Module 4 – Bond Valuation

Module 4
Bond Valuation

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 Module 4 – Bond Valuation

Module Outline

Topics
4.1) Term Structure
4.2) Bonds and Yields
4.3) No-Arbitrage Pricing
4.4) Interest Rate Risk
4.5) Forward Rates
4.6) Nominal and Real Rates
4.7) Economics of the Term Structure
4.8) [Optional] Appendix: Duration
Readings
Berk and DeMarzo, section 5.3 and sections 6.1-6.3 (incl. appendix)
Practice Problems
Problem Set #4

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 Module 4 – Bond Valuation

The Nature of Discount Rates

There are two key steps in determining the value of a project using

+⋯+ =∑ .
T
FCF1 FCF2 FCFT FCFt
NPV = FCF0 + +
1 + r (1 + r)2 (1 + r)T t=0
(1 + r)t

Free cash flows (numerator).

Discount rate r (denominator).

So far, we have simply assumed a rate r, calling it the discount rate,

(opportunity) cost of capital, or expected (required) return for investors.
But what is r? How do we determine r?

r = Risk-Free Rate + Risk Premium

In this module, we will recover the first component, the risk-free rate, from
available U.S. Treasury bond prices.
Later in the course, we will tackle the risk premium component.

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 Module 4 – Bond Valuation 4.1 Term Structure

Section 4.1
Term Structure

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 Module 4 – Bond Valuation 4.1 Term Structure

Accounting for the Term Structure of Interest Rates

So far, we have assumed that the interest rate is the same for all maturities.
In practice, the interest rate at which you can borrow/invest for, say, 1 year is
often different from the rate at which you can borrow/invest for, say, 5 years.
See page 4.6 for an example.
The relationship among interest rates for different maturities is known as the
term structure of interest rates or yield curve.
When interest rates are the same for all maturities we say the term structure is flat.
When the term structure is not flat,
⋯
should be discounted at: r1 r2 r3 ⋯
the cash flow at time: 1 2 3

and we refer to r1 , r2 , r3 , … as the spot rates.

We thus modify the present value formula to

⋯ ∑
T
C1 C2 CT Ct
PV = + 2
+ + T
=
1 + r1 (1 + r2 ) (1 + rT ) t=1
(1 + rt )t

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 Module 4 – Bond Valuation 4.1 Term Structure

Interest Rates Vary by Maturity

The interest rates offered by banks on certificates of deposit (CDs) usually
depend on their maturity.

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 Module 4 – Bond Valuation 4.1 Term Structure

Term Structure: Example

The term structure of U.S. interest rates in November 2006, 2007, and 2008 was:
6%
Term Date
(years) Nov-06 Nov-07 Nov-08 November 2006
0.5 5.23% 3.32% 0.47% 5%
1 4.99% 3.16% 0.91%

Interest Rate (EAR)

2 4.80% 3.16% 0.98% 4%
3 4.72% 3.12% 1.26% November 2007
4 4.63% 3.34% 1.69%
3%
5 4.64% 3.48% 2.01%
6 4.65% 3.63% 2.49% November 2008
7 4.66% 3.79% 2.90% 2%
8 4.69% 3.96% 3.21%
9 4.70% 4.00% 3.38% 1%
10 4.73% 4.18% 3.41%
15 4.89% 4.44% 3.86% 0%
20 4.87% 4.45% 3.87% 0 2 4 6 8 10 12 14 16 18 20
Term (Years)

The term structure was

close to flat at 5% in Nov 2006;
upward-sloping from 0.5% (short-term) to about 4% (long-term) in Nov 2008.

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 Module 4 – Bond Valuation 4.1 Term Structure

Using the Term Structure: Example

In November 2006, you hold a risk-free security that will pay you the following
cash flows:
Nov 2007 Nov 2008 Nov 2009 Nov 2010
Cash Flows 50 50 50 1,050

Use the data from the figure on page 4.7 to answer the following questions.
1) What is the present value of this security’s cash flows in November 2006?
2) It is now November 2008. You have received the first two CFs, and the security will
pay the last two CFs in 1 and 2 years respectively. What is the present value of
these CFs at that point?

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 Module 4 – Bond Valuation 4.1 Term Structure

Using the Term Structure: Example (cont’d)

1) Using the PV formula from page 4.5, we have

50 50 50 1,050
PV2006 = + + +
1.0499 (1.0480)2 (1.0472)3 (1.0463)4
= 1,012.81.

2) Similarly, in November 2008, we have

50 1,050
PV2008 = + = 1,079.27.
1.0091 (1.0098)2

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 Module 4 – Bond Valuation 4.2 Bonds and Yields

Section 4.2
Bonds and Yields

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 Module 4 – Bond Valuation 4.2 Bonds and Yields

What Is a Bond?

