PPA FEB UI

Introduction to
Fixed Income Valuation
 Bond/ Fixed Income Securities Valuation Process

Estimate the cash-flows

- Coupon payments (Coupon rate x Principal)

- Principal payment, usually as a bullet payment at maturity

Estimate appropriate discount rate(s)

PPA FEB UI
YTM (single rate)
A series of spot rates

2
 Bond/ Fixed Income Securities Valuation Process

Calculate the present value using the following formula:

n
CPNnxm M
Value   
1 1  i / mnxm 1  i / mnxm

PPA FEB UI
M = Face value of bond
CPN = Coupon payments
i = interest rate per annum (YTM)
m = number of coupons per year
n = number of years to maturity (from
today or last coupon)

3
 Valuing Bonds – Annual Pay Bonds

We have a 10-year, $1,000 par value, 10% annual pay bond. YTM is
10%. Calculate the value of this bond.

Cash-flow

Time 0 1 PPA FEB UI

2 3 4 10

The calculator solution is:

N = 10; PMT = 100; FV = 1,000; I/Y = 10; CPT  PV = -1,000
4
 Valuing Bonds – Semi Annual Pay Bonds

We have a 10-year, $1,000 par value, 10% semi-annual pay bond. YTM
is 8%. Calculate the value of this bond.

Cash-flow

Time 0 1 PPA FEB UI

2 3 4 10

The calculator solution is:

N = 20; PMT = 50; FV = 1,000; I/Y = 4; CPT  PV = -1,135.90
5
 Valuing Bonds – Zero Coupon Bonds

We have a 5-year, $1,000 par value, Zero coupon bond. YTM is 3%.
Calculate the value of this bond.

No coupon payments

Cash-flow

Time 0 1 PPA FEB UI

2 3 4 5

6
 SOAL

1. A 20-year, 10% annual-pay bond has a par value of $1,000.

What is the price of the bond if it has a yield-to-maturity o
15%?

A. $685.14
B. $687.03
C. $828.39 PPA FEB UI

7
 SOAL

2. An analyst observes a 5-year, 10% semiannual-pay bond. The face

amount is £1,000. The analyst believes that the yield-to-maturity on a
semiannual bond basis should be 15%. Based on this yield estimate, the
price of this bond would be:

PPA FEB UI
A. £828.40
B. £1,189.53
C. £1,193.04

8
 Price/Market Yield Relationship

Price
If Yield increases ----- Price decreases
If Yield decreases ----- Price increases

However, the relationship is NOT LINEAR

PPA FEB UI
Yield
n
CPNnxm M
PRICE   
1 1  i / m  1  i / m 
nxm nxm

9
 Relationship between coupon rate, discount rate and price relative to par value at
different maturities

If coupon rate > than YTM, bond is sold at premium

If coupon rate < smaller than YTM, bond is sold at discount

If coupon rate = YTM, bond is sold at par.

PPA FEB UI
Price will converge
Price toward par-value as
Premium: YTM<Coupon maturity approaches (“pull
to par value”)

At par: YTM = Coupon

Par Value

Discount: YTM> Coupon

time
maturity

10
 SOAL

3. An analyst observes a 20-year, 8% option-free bond with semiannual

coupons. The required yield-to-maturity on a semiannual bond basis was
8%, but suddenly it decreased to 7.25%. As a result, the price of this
bond:

A. increased
B. decreased
PPA FEB UI
C. stayed the same

11
 SOAL

4. A $1,000, 5%, 20-year annual-pay bond has a YTM of 6.5%. if the YTM
remains unchanged, how much will the bond value increase over the
next three years?

A. $13.62
B. $13.78
C. $13.96 PPA FEB UI

12
 Spot Rates and Arbitrage-Free Valuation

The use of a single discount factor

The use of multiple discount rates (a
(YTM) to value all cash flows of a bond
series of spot rates that reflect current
assumes a flat term structure, where
term structure) will result in more
interest rates is the same across all
accurate bond pricing and eliminate
maturities. In practice, flat term

PPA FEB UI
any arbitrage opportunities.
structures are very rare.

