Time Value, Interest Rate

Structures & Bond Valuation

Outline
Time Value of Money Present Value & Value at
time T
Interest Rates Spot Rates, Forward Rates &
Discount Factors
Defining Bond
Types of Bond
Bond Pricing I : Simple Bond (non-Callable/ nonPutable Bonds)
Bond Pricing II: Putable/Callable bonds

Time Value of Money

Suppose an investor has fund amount A today.
Time Value (Value at time T): If she invest this
amount for T years with interest rate r, her fund will
grow to F, which is given by below
T

mT

r
A 1
m
F

rT

Ae

If compounding m - times per year

If compounded continuouly

In above, r represents yield/interest-rate per annum.

3

Time Value of Money

So, given the interest rate r, value A at present (i.e.
time T=0) can be said equivalent to value F at any time T.
Present Value (PV): In other words, Present Value A of
a sum F at time T can be expressed as
T

(1 r ) mT

m
A

Fe rT

If compounding m - times per year

If continuouly compounded
4

Basic Concepts
- Spot Rates, Forward rates & Discount Factors
Spot
Rates at
time 0
Time Point 0

ri
r2

r1

t1

t2

ti

tn

Discount
Rates/
Factors

Forward
Rates at
time 0

Spot-rate, Discount Factor and Forward-rate

Spot Rate (also called as Zero-Rate/zero-coupon rate), rt
- The n-year spot rate is the rate of interest earned on an
investment that starts today and lasts for n-years. All the
interest and principal is realised at the end of n years; no
intermediate payments.

Discount Factor, (t)

- This is simply (t)=(1+rt)-t or (t) = exp(-trt) as defined
earlier, where rts represent spot-rates.
Forward Rate, (denote forward rate from time t-1 to t at time 0 as t)
- This is the interest rate implied by current spot-rates, for a
specified future time period. Interesting to see that
(1+rt)t = (1+1) (1+2)(1+ t)
Note: Knowing any one set/sequence of {rt}, {(t)} and {t},
we can easily derive other two sets/sequences.
6

Alternative Forms of Present Value (PV)

- Using Spot Rates

Consider three expressions of PV formulations

The First Expression: Present Value (PV) of all Cash
Flows (Cks, k=1,2,3,.,n) using Spot Rates.

C1
C2
Cn
F

......

2
n
n
(1

r
)
(
1

r
)
(
1

r
)
(1

r
)
1
2
n
n

C e
1

r1

C 2e 2 r2 ...... C n e nrn Fe nrn

- - Compounding m - times per year

- - Continuous Compounding

In above, rt represents Interest-Rate/Yield-to-Maturity

(YTM) in zero-coupon bond from time 0 to time t.
Note: At time 0, the rt defined above is the Spot-rate for
maturity t.
7

Alternative Forms of Present Value (PV)

- Using Discount Factors
The Second Expression: Present Value (PV) of all
Cash Flows (Cks, k=1,2,3,.,n)Using Discount
Factors.
P C (1) C (2) ...... C (n) F (n)
(1 rt ) t

where (t)
e - t rt

- - Compounding end of periods t 1,2,....

- - Continuous Compounding

Note:

(i) The (t)s defined above are also called the discount factors.
(ii) The PV is linear function of discount factors.
8

Alternative Forms of Present Value (PV)

- Using Forward Rates
The Third Expression: Present Value (PV) of all Cash
Flows (Cks, k=1,2,3,.,n)-using Forward Rates.
Ck
F
n

(1 )(1 ).....(1 ) (1 )...(1 )

1
2
k
1
n
k 1
P
n
-(1 2 ..... k )
-(1 2 ..... n )
C
e

Fe
k
k 1

- - Period end Compounding

- - Continuously Compounding

Here t represents the interest rate during end of time period (t-1)
to end of time t.

Note: The ts defined above represent forward rates at time 0.

9

Defining Bonds
What is a Bond ?

