UNIT – 3: Risk Identification in Bonds

• Risk factors - Duration, Convexity -

Immunization Strategies
• Bond price theorems –
• Malkiel bond theorems - Yield Curve Analysis -
Par Value, Zero, Spot Curve - Term Structure
of Interest Rates - Constructing Yield Curve:
Bootstrapping.
• Credit rating system
 Back Ground – Risk Factors
• Bond prices are sensitive to changes in interest rates
• This sensitivity tends to be greater for longer term bonds
• But duration is a better measure of term than maturity
• Duration for 100-year bond = 14.24
• Duration for 30-year zero = 30
• Duration for 30-year coupon = 12.64
– Long term bond has longer maturity but less
sensitivity to interest rates than the 30-year zero
bond

2
 Duration
• Bonds have value from two sources: coupons and return of
principal.
• Intuitively, bonds with high coupon rates or short maturities
will return value more quickly than those with low coupons or
long maturities.
• At the extreme is a zero coupon bond, which returns all value
at maturity.

• Duration is a measure of how quickly the (present) value of a

bond is returned.
 Duration of Bond
• Duration is a measure of the effective
maturity of a fixed income as opposed to
actual maturity.
• Only those bonds which promise a single
payment to be received at maturity (i.e no
yearly coupons) have duration equal to their
actual years to maturity.
• Zero coupon bonds are such bonds.
• For all others duration measure are always
less than their actual maturities.
 Duration
• The term duration has a special meaning in the context of bonds.
• It is a measurement of how long, in years, it takes for the price
of a bond to be repaid by its internal cash flows.
• It is an important measure for investors to consider, as bonds
with higher durations carry more risk and have higher price
volatility than bonds with lower durations.
• For each of the two basic types of bonds the duration is the
following:
– Zero-Coupon Bond – Duration is equal to its time to maturity.
– Vanilla Bond - Duration will always be less than its time to
maturity.
Let's first work through some visual models that
demonstrate the properties of duration for a zero-
coupon bond and a vanilla bond.
 Duration
• To calculate duration:
– Find the present value of each cash flow individually
– Sum these to get the present value of all cash flows (price)
– Calculate the proportion of the total value from each individual cash
flow
– Multiply each proportion by the corresponding number of periods and
sum
• The answer will give a measure of the average life of the bond
in a present value sense.
• A bonds with a low duration gets most of its value from cash
flows occurring early.
 Duration

Duration of a Zero-Coupon Bond

 Duration
• The red lever above represents the four-year time
period it takes for a zero-coupon bond to mature.
• The money bag balancing on the far right represents
the future value of the bond, the amount that will be
paid to the bondholder at maturity.
• The point holding the lever, represents duration, which
must be positioned where the red lever is balanced.
• The fulcrum balances the red lever at the point on the
time line at which the amount paid for the bond and
the cash flow received from the bond are equal.
• The entire cash flow of a zero-coupon bond occurs at
maturity, so the fulcrum is located directly below this
one payment.
 Duration of a Vanilla or Straight Bond

• Consider a vanilla bond that pays coupons

annually and matures in five years.
• Its cash flows consist of five annual coupon
payments and the last payment includes the
face value of the bond.
Duration of a Vanilla or Straight Bond
 Factors Affecting Duration
• It is important to note, however, that duration changes as
the coupons are paid to the bondholder.
• As the bondholder receives a coupon payment, the amount
of the cash flow is no longer on the time line, which means it
is no longer counted as a future cash flow that goes towards
repaying the bondholder.
• As the first coupon payment is removed from the red lever
and paid to the bondholder, the lever is no longer in balance
because the coupon payment is no longer counted as a
future cash flow.
THE model of the fulcrum
demonstrates this:
• The fulcrum must now move to the right in order to
balance the lever again:
• Duration increases immediately on the day a
coupon is paid, but throughout the life of the
bond, the duration is continually decreasing as
time to the bond's maturity decreases.
• The movement of time is represented above as
the shortening of the red lever.
• Notice how the first diagram had five payment
periods and the above diagram has only four.
• This shortening of the time line, however, occurs gradually,
and as it does, duration continually decreases.
• So, in summary, duration is decreasing as time moves closer
to maturity, but duration also increases momentarily on the
day a coupon is paid and removed from the series of future
cash flows - all this occurs until duration, eventually
converges with the bond's maturity.
• The same is true for a zero-coupon bond
 Duration: Other factors
• Bonds with high coupon rates and, in turn, high yields will
tend to have lower durations than bonds that pay low coupon
rates or offer low yields.
• This makes empirical sense, because when a bond pays a
higher coupon rate or has a high yield, the holder of the
security receives repayment for the security at a faster rate.
The diagram below summarizes how duration changes
with coupon rate and yield.
 Types of Duration
• There are four main types of duration calculations, each of
which differ in the way they account for factors such as interest
rate changes and the bond's embedded options or redemption
features. The four types of durations are
– Macaulay duration,
– modified duration,
– Effective duration and
– Key-rate duration.
 Duration
• Since price volatility of a bond varies inversely with
its coupon and directly with its term to maturity, it is
necessary to determine the best combination of
these two variables to achieve your objective
• A composite measure considering both coupon and
maturity would be beneficial
 Duration
n
C t (t ) n

t 1 (1  i ) t  t  PV ( C t )
D  t 1
n
Ct price
t 1 (1  i ) t

Developed by Frederick R. Macaulay, 1938

Where:
t = time period in which the coupon or principal payment occurs
Ct = interest or principal payment that occurs in period t
i = yield to maturity on the bond
 Characteristics of Duration
• Duration of a bond with coupons is always less than its term
to maturity because duration gives weight to these interim
payments
– A zero-coupon bond’s duration equals its maturity
• An inverse relation between duration and coupon
• A positive relation between term to maturity and duration,
but duration increases at a decreasing rate with maturity
• An inverse relation between YTM and duration
• Sinking funds and call provisions can have a dramatic effect
on a bond’s duration
 Duration and Price Volatility

An adjusted measure of duration can be used

to approximate the price volatility of a bond

M a c a ula y d ura tio n

m o d ifie d d ura tio n 
Y TM
1
Where:
m
m = number of payments a year
YTM = nominal YTM
Macaulay duration,

n = number of cash flows

t = time to maturity
C = cash flow
i = required yield
M = maturity (par) value
P = bond price
 Duration – Formulae method of computation

Where,
Y= yield or expected rate of return
N= Number of years to maturity
C = coupon rate

* formulae method is ideal for long term bonds duration computation

Find the duration of a 15 year bond with coupon rate of 8% if the expected
yield is 10%.
Hint: 8.76 yr
 Practical illustations
• Find the duration of a 30 year bond with coupon rate of 7% if
the expected yield is 8%.
• Find the duration of a 20 year bond with coupon rate of 6%, if
the expected yield is 9%.
• Find the duration of a 5 year bond with coupon rate of 7% if
the expected yield is 8%. (Hint:
• Find the duration of a 50 year bond with coupon rate of 8%, if
the expected yield is 9%. (Hint: 12.01 yrs.)
 Practice problems
• John is willing to buy either a 30 year bond currently
trading at Rs. 975 with coupon rate of 7%, or a 15yr
bond with 7.5% coupon. His expected yield is 8%.
• He is concerned about the proposed 50 basis point
rate cut by the RBI and seeks your advise on the
investments purely from the risk and return point of
view.
 Duration and Volatility
• For a zero-coupon bond with maturity n we have derived:
B 1 n

r B 1 r

• For a coupon-bond with maturity n we can show:

B 1 D

r B 1 r

– The right hand side is sometimes also called modified duration.

