Reserve Bank of India

Bond Dynamics
Arnab Kumar Chowdhury
College of Agricultural Banking
Reserve Bank of India, Pune
Agenda
Bond
FV and PV
Bond Pricing
Yield to Maturity
Modified YTM
Zero Coupon Bonds
Zero Coupon Yield
Yield Price
Relationship
Bond Theorems
Zero Coupon
Forward Rates
Synthetic Forward
Rates
FV and PV
Future Value of investment is amount the
investment will be worth at maturity i.e.
Principal + Interest up to maturity
FV
1
after 1 yr = PV x (1+r)
FV
2
after 2 yr = FV
1
x (1+r) = PV x (1+r)
2
FV
3
after 3 yr = FV
2
x (1+r) = PV x (1+r)
3
FV
n
after n yr = FV
n-1
x (1+r) = PV x (1+r)
n


FV and PV
FV
1
= PV x (1+r)
Known Unknown
FV
1
/ (1+r) = PV
FV
2
= PV x (1+r)
2
PV = FV
2
/ (1+r)
2
FV
3
= PV x (1+r)
3
PV = FV
3
/ (1+r)
3
FV
n
= PV x (1+r)
n
PV = FV
n
/ (1+r)
n
FV and PV
PV of cash flows
PV of cash received today= CF
0
/(1+r)
0
=CF
0

PV of cash received after 1 yr = CF
1
/(1+r)
1

PV of cash received after 2 yr = CF
2
/(1+r)
2
PV of cash received after 3 yr = CF
3
/ (1+r)
3
PV of cash received after n yr = CF
n
/ (1+r)
n
Example in Excel
Discount Factor
PV of cash received after n yr = CF
n
/
(1+r)
n
Here 1/(1+r)
n
is the discount factor
What is r ?
Important to remember: r is the
interest rate at which you will invest the
cash flow if you received it today,
instead of in the future.
What is a bond?
An instrument having following
features
Maturity
Coupon
Principal repayment on maturity
A secondary market
Price of a bond
Price of any asset depends on its earning
capacity
Presuming efficient markets:
Price of an asset today is todays value of its future
earnings; shall we say PV of future income given the rate of
interest
Price of a bond = PV of all cash inflows generated by the
bond discounted at todays required rate of return for
remaining maturity
Excel example 8
Price of a bond
Price of the bond is reading available from
market data.
If the price of a bond is P, the PV of the
bonds cash flows is also P. There the PV is
given, and what we have to find out is the
rate of interest at which PV of the bond
equals the price.
YTM is the rate of interest at which the PV of
all bonds cash flows equals its price.
Price of bond
Example: 10% coupon bond maturing in 3 years. YTM
= 12%. Price = 95.20/-
Year CF PV
1 10 8.93
2 10 7.97
3 110 78.30
95.20
Maturity of value of 10 invested for two years @
12%=12.54
Maturity of value of 10 invested for 1 years @ 12%=11.20
Maturity of value of 110 invested for zero years @
12%=110
Maturity value of the investment = 12.54+11.20+110.00 = 113.74
Maturity of value of 95.20 invested for 3 years
@ 12% p.a. is 95.20 x (1+12/100)
3
= 113.74
Price of a bond
Hence higher the interest rate used to
discount the cash flows, lower the PV
Example
Quiz: Price of a bond is 95.19. The PV of the
bonds cash flows at 11% is 97.56
YTM > or < 11% ?
When is a bond premium or discount

Price of a bond
Semi-annual coupons
Restate coupons as c / 2
Restate required rate of interest as r/2
Restate remaining maturity as n x 2
c/2
(1+r/2)
2n

Excel example 8A
Why is the price of a semiannual coupon bond
higher than a annual coupon bond?
100
(1+r/2)
2n

+

Price of a bond
Using the PV of annuity formula
P=PV of coupons+PV of Maturity value
P= (Annuity factor for r,n * coupon) +PV
of Maturity value
P=C * 1/r * [1- 1/(1+r)
n
] + M/(1+r)
n