A debt security, in which the authorized issuer owes the holders a

debt and is obliged to repay the principal a specified later date.
Bonds are usually issued with a par or face value representing
amount of money borrowed and issuer promised to pay a percentage
Bonds
Issuer
Bond Holder
Coupon

Loan
Borrower
Lender
Interest

A
Issue Date

Coupon Payment

Coupon Payment
Trading Day

Coupon Payment

Coupon Payment
+ Face Value

10

Types of Bonds
(A) On the Basis of Nature of Coupon

Zero-Coupon Bond
-- It pays no coupon pays only principle at maturity.
Coupon Bond
-- Pays coupon (as interest rate on principle/face value) at certain
pre-defined dates during the life of the bond and pays face-value
with coupon at maturity.
(A) Fixed Coupon Bond coupon amount is fixed
(B) Floating Rate bond/note variable coupon amounts
coupon is usually linked to a reference interest rate and reset
periodically depending upon changes in reference rate.
11

Types of Bonds
(B) On the basis of difference between market
discount rate and coupon rate

Premium Bond Coupon greater than market

discount rate

Par (or Par value) Bond Coupon and market

discount rate same

Discount Bond Coupon lower than discount rate

12

Types of Bonds
(C) Other Bond Types/Bond Options

Convertible bond grants the bond holder and/or issuer the

right to convert the bond into a predefined amount of ordinary
stock of the issuing company/entity.

Exchangeable bond - grants the bond holder the right to

convert the bond into a predefined amount of ordinary stock of a
specified company other than the issuing company.

Callable bond - A fixed rate bond where the issuer has the right
but not the obligation to repay the face value of the security at a
pre-agreed value prior to the final original maturity of the
security.

Putable bond Grants the bondholder the right to sell the bond
back to the issuer at its par value on designated dates.
13

Some Terminologies
Current Yield
The most basic measure of the yield which is simply the coupon
payment over the current price of the bond.
Example: a bond with current price $92.78 pays $10 annual
coupon. Current yield = 7/92.78 = 0.0754 or 7.54 %

Simple Yield to Maturity (SYM)

- This takes into account capital gains/losses assuming that the
capital gain/loss on the bond occurs evenly over remaining life
of the bond.
Example: Consider the same bond in current yield that is paying
coupon $7 per annum with 5 years until maturity.
Then SYM = 7/92.78 + (100-92.78)/(5 x 92.78) = 0.0910 0r 9.1 %

14

Some Terminologies
Yield to Maturity/Redemption Yield (YTM)
- The problem with SYM is that it does not take into account
the fact that coupon receipts can be reinvested and hence
further interest gained. The YTM or redemption yield takes
into account this aspect.
Thus, YTM is the yield/interest gain made on a bond if it is
held till maturity (assuming that coupons are reinvested).
The YTM, say y of a bond that is trading at price P is
calculated from the relationship (assuming it pays n annual
coupons, and face value F)
C
C
C
F
P

......

2
n
n
(1

y)
(
1

y
)
(
1

y
)
(1

y)

15

Reinvestment Risk
What is Reinvestment Risk?
- This is the risk arising from uncertainty in the interest rate at
which future cash flows may be invested.

Note:
(1) The YTM is the yield incorporating the fact that coupon
payments can be invested. However, this is subject to
reinvestment risk.
(2) Different coupon payment receipts in future may be
reinvested at different interest rates. YTM is some sort of
overall/average yield earned over the life of the bond if it is
held till maturity.
16

Bond Pricing I
(Non-Callable/Non-Putable Bonds)

17

Bond Pricing
Cash Flows from A typical Bond may be represented as follows
A
Issue Date

Coupon Payment

Coupon Payment
Trading Day

Coupon Payment

Coupon Payment
+ Face Value

Holder of the bond pays price to the issuer/seller at the time of buying

In return, holder of the bond is entitled to get (in future specified dates)
coupon payments. If hold till maturity, holder additionally get Face Value.