• Hence, in order to analyze bond volatility, duration, and not
maturity is the appropriate measure.
– Duration and maturity are the same only for zero-coupon bonds!
 Duration and Volatility
The example reconsidered

• Compute the right hand side for the two 5-year

bonds in the previous example:
– 6%-coupon bond:
D/(1+r) = 4.44/1.08=4.11
– 10%-coupon bond:
D/(1+r) = 4.20/1.08=3.89
• But these are exactly the average price responses
we found before!
– Hence, differences in duration explain variation of
price responses across bonds with the same maturity.
 Is Duration always Exact?
• Consider the two 5-year bonds (6% and 10%) from the
example before, but interest rates can change by moving
3% up or down:
Yield 6%-Bond 10%- Bond
8% $920.15 $1,079.85
11% $815.21 $963.04
% Change -11.40% -10.82%
5% $1,043.29 $1,216.47
% Change 13.38% 12.65%
Average 12.39% 11.73%

• This is different from the duration calculation which gives:

– 6% coupon bond: 3*4.11%=12.33%<12.39%
– 10% coupon bond: 3*3.89%=11.67%<11.73%
• Result is imprecise for larger interest rate movements
– Relationship between bond price and yield is convex, but
– Duration is a linear approximation
Duration and Portfolio Immunization
 Macaulay duration
The duration of a fixed income instrument is a weighted
average of the times that payments (cash flows) are made.
The weighting coefficients are the present values of the
individual cash flows.
PV (t0 )t0  PV (t1 )t1    PV (t n )t n
D
PV
where PV(t) denotes the present value of the cash flow that
occurs at time t.
If the present value calculations are based on the bond’s yield,
then it is called the Macaulay duration.
 Let P denote the price of a bond with m coupon payments
per year; also, let
y: yield per each coupon payment period,
n: number of coupon payment periods
~
C F: par value paid at maturity
Now, : coupon amount in each coupon payment
~ ~ ~
C C C F
P  2
  n

1  y (1  y ) (1  y ) (1  y ) n
~ ~ ~
1 dP 
1  1  1 C 2 C nC nF  1
then        
P d 1  y  m   1  y (1  y ) 2
(1  y ) n
(1  y ) n  P
Note that  = my.
 modified duration =
1 dP
P d
n
~
nF
(1 y ) n
 kC
(1 y ) k
Macaulay duration =
1 k 1
m P
• The negativity of
increases.
1 indicates
dP that bond price drops as yield

P d
• Prices of bonds with longer maturities drop more steeply with
increase of yield.

This is because bonds of longer maturity have longer Macaulay

duration:

P DMac
 .
P 1 y
 Example
Consider a 7% bond with 3 years to maturity. Assume that the bond
is selling at 8% yield.

A B C D E
Present value Weight = E
Year Payment Discount A
= BC D/Price
factor 8%
0.5 3.5 0.962 3.365 0.035 0.017
1.0 3.5 0.925 3.236 0.033 0.033
1.5 3.5 0.889 3.111 0.032 0.048
2.0 3.5 0.855 2.992 0.031 0.061
2.5 3.5 0.822 2.877 0.030 0.074
3.0 103.5 0.79 81.798 0.840 2.520
Sum Price = 97.379 Duration = 2.753
~
Here,  = 0.08, m = 2, y = 0.04, n = 6, C = 3.5, F = 100.
 Quatitative properties of duration
Duration of bonds with 5% yield as a function of maturity and coupon
rate.
Coupon rate

Years to 1% 2% 5% 10%
maturity
1 0.997 0.995 0.988 0.977
2 1.984 1.969 1.928 1.868
5 4.875 4.763 4.485 4.156
10 9.416 8.950 7.989 7.107
25 20.164 17.715 14.536 12.754
50 26.666 22.284 18.765 17.384
100 22.572 21.200 20.363 20.067
Infinity 20.500 20.500 20.500 20.500
Suppose the yield changes to 8.2%, what is the
corresponding change in bond price?

Here, y = 0.04,  = 0.2%, P = 97.379, D = 2.753, m

= 2.

The change in bond price is approximated by

1 P 1
 D
P  1 y

97.379 0.2% 2.753

i.e. P 
1.04
 Properties of duration

1. Duration of a coupon paying bond is always less

than its maturity. Duration decreases with the
increase of coupon rate. Duration equals bond
maturity for non-coupon paying bond.

2. As the time to maturity increases to infinity, the

duration do not increase to infinity but tend to a
finite limit independent of the coupon rate.
1  m
Actually, D   where  is the yield per
annum, and m is the number of coupon
payments per year.
3. Durations are not quite sensitive to increase in coupon
rate (for bonds with fixed yield).

4. When the coupon rate is lower than the yield, the

duration first increases with maturity to some maximum
value then decreases to the asymptotic limit value.
 Duration
Approximating the maturity of a bond
• Calculate the average maturity of a bond:
– Coupon bond is like portfolio of zero coupon bonds
– Compute average maturity of this portfolio
– Give each zero coupon bond a weight equal to the proportion in the total
value of the portfolio
• Write value of the bond as:

C1 C2 Ct Cn  F
The factor: B  ...  ... 
(1  r ) (1  r ) 2 (1  r ) t (1  r ) n

is the proportion of the t-th coupon payment in the total value of the
bond. Ct
B(1  r ) t
 Duration: A Definition
• Duration is defined as a weighted average of
the maturities of the individual payments:
C1 C2 Ct Cn  F
D 2 2
...t t
...n
B(1  r ) B(1  r ) B(1  r ) B(1  r ) n

– This definition of duration is sometimes also

referred to as Macaulay Duration.
• The duration of a zero coupon bond is equal
to its maturity.
 Calculating Duration
• Calculate the duration of the 6% 5-year bond:
Time Payment PV(Payment)(W) PV Time* (W)
1 60 55.56 0.0604 0.06
2 60 51.44 0.0559 0.11
3 60 47.63 0.0518 0.16
4 60 44.10 0.0479 0.19
5 1060 721.42 0.7840 3.92
• Calculate the duration
TOTAL of the 10%
920.15 5-year bond:
100.00% 4.44

Time Payment PV(Payment)w ( PV) Time*(W)

1 100 92.59 0.086 0.09
2 100 85.73 0.079 0.16
3 100 79.38 0.074 0.22
4 100 73.50 0.068 0.27
• The duration
5 of the bond
1100 with the
748.64 lower coupon
0.693is higher
3.47
– Why? 1079.85 100.00% 4.20
 Interest Rate sensitivity

The bond price sensitivity for a small change in interest

rate can be computed as follows. Percentage change
in bond price for a small increase in the interest rate:

Percentage change =[1/(1.Kd)][Duration]

 Duration: An Exercise
What is the interest rate sensitivity of the
following two bonds. Assume coupons are
paid annually.
Bond A Bond B
Coupon rate 10% 0%
Face value Rs.1,000 Rs.1,000
Maturity 5 years 10 years
YTM 10% 10%
Price Rs.1,000 Rs.385.54
 Duration Exercise (cont.)

Year (t) PV(A) PV(A) x t PV(B) PV(B)xt

1 $90.91 $90.91 0 0
2 $82.64 $165.89 0 0
3 $75.13 $225.39 0 0
4 $68.30 $273.21 0 0
5 $683.01 $3,415.07 0 0
6 0 0 0 0
7 0 0 0 0
8 0 0 0 0
9 0 0 0 0
10 0 0 $385.54 $3,855.43
Totals $1000.00 $4,170.47 $385.54 $3,855.43
Duration 4.17 10.00
 Duration Exercise (cont.)
 Percentage change in bond price for a small
increase in the interest rate:

Pct. Change = [1/(1.10)][4.17] = 3.79%

Bond A

Pct. Change = [1/(1.10)][10.00] = 9.09%

Bond B
 Duration of a portfolio

Suppose there are m fixed income securities with

prices and durations of Pi and Di, i = 1,2,…, m, all
computed at
a common yield. The portfolio value and portfolio
duration are then given by

P = P1 + P2 + … + Pm

D = W1D1 + W2D2 + … + WmDm

Pi
Wi  , i 1,2,, m.
P1  P2    Pm
where
 Example
Bond Market value Portfolio weight Duration

A Rs.10 million 0.10 4

B Rs.40 million 0.40 7
C Rs.30 million 0.30 6
D Rs.20 million 0.20 2

Portfolio duration = 0.1 4 + 0.4  7 + 0.3  6 + 0.2  2

= 5.4.