Yield
In previous examples we have seen how to
compute a bonds price if yield is given
How to compute yield if the price is given
There are various measures of yield
Current Yield
Yield to Maturity
Modified Yield or Total Return
Zero Coupon Yield
Yield
Current Yield = Coupon / Price x 100
Yield to Maturity (YTM) = The yield from a
bond by holding it up to maturity
YTM is also called the IRR of bond
Price of a bond reflects the PV of all returns
from the bond right up to maturity, given the
yield
So if the price of a bond is given, what is the
yield?
YTM= The yield at which PV of all the CFs of
a bond equals its price
Yield to Maturity
If the price of this bond is Rs.101.349,YTM is 5.50%
YTM
Ideally r
1
, r
2
, r
3
, r
4
should be different, because
interest rates for different maturities are
different
YTM presumes r
1
= r
2
= r
3
= r
4
Price of 6% bond with remaining maturity of 2 years is
given by:

P = 3/(1+r
1
/2) + 3/(1+r
2
/2)
2
+ 3/(1+r
3
/2)
3
+ (3+100)/(1+r
4
/2)
4

0 m 6 m 12 m 18 m 24 m
Yield to Maturity
Compute NPV at lower rate R
L
. At this rate
the NPV
L
will be more than Price (P)
Compute NPV at higher rate R
H
. At this rate
NPV
H
will be lower than Price (P)
R
L
+
(R
H
R
L
)
---------------- x
(PV
L
PV
H
)
NPV
L

YTM =
Approx YTM
Average income
Average cost
Approx YTM =
C + (100-P)/n
(100+P)/2
Where P is Price
C is annual coupon
n is maturity in years
=
Approx YTM =
y
A
+
100-P
y
A
c
------- * (P
A
- P)
Where P is price of the bond
PA is price of the bond at assumed YTM Y
A
c is the coupon rate
Some MS Excel functions
Yield function
Computes annual yield
Price function
Computes the price without accrued interest or
clean price
Price with yearfrac function
Computes dirty price, i.e., with accrued interest
XIRR function
Computes annual yield taking into account dirty
price
Demerits of YTM
All maturities have same yield: hence a
flat yield curve
The coupons received in the intervening
period are invested at YTM
Reinvestment rate remain constant not
only across maturities but also over the
time
Modified YTM/Realised Yield
Mod. YTM or Total Return of a bond takes
into account the reinvestment rate
Find out the future value of all coupon
payment using a realistic reinvestment rate
Total future value (FV) = Rs.100+FV of all
(reinvested) coupons
Total Return = (FV / Price)
1/n
1
Excel example 11
Yield to call
Some bonds may have a call option that
entitle the Govt. to redeem the bonds
before maturity on or after an exercise
date at a predetermined price.
Falling yields provide incentive to call
If the YTM falls below the YTC, call is
likely
Zero Coupon Bonds
Zero Coupon Bonds have no coupon
hence no reinvestment problem
ZC Yield has no reinvestment
assumption
ZC sovereign yield curve is the pure
risk-free interest curve
ZCY = (M/P)
1/n
1

Theoretical Zero Coupon Yield
or Spot Rates
Bond A is like a ZCB with one single cash flow of Rs.106 at the
end of one year. Hence its YTM is 1 yr ZCY.
Bond B is like a set of 2 ZCBs, a 1yr ZCB with a cash flow of
Rs.7, and a 2 yr ZCB with a cash flow of Rs.107. The PV of both
the cash flows discounted at respective ZCYs should total up to
the price. Hence the following equation:
Spot Rates
Likewise the 3 yr bond can be broken into 3 ZCBs
of 1 yr, 2 yr and 3 yr respectively. We now know
the 1 and 2 yr ZCY.
PV of all the 3 cash flows discounted at
respective ZCYs should equal the market price.
Hence:
Spot Rate-YTM Parity
How does the market ensures
consistency between YTM and the spot
rates?
If price as per spot rates>price as per
YTM, strip the bond and sell them
separately realizing the price as per
spot rates
Example in Excel
Spot Rate-YTM Parity
Yr. 1 2 3 4 n
Zero rates z
1
z
2
z
3
z
4
z
n

