Summarizing the main lessons

1. Summarizing the main lessons

You're almost at the end. You have learned a great deal about the fundamentals of bond valuation and analysis. Let's take a second to review.

2. Bond valuation

First, you learned how to value a bond. Many bonds are not traded and, even if they were traded, they do not trade frequently enough for us to be able to rely on the price of many bonds as an indicator of their value. So we have to resort to valuing bonds using fundamental valuation methods. In this course, we used a simple example of a bond so we can focus on the fundamental concepts of bond valuation. This is a bond that pays annual coupons at a fixed coupon rate with a fixed time to maturity and with no embedded options. Of course, you have to remember that bonds in the real world are heterogeneous. The same company can issue many bonds with different features. Therefore, going forward, to value a bond properly, you have to understand how each of those features affects the value of a bond.

3. Yield to maturity

The second thing you learned in this course is the bond's yield to maturity. The YTM can be thought of as the compensation for the risks that the bond investor faces when investing in that bond. You can find the YTM of a bond by looking at the YTM of comparable bonds. Alternatively, as you learned, you can also find the YTM implied by investors by solving for it using the ytm() function you created. You also learned that bond yields are comprised of a risk-free yield and a spread. The risk-free yield is the yield on a comparable US Treasury security. The spread reflects many risks, such as credit risk, inflation risk, call risk, and liquidity risk. Investors need to be compensated for each risk they are taking on when investing in a bond. The riskier the bond is for the investor, the higher the yield the investor would demand.

4. Let's practice!

You will now go through a series of exercises to solidify your knowledge of bond valuation and yield to maturity. You will be valuing a Aaa-rated bond with $100 par value, 3% coupon rate, and 8 years to maturity. You will have to find the yield on comparable Aaa-rated bonds and value the bond in a step-by-step fashion.

This exercise is part of the course

Bond Valuation and Analysis in R

IntermediateSkill Level

5.0+

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The fixed income market is large and filled with complex instruments. In this course, we focus on plain vanilla bonds to build solid fundamentals you will need to tackle more complex fixed income instruments. In this chapter, we demonstrate the mechanics of valuing bonds by focusing on an annual coupon, fixed rate, fixed maturity, and option-free bond.

Exercise 1: Introduction Exercise 2: Price vs. value Exercise 3: Time value of money Exercise 4: Computing a bond's future value Exercise 5: Computing a bond's present value Exercise 6: Bond valuation Exercise 7: Laying out the bond's cash flows Exercise 8: Discounting bond cash flows with a known yield Exercise 9: Convert your code into a function Exercise 10: Convert your code into a bond valuation function

Estimating Yield To Maturity - The YTM measures the expected return to bond investors if they hold the bond until maturity. This number summarizes the compensation investors demand for the risk they are bearing by investing in a particular bond. We will discuss how one can estimate YTM of a bond.

Exercise 1: Price-yield relationship Exercise 2: Credit ratings Exercise 3: The yield on the Moody's Baa index Exercise 4: Value the 5% bond using the Baa yield you found Exercise 5: Plotting the price/yield relationship Exercise 6: Components of yield Exercise 7: Risk-free yield Exercise 8: Plotting US Treasury yields Exercise 9: Plotting the investment grade spread Exercise 10: Estimating the yield of a bond Exercise 11: Finding a bond's yield Exercise 12: Use uniroot function to find YTM

Interest rate risk is the biggest risk that bond investors face. When interest rates rise, bond prices fall. Because of this, much attention is paid to how sensitive a particular bond's price is to changes in interest rates. In this chapter, we start the discussion with a simple measure of bond price volatility - the Price Value of a Basis Point. Then, we discuss duration and convexity, which are two common measures that are used to manage interest rate risk.

Exercise 1: Bond price volatility and the price value of a basis point Exercise 2: Price value of a basis point Exercise 3: Calculate PV01 of a 10% bond Exercise 4: Duration Exercise 5: Duration of a zero-coupon bond Exercise 6: Calculate approximate duration for a bond Exercise 7: Estimating effect on bond price using duration Exercise 8: Convexity Exercise 9: Calculate approximate convexity for a bond Exercise 10: Estimating effect of convexity on bond price Exercise 11: Estimating the bond price using duration and convexity

We will put all of the techniques that the student has learned from Chapters One through Three into one comprehensive example. The student will be asked to value a bond by using the yield on a comparable bond and estimate the bond's duration and convexity.

Exercise 1: Summarizing the main lessons

Current Exercise

Exercise 2: Find AAA bond yields as of September 30, 2016 Exercise 3: Bond valuation Exercise 4: Alternative cash flow vector code Exercise 5: Duration and convexity Exercise 6: Direction of price change Exercise 7: Calculate duration Exercise 8: Calculate convexity measure Exercise 9: The estimated price change using duration and convexity Exercise 10: Congratulations!