ASSIGNMENT-2

Bond Duration and Pricing

BY: GOVIND JAY GARG

ROLL NO:22/22021

1 Introduction
Bonds are key instruments used by corporations, governments,
and various other entities for financing, and the bond market is a
major part of our capital market. Bonds come in bewildering
varieties, but they can be distinguished from one another and
priced on the basis of a few characteristics. Because the bond
market is so huge and bonds are used in one form or another by
most players in the financial markets—from individuals to
institutions—how bonds are priced and how the price should vary
as interest rate and other factors change is of great interest. In this
chapter we will develop a few basic models to understand bonds
and their characteristics. Excel has a number of built-in functions
for valuing bonds and studying their characteristics, some of which
are similar to the models we will develop. It is likely that in the
future you will use these functions more often for bond analysis.
Nonetheless, you will develop a much better understanding of
bonds by working through these models. In addition, they will
enhance your understanding of the concept of time value of money
and help you improve your modeling skills.

1.1 Definition
A bond is a contract or instrument under which the issuer borrows
money from lenders and agrees to make one or more payments of
interest and principal on specific dates to the holder of the bond.
The issuers of bonds range from the U.S. Treasury to corporations,
municipalities, and others.

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2 KEY CHARACTERISTICS OF BONDS
Although all bonds have certain common characteristics, these may
differ because of different contractual provisions. Following are the
primary characteristics of a bond that determine its price, both
initially and over time.

2.1 Par Value

Par value is the stated value of the bond. Most bonds are originally
issued at or close to the par value, and bonds promise to repay the
par amount. For most bonds, the par value is |1,000. Some bonds
have par values that are some multiple of |1,000, but irrespective
of this, bond analysis is almost always done on the basis of |1,000
par value and bonds are generally quoted as a percentage of par
value.

2.2 Coupon Interest Rate

Most bonds promise to pay periodically (typically every six
months) a fixed number of dollars of interest called the coupon
payment. When coupon payment is expressed as a percentage of
the bond’s par value and annualized by multiplying by the number
of periods per year (for example, a semiannual payment would be
multiplied by 2), it is called the bond’s coupon interest rate or
coupon rate. Note that the coupon rate, which is an annualized
number, does not reflect any compounding. A bond with an 8%
coupon rate and semiannual payment will therefore actually
provide an effective interest rate somewhat higher than 8%. Some
bonds pay a variable or floating interest rate over the years.
Another special type of bond, called zero-coupon bonds pay no
interest or coupons over the years. They are initially sold below—
generally well below—par value, and when the par amount is paid
at maturity it constitutes the return of the capital as well as
payment of all the interest accumulated over the intervening years.

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2.3 Maturity Date
Bonds generally have a specified maturity date on which the par
value must be repaid. Because this date remains fixed, the
remaining life of the bond decreases over time. In most bond
analysis, we use remaining life rather than original maturity
because it is the remaining maturity of a bond that matters.

2.4 Call Provision

Most corporate bonds have a call provision that gives the issuer the
right to call or redeem the bonds after a few years. For example,
the issuer may have the right to call an issue of bonds at any time
after five years at par value. Alternately, there may be a declining
schedule of redemption price such that the issuer pays 105of par
value to call during the sixth year, 104so forth. Calls provide the
issuers a degree of protection against interest rate risk: if interest
rates go down sufficiently, they can call and replace the bonds with
new ones or other forms of debt at a lower rate. A compensation
for this protection is built into the interest rate on a bond.

2.5 Credit Risk

Credit risk is another important characteristic of a bond, but it
cannot be quantified precisely like the other characteristics. It is
reflected in bond analysis in the required return on a bond.

3 BOND VALUATION
Like all other financial assets, the value of a bond is the present
value of its expected future cash flows discounted at a rate
appropriate for its risk—that is, the risk of those cash flows. A
typical bond that promises to pay a fixed coupon rate of C/2 every
six months and repay the par amount FV at maturity represents an
annuity plus one additional payment at maturity and can be valued
as such. The current price P of such a bond is:

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 Here, r/2 is the appropriate semiannual discount rate and n is
the remaining life of the bond measured in the unit of the coupon
payment period (six months). This is the bond valuation equation.
All the values on the right-hand side except the discount rate are
known, and the discount rate can be estimated by looking at
comparable bonds. With these values we can use the PV annuity
function to calculate the price of a bond.

3.1 The System of Five Bond Variables

From the bond valuation equation we can see that the five key
bond variables— price, par value, coupon rate, remaining life, and
discount rate—are tied together, and any four of them determine
the fifth. We can also see how these variables affect one another.
For example, the price of a bond will go down if the discount rate
goes up and vice versa (if the other variables remain constant). We
will explore these relationships when we build models using this
equation.

