Convexity of a bond

 

Modified duration comes from first order derivative of present value of future cash flows from a bond. For small changes in yield the first order derivative is adequate, however, for large changes in yield, it gives inaccurate results.

It’s evident from the formula of duration that it’s not a static property of a bond but depends on time and change in yield. Since the price-yield relationship is not linear but convex (slope or duration is different at different points in the curve), larger the change in yield larger the error in estimating the impact on price of a bond using modified duration. Read more

June 21, 2008 | Filed Under Bonds | Leave a Comment 

Dollar Value of a Basis Point

 Amount of change in price of a bond in response to 1 basis point change in yield is Dollar value of a basis point (DVBP) or Dollar value of one basis point change (DV01).

A basis point is a one hundredth percentage i.e. 0.01%. The term basis point is used in fixed income market to measure change in interest rates.

Calculating DVBP

Going back to the formula that we derived for price sensitivity of a bond, Read more

June 15, 2008 | Filed Under Bonds | Leave a Comment 

Bonds Credit Rating

 

 

There is risk of default involved with corporate bonds. So how does an investor decide on which companies’ issues he has to invest in? The market participants can’t assess the risk involved as they may not have full information about corporates. They rely on credit rating agencies before taking an investment decision. These credit rating agencies give ratings to corporate issues by applying proprietary methodologies for assessing financial strength of the issuers and risks that may impair their capability to payback interest as well as principal. Read more

June 7, 2008 | Filed Under Bonds | Leave a Comment 

Arbitrage Opportunities in Bond Market

Arbitrage refers to buying an instrument or a commodity in one market and simultaneously selling it in another, making clear and risk less profit. Arbitrage opportunities are available when markets are not efficient. A person who makes risk less profit by using market inefficiencies is called an arbitrager.

Consider a 1 year maturity bond with face value of Rs100, coupon rate of 10%, paying coupon semi annually and bank interest rate is 5% pa.

Present value of the cash flows from this bond is

5/1.025 + 105/(1.025)2 = 104.82

If price of this bond is Rs100 in the market, one can borrow Rs100 from a bank and buy this bond.He will be able to pay Rs5 once he receives first coupon on this bond. By this time his outstanding amount will be 97.5 (100+100*2.5/100 - 5). At the end of one year he will receive Rs105 (principal + last coupon) which can be used to pay bank’s debt of Rs99.94 (97.5*1.025). He will make risk less profit of Rs 5.06 Read more

June 1, 2008 | Filed Under Bonds | Leave a Comment 

Preferred Habitat Theory and Liquidity preference Theory

Preferred Habitat Theory

This theory rejects the assertion that risk premium must increase uniformly with maturity. This theory is explained in terms of time-bucket preferences of investors. The investors who participate in bond market have different preferences in terms of maturities depending upon their liability profile. For example, Insurance companies and pension funds have long term liabilities and they prefer to invest in bonds with relatively higher maturities. Banks and mutual funds have short term liabilities, so they go for short-term bonds. These distinct investment horizons create different levels of demand and supply in different time buckets. Higher the demand for bonds in a particular time bucket, higher the price and lower the yield.

 

Liquidity Preference Theory

This theory explains the difference of interest rates for Read more

June 1, 2008 | Filed Under Bonds | Leave a Comment 

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