Roughly speaking, if all the yields affecting the four bonds

change by 100 basis points, the portfolio value will
change by approximately 5.4%.
 Case Study
Reliance Debt fund has a new manager and he is
considering to create a new scheme of debt for
is current 1 cr. AUM. The following instruments
are under considerations
a) ECL NCD 9.85% Annual coupon for 10 yrs
b) IIFL NCD 8.6% Semi-annual coupon for 5 yrs
c) NEC NCD 7.8% Annual coupon for 30 yrs
d) JPM NCD 8.5% Annual coupon for 8.5% for 15 yrs.
The portfolio allocation proposed is 1:2:3:4
The current market yield is 10%
Comment on the sensitivity of the proposed portfolio for a 100
basis point change in the interest rates.
 Malkiel’s Bond Pricing Theorems
• In 1961, Burton Malkiel published a paper where
he proved five important bond pricing theorems:
1. Bond prices move inversely to interest rates.
2. Longer maturity bonds respond more strongly to a given
change in interest rates.
3. Price sensitivity increases with maturity at a decreasing
rate.
4. Lower coupon bonds respond more strongly to a given
change in interest rates.
5. Price changes are greater when rates fall than they are
when rates rise (asymmetry in price changes)
*Note: Malkiel is also the author of “A Random Walk Down Wall Street.”
 Bond Theorems - Simplified
• Price and interest rates move inversely.
• A decrease in interest rates raises bond prices
by more than a corresponding increase in
rates lowers price.
• Price volatility is inversely related to coupon.
• Price volatility is directly related to maturity.
• Price volatility increases at a diminishing rate
as maturity increases.
 Bond Pricing Theorem I
• Bond prices and market interest rates move in
opposite directions.

1500
1400
1300
1200
1100
1000
900
800
700
600
0% 2% 4% 6% 8% 10% 12% 14%
 Bond Pricing Theorem II
• When coupon rate = YTM, price = par value.

• When coupon rate > YTM, price > par value

(premium bond)

• When coupon rate < YTM, price < par value

(discount bond)
(Note:YTM is markey yield)
 Bond Pricing Theorem III
• A bond with longer maturity has higher relative (%) price
change than one with shorter maturity when interest rate
(YTM) changes. All other features are identical.
 Bond Pricing Theorem IV
• A lower coupon bond has a higher relative (%)
price change than a higher coupon bond when
interest rate (YTM) changes. All other
features are identical.
Coupon Rate and Bond Price Volatility
Bond Value
Consider two otherwise identical bonds.
The low-coupon bond will have much more
volatility with respect to changes in the
discount rate

High Coupon Bond

Discount Rate
Low Coupon Bond
Malkiel’s Bond Pricing Theorems - Explained
• Two of Malkiel’s theorems relate directly to bond price
volatility.
• He showed that the longer the term to maturity, the
greater the change in price, but the coupon rate also
affects volatility (lower coupons = more volatility).
• These same observations led Frederick Macaulay to
look for a better measure of volatility than just the
term to maturity.
• In 1938, he discovered duration which combines
maturity and coupon rate to describe a bond’s price
volatility.
 Malkiel’s Bond Pricing Theorems - Explained
• Suppose that we have two bonds, identical
except for their term to maturity.
• Both bonds have coupon rates of 10% paid
annually (for simplicity), and face values of
Rs.1,000.
• Your required return is 10%. Bond 1 has 5
years to maturity while Bond 2 has 10 years to
maturity.
 Malkiel’s Bond Pricing Theorems - Explained
• The price of each bond is Rs.1,000 (do the math).
• Now, if your required return drops to 8%, which bond
will increase the most in value?
• Bond 1 will be worth Rs.1,079.85, and Bond 2 will be
worth Rs.1,134.20
• Bond 2 wins because of its longer maturity (see
Malkiel’s theorem 2).
(Note: that had rates risen instead, then Bond 1 would
lose less than Bond 2 so Bond 1 would be favored.)
 Malkiel’s Bond Pricing Theorems - Explained
• Now, suppose that our bonds both have 5 years to
maturity, but Bond 3 has a coupon rate of 7% and
Bond 4 has a coupon rate of 10%.
• With your required return at 10%, Bond 3 is worth
Rs.886.28, and Bond 4 is worth Rs.1,000 (do the
math).
• If your required return drops to 8%, which bond will
increase more in value?
• Bond 3 will be worth Rs.960.73 (an increase of
8.40%), and Bond 4 will be worth Rs.1,079.85 (an
increase of 7.99%).
• So Bond 3, with the lower coupon rate wins (see
Malkiel’s theorem 4).
 Malkiel’s Bond Pricing Theorems - Explained
• Finally, what if Bond 5 has a maturity of 5 years and a
5% coupon, while Bond 6 has a maturity of 10 years
and a 10% coupon?
• Now we have a conflict. Bond 5 has a lower coupon
rate, but Bond 6 has a longer maturity. How do we
know which one will change more in price when rates
drop to 8%?
• First, note that at 10% Bond 5 is worth Rs.810.46 and
Bond 6 is worth Rs.1,000.
• At 8%, Bond 5 is worth Rs.880.22 (an 8.6% increase),
and Bond 6 is worth Rs.1,134.20 (and increase of
13.42%).
• Bond 6 wins because it has a longer duration.
Duration and Portfolio
Immunization
Can there be a portfolio whose cash flows are never
affected by the external forces like interest rates?
 Portfolio Immunization

• Portfolio immunization
– An investment strategy that tries to protect the
expected yield from a security or portfolio of
securities by acquiring those securities whose
duration equals the length of the investor’s
planned holding period.
 Life Insurance Co.- Case study
• Aviva life insurance company expects to pay the beneficiary of a
policy $1,000,000 10 years from today. The manager of the life
insurance company wants to make an investment today that will
provide the necessary funding to make this payment. However,
the manager also wants to immunize her firm against interest
rate risk. The market yield is currently 7%.
– Advise the company on the strategy to ensure the cash flow
requirement with immunisation when there is ZCB are
available.
– Suppose there are two fixed income securities available for
investment: a 30-year 6% (annual) coupon bond and a 10-
year 5% (annual) coupon bond.
– What combination of these two bonds would immunize the
insurance company against interest rate risk and at the same
time provide a value of $1,000,000 ten years from today.
Hints:
SCENARIO 1: If suitable ZCB are available in the market:
•One possible solution to this problem is to purchase 1,000 10-
year zero coupon bonds.
•Each of these bonds will pay $1,000 at the maturity date, thus
providing you with the required $1,000,000.
•At a yield of 7%, these zero coupon bonds would cost $508.35
each, so the total investment would cost you $508,350.
•The zero coupon bond investment provides a hedge against
interest rate risk, because the duration is exactly equal to the 10
year investment horizon.
•However, we can do the same thing even if zero coupon bonds
are not available.
 Scenario 2: If coupon bearing bonds are available
To get the actual bond positions, we must make a total investment
equal to the present value of the $1,000,000 liability. In other words,
we need to invest:
Exp.cashflown
PVFuturecashflow 
(1  r ) n
At a yield of 7%, the total investment would cost you $508,350.
• Duration of a Bond

Where,
Y= yield or expected rate of return
N= Number of years to maturity
C = coupon rate
• Duration of a 30 year Bond is 13.636 yrs. Duration of a 10 year Bond is
7.935 yrs
We need to choose portfolio weights in the two
bonds such that:
D wB1 ( D1 )  wB 2 ( D2 )
10 W1 (13.636)  (1  W1 )7.935
10 13.636W1  7.935  7.935W1
10  7.935 13.636W1  7.935W1
2.065 5.701W1
2.065
W1  0.3622
5.701
1  W1 1  0.3622 0.6378
W30 = 36.22% and W10 = 63.78%
We can also show that the price of the 30-year bond is $875.91 and the
price of the 10-year bond is $859.53.