YTM is only an approximation or

weighted average of a set of spot rates.
That’s why usage of spot rates to
Unless term structure is actually flat,
discount bond cash flows is called an
usage of YTM in bond valuation will
arbitrage-free valuation procedure.
result in a mis-priced bond, which in turn
will provide arbitrage opportunities.

13
 Valuing a bond using spot rates

• Given the following spot rates, calculate the value of a 3-

year, 5% annual-coupon bond.
• Spot rates:
1-year: 3%

PPA FEB UI
2-year: 4%
3-year: 5%

14
 SOAL

5. If spot rates are 3.2% for one year, 3.4% for two years, and
3.5% for three years, the price of a $100,000 face value, 3-
year, annual-pay bond with a coupon rate of 4% is closest to:

PPA FEB UI
A. $101,420
B. $101,790
C. $108,230

15
 Flat Price vs Full Price

Accrued interest

Cash-flow

Time 0 PPA FEB UI

1 2 Maturity

Settlement date
(cash is exchanged for the bond)

Full price = Flat price + Accrued interest

16
 Flat Price vs Full Price

A 5%-bond makes coupon payments on June 15 and December 15 and istrading with a
YTM of 4%. The bond is purchased and will settle on August 21 when there will be our
coupons remaining until maturity. Calculate the full price of the bond using actual days.

Step 1: Calculate the value of the bond on the last coupon date:

PPA FEB UI
N = 4; PMT = 25; FV = 1,000; I/Y = 2; CPT  PV = -1,019.04

Step 2: Adjust for the number of days since the last coupon payment:
Days between June 15 and December 15 = 183 days
Days between June 15 and August 21 = 67 days
Full price = 1,019.04 x (1.02)67/183 = 1,026.46

The accrued interest on the settlement date of August 21 is $25 (67/183) = $9.15

Flat price = 1,026.46 – 9.15 = 1,017.31

17
 SOAL

6. An investor paid a full price of $1,059.04 each for 100

bonds. The purchase was between coupon dates, and
accrued interest was $23.54 per bond. What is each bond’s
flat price?

PPA FEB UI
A. $1,000.00
B. $1,035.50
C. $1,082.58

18
 Matrix Pricing

A method of estimating the required YTM of bonds that

are currently not traded or infrequently traded.

bonds: PPA FEB UI

YTM of traded YTM of a nontraded
or inrequently traded
- very close bonds
credit quality
- similar maturity
and coupon

19
 Matrix Pricing

Consider the following YTM on similar corporate bonds:

BB rated, 4-year annual-pay, 5% coupon bond: YTM = 4.738%
BB rated, 6-year annual-pay, 4% coupon bond: YTM = 5.232%
BB rated, 6-year annual-pay, 6% coupon bond: YTM = 5.284%
Estimate the value of a nontraded 4% annual-pay, BB rated bond that has five years
remaining until maturity

PPA FEB UI
Step 1: Take the average YTM of the 6-year bonds
(5.232% + 5.284%) / 2 = 5.258%

Step 2: Average the YTM of te 4-year bond with the average 6-year bond yield
(4.738% + 5.258%) / 2 = 4.998%

Step 3: Price the nontraded bond with a YTM of 4.998%

N = 5; PMT = 40; FV = 1,000; I/Y = 4.998; CPT  PV = -956.79

The estimated value is $956.79 per $1,000 par value

20
 Matrix Pricing

Consider the following YTM on similar corporate bonds:

BB rated, 4-year annual-pay, 5% coupon bond: YTM = 4.738%
BB rated, 7-year annual-pay, 5% coupon bond: YTM = 5.336%
Estimate the value of a nontraded 5% annual-pay, BB rated bond that has five years
remaining until maturity

