Introduction to Financial Engineering Aashish Dhakal Week 4: Bonds

Our Plan 1.BASIC BOND FEATURES 2.BOND VALUATION 3.ZERO COUPON BONDS 4.ZERO CURVE & BOOTSTRAPPING 5.GILT STRIPPING

Bond Basic Concept Issuer Lender BOND Certificate Cash 1.Capital For Business (Issue Price) 1.Regular Interest(Coupon Rate) 2.Redemption price

Basic Bond Features Definition: A bond is an instrument in which the issuer promises to repay the lender the amount borrowed plus interest over a specified period of time (Hull. 2003). Maturity or Duration: is the day when the debt will cease to exist, also represents the period to the redemption day.

Basic Bond Features….. Principal or face value: is the amount the issuer will pay to the bondholder. ( £100 or $ 1,000). The coupon rate: is the periodic interest payment that the issuer agrees to pay on the basis of face value.

Basic Bond Features…..  The issuers of the bond can be the governments, corporations or other institutions.  The holders of the bond are normally investors ( individual or institutional).  From the bondholder’s prospective, initially there is a cash outflow of X (e.g. £100 or $ 1,000), then for a coupon bond, there is a positive periodic cash inflows, in the end the issuer would also return the principle.

Basic Features…. In Summary.  Can be issued at, Premium, Par or discount.  Can be redeemed at Premium, Par or discount.  The coupon is applied in face value to arrive at the interest rate.  Interest is payable irrespective of the fortunes of business.  Interest is tax deductibles.

 Value of bond means: FAIR MARKET PRICE OF BOND  Fair Market Price :  This is the PV of Future cash flows associated with the bond discounted at the time value of money.

Bond Valuation….  The formula given above makes clear that the price of a financial asset depends on r and Ci i = 1..n (discount rate). N=time to maturity.  However an important simplification of the formula above is the use of the same discount rate for all cash flows. In fact this does not take into account the fact that there are different interest rates for different maturities. Generally we refer r as the yield rather than discount rate.

Bond Valuation  The “Po” is the current market price of the bond,  “Cn” is the periodic interest rate payment.  “r” is the discounted rate, so-called yield to maturity, it presents the short term interest,  “M” is the Face Value or Maturity Value,  “n” is the periods of bond life, it could be accounted at an annual, semi- annual, or quarterly basis.

Bond Valuation…… In coupon bond valuation, we normally assume that the interest rate payment is made at the end of each period. SO WHAT WE FIND…… The current market price of the bond equals to the present value of the sum of all the future cash flows.

Bond Valuation Example Example 1: Q) The company plans to issue coupon bonds with 3 years duration. Face value $1,000, coupon rate 10%, assuming the interest rate is paying semiannually, if the current market yield is quoted at (a) 8%, (b) 10%, (c) 12%, How much should be reasonable issuing price respectively? Justify the answer.

Bond Valuation Example  Answer: a) 1052 b) 1000 c) 993  So we Can Conclude……

Bond Valuation.. BUY/SELL/HOLD

Yield To Maturity A. Current Yield  Current Yield refers to return an investor earns if  invest in the bond at Prevailing market price Current Yield = (Interest / Market Price) x 100 Coupon rate x Face value

Yield To Maturity B. Yield To Maturity:  The Rate of Return that make the present value of the bond’s cash flows equal to the Present Value of the bond (Market Price).  Rate of return an investor (who buy the bond in the market today) earns if he hold the bonds till maturity.  Two method: a. Short cut method: YTM = (Interest Per Annum + Average other cost per annum)/Average fund employed x 100 b. (Redemption net – Initial cash outflow) / Bond Life (Redemption net – Initial cash outflow)/2

YTM b. Internal Rate of return: YTM = IRR = L + {NPV L / (NPV L – NPV H )} x ( H – L) Ex: Y ltd Issued 5 year redeemable bond of Face Value Rs 100 at Rs 95 with coupon rate 10%. The bonds are now available at the market at Rs 90. An investor intends to buy it and hold it till maturity which is 4 year away. Compute: YTM Issued Price Market Price Remaining life

YTM…..

Zero Coupon Bond Definition:  Sold at a discount to face value  There is no coupon payment (and so, no reinvestment risk!).  Therefore the bondholders only receive the face value back at the maturity date  Duration is equal to maturity  Maturity and amount are known Value : PV of Cash flow P o = M / ( 1 + r ) ^ n

Yield Curve  Yield Curve is a graphical representation of YTM for different maturities period.  Normally, we plot YTM on Y – axis & Maturities period on X – Axis:

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