3.2 EAR versus APR

In bond analysis, it is important to keep in mind the distinction
between the effective annual rate (EAR) and the annual percentage
rate (APR). The annual percentage rate is the periodic discount
rate multiplied by the frequency of coupon payments per year. In
the bond valuation equation as written, the coupon is paid
semiannually and by using a semiannual discount rate of r/2, we
have implicitly assumed that the appropriate annualized discount
rate, expressed as APR, is r. If we were told that the appropriate
annualized discount rate expressed as EAR is r, then we would
have used a semiannual discount rate k calculated as:

(1 + k)2 = 1 + r
or

k = (1 + r)0.5 − 1
Unless otherwise indicated, the APR convention should be
assumed in bond analysis because it is used more often.

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3.3 Current Yield
The current yield of a bond is its annualized coupon rate, that is,
the periodic coupon rate multiplied by the frequency of payment
per year divided by the current price of the bond.

3.4 Yield to Maturity

If a bond is selling at a price other than par, then its current yield
does not fully reflect the actual return a buyer will earn by buying
the bond at the current price and holding it until maturity. For
example, if a bond is currently selling at |950, then in addition to
collecting the coupons over the years, the buyer will also realize a
capital gain of |50 at maturity. This will make the overall return a
little higher than the current yield. This is captured in the yield to
maturity (YTM) measure. The yield to maturity is the discount rate
that makes the discounted value of the expected future cash flows
of a bond equal to its current price. It is the interest rate that the
buyer will actually earn if the bond is held to maturity and there is
no default. To calculate the YTM, we substitute all the other values
in the bond valuation equation and by trial and error determine
the discount rate at which the two sides of the equation become
equal. This analysis will give us a semiannual interest rate for a
bond that pays a semiannual coupon. Under the APR convention,
we would double it to get the annualized YTM. The YTM is used the
other way around as well. To determine the appropriate price of a
bond, we can estimate what its YTM should be by looking at the
YTMs for comparable bonds. We can then use our estimate of the
right YTM for the bond to calculate its price from the bond
valuation equation.

3.5 Yield to Call

If a bond has call provisions, we can also calculate a yield to call
(YTC) the same way we calculate yield to maturity. We simply use
the bond valuation equation and assume that the bond will get
called at the call price once it becomes callable. If a bond is selling
above the call price, then YTC rather than YTM may be a more

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realistic measure of what return a buyer is likely to earn by holding
the bond.

4 RISKS OF BOND INVESTING

Bond investors assume three types of risk: interest rate risk,
reinvestment risk, and credit risk. These are important for
understanding bonds as well as for investing in them.

4.1 Interest Rate Risk

Interest rate risk is the risk that a bond’s price will fall if interest
rates rise. (The reverse is also true.) We do not know when interest
rates will go up or down; it is therefore important to know how
much risk we are taking before investing in a bond, that is, how
much the price of a bond will change in response to fluctuations in
interest rates. As we will soon see, we use a bond’s modified
duration as a measure of its interest rate risk.

4.2 Reinvestment Risk

What we do with the coupon payments we receive from a bond
affects what actual return we earn on our initial investment in a
bond over the years. In calculating yield to maturity, we implicitly
assume that we will be able to reinvest all the coupons earning
returns equal to the yield to maturity. If interest rates go down
over time, this may not be possible, and if we have to reinvest the
coupons at lower rates then we will earn a lower return over time.
This uncertainty is called a bond’s reinvestment risk. Zero-coupon
bonds do not have any reinvestment risk because they do not pay
any coupons that have to be reinvested. So, if held to maturity,
zero-coupon bonds provide a return exactly equal to their YTM at
the time of purchase. However, if they are sold before maturity
then the return realized may be higher or lower than the YTM at
the time of purchase (depending on the price received).

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4.3 Credit Risk
Credit risk is the risk that because of financial problems of the
issuer, part or all of the interest or principal due on a bond may not
be received. Bonds issued by the U.S. Treasury have no credit risk
because the U.S. Government can always make payments by
printing more money. The required return or discount rate on U.S.
Treasury bonds is thus always the lowest of any bond of equivalent
maturity. The required return on all other bonds is estimated by
adding an appropriate premium to the interest rate on Treasury
bonds of comparable maturities. While we are all free to make our
own assessment of the credit risk of a bond and decide what the
premium should be, this is not an easy undertaking. Most people
use what is called a bond’s credit rating assigned by rating agencies
like S&P and Moody’s. The ratings range from AAA or Aaa (for the
most creditworthy bonds) to D (for bonds that are in default). To
determine the appropriate interest rate premium over U.S.
Treasuries of equivalent maturity or the discount rate for a bond,
people generally start with the YTM of bonds with a comparable
credit rating and maturity and make adjustments to it if necessary.
Incidentally, the credit premiums for bonds of the same rating vary
widely over time for several reasons and, therefore, a bond’s price
can vary even if its credit rating and U.S. Treasury interest rates
remain the same.