YTM of a n year bond = y
n
Coupon = C
Maturity Value = 100
1+ z
1
= Z
1
; 1+ z
2
=Z
2
; 1+ z
3
=Z
3
; 1+z
4
=Z
4
;
1+z
n
= Z
n
and 1+y
n
= Y

C* [ (Z
1
-Y) + (Z
2
2
-Y
2
) + (Z
3
3
-Y
3
) + (Z
4
4
-Y
4
) +
+ (Z
n
n
-Y
n
)] + 100*(Z
n
n
-Y
n
) = 0
Yield of a Floating Rate Bond
Future rates not known
Pricing off the forward rates
Discounted margin method
The spread over the benchmark rate at
which PV equals price
The spread the bond will earn if the
current benchmark rate remains constant
The five theorems
1. Price of bond is inversely related to yield.
2. A premium bonds loses its value faster as it
approaches closer to maturity, conversely, a
discount bond appreciates faster as it approaches
closer to maturity.
3. Appreciation in price due to a given fall in yield is
larger than the depreciation in price due to the an
equal rise in yield.
4. Higher coupon, lower the volatility.
5. Longer the term higher the volatility.
Theorem-1
Price of a bond is inversely related
to yield
Relationship between yield and price
Lower the yield higher the price & vice-versa
If coupon=yield: price=par value
If coupon>yield: price>par value
If coupon<yield: price<par value
Excel example 8
Theo. 2
Theorem 3
Appreciation in price due to a given fall
in yield is larger than the depreciation
in price due to the an equal rise in yield.
Example in Properties sheet
Construct a price line and demonstrate the
theorem
The theorem may not hold true for very small
changes in yield
Theorem 4:
Higher coupon, lower the volatility
To demonstrate the property
Work out 12% 35 yr bond with 11% and 13%
yield
Work out 10% 35 yr bond with 9% and 11% yield


Theorem 5
Higher the term, higher the
volatility
Longer term means the impact of
interest rate change will be borne
or enjoyed for a longer period


Theorem 5
Price sensitivity
7% coupon, Yield 6.5%-5.5.%
0.000%
2.000%
4.000%
6.000%
8.000%
10.000%
12.000%
14.000%
0.00 5.00 10.00 15.00 20.00 25.00
Maturity
%

c
h
a
n
g
e

i
n

p
r
i
c
e

f
o
r

1
0
0

b
p

c
h
a
n
g
e

i
n

y
i
e
l
d
Series1
Forward Rates
Rate at which I can borrow or lend in future
Borrow or lend Rs.50 lakh 1 yr from today,
for 1 yr maturity: an interest rate for such
borrowing/lending is called a 1x2 forward
rate:

0 y 1 y 2 y 3 y 4 y
2 x4 forward rate
1 x 3 forward rate
1 x 2 forward rate
Forward Rate
Forward rates can be computed from
spot ZC rates
An investment for 2 years can be made in
two ways:
Invest for 2 yrs at 4.99%: FV=(1.0499)
2

Or invest for 1 yr at 4.50% and invest the
proceeds at the end of one yr for another yr
at 1 x 2 forward rate
FV = (1.0450)x(1+
1 x 2
Forward Rate), so
(1.0450)x(1+
1 x 2
Forward Rate)=(1.0499)
2
Solve the equation to get 1 x 2 forward rate

Forward Rate
Synthetic Forward
I need a one year financing one year from today. I
do not want the uncertainty of future interest rates
So I borrow for 2 yr today at 8% and simultaneously
invest for 1 yr at 6.5%
Today
1 yr 2 yr
Borrow for 2 yr today at 8%
Invest for 1 yr today at 6.5%
Net cost is 1x2 forward rate
Duration
Duration is the effective maturity
The coupons you receive leads to
realization of your investment.
Payback period of bullet loan will be exactly
its maturity.
Payback period of a coupon paying bond
will always be less than maturity.
c/2
(1+r/2)
2n