A bond is a contract in which the issuer (borrower) promises to repay the

investor (lender) the amount borrowed plus interest over some specified period
of time.

A coupon bond promises a periodic interest payment (e.g., every 6 months or

year) and repayment of the face value (F ) of the bond at the maturity date (T ).
The periodic interest payment is also known as the coupon (C).
The annual percentage rate that the issuer agrees to pay on the face value is called
the coupon rate.
◦ For a bond that makes m payments a year, the coupon is given by

.
F × Coupon Rate
C=
m
◦ For example, a $1,000 bond with a 6% coupon rate and semiannual coupons
pays $1,000×6%
2
= $30 every 6 months.

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 Module 4 – Bond Valuation 4.2 Bonds and Yields

Bond Coupons

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 Module 4 – Bond Valuation 4.2 Bonds and Yields

Coupon Bond

Here is the time line for the payments made by a bond with an annual coupon
(and a coupon rate of CF ).
maturity
date

0 1 2 3 ⋯ T −1 T

C C C ⋯ C C+F
coupon face
value

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 Module 4 – Bond Valuation 4.2 Bonds and Yields

Zero-Coupon Bond

The simplest kind of bond is a zero-coupon bond.

There are no periodic coupon payments.
Only one payment is made: the face value F at maturity T .
Zero-coupon bonds trade at a discount (a price lower than the face value to account
for the interest over the term of the bond).

The cash flows of a zero-coupon bond are simply:

maturity
date

0 1 2 3 ⋯ T −1 T

0 0 0 ⋯ 0 F
no coupon face
value

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 Module 4 – Bond Valuation 4.2 Bonds and Yields

Treasury Securities

The U.S. Treasury is the largest single issuer of debt in the world.
U.S. Treasury securities are backed by the full faith and credit of the U.S.
government.
They are viewed by market participants as having (close to) no default risk (i.e., no
risk that the issuer defaults on payments of interest and/or principal).

There are three major types of Treasury securities:

Treasury Bills are issued with maturities of 3, 6, or 12 months.
Treasury Notes are issued with maturities between 2 and 10 years.
Treasury Bonds are issued with maturities greater than 10 years.

Treasury bills are zero-coupon bonds, while Treasury notes and bonds are
coupon bonds with interest paid every 6 months.

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 Module 4 – Bond Valuation 4.2 Bonds and Yields

How Treasury Securities Are Quoted

Here is a table of prices for Treasury notes and bonds (per $100 of face value),
from the Wall Street Journal Online on August 10, 2022.

For example, the bond maturing on Aug 15, 2051

has a coupon rate of 2% (and so pays $1 every 6 months);
can be bought for $79.188;
has a yield of 3.092%.
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 Module 4 – Bond Valuation 4.2 Bonds and Yields

Bond Yields

The yield to maturity is the hypothetical discount rate that sets the present
value of the promised bond payments equal to the current price of the bond.
Consider a T -year bond with annual coupons of C and a face value of F . As seen
on page 4.13, this bond will make the following payments:
0 1 2 3 ⋯ T −1 T

C C C ⋯ C C+F

Suppose we know the price P of this coupon bond. The yield to maturity for the
bond is the rate y that solves

P=∑
T
C F
t
+
t=1
(1 + y) (1 + y)T

Intuitively, the yield on a bond is the return that an investor will earn if she
buys the bond today and holds it until maturity.

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 Module 4 – Bond Valuation 4.2 Bonds and Yields

Bond Yields (cont’d)

In general, solving for a bond’s yield (i.e., y in the equation on page 4.17)
requires a numerical search (with a calculator or Excel).
However, because zero-coupon bonds make only one payment, their yield is
much simpler to calculate
For a T -year zero-coupon bond, the time line is as follows.

0 1 2 3 ⋯ T −1 T

0 0 0 ⋯ 0 F
P

We look for the rate y that solves

⇒
1/T

(P )
F F
P= y= −1
(1 + y)T

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 Module 4 – Bond Valuation 4.2 Bonds and Yields

Yield to Maturity: Example

Suppose we want to compute the yield of a 3-year bond with a face value of
$100, paying an annual coupon of 10%, and selling for $103.83.
This bond will pay $10 in 1 year, $10 in 2 years, and $110 in 3 years.
0 1 2 3

10 10 110
P = 103.83
We want to solve for y in

.
10 10 110
103.83 = + +
1 + y (1 + y)2 (1 + y)3

The yield to maturity is the internal rate of return (IRR) for an investment in a
bond.
There are two ways to compute the yield to maturity using Excel:
IRR function.
YIELD function.