18

Bond Pricing
Price of a Coupon-Bearing Bond

Consider a 5-year bond: Face Value F = 100

Years of maturity = 5 ; Coupon = 7% (annual payment)
Assume annual interest for next five years at 10%.
Given frequency of compounding m=1 per year
Year Coupon Principal Cash-Flow
Present Value
1
7
0
7
7/1.1 = 6.36
2
7
0
7
7/1.12 = 5.78
3
7
0
7
7/1.13 = 5.26
4
7
0
7
7/1.14 = 4.78
5
7
100
107 107/1.15 = 66.44
-------------------------------------------------------------------Value of the Bond (Total PV)
= 88.63
19

Bond Pricing
Zero-Coupon Bond
The residual maturity of a bond today is T years.
Holder of the bond receives face value F at maturity.
There is no intermediate cash flow to the holder. What
would be the Bond price P today?
T

Issue Date

Trading Day

Face Value (F)

P Would be the Present Value (PV) of F today.

(1 r ) mT
m
P

Fe rT

If compounding m - times per year

If continuouly compounded

In above, r represents yield/interest-rate per annum.

20

Bond Pricing
Coupon -Bearing Bond
One buy the bond today and on maturity (after n
periods) receive a known amount F (Face Value). In
addition gets Coupon amount C at the end of each
period (say, half-year). What would be the Bond price P
today?
P Would be the Present Value (PV) of all Cash Flows
C

C
C
F

......

2
(1 r/m) n (1 r/m)n
P (1 r/m) (1 r/m)

Ce r Ce 2 r ...... Ce nr Fe nr

- - Compounding m - times per year

- - Continuous Compounding

In above, r represents Interest-Rate/Yield per annum.

21

Bond Pricing
More General Form
One buy the bond today and on maturity (after n
periods) receive a known amount F (Face Value). In
addition gets Coupon amount C at the end of each
period. What would be the Bond price P today?
P Would be the Present Value (PV) of all Cash Flows
Ck
F
n

(1 r )(1 r ).....(1 r ) (1 r )...(1 r )

1
2
k
1
n
k 1
P
n
-(r1 r2 ..... rk )
Fe -(r1 r2 ..... rn )
Ck e
k 1

- - Period end Compounding

- - Continuously Compounding

In above, rk represents Interest-Rate during k-th period,

k=1,2,.,n. These rks represent forward-interest rates
at time 0.
22

Pricing Floating-Rate Bonds/Notes

Consider a floating-rate bond which pays coupon same as a reference rate, say,
LIBOR.
For pricing this bond, note that it is worth the Face Value immediately after a
coupon payment. This is because at that time bond is a fair deal where issuer
pays LIBOR for each subsequent accrual period.
Example:
Consider a FRN has 1.25 year residual life;
Floating coupon = 6-month LIBOR;

Face Value F = $ 100 million

Coupon payment = half-yearly

Assume 6-month LIBOR at last coupon date was 10.2 %

Time Cash-flow Cash-flow

Cash-flow

Present Value

0.25 5.1
5.1
105.1 #
102.55
0.75 0.5 x L2
0.5 x L2+100*
1.25 0.5 x L3+100
-------------------------------------------------------------------* Value of (0.5 x L3+100) at time 0.75 is 100 (discount rate L3)
# Value of (0.5 x L2+100) at time 0.25 is 100 (discount rate L2)
Value of the Bond (Total PV) at time 0 = 102.55
23

Bond Pricing
Bond Price is sensitive to changes in one or more
of the following Factors (Given Face Value F)
* Maturity
* Coupon
* Yield/interest-rate
Note:
We primarily focus on bond price sensitivity to changes in
interest rate/yield.

24

Convexity
(Price-Yield Relationship)
Increase in price for unit decrease in yield is
greater than decrease in price for the same
increase in yield
YTM

or

r1
ro

Price
p2
po
p1

r2
p1 po p2

Price

r2

ro r1

YTM
25

Convexity
Price

T
A
T
YTM

The price-yield curve is convex meaning that the

slope of the curve is continuously changing
At any point on the curve, say A, slope is the slope
of the tangent (the straight line TT) at that point
26

Price

Convexity
X

A
X
Y
YTM

In above Graph, XX and YY curves represent Price-Yield

relationship for two different portfolios
X and Y,
respectively.
The curve XX has more curvature than YY. Convexity
measures this curvature.