 1  (1  r )  n   1 
Bond Pr ice C    P n 
 r   (1  r ) 
The price of the 30-year bond is $875.91 and the price of the 10-year
bond is $859.53.
• We therefore need to invest (508,349.29)
(.3622)=$184,124.11 in the 30-year bonds and
(508,349.29(.6378)=$324,225.18 in the 10-
year bonds.
• We therefore need to purchase 210.2 30-year
bonds (or $184,124.11/$875.91) and 377.2
10-year bonds (or $324,225.18/$859.53).
• This position will provide us with a value of
approximately $1,000,000 ten years from
today regardless of what happens to interest
rates.
 Portfolio Immunization
• If the average duration of a portfolio equals
the investor’s desired holding period, the
effect is to hold the investor’s total return
constant regardless of whether interest rates
rise or fall.
– In the absence of borrower default, the investor’s
realized return can be no less than the return he
has been promised by the borrower.
 Example
• Assume we are interested in a Rs.1,000 par value
bond that will mature in two years.
• The bond has a coupon rate of 8 percent and pays
Rs.80 in interest at the end of each year.
• Interest rates on comparable bonds are also at 8
percent but may fall to as low as 6 percent or rise as
high as 10 percent.
 Example
• The buyer knows he will receive Rs.1000 at
maturity, but in the meantime he faces the
uncertainty of having to reinvest the annual
Rs.80 in interest earnings at 6%, 8%, or 10%.
 Example: Case 1
• Let interest rates fall to 6%.
– The bond will earn Rs.80 in interest payments for
year one, Rs.80 for year two, and Rs.4.80 (Rs.80 x
0.06) when the Rs.80 interest income received the
first year is reinvested at 6% during year 2.
 Example: Case 1
• How much will the investor earn over the two
years?
– First year’s interest earnings + Second year’s
interest earnings + Interest earned reinvesting the
first year’s interest earnings at 6% + Par value of
the bond at maturity.
– Rs.80 + Rs.80 + Rs.4.80 + Rs.1,000 = Rs.1,164.80
 Example: Case 2
• Let interest rates rise to 10%.
– The bond will earn Rs.80 in interest payments for
year one, Rs.80 for year two, and Rs.8.00 (Rs.80 x
0.10) when the Rs.80 interest income received the
first year is reinvested at 10% during year 2.
 Example: Case 2
• How much will the investor earn over the
two years?
– First year’s interest earnings + Second year’s
interest earnings + Interest earned reinvesting
the first year’s interest earnings at 10% + Par
value of the bond at maturity.
– Rs.80 + Rs.80 + Rs.8 + Rs.1,000 = Rs.1,168.00
 Immunization and Duration
• The investor’s earnings could drop as low as
Rs.1,164.80 or rise as high as Rs.1,168.
• But, if the investor can find a bond whose
duration matches his or her planned holding
period, he or she can avoid this fluctuation in
earnings.
– The bond will have a maturity that exceeds the
investor’s holding period, but its duration will
match it.
 Example: Case 1

• Let interest rates fall to 6%.

– The bond will earn Rs.80 in interest payments
for year one, Rs.80 for year two, and Rs.4.80
(Rs.80 x 0.06) when the Rs.80 interest income
received the first year is reinvested at 6%
during year 2.
– But, the bond’s market price will rise to
Rs.1,001.60 due to the drop in interest rates.
 Example: Case 1
• How much will the investor earn over the two
years?
– First year’s interest earnings + Second year’s
interest earnings + Interest earned reinvesting the
first year’s interest earnings at 6% + Market price
of the bond at the end of the investor’s planned
holding period.
– Rs.80 + Rs.80 + Rs.4.80 + Rs.1,001.60 =
Rs.1,166.40
 Example: Case 2
• Let interest rates rise to 10%.
– The bond will earn Rs.80 in interest payments for
year one, Rs.80 for year two, and Rs.8.00 (Rs.80 x
0.10) when the Rs.80 interest income received the
first year is reinvested at 10% during year 2.
– But, the bond’s market price will fall to Rs.998.40
due to the rise in interest rates.
 Example: Case 2
• How much will the investor earn over the
two years?
– First year’s interest earnings + Second year’s
interest earnings + Interest earned reinvesting
the first year’s interest earnings at 10% + Par
value of the bond at maturity.
– Rs.80 + Rs.80 + Rs.8 + Rs.998.40 = Rs.1,166.40
 Conclusion
• The investor earns identical total earnings
whether interest rates go up or down.
– With duration set equal to the buyer’s planned
holding period, a fall (rise) in the reinvestment
rate is completely offset by an increase (a
decrease) in the bond’s market price.
 Management of bond portfolios
Suppose a corporation faces a series of cash obligations in
the future and would like to acquire a portfolio of bonds that
it will use to pay these obligations.
Simple solution (may not be feasible in practice)
Purchase a set of zero-coupon bonds that have maturities
and face values exactly matching the separate obligations.
Portfolio Immunization
 If the yields do not change, one may acquire a bond
portfolio having a value equal to the present value of the
stream of obligations. One can sell part of the
portfolio whenever a particular cash obligation is required.
 A better solution requires matching the duration as well
as present values of the portfolio and the future cash
obligations.
This process is called immunization (protection against
changes in yield). By matching duration, portfolio
value and present value of cash obligations will
respond identically (to first order approximation) to a
change in yield.
Difficulties with immunization
procedure
1. It is necessary to rebalance or re-immunize the
portfolio from time to time since the duration
depends on yield.
2. The immunization method assumes that all
yields are equal (not quite realistic to have bonds
with different maturities to have the same yield).
3. When the prevailing interest rate changes, it is
unlikely that the yields on all bonds all change by the
same amount.
Example
Suppose Company A has an obligation to
pay Rs.1 million in 10 years. How to
invest in bonds now so as to meet the
future obligation?
• An obvious solution is the purchase of a
simple zero-coupon bond with maturity
10 years.
 Suppose only the following bonds are available for its choice.

coupon rate maturity price yield duration

Bond 1 6% 30 yr 69.04 9% 11.44
Bond 2 11% 10 yr 113.01 9% 6.54
Bond 3 9% 20 yr 100.00 9% 9.61

• Present value of obligation at 9% yield is Rs.414,643.

• Since Bonds 2 and 3 have durations shorter than 10 years, it is not

possible to attain a portfolio with duration 10 years using these
two bonds.

Suppose we use Bond 1 and Bond 2 of amounts w1 & w2,

10 W1 ( D1 )  (1  W1 )( D2 )
Giving Bond1 = Rs.292,788.64, Bond2 = Rs.121,854.78.
 Yield
9.0 8.0 10.0
Bond 1
Price 69.04 77.38 62.14
Shares 4241 4241 4241
Value 292798.64 328168.58 263535.74

Bond 2
Price 113.01 120.39 106.23
Shares 1078 1078 1078
Value 121824.78 129780.42 114515.94
Obligation
value 414642.86 456386.95 376889.48
Surplus -19.44 1562.05 1162.20

Observation
At different yields (8% and 10%), the value of the portfolio almost agrees
with that of the obligation.
 Duration and Portfolio
Immunization
Duration computation alternative equations
(1  r ) (1  r )  n(c  r )
D  ( n
)
r c((1  r )  1)  r

