MASTER MBA
BUSINESS
ADMINISTRATION
Objectives
For the investors, we are going to study the risks of buying
a bond, especially the credit risk and the impacts of the
volatility of interest rate in the bond valuation (market
risk). We will discuss about some risk measures and how
the investors can hedge the risks. Also, we will talk about
the investment portfolio management and the main
risk/performance measures for investment portfolios.
For the companies, we will present some mechanisms used
to mitigate the volatility of interest rate.
Methodology and Grade
Slides exposition with pratical examples
Participation of students
You ALWAYS can interrupt and ask anything!!
Individual and Group exercises
Possibility of one/two simple tests
Course Content
1) Interest Rate: i) types of rates; ii) ways of computing
interest rates (simple, compound and continuously
compounded) iii) Zero Rates
2) Bond Valuation
3) The characteristics of a Bond.
4) Credit Risk – Spread interest Rate and Rating Agencies
5) Duration
Course Content
6) Derivatives: forward and future contracts
7) Yield Curve: i)Factors which impact the curve; ii) The
Yield Curve Shapes; iii) Forward Rates
8) Forward Rate Agreements
9) Interest Rate Swaps
10) Valuation of Interest Rate Swaps
11) Investment Portfolio Management: i) return and risk of
portfolios; ii) risk and performance measures
Interest Rate
An interest rate is the percentage return that a lender
expects to earn — or actually earns — from lending
money.
There are many ways of computing interest rates, but we
will focus one the three basic kinds: simple, compound,
and continuously compounded rates.
Simple Interest Rate
Commonly used in some derivatives, such as swaps.
To calculate a rate for periods shorter than a year, just take
a proportional fraction of the annual rate.
Simple Interest Rate
Example: assume we a rate of 12% per year. Let’s suppose
that we invest $100 and the rate per year is 12%. After one
year, we have:
𝐹𝑉 = 100 ∗ 1 + 12% = 112
After six months:
12%
𝐹𝑉 = 100 ∗ 1 + = 106
2
Compound Interest
Interest is earned on both the original principal and on the
accumulated interest.
To calculate compound interest, divide the annual rate by
the number of compounding periods (e.g., monthly, daily),
apply it at each interval, and multiply the results over time
to get the final value.
The more frequent the compounding, the greater the final
amount — even with the same annual rate.
Compound Interest
Example: assume we a rate of 12% per year. Let’s suppose
that we invest $100, the rate per year is 12% and the
interest is compounded semiannually. After one year, we
have: 12%
𝐹𝑉 = 100 ∗ 1 + = 112.36
2
After six months:
12%
𝐹𝑉 = 100 ∗ 1 + = 106
2
Compound Interest
Consider the following cases (with annual rate of 12% and
$100 invested):
a) Compouding is quarterly
b) Compounding is monthly
What is the future after 1 year value in each case?
Compound Interest - Effective Rate per Period
Assume an annual interest rate with annual compounding.
What is the equivalent interest rate per:
a)Semester (6 months)
b) Quarter (3 months)
Continuous Compounding
It is the limit of compound interest when the number of
compounding intervals gets very large and the time
between earning interest gets very small. It can be shown
that:
𝐹𝑉 = 𝑃𝑉 ∗ 𝑒
Continuous Compounding
Example: assume we a rate of 12% per year. Let’s suppose
that we invest $100, the rate per year is 12% and the
interest is continous compounded. After one year, we have:
𝐹𝑉 = 100 ∗ 𝑒 %
= 112.75
After six months:
𝐹𝑉 = 100 ∗ 𝑒 %/
= 106.18
Zero Rates
The n-year zero-coupon interest rate is the rate of interest
earned on an investment that starts today and lasts for n
years.
All the interest and principal is realized at the end of n
years and there are no intermediate payments.
Example: Treasury Bills (US)
Zero Rates
The n-year zero-coupon interest rate is sometimes also
referred to as the n-year spot rate, the n-year zero rate, or
just the n-year zero.
Example: Let’s suppose an investment of $ 1,000 in a one-
year zero rate. The rate is compounded quarterly, and it is
quoted as 10% per annum.
10%
𝐹𝑉 = 1000 ∗ 1 + = 1,103.81
4
Bonds
When a company or the government wants to borrow
money for long-term payment, it can do so by issuing
bonds/bonds.
These securities are interest-based loans, where the
borrower will remunerate the lender in certain periods.
Coupons: regular interest payments.
Bonds
Face Value: The amount to be paid at the maturity of the
loan.
Coupon Rate: Coupon divided by face value.
Maturity: The term until the face value is paid.
Bonds – Yield to Maturity
Return of the investor, assuming that he will take the bond
to maturity and that all coupons and principal will be paid
on the due date.
The same that Internal Rate Return (IRR).
C1 C2 C3 C n Pn
P ...
