Let’s start with
something which every
finance student must
note!
Important pillar
of Finance
Pillar of Finance: INTEGRITY
• There is no striking a cheap bargain with
prosperity.
• It must be purchased, not only with
intelligent labor, but with moral force.
• As the bubble cannot endure, so the fraud
cannot prosper.
Let’s continue our journey
into the world of BONDS!
Whatever, we discussed about the dynamics
of the bonds, the same can be summarized
largely in terms of …
MALKIEL’S BOND THEOREMS
FUNDAMENTAL THEOREMS OF BOND PRICES
[MALKIEL’S BOND THEOREMS]
• Theorem #1: Bonds prices move inversely to bonds YTM.
• Theorem #2: If all other factors are held constant, a bond’s
interest rate risk increases with the length of time remaining
until it matures.
• Theorem #3: A bond’s interest rate risk increases at a
diminishing rate as the time remaining until its maturity
increases.
FUNDAMENTAL THEOREMS OF BOND PRICES
[MALKIEL’S BOND THEOREMS] (continued)
• Theorem #4: The price change that results from an
equal-sized increase or decrease in a bond’s YTM is
asymmetrical. More specifically, for any given maturity,
a decrease in yields causes a price rise that is larger
than the price loss that results from an equal increase in
yields.
• Theorem #5: A bond’s interest risk varies inversely with
its coupon rate.
LEARNING THROUGH CASE STUDY...
• Assume that Mr. Sujit Roy bought a 10-year bond with
coupon 10% p.a. today at a yield to maturity of 6%. The
very next day market interest rates shoot up to 8%.
What happens to Mr. Roy investment?
A. You lose money.
B. You make money.
C. Nothing happens.
D. All of the above.
What are the learning from this case?
Let’s take another case…
This boy is confused about the behaviour of the bonds’
prices between two coupon payment dates.
I can understand that the
Dirty Price changes
between the two coupon
payment dates. But,
what about the Clean
Price?
Please resolve
the confusion
of this boy!
What NEXT?
Any Question before we
proceed further?
WHAT NEXT?
Time to know about RBI Policy
rates.
RBI Policy Rates…as on
October 22,
2024
• CRR: 4.50%
• SLR: 18.00%
• Repo Rate: 6.50%
• Reverse Repo
Rate: 3.35%
Think – What is the implication of the following on the
bond market?
Coming back to our original discussion…
Now, we shall move to a different road in our
journey of bonds …
Assume that you have been offered the following two bonds...
• BOND A: It has a maturity of 4 years and
is paying a yield-to-maturity of 14%.
• BOND B: It has a maturity of 10 years
and is paying a yield-to-maturity of 14%
Are you indifferent between
these two bonds?
If you say NO, it means that for
different maturity periods, you need
different YTMs.
• Does it mean that there is
some relation between YTM
and time to maturity?
Why do we find different
yields of different maturity?
Another issue…
• Whenever we use or calculate YTM, we assume that all
cash flows will be reinvested at the same rate which is
equal to YTM.
• And, when we calculate the price based on the
assumption all cash flows will be reinvested at the rate
equal to YTM, then, are we getting the proper prices?
That’s …
C1 C2 C3 Cn
P 1
2
3
... n
(1 Y ) (1 Y ) (1 Y ) (1 Y )
Should these Ys be same
to calculate the price?
Two issues are identified to be addressed.
ISSUE#1: What is the relation be-
tween the maturity of a bond and
its yield?
ISSUE#2: When calculating the
bond price, should we use the
same discount rate or yield?
Before we answer these
issues, let’s first understand-
* SPOT Interest Rates; and
* FORWARD Interest Rates
SPOT INTEREST RATE vs FORWARD INTEREST RATE
• SPOT INTEREST RATE : interest rates for bonds that are
currently existing and are being traded currently. Or, it
is that interest rate which prevails today for a loan
made with a maturity of t period.
• FORWARD INTEREST RATE : interest rate that are
expected to exist in future but whose terms and
conditions are determined today.
Spot Rates and
Forward Rates are
different, yet they
are connected!
What is the implication
of this?
Spot Rates and Forward Rates are connected as well!
• We may see the following relation between the spot rates and
forward rates…
3
(1 S 3 ) (1 S1 )(1 ff12 )(1 23 )
2
(1 S1 )(1 f13 )
• This relation exists under the assumption that there is no arbitrage
opportunities in the market.
• It means that if we know the spot rate, we can estimate the forward
rates and if know the forward rates, we can determine the spot
rates.
Time to practice
Practice Question#1
• On October 22, 2024, the following spot rates are observed for the G-Securities.
Maturity (years) Spot Rate (%)
1 6.50%
2 6.75%
3 7.00%
4 7.10%
5 7.25%
• Calculate the forward rates:
• f23 Answer:
• f14 • f23 = 7.5018%
• f14 = 7.4383%
Practice Question#2
• On October 22, 2024, the following forward rates are observed for the G-
Securities.
Forward Rate Rate(%)
f24 6.50%
f01 6.50%
f12 7.00%
f13 7.10%
f35 7.25%
• Calculate the following spot rates:
Answer:
• S2 • S2 = 6.7497%
• S5 • S5 = 7.0396%
THE YIELD CURVE
• It is graph depicting a relation between the yield-to-maturity as
a dependent variable and time to maturity as an independent
variable as on a particular date.
• It is a curve depicting the relationship between the maturity of
defaultless bonds and their yield-to-maturity.
• It provides an estimate of the current term structure of interest
rates and changes daily as yields to maturity change.
Another similar way to study such
a relation is known as TERM
STRUCTURE OF INTEREST RATES.
But, there exists
some finer
differences
between the Yield
Curve and the
Term Structure of
Interest Rates
TERM STRUCTURE OF INTEREST RATES
• The structure of nominal interest rates for a set of bonds that differ
only with respect to the length of time until they reach maturity.
• The various levels of interest rates for different maturity for same
quality of bonds is called term structure of interest rate.
• Term structure of interest rates reflects the behaviour of the yield
curve.
• It is a curve of spot interest rates of different maturities.
The difference between the Yield
Curve and the Term Structure…
…is a matter of ‘REINVESTMENT
ASSUMPTION’.
Though there is
a difference
between the
Yield Curve and
Term Structure of
Interest Rate,
yet they are
connected!
What is the implication of this?
If we know Yield Curve…
then we can find the Term Structure of Interest Rates;
and
If we know the Term Structure of Interest Rates, then
we can derive the yield curve!
Connect between the Yield Curve and
Term Structure of Interest Rates (Spot
Rates)
• YTM of a zero-coupon bond of maturity n is
equivalent spot rate of period n!
Go to EXCEL to appreciate the
difference between the Yield Curve
and the Term Structure of Interest
Rate
What is determined FIRST in a bond
market – Price or Yield?
We always observe in the market…
• PRICE!!!
• How markets are determining prices?
• Markets are determining prices on the basis of Spot Rates
available.
• Once, prices are determined then, we can determine the yield
on a bond.
How to determine the bond
prices and bond yield for
coupon bearing?
That we shall take after
the BREAK!
