Questions

Module 2

Dr Rajiv U K – 376
1) Full Price
A bond has a clean price of Rs 950, and the accrued interest calculated was Rs 30. What is the full
price of the bond?
Answer
Full price = Clean price + Accrued interest
= Rs 950 + Rs 30 = Rs 980

2)
A bond with a face value of ₹5,000 pays a semi-annual coupon of 6% and has 10 years left to maturity. The required rate of return
(discount rate) is 8% per annum. Calculate the value of the bond.

₹4,320.13.

3) A bond with a face value of ₹10,000 pays an annual coupon 4) A bond with a face value of ₹2,000 pays quarterly
of 7% and matures in 8 years. The required rate of return is 9%. coupons at an annual rate of 5% and has 6 years to
Calculate the present value of the bond. maturity. The required rate of return is 6% per annum.
The present value of the bond is ₹8,894.66. Calculate the price of the bond.
The bond value is ₹1,902.31.
5) A bond with a face value of ₹50,000 pays a semi-annual
coupon of 9% and matures in 15 years. The required rate of
return is 7.5% per annum. Calculate the present value of the
bond.
₹56,666.83.

6) A bond with a face value of ₹100,000 pays a quarterly

coupon of 7.5% and matures in 20 years. The market requires a
6% return on this bond. What is the value of the bond?
The value of the bond is ₹117,446.49.

7) A bond with a face value of ₹200,000 pays a 10% annual

coupon and matures in 25 years. The required rate of return is
12%. Calculate the present value of the bond.

₹169,185.88.
Accrued Interest

A bond pays interest of 6% Semi annually and has a face value of Rs 1,000. If you purchase the bond 3
months after the last interest payment, what is the accrued interest you need to pay to the seller?

For the given bond:

•Annual interest = 6% of Rs1,000 = Rs 60
•Number of payments per year = 2 (for semi-annual payments)
•Time since last payment = 3 months (which is half a period)

Using the formula:

1.Calculate the semi-annual interest payment: Rs 60 / 2= Rs30

2.Since 3 months is half of the payment period, the accrued interest is: Rs30×0.5=Rs 15

So the correct accrued interest for this bond, purchased 3 months after the last payment, should be Rs15,
Duration of Bond
•Define Duration:
•What is bond duration, and how does it differ from maturity?
•Types of Duration:
•What are the different types of duration (Macaulay duration, modified duration, and effective duration), and how do they
each relate to interest rate sensitivity?
•Impact of Coupon Rate:
•How does a bond's coupon rate affect its duration? Why do lower coupon bonds typically have a longer duration than
higher coupon bonds?
•Interest Rate Movements:
•If interest rates increase, how would you expect the prices of bonds with different durations to react? Provide a rationale for
your answer.
•Portfolio Duration:
•How can investors use duration to manage the interest rate risk of a bond portfolio?

Lets Do Calculation
Calculate
• Macaulay Duration
• Modified Duration
• Effective Duration.
Duration of Bond
• Example
• Consider Two Bonds:
1. Bond A:
1. Maturity: 10 years
2. Coupon Rate: 6%
3. Face Value: Rs1,000
4. Annual Coupon Payment: Rs60
2. Bond B:
1. Maturity: 10 years
2. Coupon Rate: 2%
3. Face Value: Rs1,000
4. Annual Coupon Payment: Rs20

To illustrate, let’s assume the yield to

maturity (YTM) for both bonds is 4%.
 • Calculating Present Value for Each Bond:
1. Bond A:
1. PV of Coupons (Years 1-10): The present value of $60 cash flows each year for 10 years plus $1,000 in year 10.
2. Macaulay Duration can be calculated using the formula for each cash flow weighted by its present value.
2. Bond B:
1. PV of Coupons (Years 1-10): The present value of $20 cash flows each year for 10 years plus $1,000 in year 10.
2. Similarly, Macaulay Duration is calculated using the same method.

