FI BOND VALUATION

YIELD AND YIELD SPREAD MEASURES FOR FIXED-RATE BONDS,

FLOATING-RATE BONDS
THE TERM STRUCTURE OF INTEREST RATES: SPOT, PAR, AND
FORWARD CURVES
LOS a: Calculate a bond’s price given a market discount rate.
LOS b: Identify the relationships among a bond’s price, coupon rate, maturity,
and market discount rate (yield-to-maturity).
 The price of a bond is the present value of its future cash flows, discounted at
the bond’s CURRENT YIELD TO MATURITY (YTM).
 YTM is computed on the assumption that the investor is holding the bond till
maturity and the interest received gets reinvested at rate equal to YTM.
 YTM is also market rate of discount or investors required yield.

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Example: Consider a newly issued 3-year, $1,000 par value, 10% coupon,
annual-pay bond.
Compute the market value of bond assuming market discount rate (YTM)
to be: Case I 10%, Case II 15%, Case 5%.
Conclusion:
There is inverse relationship between YTM and bond prices. (However,
bond’s price-yield relationship is convex.) (explained in more detail in
later topics)
Particulars Bond will
trade at Always keep
If coupon rate = Par value in mind, zero
YTM coupon bond.
If coupon rate > Premium
YTM value
If coupon rate < Discount value
YTM

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Other things equal, the price of a bond with a lower coupon rate is more
sensitive to a change in yield than is the price of a bond with a higher
coupon rate.
Other things equal, the price of a bond with a longer maturity is more
sensitive to a change in yield than is the price of a bond with a shorter
maturity.
A bond’s price moves toward par value as time passes and maturity
approaches. This is known as constant yield price trajectory.
• Example: Consider a newly issued 5-year, $1,000 par value, 10% coupon,
semi-annual pay bond. Compute the market value of bond assuming
market discount rate (YTM) to be 9%.

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LOS c: Define spot rates and calculate the price
of a bond using spot rates.
Spot rates are market discount rates for single
payments to be made in the future i.e. YTM of
zero coupon bonds.
The no-arbitrage price of a bond is calculated
using (no-arbitrage) spot rates as follows:
No-arbitrage price = + + ……. +
Series of zero coupon bond, with
different maturities. 5
• Example: Given the following spot rates, calculate the
value of a 3-year, 5% annual-coupon bond and YTM.
Spot rates: 1-year: 3%, 2-year: 4% ,3-year: 5%

• Example: Given the following spot rates, calculate the

value of a 1.5-year, 7% semi-coupon bond.
Spot rates: 0.5-year: 5%, 1-year: 6% ,1.5-year: 7%

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• A portfolio manager is considering the purchase of a bond with a 5.5% coupon rate that pays interest annually
and matures in three years. If the required rate of return on the bond is 5%, the price of the bond per 100 of
par value is closest to:
A. 98.65.
B. 101.36.
C. 106.43.
• A bond with two years remaining until maturity offers a 3% coupon rate with interest paid annually. At a
market discount rate of 4%, the price of this bond per 100 of par value is closest to:
A. 95.34.
B. 98.00.
C. 98.11.
• A zero-coupon bond matures in 15 years. At a market discount rate of 4.5% per year and assuming annual
compounding, the price of the bond per 100 of par value is closest to:
A. 51.30.
B. 51.67.
C. 71.62.

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• An investor who owns a bond with a 9% coupon rate that pays interest semiannually and matures in three
years is considering its sale. If the required rate of return on the bond is 11%, the price of the bond per 100
of par value is closest to:
A. 95.00.
B. 95.11.
C. 105.15.
• A bond offers an annual coupon rate of 4%, with interest paid semiannually. The bond matures in two years.
At a market discount rate of 6%, the price of this bond per 100 of par value is closest to:
A. 93.07.
B. 96.28.
C. 96.33.
• A bond offers an annual coupon rate of 5%, with interest paid semiannually. The bond matures in seven
years. At a market discount rate of 3%, the price of this bond per 100 of par value is closest to:
A. 106.60.
B. 112.54.
C. 143.90.

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• Consider the following two bonds that pay interest annually:
Bon Coupon Time to
d rate maturity
A 5% 2 years
B 3% 2 years

At a market discount rate of 4%, the price difference between Bond A

and Bond B per100 of par value is closest to:
A. 3.70.
B. 3.77.
C. 4.00.

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• Suppose a bond’s price is expected to increase by 5% if its market
discount rate decreases by 100 basis points. If the bond’s market
discount rate increases by 100 basis points, the bond price is most
likely to change by:
A. 5%.
B. less than 5%.
C. more than 5%.

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• An investor considers the purchase of a 2-year bond with a 5% coupon
rate, with interest paid annually. Assuming the sequence of spot rates
shown
Time tobelow, the price
Spot ratesof the bondis closest to:
maturity
1 year 3%
2 years 4%

A. 101.93
B. 102.85
C. 105.81

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• A 3-year bond offers a 10% coupon rate with interest paid annually.
Assuming the following sequence of spot rates, the price of the bond is
closest
Time to to: Spot rates
maturity
1 year 8.0%
2 years 9.0%
3 years 9.5%

A. 96.98
B. 101.46
C. 102.95

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LOS h: Define forward rates and calculate spot rates from
forward rates, forward rates from spot rates, and the price of
a bond using forward rates.
• Forward rates are current lending/borrowing2y1y
rates for short-term loans
means
to be made in future periods. want to
invest for
This relation is illustrated as: 1 year
after 2
• = (1+)(1+1y1y)
years.
• = (1+)(1+1y1y)(1+2y1y)
or, = (1+2y1y)

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• Example: Computing spot rates from forward rates
If the current 1-year spot rate is 3%, the 1-year forward rate
one year from today (1y1y) is 4%, and the 1-year forward rate
two years from today (2y1y) is 5%, what is the 3-year spot
rate?