At point A, both the portfolios have same price change for

very-small change in yield. But for larger change in yield,
portfolio Y experiences higher price change. This is the impact of
convexity.
27

Price Sensitivity to Interest Rate Changes

Maturity Effect
The longer the term to maturity, the greater
the sensitivity to interest rate changes.
Example:
-Let zero coupon yield curve is flat at 12%.
-Bond A pays 176.234 in 5 years
-Bond B pays 310.584 in 10 years
Note: Both Bonds are currently priced at 100.
28

Price Sensitivity to Interest Rate Changes

Maturity Effect
Example continued...

Bond A: P = 100 = 176.234/(1.12)5

Bond B: P = 100 = 310.584/(1.12)10
Now suppose the interest rate increases by 1%.
Bond A: P = 176.234/(1.13)5 = 95.653
Bond B: P = 310.584/(1.13)10 = 91.494
The longer maturity bond has the greater drop
in price.
29

Price Sensitivity to Interest Rate Changes

Coupon Effect
Bonds with identical maturities will respond
differently to interest rate changes when the
coupons differ.

It is readily understood by recognizing that

coupon bonds consist of a bundle of zerocoupon bonds. With higher coupons, more of the
bonds value is generated by cash flows which
take place sooner in time.
30

Price Sensitivity to Interest Rate Changes

- Coupon Effect

Maturity
(n)
40
20
10
2

Sensitivity of 6% Coupon Bond

Yield (r)
7%
6%
5%
Range
86.7
89.4
93.0
98.2

100
100
100
100

117.2
112.5
107.7
101.9

30.5
23.1
14.7
3.7

Sensitivity of 8% Coupon Bond

Maturity
Yield (r)
(n)
9%
8%
7%
Range
40
20
10
2

89.2
90.9
93.6
98.2

100
100
100
100

113.3
110.6
107.0
101.8

24.1
19.7
13.4
3.6
31

Price Sensitivity to Interest Rate Changes

The longer maturity bonds experience
greater price changes in response to any
change in the discount rate.
The range of prices is greater when the
coupon is lower.
The 6% bond shows greater changes in price in
response to a 1% change than the 8% bond.
The first bond is riskier.
32

Bond Value Theorems

Price and Yield move in opposite directions.
Price-yield curve is convex in shape.
Discount/Premium decreases with decrease in
maturity period - decreases at an increasing
rate as time to maturity decreases (longer
maturity bonds have greater change in price
due to unit change in interest rate/yield).
Sensitivity of bond price to changes in yield is
lower if coupon is higher.
33

Bond Pricing II
(Callable/Putable Bonds)

34

Callable Bonds
Callable bonds are issued to borrow money for whatever
reason.
Being
callable,
such bonds
give
the issuer
the right to call home the bonds repay their borrowings
when seems good/fit, which usually
means when interest
rates are low.
To pay off the bonds, the issuers usually have to pay the
holder the face value of the bonds.

For many callable bonds, however, the issuers need to

pay some premium on top of the face value. This premium
acts as some compensation for the lenders who upon being
prepaid, have to find new borrowers at generally lower
interest rates. The price that the issuers have to pay is
the call price.
35

Example: Typical Callable Bond Structure

Take an example of a typical 10 NC 2 bond (10 years
stated maturity, only callable after 2 years) may have
following features
Face Value : $ 100
Lockout period : 2 years (i.e. no call privileges in first 2
years)
After the lockout period, issuer might have the right to
buy the bond back at following prices
$ 110 in years 3 & 4
$ 107.5 in years 5 & 6
$ 106 in years 7 &8
$ 103 in years 9 & 10
36