Conclusion
Expected Results In this example, while both bonds have the same maturity of 10
Bond A (higher coupon rate) will likely have a duration less years, their durations will differ due to their coupon rates.
than 10 years, as it receives larger cash flows earlier. Bond A with a higher coupon will have a shorter duration
Bond B (lower coupon rate) will have a duration that is because a significant portion of its cash flows is received
significantly longer because it receives smaller cash flows, earlier, making it ess sensitive to interest rate changes.
which are spread out more over the bond's life, and a Bond B with a lower coupon will have a longer duration,
larger proportion of the total cash flow occurs at maturity. making it more sensitive to interest rate changes despite
having the same maturity.
• Definition of Maturity and Duration

• Maturity: This is the date when a bond's principal (face value) is repaid to the

bondholder. It represents the total time until the bond is due. For example, if

a bond matures in 10 years, that means in 10 years the issuer will return the

principal amount to the bondholder.

• Duration: This is a measure of the sensitivity of a bond's price to changes in

interest rates. It takes into account the present value of all cash flows (both

coupon payments and the final principal repayment) and reflects the average

time until those cash flows are received. Duration is expressed in years,

similar to maturity, but it is typically shorter than or equal to maturity for

most bonds.
• 1. Define Duration:

• What is bond duration, and how does it differ from maturity?

• Duration is a measure of the sensitivity of a bond's price to changes in interest rates. It considers the time-weighted present value
of a bond's cash flows, making it a more comprehensive indicator than maturity.

• Maturity simply refers to the time remaining until the bond’s principal is repaid. A bond with a longer maturity doesn’t always
have a longer duration, especially if it has high coupon payments, which bring cash flows sooner.

• 2. Types of Duration:

• What are the different types of duration (Macaulay duration, modified duration, and effective duration), and how do they each relate
to interest rate sensitivity?

• Macaulay Duration is the weighted average time until cash flows are received, measured in years. It helps investors understand
the time value of money.

• Modified Duration adjusts Macaulay duration to reflect how the bond’s price changes with interest rate movements. It provides
an estimate of the percentage change in price for a 1% change in yield.

• Effective Duration accounts for changes in cash flows due to embedded options (like callable bonds). It provides a more accurate
measure of interest rate risk for bonds that may not have fixed cash flows.
• 3. Impact of Coupon Rate:

• How does a bond's coupon rate affect its duration? Why do lower coupon bonds typically have a longer duration than higher coupon
bonds?

• A lower coupon rate means that a smaller portion of the bond’s cash flows comes from coupon payments, pushing a greater
percentage of cash flows toward the maturity date.

• As a result, the bond’s price becomes more sensitive to interest rate changes. In contrast, higher coupon bonds provide more cash
earlier, reducing the average time to receive cash flows and thus resulting in a shorter duration.

• 4. Interest Rate Movements:

• If interest rates increase, how would you expect the prices of bonds with different durations to react? Provide a rationale for your
answer.

• When interest rates increase, bond prices fall. Bonds with longer durations (lower coupon rates) will experience a more significant
price decline compared to bonds with shorter durations (higher coupon rates). This is because longer duration bonds have a larger
proportion of their cash flows concentrated at maturity, which are discounted more heavily as rates rise.
5. Portfolio Duration:
•How can investors use duration to manage the interest rate risk of a bond portfolio?
• Investors can calculate the weighted average duration of their bond portfolio to assess its sensitivity to interest rate changes. By
adjusting the duration of their holdings—by buying bonds with shorter durations or employing interest rate derivatives—they can
better manage their exposure to interest rate fluctuations and align their risk profile with their investment strategy.
 Questions
Consider two bonds with the following characteristics: Required:
Bond A Bond B a) Assume market interest rates rise from 4% to 5%.
Estimate the price changes using the present value of
Price Rs 1000 Rs 1000 cash flows.
Coupon Rate 3% ( Lower Coupon) 6% (Higher Coupon) b) "Lower coupon bonds respond more strongly to a given
Maturity 10 Years 10 Years change in interest rates." Do you agree?