PPA FEB UI
N = 5; PMT = 50; FV = 1,000; I/Y = 4.937; CPT  PV = -1,002.73

The estimated value is $1,002.73 per $1,000 par value

21
 Matrix Pricing

Consider the following YTM on similar corporate bonds:

5-year, U.S. Treasury Bond, YTM 1.48%
5-year, A rated Corporate Bond, YTM 2.64%
7-year, Treasury Bond, YTM 2.15%
7-year, A rated Corporate Bond, YTM 3.55%
6-year, U.S. Treasury Bond, YTM 1.74%
Estimate the required yield on a newly issued 6-year, A rated Corporate Bond

PPA FEB UI
Step 1: Calculate the spreads to the benchmark (Treasury) yields
Spread on the 5-year corporate bond is 2.64% - 1.48% = 1.16%
Spread on the 7-year corporate bond is 3.55% - 2.15% = 1.40%
Step 2: Calculate the average spread because the 6-year bond is the midpoint of five
and seven years
Average spread = (1.16% + 1.40%) / 2 = 1.28%
Step 3: Add the average spread to the YTM of the 6-year Treasury (benchmark) bond
1.74% + 1.28% = 3.02%
The estimated YTM on the newly issued 6-year, A rated bond is 3.02%

22
 SOAL

7. Cathy Moran, CFA, is estimating a value for an infrequently traded

bond with 6 years to maturity, an annual coupon of 7%, and a single-B
credit rating. Moran obtains yields-to-maturity for more liquid bonds
with the same credit rating:
- 5% coupon, 8 years to maturity, yielding 7.20%

PPA FEB UI
- 6.5% coupon, 5 years to maturity, yielding 6.40%
The infrequently traded bond is most likely trading at:

A. par value
B. a discount to par value
C. a premium to par value

23
 Yield Measures for Fixed-Rate Bonds, FRN, & Money Market Instruments

Effective yield Current yield

depends on periodicity
 coupon payments Annual cash coupon payments
frequency per year Bond price

PPA FEB UI Yield-to-call

Calculated for each possible call date and price.
The lowest of YTM and various YTC is yield-to-worst

Option-adjusted yield
Adding the value of the call option to the bond’s
current flat price

24
 Effective Yield

An Atlas Corporation bond is quoted with a YTM of 4% on a semiannual bond basis.

What yield should be used to compare it with a quarterly-pay bond and an annual-
pay bond?

PPA FEB UI
4% on a semiannual bond basis is an effective yield of 2% per 6-month period
The effective annual yield on the semiannual coupon bond is 1.022 – 1 = 4.04%

The quarterly yield that is equivalent to a yield of 2% per six months is

1.021/2 – 1 = 0.995%

The quoted annual rate for the equivalent yield on a quarterly bond basis is
4 x 0.995% = 3.98%

25
 Current Yield

Consider a 20-year, $1,000 par value, 6% semiannual-pay bond that is currently

trading at a flat price of$802.07. Calculate the current yield.

PPA FEB UI
The annual cash coupon payments:
par value x stated coupon rate = $1,000 x 0.06 = $60

Because the bond is trading at $802.07, the current yield is:

26
 Yield-to-Call

Consider a 10-year, semiannual-pay 6% bond trading at 102 on January 1, 2014. The

bond is callable according to the following schedule:
Callable at 102 on or after January 1, 2019
Callable at 100 on or after January 1, 2022
Calculate the bond’s YTM, yield-to-first call, yield-to-first par call, and yield-to-worst.

PPA FEB UI
YTM on the bond is calculated as:
N = 20; PMT = 30; FV = 1,000; PV = -1,020; CPT --> I/Y = 2.867%
2 x 2.867% = 5.734%
The yield-to-first call:
N = 10; PMT = 30; FV = 1,020; PV = -1,020; CPT --> I/Y = 2.941%
2 x 2.941% = 5.882%
The yield-to-first par call:
N = 16; PMT = 30; FV = 1,000; PV = -1,020; CPT --> I/Y = 2.843%
2 x 2.843% = 5.686%
The lowest yield, 5.686%, is realized if the bond is called at par on January 1, 2022,
so the yield-to-worst is 5.686%.