Where,
D =Duration
r = Discount rate
C= Cash flow
N = maturity period
 Case study
Vikrant Ltd has a cash obligation of Rs.20,00,000 to one of its client to be paid 5
years from now. The company has very uneven cash flow structure due to
stressed market conditions for its products. If you are the finance manager of the
company how would you make provisions for this obligation
Assume that the there are three investment alternatives available.
1.Zero coupon bond
2.Two Dated Bonds of IDFC currently trading at Rs.920 (8%, 6yrs) and 950
(9%,10 yrs)
3.Two bonds of L&T finance is also available
1. 10%, 10 yr Bond
2. 9%, 5 yr Bond
Give your suggestions (assuming the common yield as 10% and all annual
payments) if you were the finance manager of the company.
 Present value of Bond
n
1  (1  r ) 1
c( )  p( n
)
r (1  r )
Where,
C Coupon rate in value
P Principal value
R Discounting rate
 Cash flows required to invest today 12,41,850
value of ZCB 620.95
No.of ZCB 2000 bonds

Coupon Yield price maturity duration

LT 1 10% 10% 1000 10yrs 6.757
LT2 9% 10% 962.09 5yrs 4.224
IDFC 1 8% 10% 920 6yrs 4.9401
IDFC2 9% 10% 950 10yrs 6.8916
Since the combination of LT1 and IDFC2 not leading to a porfolio a bond with
10% par and a bond with close to par can be chosen

D wB1 (6.757)  wB 2 (4.221)

W1 = 30.71% and W2 = 69.29%

 Convexity and Duration
• For any given bond, a graph of the
relationship between price and yield is
convex.
• This means that the graph forms a curve
rather than a straight-line (linear).
• The degree to which the graph is curved
shows how much a bond's yield changes in
response to a change in price.
 Convexity and Duration
• If the graph is a tangent at a particular price of the
bond (touching a point on the curved price-yield
curve), the linear tangent is the bond's duration,
which is shown in red on the graph below.
• The exact point where the two lines touch
represents Macaulay duration.
 Convexity

• Duration is a measure of the slope of the price-

yield curve at a given point -- first-order
derivative.

• Convexity is a measure of the change in the slope

of the price-yield curve -- second-order derivative.

• Convexity measures how bowed-shaped the price-

yield curve is.
 Convexity measure
Taylor series expansion

dP 1 d 2P
P    (  ) 2
 higher order terms.
d 2 d 2

To first order approximation, the modified duration

1 dP
measures the percentage price change due to change in yield
P d
.

Zero convexity
This occurs only when the price yield curve is a straight line.
 price

error in estimating price

based only on duration

yield


1 d 2P
The convexity measure captures the percentage price change
P d2
due to the convexity of the price yield curve.
P
P
Percentage change in bond price =
 modified duration  change in yield
+ convexity measure  (change in yield)2/2
 Convexity

• Property: The greater a bond’s convexity, the

greater its capital gains and the smaller its capital
losses for given absolute changes in yields.
y1  y0  y2  y0
PB PB

{
Gain
 Gain
{ 
Loss {  {
Loss



y1 y0 y2 YTM y1 y0 y2 YTM
 Convexity

• Measures:
Slope / P0B 1  M t( t  1)(CFt ) 
Convexity   B 
y P0  t 1 (1  y) t 2 

Convexity for bond with

n  payments per year
Annualized Convexity 
n2
 Convexity (4)
• The convexity measure for a bond that pays
coupons each period and its principal at
maturity:
2C  1  2CM M (M  1)[F (C / y)]
3 
1 M
 2 M 1

y  (1  y)  y (1  y) (1  y) M 2
Convexity 
P0B

• C=coupon value, M=Total number of payments, F=Face Value, Y=Yield rate

 Convexity

• Example: The convexity in half-years for a 10-year,

9% coupon bond selling at par (F = 100) and paying
coupons semiannually is 225.43 and its annualized
convexity is 56.36:

2(4.5)  1  2(4.5)(20) (20)(21)[100  (4.5 / .045)]

1   
.045 3  (1.045) 20  (.045) 2 (1.045) 21 (1.045) 22
Convexity   225.43
100
225.43
Annualized Convexity  2
 56.36
2
 Convexity Uses
• Descriptive Parameter: Convexity measures
the asymmetrical gain and loss relation of a
bond: Greater k-gains and smaller k-losses the
greater a bond’s convexity.

• Estimation of price sensitivity to rate changes:

Using Taylor Expansion, a better
estimate of percentage price changes to
discrete yield changes than the duration
measure can be obtained by combining
duration and convexity measures.
 Convexity Uses
• Taylor Expansion:
1
%P  [ Modified Duration]y  [Convexity](y ) 2
B

2
• For 10-year, 9% bond, an increase in the annualized
yield by 200 BP (9% to 11%) would lead to an
estimated 11.87% decrease in price using Taylor
Expansion (the actual is 12%):

B 1
% P  [  6.5](.02)  [56.36](.02) 2   .1187
2
 Convexity Uses
• Note: Using Taylor Expansion the percentage
increases in price are not symmetrical with the
percentage decreases for given absolute changes in
yields.
y  from 9% to 11 % :
1
%P  [ 6.5](.02) [56.36](.02) 2   .1187
B

2
y  from 9% to 7%:
B 1
%P  [ 6.5]( .02) [56.36]( .02) 2  .1413
2
 Case Study
Naik a conservative investor plans to invest in one of the
following bond. Comment on the risk and return of the bonds
using advanced Bond market tools. If RBI announces 200BP
rate cut in the Interest rate which bond price is more sensitive?

Particulars Bond A Bond B

Face value 1000 1000
CMP 1020 980
Coupon % 8 8.5
Yield 8.25 8.25
Interest Pay-out Annual Semi-annual
Maturity 10 yrs 5 yrs
Hint..
Compute Duration, modified duration, convexity and Treynors expansion and
comment on risk and return
(1  r ) (1  r )  n(c  r )
D  ( n
)
r c ((1  r )  1)  r
Where,
D =Duration, r = Discount rate, C= Cash flow, N = maturity period

Percentage change =[1/(1.Kd)][Duration]

2C  1  2CM M (M  1)[F (C / y)]

3 
1 M
 2 M 1

y  (1  y)  y (1  y) (1  y) M 2
Convexity 
P0B
Where,
Y = Yield/Discount rate, C= Coupon Value, M = maturity period, F=Face value
 Convexity
Annualized Convexity 
n2

1
%P  [ Modified Duration]y  [Convexity](y ) 2
B

2
 Properties of Convexity
• Convexity is also useful for comparing bonds.
• If two bonds offer the same duration and yield but
one exhibits greater convexity, changes in interest
rates will affect each bond differently.
• A bond with greater convexity is less affected by
interest rates than a bond with less convexity.
• Also, bonds with greater convexity will have a higher
price than bonds with a lower convexity, regardless of
whether interest rates rise or fall. This relationship is
illustrated in the following diagram:
• As you can see Bond A has greater convexity than Bond B, but
they both have the same price and convexity when price
equals *P and yield equals *Y.

• If interest rates change from this point by a very small

amount, then both bonds would have approximately the
same price, regardless of the convexity.

• When yield increases by a large amount, however, the prices

of both Bond A and Bond B decrease, but Bond B's price
decreases more than Bond A's.

• Notice how at **Y the price of Bond A remains higher,

demonstrating that investors will have to pay more money
(accept a lower yield to maturity) for a bond with greater
convexity.
• Furthermore, as yield moves further from Y*, the
yellow space between the actual bond price and the
prices estimated by duration (tangent line) increases.
• The convexity calculation, therefore, accounts for the
inaccuracies of the linear duration line.
• Convexity is that it shows how much a bond's yield
changes in response to changes in price.
 What Factors Affect Convexity?
Here is a summary of the different kinds of convexities
produced by different types of bonds:
1)The graph of the price-yield relationship for a plain
vanilla bond exhibits positive convexity. The price-yield
curve will increase as yield decreases, and vice versa.
Therefore, as market yields decrease, the duration
increases (and vice versa).
• 2) In general, the higher the coupon rate, the lower
the convexity of a bond. Zero-coupon bonds have
the highest convexity.
• 3) Callable bonds will exhibit negative convexity at
certain price-yield combinations. Negative convexity
means that as market yields decrease, duration
decreases as well.
• For callable bonds, modified duration can be used for an
accurate estimate of bond price when there is no chance that
the bond will be called.