The present values will show that Bond X, with the lower
coupon rate, experiences a more significant decrease in price
than Bond Y when interest rates rise.
Summary
In Summary, Lower coupon bonds indeed respond more
strongly to changes in interest rates due to their longer
duration and the timing of their cash flows. This makes them
more sensitive to interest rate movements, leading to larger
price fluctuations compared to higher coupon bonds.
Understanding this relationship is crucial for bond investors in
managing interest rate risk effectively.
 Practice
Consider two bonds with the following characteristics: Required:
Bond A Bond B a) Assume market interest rates rise from 5% to 6%.
Estimate the price changes using the present value of
Price Rs 1000 Rs 1000 cash flows.
Coupon Rate 4% ( Lower Coupon) 7% (Higher Coupon) b) "Lower coupon bonds respond more strongly to a given
Maturity 10 Years 10 Years change in interest rates." Do you agree?
 Question
Consider two bonds with the following characteristics: Required:
Bond A Bond B a) Assume market interest rates rise from 5% to 6%.
Estimate the price changes using the present value of
Price Rs 1000 Rs 1000 cash flows.
Coupon Rate 5% 5% b) "Lower coupon bonds respond more strongly to a given
Maturity 10 Years (Lower Time) 5 Years (Higher Time) change in interest rates." Do you agree?

Answer:
PV of Bond B with a 10-year maturity, experiences a larger decrease in price
compared to Bond A when interest rates rise by the same amount. This is a
direct consequence of the longer duration and the fact that more cash flows are
weighted toward the future.
Summary:
In Summary, longer tenure bonds with the same coupon rates do respond more
strongly to changes in interest rates due to their longer duration, the time value
of money, and the structure of their cash flows. This understanding is critical for
investors in managing interest rate risk effectively and making informed
investment decisions. The price volatility of longer-term bonds is an important
consideration in bond investing and risk management strategies.
Discussion
XYZ plans to raise INR 500 crore by dated securities to fund their Required:
new project at Raipur. The NCD face value is Rs.100, and it is a) Is it advisable to buy the NCD if the expected yield is 8%?
issued at par with a coupon of 7%, redeemable at a 10% b) Would your decision change if the market yield moves to
premium. CRISIL rates the bond with A. Time is 10years 7.5% and the firm offer no redemption premium?

Given Information: Answer

•Face Value: ₹100 1) Since the present value (₹97.88) is less than the face
•Coupon Rate: 7% (annual coupon payment = ₹7) value (₹100), the expected yield of 8% is higher than the
•Redemption Price: ₹100 + 10% premium = ₹110
•Market Yield (Expected Yield): 8% initially; then changes to 7.5% bond's yield, suggesting it is not advisable to buy the NCD at
•CRISIL Rating: A- this expected yield.

Part (b):
Cash Flows: Would your decision change if the market yield moves to 7.5%
1.Annual Coupon Payment: ₹7 for 10 years (assuming a 10-year maturity). and the firm offers no redemption premium?
2.Redemption Amount at Maturity: ₹110.
New Cash Flows:
Total Cash Flows: •Annual Coupon Payment: ₹7
•Cash flows over 10 years: ₹7 for each of the 10 years + ₹110 •Redemption Amount: ₹100 (no premium).
At maturity = ₹7 * 10 + ₹110 = ₹70 + ₹110 = ₹180. Present Value Calculation with 7.5% Yield:
Total Present Value:
PV total=46.97+50.91≈97.88 PV total=51.34+48.54≈99.88
In this case, since the present value (₹99.88) is closer to the face
value (₹100) and only slightly less than it, the attractiveness of the
investment improves.
Present Value vs. Face Value:
•The face value of the NCD is ₹100. If the present value (PV) of the cash flows from the bond is less than ₹100, it implies that the
bond is overvalued at that price given the market yield.
•In this case, the calculated present value of the cash flows (coupons and redemption) is approximately ₹97.88, which is less than
₹100.
Comparison of Expected Yield to Market Yield:
•The expected yield of 8% is higher than the coupon rate of 7%. This indicates that investors require a higher return than what the
bond is offering based on its coupon payments.
•Since the expected yield exceeds the coupon rate, the market price of the bond will adjust downward to provide the required yield.
Hence, if you buy it at face value (₹100), you're not getting a sufficient return relative to the market’s expectations.
Opportunity Cost:
•If you can invest in other securities that yield 8% or higher, it makes more financial sense to pursue those options rather than
investing in a bond that is providing a yield lower than what you could achieve elsewhere.
Summary
Given these factors, buying the NCD at an expected yield of 8% would not be advisable because you would effectively be
paying ₹100 for an investment that yields a lower return compared to available market alternatives, resulting in a potential
loss in value and return on investment.
Bond Spread
• Credit Rating
 Mr.X is a moderate risk taker and would like to create a corpus of Rs.50,00,000 in the next five years to meet his specific needs. He
is planning to invest in the following fixed-income securities.
1.Rs.20,00,000 DHFL quarterly compounding NCD with a coupon of 8.5% for 5 years.
2.Rs.3,00,000 IIFL Tier-I bond with a semi annual Compounding interest of 3.75% for 5 years.
3.Rs.5,00,000, SBI tax gain deposit scheme of 6.5% interest per annum for 5 years.
a) What would be the annualized yield of each of these instruments?
b) Will he be able to generate the required corpus through the redemption of his holdings at the end of the five years?
c) Comment on the risk aspects of these investments.