1 YTM 1 YTM 1 YTM
2 3
1 YTM n
Cash Flow of Bonds
Face Value
0 1 2 3 4 5 6
Cupons
Maturity
Theoretical Price of the Bond
We can also calculate the price by Excel or Hp-12C.
Examples
Consider that a company has issued bonds with a maturity
of 10 years, coupon of $ 100, YTM of 10% and face value
of $ 1,000. What is the price of the bond?
1000 1 “Par value bond”
𝑃𝑟𝑖𝑐𝑒 = + 100 × (1 − )/0,1
1, 1 1, 1
Examples
Consider that a year later, the yield is 12% per annum,
what is the price?
1000 1
𝑃𝑟𝑖𝑐𝑒 = + 100 × (1 − )/0,12
1,12 1,12
“Discount bond”
Examples
And if the yield was 8% per annum, what is it supposed to
be the price?
1000 1
Pr eço 9
100 (1 9
) / 0,08
1,08 1,08 “Premium bond”
Examples
Calculate the price of a bond with a maturity of 12 years,
face value of $1,000, and a coupon rate of 12% per year
(with annual compounding). The bond pays coupons
semiannually and is trading at a YTM of 14% per year
(also with annual compounding).
Examples
A bond trades at 30% of discount. The maturity is in
exactly 12 years, with annual coupons at a rate of 7%.
What's your YTM?
Microsoft Excel
Worksheet
Examples
A bond trades at a premium of 15%. It has 4 years to
maturity, with a coupon rate of 12%. Coupons are paid
semi-annually. Determine the YTM (annual) of that bond.
The compounding is semi-annually.
Microsoft Excel
Worksheet
Current Yield
Ratio of the annual coupon and the bond's current price:
The current yield refers to the yield of the bond at the
current moment and it does not reflect the total return
over the life of the bond
Coupon, CY and YTM
Discount bond: YTM > Current Yield > Coupon Yield
Premium bond: Coupon Yield > Current Yield> YTM
Par bond: YTM = Current Yield = Coupon Yield
Callable Bonds
Redeemable Bonds
Issuer can redeem before expiration.
In what situations does this make sense?
Usually, a premium is paid to the investor.
That is, the issuer has a Call.
The investor's final profitability is called in this case the
Yiel of the Call.
Yield to Call and Yield toWorst
Yield to Call: when a bond is callable (can be
repurchased by the issuer before the maturity), the market
looks also to the Yield to Call, which is the same
calculation of the YTM, but assumes that the bond will be
called, so the cashflow is shortened
Yield to Worst: when a bond is callable, puttable,
exchangeable, or has other features, the yield to worst is
the lowest yield of yield to maturity, yield to call, yield to
put, and others
Group Exercise
YTM, YTC1, YTC2 and YTC3?
Group Exercise
A 30-year zero-coupon bond has a face value of $1,000
and is priced to yield 12% per year.
What is its price? Over the next 30 years, the bond’s price
will rise to $1,000, generating an annualized return of
12%. But what happens in the meantime? Suppose that
after the first 10 years of holding the bond, market interest
rates drop, and the yield to maturity (YTM) falls to 8%.
What is the bond’s price now? Even though the new YTM
for the remaining life of the bond is just 8%, and the
original YTM at the time of purchase was 12%, what was
the actual return earned over those first 10 years?
Ratings
Companies often pay for their bond to be evaluated by a
rating agency.
If a company wants to raise funds in the market and offers
interest-bearing bonds to investors, the agency prepares
the rating of these securities for investors to assess the
risks.
Ratings
The agencies observe the capacity of the companies to
honor their obligations to the investors.
The main rating agencies are:
Moody’s
Standard & Poor’s
Fitch
Ratings
The ratings express only the opinion on the possibility of
default, not making considerations about profitability or
interest rate risk.
Each agency has its own methodology for measuring
credit quality.
Specific rating scale to publish the ratings. They are
expressed by means of letters ranging (AAA to D).
Ratings
Only bonds with ratings
of Baa or above are
considered to be
investment grade.
Ratings
2008 crisis – Agencies assigned top ratings to U.S.
mortgage securities.
Lehman Brothers crash – they gave Lehman Brothers
excellent grades a few days before the bank crashed.
Movie – Inside Job
Interest Rate Risk
The market risk of a bond comes from the fluctuation of
rates in the market. The impact of the risk in this case is
proportional to how sensitive the bond is to rate
fluctuations.
This sensitivity depends on two factors: the time to
maturity and the coupon rate.
Keeping everything else unchanged, the longer the time to
maturity, higher is the interest rate risk.
Keeping everything else unchanged, the lower the coupon
rate, higher the interest rate risk.
Interest Rate Risk – Coupon Rate
Interest Rate Risk – Maturity
Macauly Duration
1938 – Macaulay – maturity can omit important
information about intermediate flows.
He proposed a solution, a measure that would take into
account the amounts and the time of all payments –
Duration.