• The callable bond will behave like an option-free bond at any

point to the right of *Y.

• This portion of the graph has positive convexity because, at

yields greater than *Y, a company would not call its bond issue:
doing so would mean the company would have to reissue new
bonds at a higher interest rate.
• As bond yields increase, bond prices are decreasing and thus
interest rates are increasing.
 Bond issues perspective
• A bond issuer would find it most optimal, or cost-
effective, to call the bond when prevailing interest
rates have declined below the callable bond's
interest (coupon) rate.
• For decreases in yields below *Y, the graph has
negative convexity, as there is a higher risk that the
bond issuer will call the bond.
• As such, at yields below *Y, the price of a callable
bond won't rise as much as the price of a plain vanilla
bond.
 Conclusion
• Convexity is the final major concept you need
to know for gaining insight into the more
technical aspects of the bond market.
• Understanding even the most basic
characteristics of convexity allows the investor
to better comprehend the way in which
duration is best measured and how changes in
interest rates affect the prices of both plain
vanilla and callable bonds.
 Yield curve
• In finance, the yield curve is the relation between the
interest rate (or cost of borrowing) and the time to
maturity of the debt for a given borrower in a given
currency.
• For example, the rupee interest rates paid on indian
Treasury securities for various maturities are closely
watched by many traders, and are commonly plotted
on a graph which is informally called "the yield
curve."
• More formal mathematical descriptions of this
relation are often called the term structure of
interest rates.
 Yield Curve
– A graph of bond yields to maturity by time to
maturity is called a yield curve.

7.00%

6.50%

6.00%

5.50%

5.00%

4.50%

4.00%
3mo 6mo 1yr 2yr 3yr 5yr 10yr 30yr
 Yield Curve
– Typically, the yield curve is upward sloping
• Yield to maturity rises with term to maturity
• The excess of the long yield over the short yield is called a “term
premium”
7.00%

6.50%

6.00%

5.50%

5.00%

4.50%

4.00%
3mo 6mo 1yr 2yr 3yr 5yr 10yr 30yr
 Yield Curve
– Other shapes are also possible, however
• Inverted: Commonly associated with recessions
• Flat
15.00%

13.00%

11.00%

9.00%

7.00%

5.00%

3.00%

1.00%

-1.00% 3mo 6mo 1yr 2yr 3yr 5yr 10yr 30yr

 Yield Curve
– It used to be that most fixed income securities
were priced at a spread relative to the Treasury
yield curve.
– For example:
• If the yield to maturity on the 10-year Treasury bond
was 7%, then a 10-year Baa corporate bond would be
priced to yield 7% plus the Baa credit spread.
 Yield Curve
– Here’s yield curve data for on-the-run Treasuries
of various maturities:
Coupon Term (yrs) Yield Price
8.50% 1/2 5.10% $101.66
Notice the
range of 7.38% 1 5.49% $101.81
coupons. 9.00% 1 1/2 5.63% $104.78
8.88% 2 5.81% $105.72
These bonds 6.75% 2 1/2 5.86% $102.03
have very 7.75% 3 5.93% $104.94
different cash
flow patterns. 6.25% 3 1/2 6.03% $100.69
5.63% 4 6.09% $98.38
6.50% 4 1/2 6.10% $101.56
7.50% 5 6.16% $105.69
 A Better Approach
– To avoid the problems of comparability caused
by differing cash flow patterns among on-the-run
Treasuries, we can realize that each coupon bond
is really a package of single payment bonds.
– For example, a 2-year 10% coupon bond is really
a package of five single payment bonds:
• four for the semi-annual coupon payments and
• one for the repayment of the corpus.
 Zeroes
– A single payment bond is called a “zero.”
– A coupon bond can be thought of as a package of
zeroes,
• one for each of the coupon payments and
• one for the corpus.
– In principle, any coupon bond could be “stripped”
or “unbundled” into its constituent zeroes.
• US Treasury STRIPS are unbundled coupon bonds.
 Spot Yields
– A “spot yield” is the current yield to maturity on a
zero coupon bond.
• For example, the 1-year spot yield is the yield to
maturity on a 1-year zero.
– The price (per rupee of corpus) of an n-year zero
is related to the n-year spot rate by the formula:

1
P 
0 n 2n
 i n 
1
 2 
 Spot Yields
– For example, if the 3 1/2 year spot yield is 6.05%,
then the price (per rupee of corpus) of the 3 1/2
year zero is:
1 1
P3.5   7 .811
 
0 2*3.5
1  .0605 1.03025
2
 Spot Yields
– Alternatively, we can express the n-year spot yield
as a function of the price of an n-year zero:

 1

 1 
2n
in 
2   1

 
0 Pn 
 
 Spot Yields
– For example, if a 4 year zero is priced at Rs.79 per
rupee of face value, then the 4-year spot rate is:

 1
  1

 1 2*4 1 8
i4 2   121.03059  1 6.12%
 P  2.79  
1
 0 4   
 Spot Yields
Term (yrs) Spot Yield Price of zero P  1
0 2.5 5 .87
1/2 5.10% $0.98  .0588 
1
1 5.49% $0.95  2 
1 1/2 5.64% $0.92
2 5.82% $0.89
2 1/2 5.88% $0.87
3 5.95% $0.84
3 1/2 6.05% $0.81
4 6.12% $0.79  1

 1 9
4 1/2 6.12% $0.76 i4.5 2  16.12%
.76 
5 6.19% $0.74  
 Price of a Coupon Bond
– In principle, the price of an n-year coupon bond
ought to be equal to the total value of all its
constituent zeroes:

2n c 1 2n c 1
P  2 2
s  2n  s  2n
s1  y   y  s1  i s   i n 
1 1 1 2  1
 2   2  2 
 2 

Priced using yield to maturity Priced using spot yields

 Price of a Coupon Bond
– For example:

5-year 7.5% coupon bond

n Spot Yield Price of zero Cash flow Value
1/2 5.10% $0.98 $0.0375 $0.0366
1 5.49% $0.95 $0.0375 $0.0355
1 1/2 5.64% $0.92 $0.0375 $0.0345
2 5.82% $0.89 $0.0375 $0.0334
2 1/2 5.88% $0.87 $0.0375 $0.0324
3 5.95% $0.84 $0.0375 $0.0315
3 1/2 6.05% $0.81 $0.0375 $0.0304
4 6.12% $0.79 $0.0375 $0.0295
4 1/2 6.12% $0.76 $0.0375 $0.0286
5 6.19% $0.74 $1.0375 $0.7647
$1.0571

This bond actually traded at a price of Rs.1.0569 or

a yield to maturity of 6.16%
 Term Structure
– The term structure of interest rates is the pattern
of spot rates over the range of maturities.
• A flat term structure means that spot yields are equal
at all maturities.
• A normal term structure slopes upward
• An inverted term structure slopes downward
– Modern pricing practice is to regard any bond as a
package of zeros and price the package using
spreads relative to the term structure.
 'bootstrapping'
• Many investors assume that the value of a zero
coupon bond, or 'zero', is derived in the same
manner as the yield to maturity on a par coupon
bond, such as a Government of India bond.
• This is not the case. Yields on zero coupon bonds
involve greater mathematical sophistication in
order to account for the individual cash flows and
unique maturity dates.
• This is where the 'bootstrapping' method of
deriving a yield curve comes to bear rewards for
investors and dealers alike.
 Bootstrapping
• Bootstrapping is a method for constructing a (zero-
coupon) fixed-income yield curve from the prices of
a set of coupon-bearing products by forward
substitution.
• Using these zero-coupon products it becomes
possible to derive par swap rates (forward and spot)
for all maturities by making a few assumptions
(including linear interpolation).
• The term structure of spot returns is recovered from
the bond yields by solving for them recursively, this
iterative process is called the BootStrap Method.
• Given that, in general, we lack data points in a yield
curve (there are only a fixed number of products in
the market) and more importantly these have
varying coupon frequencies, it makes sense to
construct a curve of zero-coupon instruments from
which we can price any yield, whether forward or
spot, without the need of more external information.
 General Methodology
• Define set of yielding products, these will generally
be coupon-bearing bonds.
• Derive discount factors for all terms, there are the
internal rates of return of the bonds.
• 'Bootstrap' the zero-coupon curve step-by-step.
• For each stage of the iterative process, we are
interested in deriving the n-year zero-coupon bond
yield, also known as the internal rate of return of the
bond.
• As there are no intermediate payments on
this bond, (all the interest and principal is
realized at the end of n years) it is sometimes
called the n-year spot rate.
• To derive this rate we observe that the
theoretical price of a bond can be calculated
as the present value of the cash flows to be
received in the future.
• In the case of swap rates, we want the par
bond rate (Swaps are priced at Par when
created) and therefore we require that the
present value of the future cash flows and
principal be equal to 100
 Forward substitution

