Bond Value Theorems in investment management

Bond Value Theorems

1. Sri Ramakrishna College of Arts & Science Coimbatore – 06. Topic : Bond Value Theorems M.VADIVEL Assistant Professor Department of B.Com PA Sri Ramakrishna College of Arts & Science Coimbatore . M.Vadivel

2. Bond Value Theorems M.Vadivel

3. Bond Theorem Bond valuation is a technique for determining theoretical fair value of a particular bond. Bond valuation includes calculating the present value of the bond’s future interest payments, also known as its cash flow, and the bond’s value upon maturity, also known as its face value or par value. Because a bond’s par value and interest payments are fixed, an investor uses bond valuation to determine what rate of return is required for a bond investment to be worthwhile. M.Vadivel

4. Understanding Bond Valuation A bond is a debt instrument that provides a steady income stream to the investor in the form of coupon payments. At the maturity date, the full face value of the bond is repaid to the shareholders. M.Vadivel

5. The characteristics of a regular bond include: M.Vadivel

6. Coupon rate: Some bonds have an interest rate, also known as the coupon rate, which is paid to bondholders semi-annually. The coupon rate is the fixed return that an investor earns periodically until it matures. M.Vadivel

7. Maturity date: All bonds have maturity dates, some short-term, others long-term. When the bond matures, the bond issuer repays the investor the full face value is Rs.10,000. The face value is not necessarily the invested principal or purchase price of the bond. M.Vadivel

8. Current Price: Depending on the level of interest rate in the environment, the investor may purchase a bond at par value, below par or above par value. Exp: If interest rates increase, the value of a bond will decrease since the coupon rate will be lower than the interest rate in the economy. When this occurs, the bond will trade at a discount, that is below par. However, the bondholder will be paid the full face value of the bond at maturity even though he purchased it for less than the par value. M.Vadivel

9. Bond Theorems 1. Price and interest rates move inversely 2. A decrease in interest rates raises bond prices by more than a corresponding increase in rates lowers the price 3. Price volatility is inversely related to coupon 4. Price volatility is directly related to maturity 5. Price volatility increases at a diminishing rate as maturity increases M.Vadivel

10. Price and interest rates move inversely 1. Lets assume 3 year 10% coupon paying bond When YTM = 10% Price = 100 When YTM = 11% Price = 97.55 When YTM = 9% Price = 102.53 Hence it can be concluded that as yield increase price of the bond decline and vice-versa. M.Vadivel

11. 2. A decrease in interest rates raises bond prices by more than a corresponding increase in rates lowers price. Lets assume 3 year 10% coupon paying Answer : When YTM = 10% Price = 100   When YTM = 11% Price = 97.55 Change in price = -2.45% When YTM = 9% Price = 102.53 Change in price = +2.53% In above illustration you can clearly see that when yield declines by 1% price increases by 2.53% while in case of increase in yield by 1%, price decline is 2.45%. As price curve of the bond is convex, you gain more than you lose. M.Vadivel

12. Theorem-3 : Price volatility is inversely related to coupon. Lets assume 3 year 10% coupon paying bond and 3 year 11% coupon paying bond 3 year 10% coupon paying bond When YTM = 10% Price = 100   When YTM = 11% Price = 97.55 Change in price = -2.45% When YTM = 9% Price = 102.53 Change in price = +2.53% M.Vadivel

13. 3 year 11% coupon paying bond When YTM = 10% Price = 102.48   When YTM = 11% Price = 100 Change in price = -2.42% When YTM = 9% Price = 105.06 Change in price = +2.52% Lets assume current YTM is 10% and then it increases to 11% and declines to 9%. You can clearly see in the above tables that price movement of the 11% coupon bond is lower than 10% coupon bond. It can be concluded that higher coupon bonds are less volatile than smaller coupon bonds. M.Vadivel

14. Thank You…. M.Vadivel