5 BOND DURATION
What is the effective average life of an investment in a bond? It is
tempting to think that it is equal to its maturity or half of its
maturity. This is generally not true, however. Why? Because bonds
make coupon payments over the years, and even though all the
coupon payments are generally equal in amount, the present
values of the distant coupon payments are much smaller than
those of the earlier ones. Also, the present value of the final
principal payment is less than its nominal value. So we have to
measure the effective average life, taking the time value of money
into consideration.

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5.1 Macauley Duration
Macauley duration (also called simply duration) is the average life
of a bond’s payments calculated using the present value of the
coupon and principal payments as the weights. If annual interest
rate is r, then for a bond that pays annual coupon of C, has
remaining life of n years, and has a current price of P, the duration
can be calculated as:

!
5.2 Modified Duration It can be
shown that for a bond,

or

The significance of this equation is that if we define D’ = D/(1 + r)

to be the modified duration of a bond, then the modified duration
measures the interest rate sensitivity of a bond’s price for small
changes in interest rate. For example, if the modified duration of a
bond is 10 years, then a 0.25% increase in interest rate will reduce
the bond’s price by 2.5%. Because of this simple relationship,
modified duration is widely used as a measure of the interest rate
risk of bonds. Keep in mind that the relationship holds strictly only
for small changes in interest rates because the modified duration
itself changes with the interest rate. Nonetheless, it is always true
that bonds with longer modified durations have higher interest
rate risk. Although the modified duration is the correct measure of
interest rate risk, the duration itself is often used as an
approximate measure of interest rate risk as well. Since zero-
coupon bonds pay no intermediate coupons, their duration is
always equal to their remaining life, and, therefore, they have much
higher interest rate risk than coupon bonds of equal maturity.

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6 THE YIELD CURVE AND FORWARD RATES
Even casual observations show that interest rates depend both on
maturity and the credit risk of the borrower. Generally the longer
the maturity of a loan, the higher the interest rate the borrower has
to pay (although at times this relationship gets inverted). As
mentioned before, it is customary in the credit market to
determine the appropriate interest rate for different borrowers by
adding suitable premiums to the equivalent U.S. Treasury rate
because Treasuries have no credit risk. Therefore, the interest
rates on Treasuries of various maturities are watched closely.

6.1 Yield Curve

The yield curve is a plot (or table) of the interest rates on U.S.
Treasuries as a function of their maturities at any point in time.
Generally, interest rates for a few months to up to 30 years are
included. The yield curve is customarily based on the interest rates
on zero-coupon Treasuries because zero coupons have no
reinvestment risk. To emphasize the point, such yield curves are
often called zerocoupon yield curves. The yield curve generally
slopes upward, meaning interest rates tend to be higher for longer
maturities. There is no law that says it has to be that way, though,
and over time yield curves take on all kinds of shapes. Sometimes
they are even downward-sloping (called inverted).

6.2 Forward Rates

If we find from the yield curve that the five-year interest rate is 6be
for a one-year borrowing 5 years from now? We can actually
determine exactly at what rate we should be able to enter into a
contract today to borrow one-year money in five years. This is
called the forward rate, and it is exactly determined by the fiveand
six-year rates because otherwise there will be opportunity to make
arbitrage or riskless profit. However, recognize that forward rates
tell you at what rate you can enter into a contract today to borrow
money in the future. They do not tell you what the rate will be at
that time, and if instead of entering into a contract today you wait
five years, the rate for borrowing oneyear money at that time will

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probably be much different. We can show that if yt represents t
year interest rate and ft,T represents the forward rate for borrowing
money for (T-t) years t years in the future, then:

6.3 Bond Pricing Using the Yield Curve

Earlier it was mentioned that bonds can be priced using yield to
maturity. However, this actually provides only an approximate
value because in such valuations we discount all future cash flows
—no matter when they take place—at the same rate. Now we
know that

Figure 1: Bond Yield of US Treasury

this cannot be appropriate unless the yield curve happens to be

flat. Bonds can be more accurately valued by discounting each
coupon and the par amount by maturity-matched discount rates
based on the yield curve. Maturity-matched discount rate means
the zerocoupon U.S. Treasury interest rate for the particular
maturity plus the appropriate credit risk premium for the rating of
the bond we are pricing. However, depending on the shape of the

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yield curve at the time, this may or may not make a big difference
vis-a`-vis YTM–based valuation.

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