(this formula is precisely forward substitution)

where
cfn is the coupon of the n-year bond
dfi is the discount factor for that time period
dfn is the discount factor for the entire period, from which
we derive the zero-rate.
 Bootstrapping
– We can derive the theoretical term structure from
the yield curve using a procedure known as
“bootstrapping.”
– Here’s yield curve information
Coupon Term (yrs) Yield Price
8.50% 1/2 5.10% $101.66
7.38% 1 5.49% $101.81
9.00% 1 1/2 5.63% $104.78
8.88% 2 5.81% $105.72
6.75% 2 1/2 5.86% $102.03
7.75% 3 5.93% $104.94
6.25% 3 1/2 6.03% $100.69
5.63% 4 6.09% $98.38
6.50% 4 1/2 6.10% $101.56
7.50% 5 6.16% $105.69
 Bootstrapping
– The first bond has 1/2 year to run
– It is a single payment bond that will pay Rs.1.0425
per rupee of face value at maturity.
– Its price is Rs.1.0166 per rupee of face value.
– Therefore the 1/2 year spot rate is

1.0425 1 
i1/ 2 2  12.0255 5.10%
1.0166  
 Bootstrapping
– Given the 1/2 year spot rate, we can
determine the price of the 1/2 year
zero:
1 1
P
0 1/ 2  2 1/ 2  .9751
 i1/ 2   .0510 
1  1
 2   2 
 Bootstrapping
– For each rupee of face value, the 1-year bond will
pay Rs.03675 in 6 months and Rs.1.03675 in one
year.
– It’s price (Rs.1.0181 per rupee of face value)
should equal
$0.03675 $1.03675
$1.0181  1  2
 i1 / 2   i1 
1 1
 2   2 
 Bootstrapping
– But since the 6-months spot rate is 5.10%,

$0.03675 $1.03675
$1.0181  1  2
 .0510   i1 
1 1
 2   2 
Which we can solve for the 1-year spot rate as


 1.03675
1/ 2
 
i1 2  15.49%

1.0181  .03596  
 Bootstrapping
– Or, we could write

$0.03675 $1.03675
$1.0181  1  2
 i1 / 2   i1 
1 1
 2   2 

$1.0181 $0.03675*0 P1/ 2  $1.03675*0 P1

as $0.3675.9751 $1.03675*0 P1
$0.03596  $1.03675*0 P1
solve for 0P1 and then i1
 Bootstrapping
– You continue this process to complete the
theoretical term structure

Coupon Maturity Yield Price Zero Price Spot Yield

8.50% 0.5 5.10% $101.66 $97.51 5.10%
7.38% 1 5.49% $101.81 $94.73 5.49%
9.00% 1.5 5.63% $104.78 $92.00 5.64%
8.88% 2 5.81% $105.72 $89.16 5.82%
6.75% 2.5 5.86% $102.03 $86.51 5.88%
7.75% 3 5.93% $104.94 $83.88 5.95%
6.25% 3.5 6.03% $100.69 $81.16 6.05%
5.63% 4 6.09% $98.38 $78.58 6.12%
6.50% 4.5 6.10% $101.56 $76.23 6.12%
7.50% 5 6.16% $105.69 $73.71 6.19%
 Forward Rates
– A forward rate of interest is a yield quoted now on
a zero coupon bond to be delivered in the future.
– For example, a 2-year rate 1-year forward is the
yield quoted today on a 2-year zero starting one
year from now and maturing 3 years from now.

0 1 2 3
 Forward Rates
– Forward rates are embedded in the term
structure.
– Suppose you own a zero that matures in 1 year
and yields 6%.
• Interest could accumulate at the same rate over the
entire year or
• It could accumulate at one rate for the first half year
and at another rate for the second half year such that
the average is 6%.
 Forward Rates

0 1/2 1
 Forward Rates
– Algebraically, if you invest 0P1 at 6% for 1 year, and
interest accumulates at the same rate throughout
the year, then at the end of a half year you will
have

 .06 
0 P1 1
And at the end of a year  2 
you will have
2
 .06 
0 P1 1
 2 
 Forward Rates
– Alternatively, if you invest 0P1 at say 4% for 1/2
year, and then reinvest the proceeds at another
rate, say 1r1, then at the end of a half year you will
have

 .04 
0 P1 1
And at the end of a year  2 
you will have
 .04  1 r1 
0 P1 1 1
 2  2 
What is Credit Rating?
 A Credit Rating is an opinion on the
 Relative degree of risk associated with
 Timely payment of interest and
principle
 on a Debt Instrument
Definition :
“Credit Rating is an
assessment of an entity’s ability
to pay its financial obligations.”
 Meaning
i. Assesses the credit worthiness of
business(company)
ii. Based on Financial history and current
Assets and Liabilities
iii. Determined by Credit Rating Agencies
iv. Tells a lender or Investor the probability
of the subject being able to pay back a
loan
 Nature of Credit Rating
 Rating is based on Information
 Many factors affect rating
i. Quality of Management
ii. Corporate Strategy
iii. International Environment
 Rating by more than one agency
 Publication of ratings
 Rating of Rating agencies
 Rating can be done in symbols
 Rating are undertaken only at the
request of the issuers in India
 Rating is for instrument and not for
issuer company
 Rating is not applicable to equity
shares
 Time taken in rating process
 Success of Rating Agency
 Types of Credit Rating
1. Sovereign Credit Rating
i. Sovereign Entity
ii. Risk level of the investing environment
iii. Used by investor looking to invest Abroad
iv. Political Risk into account
2. Short – Term
i. probability factor
ii. Contrast to long-term rating
iii. Commonly used
3. Corporate Credit Rating
i. Financial indicator to potential
investors of debt securities such as
bonds
 Financial Obligations
1.EMPLOYEE: Salaries, Bonus on time
2.SHAREHOLDERS: Dividend on time
3.GOVERNMENT: Taxes payable on time
4.FINANCIAL INSTITUTION: Installments,
interest
5.CUSTOMERS: Quality products,
competitive price
 Benefits of Credit Rating
A. Benefits to investors
i. Minimization of Risks
ii. Risk Recognition
iii. Credibility of Issuer
iv. Ease in Decision Makings
v. Independent Decision Making
vi. Wider Choice
vii. Saving in Time and Resources
viii. Benefits of intensive surveillance
ix. Exploits Market Conditions
B. Benefits to Company
i. Easy to sell
ii. Lower cost of borrowing
iii. Wider Market
iv. Image Building
v. Lower cost of Public Issues
vi. Facilitates Growth
vii. Beneficial to new, unknown and Small
Companies
C. Benefits to Financial Intermediaries
i. Brokers
ii. Agents
iii. Portfolio Managers
 Factors Responsible for the
growth of credit rating
i. Growth of information Technology
ii. Globalization of financial markets
iii. Increasing role of capital and money
markets
iv. Inadequate government safety
measures
v. Trend towards Privatization
vi. Securitization of debt
Credit Rating Process
 Credit ratings
• A credit rating agency is equipped with all the required
information to rate an entity (maybe an individual or an
organization) based on its creditworthiness.
• These agencies provide highly essential risk assessment
reports and analytical solutions and assign a definitive
credit score to both individuals as well as organizations.
• This credit score reports are considered highly
important for getting the loan. Not only the credit score
but also certain documents are also needed for getting
the loan..
CIBIL – Credit Information Bureau
India Limited
Year of
2000
Establishment

Headquarters Mumbai, India

The main function of CIBIL is to track the credit history of

Main Objective an individual or a company and rate their
creditworthiness.