Yields for Callable Bonds

Consider 2-year bond that can only be called at end of year 1 for a call
price $100, has a face value $100 and currently selling at $99. Assume
semi-annual coupon rate of 8% p.a.
Yield to Maturity
The yield to maturity of this callable bond is calculated assuming
that the bond will be held till maturity regardless.
Therefore, the cash flows from the bond will simply be:
At time 0.5: $4
At time 1.0: $4
At time 1.5: $4
At time 2.0: $104
The yield to maturity of the bond will then be y such that:

99

y y
1 1
2 2

4
y
1
2

Solve this for y, we have y=8.55 %

104
y
1
2

38

Yields for Callable Bonds

Yield to Call (YTC)
In our example, Yield to Call is calculated assuming that the
bond will be called with certainty (at end of first year).
Therefore, the cash flows from the bond will simply be:
At time 0.5: $4 & At time 1.0: $104
The yield to call of the bond y will then be such that:
99

4
y

1
2

104
y

Solve this for y, we have y=9.07 %

Yield to Worst
Yield to Worst = Minimum (YTM, YTC)
In our example, Yield to Worst = Min(8.55%, 9.07%) = 8.55 %

39

Pricing Callable Bonds

Consider the Cash Flow of the Callable bond in our example
---------------------------------------------------------------------------------Cash Flow at time
-------------------------------------------------------Bond
0.5 1.0
---------------------------------------------------------------------------------1-year Non-Callable $ 4 $104
2-year Non-Callable $ 4 $ 4 + Price of 2-year Non-Callable at time 1
Callable
$ 4 $ 4 + Min (100, Price of 2-year Non-Callable
---------------------------------------------------------------------------------------Note that the Cash Flow of Callable bonds identical at time 0.5.
But at time 1, Cash Flow is smallest in the case of Callable Bond

So, the Callable Bond here will be cheaper than

1-year Non-callable as well as 2-year Non-callable
bonds.
40

Pricing Callable Bonds

To value the Callable Bond in our example, assume following
tree of semi-annual interest rates

41

Pricing Callable Bonds

For Similar Non-Callable Bond, Cash Flow would be
Time 0
0.5
1.0
1.5
2.0
CF
4
4
4
104
------------------------------------------------------------------------------------------------------Price of the Non-Callable Bond using Interest rate Tree would be
(assume probability of moving up or down in the tree at any time is 0.5)

96.5451

95.7549
96.7878

99.1005

98.3727

98.7160
99.7719

100.4394 101.0012
100.8344
96.5451 = 104/(1+15.54%/2)
95.7549 = [0.5*(96.5451+98.3727)+4] / (1+11.91%/2)

42

Pricing Callable Bonds

Now turn to Price the Callable Bond in our Example

At time 1, issuer may call the bond. However, issuer will call only if value of bond at
time 1 is higher than call price; $100.

Time 0
0.5
1.0
1.5
2.0
----------------------------------------------------------------------------------------------------------------------------- -Checking 3-scenarios in time 1, it will make sense to buy back the bond if its value is 101.0012.
Paying $100, he gains $1.0012
Price of the Callable Bond using Interest rate Tree would be (assume probability of moving up or
down in the tree at any time is 0.5)

95.7549
96.7878

99.1005
98.8667

96.5451

98.3727

98.7160
99.7719

100.4394 101.0012
99.9552
100.00
96.5451 = 104/(1+15.54%/2)
99.9552 = [0.5*(98.7160+100.00)+4] / (1+11.91%/2)

100.8344
43

Pricing Callable/Putable Bonds

Issues and further detail on pricing of callable/putable bonds
are discussed seperately in the context of callable bonds
following the write-up/chapter by Professor Anh Le, The
write-up/Chapter on Callable Bonds.
Also we discussed relevant issues using hands-on in MS-Excel
platform.

44

Select References
Hull, John C. (2004), Options, Futures, and
Other Derivatives, Fifth Edition, PrenticeHall of India Pvt. Ltd.
or
Hull, John C. (2005), Options, Futures and
Other Derivatives, Sixth Edition (Chapters
4 & 6), Prentice-Hall of India Pvt. Ltd.
Professor Anh Le, The write-up/Chapter on
Callable Bonds.
45

Thank You

46