100
(1+r/2)
2n


P =
+
Duration
Maturity of a coupon paying bond is not
the true maturity because of coupons
Maturity of a ZCB is true maturity
If we could somehow convert a coupon
bond into a ZCB giving the same yield,
the maturity of this ZCB will be the true
maturity of the coupon bond
Duration is the maturity of that
equivalent ZCB
Duration
It is weighted average maturity of a
bond
If a coupon paying bond were to be
converted into an equivalent ZCB what
should be the maturity of the ZCB?
The coupon paying bonds duration
Duration
7% bond, maturity 5 years
Duration 4.6 yr
Years 1 2 3 4 5
Duration
7% bond, maturity 4 years
Duration 4.6 years
Years 1 2 3 4 5
Duration
20% bond, maturity 4 years
Duration 3.5 yr
Years 1 2 3 4
Duration
Zero coupon bond maturity 5 years
Years 1 2 3 4 5
Duration
Zero coupon bond maturity 5 years
Duration 5 years
Years 1 2 3 4 5
Duration
An indicator of price volatility of a bond with
reference to (small) changes in interest rates
Higher duration, higher price volatility
Exercise 12, 13
For a given yield and coupon, longer the term
longer the duration
For a given term and coupon, higher the
yield, shorter the duration
For a given yield and term, higher the coupon
lower the duration
Duration
Duration (in half years)=
Sum of the products of time &
discounted cash inflows
Price of the bond (PV of cash inflows)
Mod. Duration (in half years)=
Duration (in half years)
[1 + (annual yield)/2]
Mod. Duration (in years)=
Duration (in years)
[1 + annual yield]
Portfolio duration
Market Value of each item x duration of the
item
Divide the product by market value of the
portfolio
Alternatively, workout the cash flows for the
entire portfolio and compute duration
M.Dur(portfolio) = Dur (Portfolio)
(1+portfolio yield)
Use of Duration

Setting appropriate risk level
Immunization
Managing portfolio duration through
swaps
To increase duration buy receive-fixed swap of
desired duration
To reduce duration buy pay-fixed swap
Managing balance sheet duration
Convexity
A bonds appreciation due to a fall in
yield is more than depreciation due to
identical rise in yield
Convexity is a measure of that
asymmetry
According to duration, a bonds
appreciation and depreciation are
symmetrical
Y-P Relationship
392.21
291.18
224.54
147.32
124.24
189.02
0.00
50.00
100.00
150.00
200.00
250.00
300.00
350.00
400.00
450.00
0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00%
Yield
P
r
i
c
e
Price
Convexity
Fall in yield increases convexity
For a given term and yield, higher
coupon have higher convexity
For a given m-duration, higher coupon
lower the convexity
For given coupon and yield, higher
maturity, higher convexity
Immunization
Set portfolio duration equal to holding
period
Portfolio maturity > holding period
At the end of the holding period:
If yields have fallen: Capital gain will be realised
exactly offsetting reinvestment loss
If yield has risen: Capital loss will be realised
exactly offsetting reinvestment gain
Immunization
Duration can also be defined as the re-
pricing maturity of an asset or liability
Hence, if you hold an asset exactly till
its duration you are not impacted by the
change in its price
Immunization
Limitations:
As with all duration models: Flat yield
curve or parallel shift
Need to rework the immunization strategy
with passage of time and change in yield
High transaction costs
Duration ratio
Duration Ratio = D (Assets) / D (Liabilities)
Duration Ratio
Rs. 100 crore 1 year (duration) assets are
funded by Rs.100 crore 3 month
(duration) liabilities
Duration ratio = 1/0.25 = 4 >1
0 - 3
months
4 - 6
month
s
7 - 12
month
s
Assets 0 0 100
Liab. 100 0 0
Gap -100 0 100
NII & MVE
NII is Net Interest Income, MVE Market
Value of Equity
You can (explicitly) protect the NII by
managing the gap between RSA and
RSL
Alternatively, you can (explicitly)
protect MVE by using Duration Gap
You cannot explicitly protect both at the
same time
NII & MVE
Protecting NII indirectly protects the
balance sheet, since NII is the net of
income from assets and cost of
liabilities
Protecting the MV of balance sheet
indirectly protects the NII since value of
an asset/liability is the PV of its
earnings/cost
RBI Guidelines aim at protecting NII
Duration of balance sheet
Durations of all assets are weighted
by its respective MV weight
As loans have no market value,
either
Find out theoretical MV on the basis
revised yield or
Treat coupon=YTM, and hence book
value=MV
Weighted average duration of
assets
Duration of balance sheet
Ascertain weighted duration of
liabilities in the same fashion
Duration of demand/semi-demand
liabilities such as deposits is their
expected re-pricing maturity
Current Deposits
Saving Deposits
Cumulative Fixed Deposits
Non-cumulative fixed deposits
Duration Gap
DGAP = DA (MVL / MVA) DL
If DGAP is +ve
Asset are more IR sensitive than
liabilities
If IR rises, asset values suffer more
than liability values, hence MVE
declines
If IR falls, MVE rises by the same
logic
Duration Gap
DGAP = DA (MVL / MVA) DL
If DGAP is -ve
Liabilities are more IR sensitive than
assets
If IR rises, liability values fall more than
asset values, hence MVE rises
If IR falls, MVE falls by the same logic
Impact on MVE
MVE = DGAP*MVA*y /(1+y)
= [DA(MVL / MVA) DL]*MVA*y/(1+y)
= (DA*MVA DL*MVL)*y /(1+y)
=[(DA*MVA DL*MVL) / (1+y)]*y
= If we divide the above expression with MVE
=Modified Duration (Equity)*y
Impact on MVE
EXAMPLE: Balance Sheet Duration