Summary of Annualized Yields:

•DHFL NCD:
•IIFL Tier-I Bond:
•SBI Tax Gain Deposit:

b) Total Corpus After 5 Years

The total corpus generated from each investment at the end of five years:
1.DHFL NCD: ₹
2.IIFL Tier-I Bond : ₹
3.SBI Tax Gain Deposit : ₹
Total Corpus:
Total Corpus=29,71,880+3,62,346+6,62,500= ₹39,96,726 (Reference)

Corpus Requirement:
Mr. X will be able to generate the required corpus of ₹50,00,000 in five years; if
the total projected is more than or equal to ₹50,00,000.
 • Risk Aspects of These Investments
1. DHFL NCD:
1. Credit Risk: There’s a risk of default by the issuer, DHFL, especially in the context of market conditions and its
financial health.
2. Interest Rate Risk: With changes in interest rates, the market value of NCDs may fluctuate.
2. IIFL Tier-I Bond:
1. Credit Risk: Similar to the NCD, the risk of default exists, particularly if IIFL's financial health deteriorates.
2. Liquidity Risk: These bonds may not be as liquid as government securities.
3. SBI Tax Gain Deposit:
1. Low Risk: This is backed by the government, making it a relatively safer option.
2. Inflation Risk: The returns may not keep pace with inflation, eroding purchasing power over time.
 • Key Features of Gilt Securities Market
1. Safety and Credit Risk: Gilt securities are backed by the government, making them virtually risk-free concerning
credit defaults. This safety is a significant attraction for conservative investors.
2. Liquidity: The Gilt market is relatively liquid, allowing investors to buy and sell securities with ease. The
presence of a secondary market facilitates this liquidity.
3. Variety of Instruments: Gilt securities come in various forms, including dated securities, treasury bills, and
long-term bonds. This variety allows fund managers to tailor their investments according to their risk-return
profiles.
4. Interest Rate Sensitivity: Gilt securities are sensitive to changes in interest rates. When interest rates rise, the
prices of existing bonds tend to fall, and vice versa. This feature can be leveraged by fund managers to optimize
returns based on interest rate forecasts.
5. Tax Benefits: Certain gilt securities, like those held until maturity, may offer tax advantages, particularly in the
case of long-term capital gains.
6. Regulatory Framework: The Gilt market is regulated by the RBI and the Securities and Exchange Board of India
(SEBI), ensuring transparency and stability.
7. Role in Monetary Policy: Gilt securities are instrumental in the implementation of monetary policy, as they are
used in open market operations by the RBI to control liquidity in the economy
 • Bonds
•Coupon Payments: Regular income.
•Price Appreciation: Changes in market value.
•Reinvestment Income: Earnings from reinvested coupons.
•Principal Repayment: Return of initial investment.
•Spread Compression: Benefits from narrowing credit spreads.
•Tax Considerations: Effects of taxation on overall returns