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 Module 4 – Bond Valuation 4.2 Bonds and Yields

Computing the Yield of a Bond Using Excel

IRR function.
Recall that the internal rate of return is the discount rate that makes the NPV of an
investment equal to zero.
We can treat
◦ the price of the bond as the initial investment;
◦ the payments made by the bond as the future CFs.

YIELD function.
Excel includes a YIELD function, which has several arguments describing a coupon
bond.

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 Module 4 – Bond Valuation 4.2 Bonds and Yields

Bond Yields and Bond Prices

Know Price → Infer Yield.

As we have seen, the yield of a bond is calculated from
◦ the price of the bond;
◦ the characteristics of the bond (maturity, coupon rate, etc.).
Know Yield → Infer Price.
Conversely, if we know
◦ a bond’s yield to maturity and
◦ the characteristics of the bond,
we can calculate its price.
◦ Indeed, we see from page 4.17 that the price of a bond is the present value of
all its payments, discounted at the yield to maturity.

P =∑
T
C F
+
t=1
(1 + y)t (1 + y)T

In practice, market participants often quote the yield of a bond instead of its
price.
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 Module 4 – Bond Valuation 4.2 Bonds and Yields

Bond Yields and Bond Prices: Example

You are given the following information about a bond.

Face value: $100.
Maturity: 4 years.
Annual coupons with a coupon rate of 8%.
Yield to maturity: 9.25%.
Question: What is the price of this bond?
Solution.
The bond will make the following payments:
0 1 2 3 4

8 8 8 108
The price is the PV of these payments at 9.25%:
8 8 8 108
P= + + + = 95.97
1.0925 (1.0925)2 (1.0925)3 (1.0925)4

Again, quoting a bond’s price is equivalent to quoting its yield, and vice versa.

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 Module 4 – Bond Valuation 4.2 Bonds and Yields

Yield on U.S. 2-Year Treasury Bond, 2016-2022

The following graph shows the evolution of the yield to maturity on U.S. 2-year
treasury bonds.
The shaded area indicates the U.S. recession.

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 Module 4 – Bond Valuation 4.2 Bonds and Yields

Yield on Germany 2-Year Bond, 2010-2022

The following graph shows the evolution of the yield to maturity on Germany’s
2-year bonds.
Notice that the yield was negative since 2014 until recently.
What does this mean?

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 Module 4 – Bond Valuation 4.2 Bonds and Yields

Why Investors Buy Bonds with Negative Yields

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 Module 4 – Bond Valuation 4.3 No-Arbitrage Pricing

Section 4.3
No-Arbitrage Pricing

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 Module 4 – Bond Valuation 4.3 No-Arbitrage Pricing

Present Value and Market Price

Consider a Treasury bill with 1 year to maturity and a face value of $100.
Suppose that the 1-year interest rate (r1 ) is 10%.
◦ This is the rate at which investors can borrow or invest for one year.
Then the present value of the T-bill’s one payment is 100/1.10 = 90.91.

Now suppose that the T-bill is traded in the market: what should its price be?
The price cannot be greater than $90.91, as nobody would buy the T-bill.
Suppose the price were $92.00.
One can arrange to receive $100 in one year by
1) investing $90.91 at r1 = 10% for one year (as $90.91 × 1.10 = $100), or
2) buying the T-bill at $92.00 (as it promises $100 in one year).
Clearly, the first option is preferable and so no one would buy the T-bill.
The price of the T-bill would need to go down to attract investors.

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 Module 4 – Bond Valuation 4.3 No-Arbitrage Pricing

Present Value and Market Price (cont’d)

The price of the T-bill cannot be lower than $90.91 either; why not?
Suppose the price were $90.00.
Consider the following strategy.
◦ Borrow $90.91 at r1 = 10%.
◦ Buy the T-bill for $90.00 (and pocket the difference of $0.91 today).
In one year, you will receive $100 from the T-bill and use this money to repay the
loan with interest (i.e., $90.91 × 1.10 = $100).
Position 0 1
Borrow $90.91 +$90.91 −$100.00
Buy T-bill −$90.00 +$100.00
Total 0.91 0.00
This is an arbitrage that would lead to infinite demand for the T-bill.
Clearly, this would push up the price of the T-bill.
Therefore, the market price of the bill must be $90.91.
This is true in general: In a well-functioning (efficient) market, the price of a
security equals the present value of its cash flows.
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 Module 4 – Bond Valuation 4.3 No-Arbitrage Pricing

Pricing of Default-Free Coupon Bonds

Consider a T -year U.S. government coupon bond with a face value of F and
semi-annual coupon payments of C.