Assets Rs Duration (yrs) Liabilities Rs. Duration
(yrs)
Cash 100 0 Dep, 1 year 600 1.0
Business loans 400 1.25 Dep, 5 year 300 5.0
Total liabilities 900 2.33
Mortgage loans 500 7.0 Equity 100
1,000 4.0 1,000

DGAP = 4.0 - (.9)(2.33) = 1.90 years
Suppose interest rates increase from 11% to 12%. Now,
E = (-1.90)*(0.01/1.11)*1000= - 17.27

Impact on MVE
M.Dur BL = 1.25 /1.1 = 1.14
M.Dur ML = 7/1.1 = 6.36
Decrease in BL = 1.14*1%*400= 4.56
Decrease in ML=6.36*1%*500= 31.80
Total change in assets = -36.36
M.Dur 1Y Dep = 1/1.1 = 0.91
M.Dur 5Y Dep = 5/1.1 = 4.54
Decrease in 1 y Dep=0.91*1%*600 = 5.46
Decrease in 3 y Dep=4.54*1%*300 = 13.62
Total Change in Liabilities = -19.08
Change in Equity = -36.36 (-19.08) = - 17.28
Impact on MVE
M Dur of Equity = (MVA*DA MVL*DL)/
[(1+y)*MVE]
= [100*4 900*2.33] / [100*(1+0.10)]
= (4000 2097)/(100*1.1)
= 1903 / (100*1.1)
= 17.30
That is for every 1% point change in the yield,
equity changes by 17.3*1%=17.3%
So if yield goes up from 11% to 12%, the
decline in equity = 17.3%*100 = 17.30
Balance sheet duration
- Leverage Hedging
Leverage = Equity /Assets
A change in interest rate should not
affect leverage
For achieving this, set duration of
equity = duration of assets
Buy receive-fixed or pay-fixed swap of
required duration
Duration of a swap
Key Rate Duration
Holding all other maturities constant, this
measures the sensitivity of a security or value
of a portfolio to a 1% change in yield for a
given maturity.
The calculation is as follows:
There are 11 maturities along the Treasury
spot rate curve, and a key rate duration is
calculated for each. The sum of the key rate
durations along a portfolio yield curve is equal
to the effective duration of the portfolio.
Key Rate Duration
Holding all other maturities constant, this
measures the sensitivity of a security or value
of a portfolio to a 1% change in yield for a
given maturity.
The calculation is as follows:
There are 11 maturities along the Treasury
spot rate curve, and a key rate duration is
calculated for each. The sum of the key rate
durations along a portfolio yield curve is equal
to the effective duration of the portfolio.
Bond price volatility
Convexity
The second term in Taylors series
Convexity adjustment
Convexity in Years = Convexity in half
years/4
Adjustment= x Convexity x (change in yield)
2
Add adjustment to revised price as
computed from modified duration
Thank You