27
 FRN
A semiannual $1,000 par value FRN has two years to maturity, the reference rate is 180-
day LIBOR, and the quoted margin is 60 basis points. 180-day LIBOR today (a coupon
payment and reset date) is 3% and the required (discount) margin is 86 basis points.
Calculate the value of the FRN.

Both LIBOR and the margins are quoted on annual basis and must be divided by two

PPA FEB UI
to get the coupon rate for the FRN because it pays two coupons each year.
Coupon rate = (180-day LIBOR + quoted margin) / 2 = (3% + 0.6%) / 2 = 1.8%
Coupon payments = 1.8% x $1,000 = $18 every six months for two years.
The appropriate discount rate is (180-day LIBOR + discount margin) / 2
= (3% + 0.86%) / 2 = 1.93%

The estimated value of the FRN today:

N = 4; PMT = 18; I/Y = 1.93; FV = 1,000; CPT --> PV = -995.04
Because the discount margin is greater than the quoted margin, the FRN will trade at
a discount.

28
 Money Market Instruments

A $1,000 90-day T-bill is priced with an annualized discount of 1.2%. Calculate its market
price and its annualized add-on yield based on a 365-day year.

The discount from face value is 1.2% x 90/360 x $ 1,000 = $3

The current price is $1,000 - $3 = $997
The equivalent add-on yield for 90 days is $3 / $997 = 0.3009%
The annualized add-on yield based on a 365-day year is 0.3009% x 365/90 = 1.2203%

PPA FEB UI
(bond equivalent yield)

A $1 million negotiable CD with 120 days to maturity is quoted with an add-on yield of
1.4% based on a 365-day year. Calculate the payment at maturity for this CD and its bond
equivalent yield.

The add-on interest for the 120-day period is 1.4% x 120/365 = 0.4603%
At maturity, the CD will pay $1 million x (1 + 0.004603) = $1,004,603
The quoted yield on the CD is the bond equivalent yield because it is an add-on yield
annualized based on a 365-day year

29
 Money Market Instruments

A bank deposit for 100 days is quoted with an add-on yield of 1.5% based on a 360-day
year. Calculate the bond equivalent yield and the yield on a semiannual bond basis.

The bond equivalent yield, which is based on a 365-day year is 1.5% x 365/360 =
1.5208%

PPA FEB UI
The 100-day holding period return is 1.5% x 100/360 = 0.4167%.
The effective annual yield is 1.004167365/100 – 1 = 1.5294%
The equivalent semiannual yield is 1.0152941/2 – 1 = 0.7618%
The annual yield on a semiannual bond basis is 2 x 0.7618% = 1.5236%

Because the periodicity of the money market security (365/100) is greater than the
periodicity of semiannual-pay bond (2), the simple annual rate for the money market
(1.5%) is less than the yield on a semiannual bond basis (1.5236%)

30
 SOAL

8. A market rate of discount for a single payment to be made

in the future is:

A. a spot rate.

PPA FEB UI
B. a simple yield.
C. a forward rate.

31
 SOAL

9. Based on semiannual compounding, what would the YTM

be on a 15-year, zero-coupon, $1,000 par value bond that’s
currently trading at $331.40?

PPA FEB UI
A. 3.750%
B. 5.151%
C. 7.500%

32
 SOAL

10. An analyst observes a Widget & Co. 7.125%, 4-year,

semiannual-pay bond trading at 102.347% of par (where par
is $1,000). The bond is callable at 101 in two years. What is
the bond’s yield-to-call?

PPA FEB UI
A. 3.167%
B. 5.664%
C. 6.334%

33
 SOAL

11. A floating-rate note has a quoted margin of +50 basis

points and a required margin of +75 basis points. On its next
reset date, the price of the note will be:

A. equal to par value

PPA FEB UI
B. less than par value
C. greater than par value

34
 SOAL

12. Which of the following money market yields is a bond-

equivalent yield?

