# Money and Banking

<<< Previous BOND PRICING & RISK:Valuing the Principal Payment, Risk Next >>>

Money & Banking ­ MGT411
VU
Lesson 10
BOND PRICING & RISK
Bond Pricing
Real Vs Nominal Interest Rates
Risk
Characteristics
Measurement
Bond Pricing
A bond is a promise to make a series of payments on specific future date.
It is a legal contract issued as part of an arrangement to borrow
The most common type is a coupon bond, which makes annual payments called coupon
payments
The percentage rate is called the coupon rate
The bond also specifies a maturity date (n) and has a final payment (F), which is the principal,
face value, or par value of the bond
The price of a bond is the present value of its payments
To value a bond we need to value the repayment of principal and the payments of interest
Valuing the Principal Payment
A straightforward application of present value where n represents the maturity of the bond
Valuing the Coupon Payments:
Requires calculating the present value of the payments and then adding them; remember,
present value is additive
Valuing the Coupon Payments plus Principal
Means combining the above
Payment stops at the maturity date. (n)
A payment is for the face value (F) or principle of the bond
Coupon Bonds make annual payments called, Coupon Payments (C), based upon an interest
rate, the coupon rate (ic), C=ic*F
A bond that has a \$100 principle payment in n years. The present
Value (PBP) of this is now:
F
\$ 100
=
=
P
BP
(1 + i )
(1 + i )
n
n
If the bond has n coupon payments (C), where C= ic * F, the Present Value (PCP) of the coupon
payments is:
C
C
C
C
P  CP  =
+
+
+ ...... +
(1 + i )  1
(1 + i ) 2
(1 + i ) 3
(1 + i ) n
29
Money & Banking ­ MGT411
VU
Present Value of Coupon Bond (PCB) = Present value of Yearly Coupon Payments (PCP) + Present Value
of the Principal Payment (PBP)
C  ⎤
C
C
C
F
+
PCB = PCP + PBP = ⎢
+
+
+ ...... +
(1 + i)  n  (1 + i)  n
(1 + i)  (1 + i)
(1 + i)  3
1
2
Note:
The value of the coupon bond rises when the yearly coupon payments rise and when the interest
rate falls
Lower interest rates mean higher bond prices and vice versa.
The value of a bond varies inversely with the interest rate used to discount the promised
payments
Real and Nominal Interest Rates
So far we have been computing the present value using nominal interest rates (i), or interest
rates expressed in current-dollar terms
But inflation affects the purchasing power of a dollar, so we need to consider the real interest
rate (r), which is the inflation-adjusted interest rate.
The Fisher equation tells us that the nominal interest rate is equal to the real interest rate plus
the expected rate of inflation
Fisher Equation:
i=r+  e
Or
r = i - še
Figure: Nominal Interest rates, Inflation, and real interest rates
20
15
10
5
0
-5
-10
1982
1985
1988
1991
1994 1997 2000
1979
2003
30
Money & Banking ­ MGT411
VU
Figure: Inflation and Nominal Interest Rates, April 2004
30
Turkey
45º line
·
25
20
Brazil
Russia
·
·
15
10
South Africa
5
US
UK
15
25
20
5
10
30
0
Inflation (%)
Risk
Every day we make decisions that involve financial and economic risk.
How much car insurance should we buy?
Should we refinance the home loan now or a year from now?
Should we save more for retirement, or spend the extra money on a new car?
Interestingly enough, the tools we use today to measure and analyze risk were first developed to
help players analyze games of chance.
For thousands of years, people have played games based on a throw of the dice, but they had
little understanding of how those games actually worked
Since the invention of probability theory, we have come to realize that many everyday events,
including those in economics, finance, and even weather forecasting, are best thought of as
analogous to the flip of a coin or the throw of a die
Still, while experts can make educated guesses about the future path of interest rates, inflation,
or the stock market, their predictions are really only that--guess.
And while meteorologists are fairly good at forecasting the weather a day or two ahead,
economists, financial advisors, and business gurus have dismal records.
So understanding the possibility of various occurrences should allow everyone to make better
choices. While risk cannot be eliminated, it can often be managed effectively.
Finally, while most people view risk as a curse to be avoided whenever possible, risk also
creates opportunities.
The payoff from a winning bet on one hand of cards can often erase the losses on a losing hand.
Thus the importance of probability theory to the development of modern financial markets is
hard to overemphasize.
People require compensation for taking risks. Without the capacity to measure risk, we could
not calculate a fair price for transferring risk from one person to another, nor could we price
stocks and bonds, much less sell insurance.
The market for options didn't exist until economists learned how to compute the price of an
option using probability theory
We need a definition of risk that focuses on the fact that the outcomes of financial and
economic decisions are almost always unknown at the time the decisions are made.
Risk is a measure of uncertainty about the future payoff of an investment, measured over some
time horizon and relative to a benchmark.
31
Money & Banking ­ MGT411
VU
Characteristics of risk
Risk can be quantified.
Risk arises from uncertainty about the future.
Risk has to do with the future payoff to an investment, which is unknown.
Our definition of risk refers to an investment or group of investments.
Risk must be measured over some time horizon.
Risk must be measured relative to some benchmark, not in isolation.
If you want to know the risk associated with a specific investment strategy, the most appropriate
benchmark would be the risk associated with other investing strategies
Measuring Risk
Measuring Risk requires:
List of all possible outcomes
Chance of each one occurring
The tossing of a coin
What are possible outcomes?
What is the chance of each one occurring?
Is coin fair?
Probability is a measure of likelihood that an even will occur
Its value is between zero and one
The closer probability is to zero, less likely it is that an event will occur.
No chance of occurring if probability is exactly zero
The closer probability is to one, more likely it is that an event will occur.
The event will definitely occur if probability is exactly one
Probabilities can also be expressed as frequencies
Table: A Simple Example: All Possible Outcomes of a Single Coin Toss
Possibilities
Probability
Outcome
#1
1/2
#2
1/2
Tails
We must include all possible outcomes when constructing such a table
The sum of the probabilities of all the possible outcomes must be 1, since one of the possible
outcomes must occur (we just don't know which one)
To calculate the expected value of an investment, multiply each possible payoff by its
probability and then sum all the results. This is also known as the mean.
Case 1
An Investment can rise or fall in value. Assume that an asset purchased for \$1000 is equally likely to
fall to \$700 or rise to \$1400
Table: Investing \$1,000: Case 1
Possibilities
Probability
Payoff
Payoff ×Probability
#1
1/2
\$700
\$350
#2
1/2
\$1,400
\$700
Expected Value = Sum of (Probability times Payoff) = \$1,050
32
Money & Banking ­ MGT411
VU
Expected Value = ½ (\$700) + ½ (\$1400) = \$1050
Case 2
The \$1,000 investment might pay off
\$100  (prob=.1) or
\$2000 (prob=.1) or
\$700  (prob=.4) or
\$1400 (prob=.4)
Table: Investing \$1,000: Case 2
Possibilities
Probability
Payoff
Payoff ×Probability
#1
0.1
\$100
\$10
#2
0.4
\$700
\$280
#3
0.4
\$1,400
\$560
\$200
#4
0.1
\$2,000
Expected Value = Sum of (Probability times Payoff) = \$1,050
Investment payoffs are usually discussed in percentage returns instead of in dollar amounts; this
allows investors to compute the gain or loss on the investment regardless of its size
Though both cases have the same expected return, \$50 on a \$1000 investment, or 5%, the two
investments have different levels or risk.
A wider payoff range indicates more risk.
33