• Example: Computing a forward rate from spot rates

The 2-period spot rate, S2, is 9%, and the 1-period spot rate,
S1, is 5%. Calculate the forward rate for one period, one period
from now, 1y1y.
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• For a 3-year annual-pay bond:
No-arbitrage price = + +

• Example: Computing a bond value using forward rates: The

current 1-year rate, S1, is 5%, 1y1y = 6%, and 2y1y = 7%. Value a 3-
year annual pay bond with a 7% coupon and a par value of $1,000.

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All rates are annual rates stated for a periodicity of one (effective annual
rates). Time Forward
period rate
• The 3-year implied spot rate is closest to: 0y1y 0.80%
1y1y 1.12%
A. 1.18%.
2y1y 3.94%
B. 1.94%. 3y1y 3.28%
4y1y 3.14%
C. 2.28%.
• The value per 100 of par value of a two-year, 3.5% coupon bond, with
interest payments paid annually, is closest to:
A. 101.58.
B. 105.01.
C. 105.82.
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Summary
• The price of the bond is the present value of cash flows, discounted at
a) Current YTM
b) Series of spot rates
c) Series of forward rates

• There is inverse relationship price of a bond and YTM, however, the

relationship is not linear.
• Following bonds are more sensitive to change in YTM:
a) Bond with lower coupon
b) Bond with longer maturities

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LOS d: Describe and calculate the flat price, accrued interest, and the full
price of a bond.
Dealers usually quote flat prices, and then if a deal is executed the
accrued interest is added to the flat price to determine the full price
that must be paid by the buyer to the seller on the settlement date.

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Bond G, described in the exhibit below, is sold for settlement on 16 June 2014.
Annual Coupon 5%
• The full price that Bond G will settle at on 16 June 2014 is closest to:
Coupon Payment Frequency Semi-annual
A. 102.36. 10 April and 10
Interest Payment Dates
October
B. 103.10. Maturity Date 10 October 2016
C. 103.65. Day Count Convention 30/360
Annual Yield-to-Maturity 4%
• The accrued interest per 100 of par value for Bond G on the settlement date of 16 June 2014 is
closest to:
A. 0.46.
B. 0.73.
C. 0.92.
• The flat price for Bond G on the settlement date of 16 June 2014 is closest to:

A. 102.18.
B. 103.10.
C. 104.02.

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• Bond dealers most often quote the:
A. flat price.
B. full price.
C. full price plus accrued interest.

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LOS e: Describe matrix pricing.
• [Applying Matrix Pricing to Value a Bond] An analyst is trying to estimate the value of a relatively
illiquid 6-year, 5% annual-pay coupon bond. She identifies two corporate bonds that have similar
credit quality:
• Bond A is a 5-year, 6% annual-pay bond priced at 103.25 per 100 of par value.
• Bond B is an 8-year, 5% annual-pay bond priced at 97.75 per 100 of par value.

Estimate the price of the illiquid bond per 100 of par value.
• [Application of Matrix Pricing to Estimate the Credit Spread on a New Issue] Estimating the spread
for a new 4-year, A rated bond issue. Consider the following market yields:
• 3-year, U.S. Treasury bond, YTM 1.38%
• 3-year, A rated corporate bond, YTM 2.54%
• 5-year, U.S. Treasury bond, YTM 2.05%
• 5-year, A rated corporate bond, YTM 3.45%
• 4-year U.S. Treasury bond, YTM 1.64%
• Estimate the required yield on a newly issued 4-year, A rated corporate bond.

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• Matrix pricing allows investors to estimate market discount rates and
prices for bonds:
A. with different coupon rates.
B. that are not actively traded.
C. with different credit quality.
• When underwriting new corporate bonds, matrix pricing is used to get an
estimate of the:
A. required yield spread over the benchmark rate.
B. market discount rate of other comparable corporate bonds.
C. yield-to-maturity on a government bond having a similar time-to-
maturity.
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LOS f:
A two-year floating-rate note pays 6-month Libor plus 80 basis points.
The floater is priced at 97 per 100 of par value. Current 6-month Libor
is 1.00%. Assume a 30/360day-count convention and evenly spaced
periods. The discount margin for the floater in basis points (bps) is
closest to:
A. 180 bps.
B. 236 bps.
C. 420 bps.

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• An analyst evaluates the following information relating to floating rate notes
(FRNs) issued at par value that have 3-month Libor as a reference rate:
FRN Quoted Discount
margin margin
X 0.40% 0.32%
Y 0.45% 0.45%
Z 0.55% 0.72%

Based only on the information provided, the FRN that will be priced at a
premium on the next reset date is:
A. FRN X.
B. FRN Y.
C. FRN Z.

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• LOS i: A corporate bond offers a 5% coupon rate and has exactly 3 years remaining
to maturity. Interest is paid annually. The following rates are from the benchmark
spot curve:
Time to Spot rate
maturity
1 year 4.86%
2 years 4.95%
3 years 5.65%

The bond is currently trading at a Z-spread of 234 basis points. The value of the bond
is closest to:
A. 92.38.
B. 98.35.
C. 106.56.

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