. The five bond value theorems are as follows: Theorem 1 : If the bond’s market price increases then its yield declines and vice versa. Theorem 2 : If the bond’s yield remains constant over its life, then the discount or premium depends on the maturity period. Theorem 3 : If the yield remains constant over its life, the discount and premium on bonds will decline at an increasing rate as its life gets shorter. Theorem 4 : A raise in the bond’s price for a decline in the bond’s yield is greater than the fall in the bond’s price for a raise in the yield. Theorem 5 : The percentage change in the bond’s price owing to change in its yield will be small if the coupon rate is high.

Duration: 

Duration It measures the time structure and interest rate risk of the bond. The formula for calculating the duration is as follows: where D = Duration C = Cashflow R = Current yield to maturity T = Number of years P v (c t ) = Present value of the cashflow P 0 = Sum of the present value of cashflow

Immunisation: 

Immunisation It is a technique that makes a bondholder relatively certain about the promised cash stream. An immunisation can be achieved by reinvesting the coupons in the bonds that offer higher interest rate .

Chapter Summary: 

Chapter Summary By now, you should have: Understood the basics of bond Understood the concept of bond return and valuation Learnt about the types of bond risks Understood the various bond value theorems Learnt the concept of immunisation