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Slide 14.1

Investments

Chapter 14: Bonds: Analysis and Management

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Slide 14.2

Pricing Bonds

The price of a bond is the present value of all future coupon payments plus the par

value discounted at the yield to maturity:

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Slide 14.3

Bond Pricing Principles: I

Exhibit 14.1 Bond prices and the passage of time for different yields to maturity (spikes due to the coupon accrual)Source: From Introduction to Investments, 2nd edn, by Levy. © 1999. Reprinted with permission of South-Western, a division of Thomson Learning: www.thomsonrights.com. Fax 800 730-2215.

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Slide 14.4

Bond Pricing Principles: IIBond Prices are Related Inversely to the Yield to Maturity:

Exhibit 14.2 Convex relationship between bond prices and yield to maturitySource: From Introduction to Investments, 2nd edn, by Levy. © 1999. Reprinted with permission of South-Western, a division of Thomson Learning: www.thomsonrights.com. Fax 800 730-2215.

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Slide 14.5

Bond Pricing Principles: IIIThe Longer the Maturity, the More Sensitive a Bond’s Prices are to Changes in the Yield to Maturity:

Exhibit 14.4 Bond prices and yield to maturity for different lengths to maturitySource: From Introduction to Investments, 2nd edn, by Levy. © 1999. Reprinted with permission of South-Western, a division of Thomson Learning: www.thomsonrights.com. Fax 800 730-2215.

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Slide 14.6

Bond Pricing Principles: IVThe Sensitivity of the Price of a Bond to Changes in the Yield to Maturity Increases at a Decreasing Rate with the Length to Maturity:

Exhibit 14.5 Difference between bond prices for different yields to maturity for bonds of different maturitiesSource: From Introduction to Investments, 2nd edn, by Levy. © 1999. Reprinted with permission of South-Western, a division of Thomson Learning: www.thomsonrights.com. Fax 800 730-2215.

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Slide 14.7

Bond Pricing Principles: VThere is a Linear Relationship between a Bond’s Coupon Rate and its Price:

Exhibit 14.6 Linear relationship between bond price and coupon rate for different yields to maturity

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Slide 14.8

Duration

Two competing interest-rate effects on the value of bond portfolios:

1. The price effect.2. The reinvestment effect.

The holding period for which the two effects cancel each other out is known as the duration of the bond portfolio.

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Slide 14.9

The Trade-off between the Price Effect and the Reinvestment Effect

Exhibit 14.10 Duration as a measure of the holding period that minimises interest-rate risk measured as the standard deviation of rates of return (holding period is assumed to be four years)

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Slide 14.10

Formal Definition of Duration

Duration is ‘a present value-weighted average of the number of years investors weight to receive cash flows’:

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Slide 14.11

Duration Principles

1. Duration is related inversely to yield to maturity.

2. Duration depends positively on the length to maturity.

3. Duration is related inversely to the level of coupon payments.

4. Duration of a bond portfolio is equal to a weighted average of the durations of the individual bonds.

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Slide 14.12

Convexity

• Duration is a measure of the slope of a bond’s price–yield relationship.

• Convexity is a measure of the curvature of this price–yield relationship.

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Slide 14.13

Convexity Principles

1. Convexity is related inversely to yield to maturity.

2. Convexity is related positively to length to maturity.

3. Convexity is related inversely to the coupon.

4. The convexity of a bond portfolio is equal to a weighted average of the convexity of the individual bonds.

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Slide 14.14

Passive vs. Active Bond Management

• Passive Bond ManagementManager does not attempt to identify bonds that are under- or overpriced.

• Active Bond ManagementManager does attempt to identify bonds that are under- or overpriced.

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Slide 14.15

Passive Bond Management Strategies

• Indexing strategies.

• Immunisation strategies/duration-matching strategies.

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Slide 14.16

Active Bond Management Strategies

There are many different bond-management strategies, for example:

A substitution swap.

A pure yield pick-up swap.

A rate anticipation swap.