PPA FEB UI
A. Add-on yield based on a 365-day year
B. Discount yield based on a 360-day year
C. Discount yield based on a 365-day year

35
 Yield Curve, Par Curve, and Forward Curve

Yield curve
Par curve
Shows yields by
Constructed from spot curve
maturity

PPA FEB UI Forward curve

Shows the future rates for bonds or money market
securities for the same maturities for annual periods
in the future

36
 U.S. Treasury Yield Curve

4
Maturity Yield
3.5 1 month 0,02
3 month 0,04
3
6 month 0,08
1 year 0,13
Yield

2.5

PPA FEB UI
2 year 0,35
2
3 year 0,65
1.5 5 year 1,49
7 year 2,15
1 10 year 2,74
20 year 3,48
0.5
30 year 3,77
0

Maturity

37
 Par Bond Yield Curve

Consider a 3-year annual-pay bond. With spot rates of 1%, 2%, and
3%, a 3-year annual par bond will have a payment that will satisfy:

PPA FEB UI
So, the payment is 2.96 and the par bond coupon is 2.96%

38
 SOAL

13. Which of the following yield curves is least likely to

consist of observed yields in the market?

A. Forward yield curve

PPA FEB UI
B. Par bond yield curve
C. Coupon bond yield curve

39
 Spot Rates vs Forward Rates

Forward rate
A borrowing/lending rate for a loan to be made at some future
date.

Forward rate notation

PPA FEB UI
Identify both the length of the lending/borrowing period and
when in the future the money will be loaned/borrowed
e.g. 2y1y = the rate for a 1-year loan, to be made two years from now

The concept
Borrowing for three years at the 3-year spot rate, or borrowing for
1-year periods in three consecutive years, should have the same
cost

40
 Spot Rates vs Forward Rates

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

S3 = [(1.02) (1.03) (1.04)]1/3 – 1 = 2.997%

The 2-period spot rate, S2, is 8%, and the 1-period spot rate, S1, is 4%. Calculate the

PPA FEB UI
forward rate for one period, one period from now, 1y1y.

(1.08)2 = (1.04) (1 + 1y1y)

1y1y = 12.154%

In other words, investors are willing to accept 4% on the 1-year bond today (when
they could get 8% on the 2-year bond today) only because they can get 12.154% on a
1-year bond, one year from today. This future rate that can be locked in today is a
forward rate.

41
 Forward Rates and Bond Price

The current 1-year rate, S1, is 4%, the 1-year forward rate for lending from time =1 to
time = 2 is 1y1y = %%, and the 1-year forward rate for lending from time = 2 to time = 3
is 2y1y = 6%. Value a 3-year annual-pay bond with a 5% coupon and a par value of
$1,000.

PPA FEB UI

42
 SOAL

14. The 4-year spot rate is 9.45%, and the 3-year spot rate is
9.85%. what is the 1-year forward rate three years from
today?

PPA FEB UI
A. 8.258%
B. 9.850%
C. 11.059%

43
 SOAL

15. Given the following spot and forward rates:

- Current 1-year spot rate is 5.5%
- One-year forward rate one year from today is 7.63%
- One-year forward rate two years from today is 12.18%
- One-year forward rate three years from today is 15.5%

PPA FEB UI
The value of a 4-year, 10% annual-pay, $1,000 par value bond is closest
to:

A. $996
B. $1,009
C. $1,086

44
 Yield Spread Measures and the Valuation of Non-Treasury Securities

 Value of a non Treasury 24%

Benchmark Spot Rate
security is found by Yield Curve AA
23% 23.00%
discounting cash flows by the
22%
Treasury spot rate plus a yield 22.00%

