Unit 4

UNIT 5
FIXED INCOME SECURITIES
Dr Suresha B
School of Business and Management
MISSION VISION CORE VALUES

CHRIST is a nurturing ground for an individual’s holistic development to Excellence and Service Faith in God | Moral Uprightness
make effective contribution to the society in a dynamic environment Love of Fellow Beings
Social Responsibility | Pursuit of Excellence
CHRIST
Deemed to be University
Unit Outline
● Introduction to the Valuation of Debt Securities
● Steps in the bond valuation process,
● Difficulties in estimating the expected cash flows;
● Valuation of coupon and zero-coupon bonds;
● Changes in price of a bond if the discount rate changes and/ or maturity approaches;
arbitrage-free valuation approach and
● Possibility of arbitrage profit ,if a bond is mispriced.
Excellence and Service

CHRIST
Valuation of Debt Securities
● Bonds and their variants such as loan notes, debentures and loan stock, are IOUs issued by
governments and corporations as a means of raising finance.
● As with any asset valuation, the investor would be willing to pay, at the most, the present value
of the future income stream discounted at the required rate of return (or yield).
● Valuation of debt securities follow the time value of money principle on its cash flow.
● Estimating cash flows and determining the key rates are critical point of valuations
● Concept of PV, Future value, YTM, YTC and Holding period yield is important for valuation
based decisions.

CHRIST
Bond Valuation Steps
Since a bond pays periodic coupon payments and a lump sum (par value) at maturity, its
price is best calculated by using the following steps:
● Step 1. Lay out the cash flows on a time line;
● Step 2. Determine an appropriate discount rate (yield to maturity);
● Step 3. Calculate the present value of the coupons and the par value;
● Step 4. Add up the two present values to calculate the bond price.

4-5
Formula for Fv for a series of Payment
Vn = R1(1+i)^n-1 + R2(1+i)^n-2 + ……
What is maturity/redemption value of Rs.25,00,000 invested now for a period of
5 years in a Bond at 8% coupon?
Ans: FV:36,73,320
If given a choice between annual and semi-annual compounding which one you
choose and why?
FV: Rs.37,00,611
4-6
Effective interest rates

• The interest rate quoted on a deposit or loan is usually the flat rate.
• However we are often required to compare two interest rates which apply for a
similar investment period but have different interest payment frequencies, for
example a two-year interest rate with interest paid quarterly compared to a two-
year rate with semi-annual interest payments.
• This is normally done by comparing equivalent annualised rates.
• The annualised rate is the interest rate with annual compounding that results in
the same return at the end of the period as the rate we are comparing.
4-7
Effective interest rates

4-8
Effective interest rates – Case lets
 Farhana has deposited funds in a building society 1-year fixed rate account with
interest quoted at 5%, payable in semi-annual instalments. What is the effective rate
that she earns at the end of the period?
 Hint: 5.062%
 Rupert is quoted a nominal interest rate of 6.40% for a 1-year time deposit where the
interest is credited at maturity. What is the equivalent rate for the same building
society’s 1-year account that pays interest on a monthly basis?
 Hint: 6.59%
4-9
Financial Asset Valuation
0 1 2 n
r
...
Value CF1 CF2 CFn
CF 1 CF 2 CF n
PV = + + . .. + .
1 + r 1
1 + r  2
1 + r  n
4 - 10
The discount rate (ri) is the

opportunity cost of capital, i.e., the
rate that could be earned on
alternative investments of equal risk.
4 - 11
Methods of Bond Valuation
 Generally, there are four methods of bond valuation at our disposal.

Each is based on the time value of money concept.
 What distinguishes these methods is the applied discount rate.
 We can value a bond using:
 A market discount rate,
 Spot rates and forward rates,
 Binomial interest rate trees, or
 Matrix pricing.
Bond Valuation
Present value of a Bond is equal to the sum of PV of its cash flows.
What’s the value of a Rs.1000, 10-year, 10% coupon bond if rd = 12%?
https://www.youtube.com/watch?v=tJLR3se4Pa4
4 - 13
What’s the value of a 10-year, 10% coupon bond if rd

= 10%?
0 1 2 10
10%
...
V=? 100 100 100 + 1,000
100 100 1 ,000

VB  1 + . . . + 10 + 10
1 + rd  1 + r d  1 + r d 
= 90.91 + . . . + 38.55 + 385.54
= 1,000.
4 - 14
The bond consists of a 10-year, 10% annuity of

100/year plus a 1,000 lump sum at t = 10:
PV annuity = 614.46
PV maturity value = 385.54
Value of bond = 1,000.00
INPUTS
10 10 100 1000
N I/YR PV PMT FV
OUTPUT -1,000
4 - 15
What would happen if expected inflation rose by

3%, causing r = 13%?
INPUTS
10 13 100 1000
N I/YR PV PMT FV
OUTPUT -837.21
When kd rises, above the coupon rate, the bond’s

value falls below par, so it sells at a discount.
4 - 16
What would happen if inflation fell, and rd declined

to 7%?
INPUTS
10 7 100 1000
N I/YR PV PMT FV
OUTPUT -1,210.71
If coupon rate > rd, price rises above par, and bond
sells at a premium.
4 - 17
Suppose the bond was issued 20 years ago and

now has 10 years to maturity. What would
happen to its value over time if the required rate
of return remained at 10%, or at 13%, or at 7%?
4 - 18
Bond Value ( Rs)

1,372
rd = 7%.
1,211
1,000
rd = 10%. M
837
rd = 13%.
775
30 25 20 15 10 5 0
Years remaining to Maturity

4 - 19
 At maturity, the value of any bond must equal its

par value.
 The value of a premium bond would decrease to
1,000.
 The value of a discount bond would increase to
1,000.
 A par bond stays at 1,000 if rd remains constant.
4 - 20
Pricing the ZCB
 Some bonds do not make any periodic coupon payments. Instead the investor
realizes interest rate as the difference between the maturity value and the
purchase price. These are known as Zero Coupon bonds. The Price of ZCB is
calculated as follows
M
P = ______
(1+r)^n
In calculating the PV of ZCB double the number of years to
maturity and divide the discount rate by 2.
Valuing Zero Coupon Bonds
What is the current market price of a U.S. Treasury strip that matures in exactly 5 years
and has a face value of $1,000. The yield to maturity is rd=7.5%. If the Rd moves to
7.75% what would be the price?
1000
5 = $696 .56
1.075
1000
5 = $688 .51
1.0775
21
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UNIT 5

FIXED INCOME SECURITIES

MISSION VISION CORE VALUES

Excellence and Service

Valuation of Debt Securities

Excellence and Service

Bond Valuation Steps

Excellence and Service

Formula for Fv for a series of Payment

Effective interest rates

Effective interest rates

Effective interest rates – Case lets

Financial Asset Valuation

The discount rate (ri) is the

Methods of Bond Valuation

 Generally, there are four methods of bond valuation at our disposal.

What’s the value of a Rs.1000, 10-year, 10% coupon bond if rd = 12%?

What’s the value of a 10-year, 10% coupon bond if rd

100 100 1 ,000

The bond consists of a 10-year, 10% annuity of

What would happen if expected inflation rose by

When kd rises, above the coupon rate, the bond’s

What would happen if inflation fell, and rd declined

Suppose the bond was issued 20 years ago and

Bond Value ( Rs)

Years remaining to Maturity

 At maturity, the value of any bond must equal its

Pricing the ZCB

Excellence and Service

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