Macauly Duration
Definition: is the weighted average maturity of the bond,
using the present value of the payments as weights for
weighting.
Assuming a bond with n periodic payments:
CF1 CF2 CFn
1 2 ... n
(1 YTM)1
(1 YTM) 2
(1 YTM) n
Duration
P
Macauly Duration
Definition: is the weighted average maturity of the bond,
using the present value of the payments as weights for
weighting.
Assuming a bond with n periodic payments:
CF1 CF2 CFn
1 2 ... n
(1 YTM)1
(1 YTM) 2
(1 YTM) n
Duration
P
Macauly Duration
0 1 2 3 4 5 6
0 ???
Macauly Duration
0 6
0 Duration = 6 anos
Macauly Duration
Example
Ano Year 0 1 2 3 4 5 6 7 8 9 10
Coupon $80 $80 $80 $80 $80 $80 $80 $80 $80 $80
Valor de Face $1000
YTM = 8% a.a
Macauly Duration
Year CF ValorDCF
Rendimentos presente à Weighting
Data Ponderação
(R$) taxa de 8% a.a.
n c c/(1+r)^n n*(c/(1+r)^n)
1 80 74,07 74,07407407
2 80 68,59 137,1742112
3 80 63,51 190,5197378
4 80 58,80 235,2095529
5 80 54,45 272,2332788
6 80 50,41 302,4814209
7 80 46,68 326,7546213
8 80 43,22 345,7720861
9 80 40,02 360,1792563
10 1080 500,25 5002,489671
Total 1800 1000,00 7246,887911 Duration 7,24689
Macauly Duration
Duration
Duration is positively related to bond maturity.
Duration is negatively related to YTM, because more
distant cash flows are more sensitive to interest rates.
Duration is negatively related to coupon rate.
Duration
Duration always allows you to evaluate the sensitivity of
an asset’s price in relation to changes in the interest rate.
n
CF t
P t 1
(1 YTM ) t
Calculating the derivative of the price in relation to the
interest rate in the above equation yields, after some
algebraic transformations:
dP 1 1 n CFt
P t
dYTM (1 YTM ) P t 1 1 YTM t
Duration
It is the same as:
dP 1
P duration
dYTM (1 YTM )
Rewriting in its differential form:
P duration
YTM
P (1 YTM)
Modified Duration
P P 2 P1 YTM YTM 2 YTM 1
Duration
Calculate the price change with the YTM raises to 8.25%
(25 basis points).
Duration
P
% P D mod YTM
P
The modified duration is a linear measure of how the price
of a bond changes in response to interest rate changes.
Price
Yield
However, the duration is efficient to evaluate the price
change if the interest rate change is small, because the
relationship between the price and the rate is not linear.
Practice Questions
Maturity 7 years
FV 1000
Coupon Rate 5%
YTM 5%
a) Duration
b) Modified Duration
c) If the interest rate raises to 5,8%, what is the new price
of the bond? (Discounted Cash Flow)
Practice Questions
d) New price using the modified duration
e) If the market interest rate rises to 8%, what do you think
happens to the price calculated by the modified duration
Explain.
Yield Curve
Relationship between interest rate and maturity.
The graph of the yield curve is called the term structure of
interest rates
The curve expresses how the YTM of a set of bonds varies
depending on their maturity.
His prediction is of great interest to the market: the shape
of the yield curve is an indicator of the impact of monetary
policy on the economy.
Companies can make decisions today based on predicted
interest rates.
Yield Curve
The curve expresses how the YTM of a set of bonds varies
depending on their maturity.
His prediction is of great interest to the market: the shape
of the yield curve is an indicator of the impact of monetary
policy on the economy.
Companies can make decisions today based on predicted
interest rates.
Yield Curve
Sometimes these curves are referred to as the term
structure of interest rates.
The yield curve can tell us a lot about investors'
expectations for interest rates and whether they believe the
economy is going to be expanding or contracting. Yield
curves come in three standard types: the normal yield
curve, the flat yield curve and the inverted yield curve.
Yield Curve
Interest
Rate
Maturity
Yield Curve
Interest
Rate
Maturity
Yield Curve
Interest
Rate
Maturity
Shape of the Yield Curve - Influencing Factors
Maturity
Inflation
Economic Growth
Political Factors
Others
Forward Rates
Forward interest rates are the future rates of interest
implied by current zero rates for periods of time in the
future.
Forward Rates
Interest Rate Yield ???
???
Maturity
Flat Forward
The hypothesis is that the forward rates between two terms
are constant.
F
Flat Forward
Year (n) Spot Rate (p.y.) Forward Rate
(p.y.)
1 3.0
2 4.0
3 4.6
4 5.0
5 5.5
What is the spot rate for 3.7 years?
Financial Risk Management
The four components of market risk are
1) Equity Risk
2) Currency Risk
3) Interest rate risk
4) Commodity price risk
These risks are managed using hedging techniques, among
the derivatives contracts.