The CIBIL scores are used by lending organizations to

Benefit sanction loans quickly and for the approval of credit cards
too.

Ratings vary between 350 and 900. Generally, a rating of

above 700 is considered favorable. A high credit score
Rating scale
allows consumers to avail all types of loans easily and at
good interest rates.
CRISIL – Credit Rating Information
Services of India (Limited)
Year of
1987
Establishment

Headquarters Gurgaon, India

The main function of CRISIL is to establish the creditworthiness of

companies based on the business strengths, the board, the market
Main Objective share, and reputation of the company and so on. CRISIL rates
organization like public limited companies, banks and financial
organizations and not individuals.

Allows investors to obtain a clear idea about an organization before

Benefit
investing in their debentures and bonds.

CRISIL offers 8 different grades credit scoring. They are,

1. CRISIL AAA, CRISIL AA, CRISIL A – The three grades offer maximum
Rating scale safety for timely servicing of the loans.
2. CRISIL BBB, CRISIL BB – Offer moderate safety.
3. CRISIL B, CRISIL C, CRISIL D – High-risk individuals
ICRA – Investment Information and
Credit Rating Agency of India
Year of
1991
Establishment

Headquarters Mumbai, India

ICRA offers 12 types of ratings which include, Corporate debt rating,

Financial sector rating, Issuer rating, Bank loan credit rating, Public
Main Objective finance rating, Corporate governance rating, Structured finance
rating, SME rating, Mutual fund rating, Infrastructure sector rating,
Project finance rating and Insurance sector rating,

Benefit Comprehensive ratings offered through a transparent rating system.

The ICRA rating system includes symbols that represent the ability of
Rating scale a corporate entity to service its debt obligations in a timely manner.
The rating symbols vary with the financial instruments considered.
CARE – Credit Analysis & Research
Limited
Year of
1993
Establishment
Headquarters Mumbai, India
Offers a complete range of credit rating services that helps investors to make
informed decisions and companies to raise capital. The company offers its
Main Objective credit rating and grading services in the following areas: Debt ratings, Bank
loan ratings, Issuer ratings, Corporate governance, Recovery ratings, Financial
sector, and Infrastructure ratings.
All services adhere to international quality standards thus ensuring maximum
Benefit
reliability.
CARE offers two different categories of bank loan ratings, one for long-term
debt instruments and the other for short-term debt instruments.
1. The short-term debt ratings are as follows and mentioned in the
descending order of safety level for servicing loans appropriately.
Rating scale CARE AAA, CARE AA, CARE A, CARE BBB, CARE BB, CARE
B, CARE C, CARE D.
2. The long-term debt ratings are as follows and mentioned in the descending
order of safety level for servicing loans appropriately.
CARE A1, CARE A2, CARE A3, CARE A4 and CARE D.
ONICRA – Onida Individual Credit
Rating Agency of India
Year of
1993
Establishment
Headquarters Mumbai, India

ONICRA credit assessment and scoring services for both individuals

and businesses and is also a reliable employee background screening
company. ONICRA also offers risk assessment reports and analytical
Main Objective solutions for individuals, MSME’s as well as for well-established
corporate organizations. ONICRA grades the players in the education,
healthcare and solar industries and provides a detailed assessment of
each of the APMC.

Offers a holistic view of an individual or an entity and thus allows

Benefit
lenders and service providers to make value-based decisions.

Credit ratings for MSME’s are based on two factors: financial strength
Ratings
and performance capability.
SMERA – SME Rating Agency of
India Limited
Year of
2005
Establishment
Headquarters Mumbai, India
SMERA compromises of two main divisions: SMERA Bond Ratings and SMERA
SME Ratings. The first division was started in 2011 and is responsible for the
Main Objective credit assessment of issuers of bonds, debentures and fixed deposits. The SME
rating division of SMERA rates MSME’s, all types of bank facilities, renewable
energy and services companies, micro-finance institutions and other vendors.
Accredited by the RBI, SMERA is home to a strong team of finance
Benefit professionals. It is a body of trust and excellence that helps the different
entities to control risk efficiently
The bank loan ratings offered by SMERA can be summarised as AAA – Highest
Safety, Lowest Credit Risk
AA – Highest Safety, Very Low Credit Risk
A – High Safety, Low Credit Risk
BBB – Moderate Safety, Moderate Credit Risk
Ratings
BB – Moderate Risk, Moderate Risk of Default
B – High Risk, High Risk of Default
C – Very High Risk, Very High Risk of Default
D – Default / Expected to be in Default soon
All ratings are preceded by “SMERA”.
 Brickwork Ratings India Private
Limited
Year of
2007
Establishment
Headquarters Bangalore, India
Brickwork Ratings takes up the responsibility of rating bank loans,
municipal corporation, capital market instrument, financial
institutions, SME’s and corporate governance ratings. It also grades
Main Objective initial public issue by a company and is one of the very few credit
agencies that play a significant role in the grading of real estate
investments, hospitals, educational institutions, tourism, NGOs, IREDA,
MFI and MNRE.
Organizations rated higher by this SEBI registered credit agency can
easily negotiate lower interest rates and enjoy higher valuations. The
Benefit
ratings and grade services offered by Brickwork help the investor to
obtain relevant information in totality.
Brickwork Ratings rates the different financial instruments using its
Ratings signature rating scale that starts with “BW” and is followed by unique
rating symbols.
 Equifax India (Equifax Credit Information
Services Private Limited, ECIS)
Year of Establishment 2010

Headquarters Mumbai, India

Equifax India is a subsidiary of Equifax US and was formed a joint venture between
the parent company and seven prime financial institutions in India (UBI, SBI, Bank
of Baroda, Bank of India, Kotak Mahindra, Sundaram Finance and Religare). Equifax
Main Objective India collects and processes financial information from all members and offers a
whole range of credit assessment reports for individual consumers. The different
types of reports provided by Equifax include Basic or Enhanced consumer
information report, Equifax alerts and Microfinance institution credit information.

Consumer credit information establishes the creditworthiness of the individual and

Benefit
allows easy processing of loans by the bank and other financial institutions.

The Equifax Credit Score carries a numerical range between 280 and 850. The
credit score can be defined as follows,
a) Above 800 – Excellent. Highest safety.
b) Between 750 and 800 – Very Good. High safety.
Ratings
c) Between 700 and 750 – Good. High Safety.
d) Between 650 and 700 – Very Fair. Moderate Risk.
e) Between 600 and 650 – Poor. High Risk.
f) Lesser than 600 – Highest Risk.
 Experian India
Year of
2006
Establishment
Headquarters Mumbai, India
Experian India consists of two companies, Experian Credit Information
Company of India Private Limited (provides credit information) and
Main Objective
Experian Services India Private Limited (provides relevant data for
organizations to minimize risk and maximize revenue)
Experian India is equipped with outstanding analytical tools and data
Benefit resources that make is an important entity of consumer economy in
the country.
The Experian Credit Score carries a numerical range between 330 and
830.
The credit score can be defined as follows,
a) Above 800 – Excellent. Highest safety.
Ratings b) Between 750 and 800 – Very Good. High safety.
c) Between 700 and 750 – Good. High Safety.
d) Between 650 and 700 – Very Fair. Moderate Risk.
e) Between 600 and 650 – Poor. High Risk.
f) Lesser than 600 – Highest Risk.