PPA FEB UI
spread to reflect the 21%
21.00%

Yield
additional risks. 20%
19.70% 20.00%
19% 19.50%
 The credit spread increases 19.00%
Spot Rate Yield Curve
18%
with the maturity of the 17.70% 18.20%

bond. There is a term 17%

structure of credit spreads 16%

16.70%

0%
15%
 Typically, the lower the credit 1 2 3 4 5
rating, the steeper the term Maturity (years)
structure of credit spreads

45
 Yield Spread Measures

G-spread I-spread
A yield spread over a A yield spread relative to swap
government bond rates

PPA FEB UI
Z-spread
A yield spread that must be added to each spot rate
on the benchmark yield curve to make the present
value of a bond equal o its price

Option adjusted spread

Used for bonds with embedded options

46
 Yield Spread Measures

1-, 2-, and 3-year spot rates on Treasuries are 4%, 8.167%, and 12.377%, respectively.
Consider a 3-year, 9% annual coupon corporate bond trading at 89.464. The YTM is
13.50%, and the YTM of a 3-year Treasury is 12%. Compute the G-spread and the Z-
spread of the corporate bond.

PPA FEB UI
G-spread = YTMBond – YTMTreasury = 13.5% - 12% = 1.5%

The Z-spread is calculated using the following equation:

ZS = 1.67% or 167 basis points

47
 SOAL

16. A corporate bond is quoted at a spread of +235 basis points over an

interpolated 12-year U.S. Treasury bond yield. This spread is a(n):

PPA FEB UI
A. G-spread
B. I-spread
C. Z-spread

48
 JAWABAN

1. N = 20; I/Y = 15; FV = 1,000; PMT = 100; CPT  PV = -$687.03

2. N = 10; I/Y = 7.5; FV = 1,000; PMT = 50; CPT  PV = -$828.40

PPA FEB UI
3. The price-yield relationship is inverse. If the required yield decrease, the
bond’s price will increase, and vice versa.

4. With 20 years to maturity, the value of the bond with annual-pay

yield of 6.5% is N = 20, PMT = 50, FV = 1,000, I/Y = 6.5, CPT  PV = -
834.72. With N = 17. CPT  PV = -848.34, so the value will increase
$13.62.

49
 JAWABAN

5.

6. The full price includes accrued interest, while the flat price does not.
Therefore, the flat (or clean) price is 1,059.04 – 23.54 = $1,035.50.

PPA FEB UI
7. Using linear interpolation, the yield on a bond with six years to maturity
should be 6.40% + (1 / 3)(7.20% - 6.40%) = 6.67%. A bond with a 7% coupon an
a yield of 6.67% is at a premium to par value.

8. A spot rate is a discount rate for a single future payment. Simple

yield is a measure of a bond’s yield that accounts for coupon interest
and assumes straight-line amortization of a discount or premium. A
forward rate is an interest rate for a future period, such as a 3-
month rate six months from today.
50
 JAWABAN

9. N = 30; FV = 1,000; PMT = 0; PV = -331.40; CPT  I/Y = 3.750 x 2 =

7.500%

10. N = 4; FV = 1,010; PMT = 35.625; PV = -1,023.47; CPT  I/Y = 3.167

PPA FEB UI
x 2 = 6.334%

11. If the required margin is greater than the quoted margin, the credit quality
of the issue has decreased and the price on the reset date will be less than par
value.

12. An add-on yield based on a 365-day year is a bond-equivalent yield.

51
 JAWABAN
13. Par bond yield curves are based on the theoretical yields that
would cause bonds at each maturity to be priced at par. Coupon
bond yields and forward interest rates can be observed directly from
market transactions.

14. (1.0945)4 = (1.0985)3 x (1 + 3y1y)

PPA FEB UI
Approximate forward rate = 4(9.45%) – 3(9.85%) = 8.25%.

15. Bond value

16. G-spreads are quoted relative to an actual or interpolated government

bond yield. I-spreads are quoted relative to swap rates. Z-spreads are
calculated based on the shape of the benchmark yield curve.
52
 Hak Cipta © 2020 PPA FEB UI

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