We can price the coupon bond using the spot rates:

+⋯+
C C C C C+F
P= 0.5
+ 1
+ 1.5
+ 2
(1 + r0.5 ) (1 + r1 ) (1 + r1.5 ) (1 + r2 ) (1 + rT )T

This follows from the principle of No-Arbitrage Pricing.

The value of a bond, and its market price, equals the present value of its promised
payments.
If financial markets work correctly, then risk-free spot rates must be the correct
discount rates for any risk-free cash flows.
Cash flows of Treasury coupon (and zero-coupon) bonds are all risk-free; therefore,
they must be priced using the corresponding risk-free discount rates.

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 Module 4 – Bond Valuation 4.3 No-Arbitrage Pricing

Example: Pricing a Coupon Bond

Suppose that the term structure of interest rates is as follows:

r0.5 = 4.0%, r1 = 4.1%, r1.5 = 4.3%, r2 = 4.5%.
r0.5 denotes the equivalent annual rate (EAR) for an investment made at time 0 for
6 months.
Similarly, r1.5 denotes the EAR for an investment made at time 0 for 18 months.
What is the current price of a T-note with 2 years to maturity, a coupon rate of
8%, semiannual coupons, and a face value of $100?
Solution.
The semiannual coupon is $100×8%
2
= $4.
The payments to be made by this bond are as follows.
0 0.5 1 1.5 2

$4 $4 $4 $104
Using the general PV formula (from page 4.5), we have:
4 4 4 104
P = + + + = 106.756
(1.040)0.5 (1.041)1 (1.043)1.5 (1.045)2

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 Module 4 – Bond Valuation 4.3 No-Arbitrage Pricing

Example: Pricing a Coupon Bond (cont’d)

Now that we know the price of the bond, we can find its yield.
We must solve for y in
4 4 4 104
106.756 = + + +
(1 + y)0.5 1 + y (1 + y)1.5 (1 + y)2

We find y = 4.48%.

Notice that this number is larger than the smallest spot rate (r0.5 = 4.0%) and
smaller than the largest spot rate (r2 = 4.5%).

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 Module 4 – Bond Valuation 4.3 No-Arbitrage Pricing

Spot Rates and Bond Yields

Contrast between spot rates and yields.
From the no-arbitrage argument (see page 4.29):

+⋯+
C C C C+F
(1 + rT −1 )T −1 (1 + rT )T
P= + +
(1 + r1 )1 (1 + r2 )2
From the definition of bond yields (see page 4.17):

+⋯+
C C C C+F
(1 + y)T −1 (1 + y)T
P= + +
(1 + y)1 (1 + y)2
Some implications.
The yield of a bond is a “complicated average” of the spot rates.
The yields of two bonds with the same maturity but with different coupon rates
will generally differ. We cannot use the yield of one bond to price other bonds.
For a T -year zero-coupon bond, the above two equations reduce to:
F F
P= and P =
(1 + rT )T (1 + y)T
In a well-functioning market, the T -year spot rate must equal the yield on a T -year
zero-coupon bond. Thus, spot rates are at times referred to as zero-coupon yields.
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 Module 4 – Bond Valuation 4.3 No-Arbitrage Pricing

Computing the Term Structure

Know Term Structure → Calculate Bond Prices.

We have seen that bond prices reflect the term structure (rt for all maturities t).
In other words, if we know the entire term structure of interest rates, we are able to
find the price of any bond (see example on page 4.30).

Know Bond Prices → Calculate Term Structure.

?

In practice, we observe bond prices (for example, see page 4.16), not the spot rates
rt ’s.
Question: Can we use bond prices to compute the term structure?
Answer: Yes, provided that we have a sufficient number of bonds with differing
maturities and/or coupons.
As shown on page 4.32, zero-coupon bonds (ZCBs) make computing the term
structure of interest rates especially convenient.
The T -year spot rate (rT ) is simply the yield on a T -year ZCB.
Thus, as long as we have one ZCB for each maturity, we can compute the entire
term structure.

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 Module 4 – Bond Valuation 4.3 No-Arbitrage Pricing

The Convenience of Zero-Coupon Bonds: Example

You have retrieved the following information about three zero-coupon bonds of
different maturities but all with a face value of $10,000.
ZCB Maturity Price
a 1 year 9,756.10
b 2 years 9,407.68
c 3 years 9,045.62

Question: Using this information, calculate the spot rates for 1, 2 and 3 years.

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 Module 4 – Bond Valuation 4.3 No-Arbitrage Pricing

The Convenience of Zero-Coupon Bonds: Example (cont’d)

First, let us draw the time line for each of the three zero-coupon bonds.
0 1 2 3

Pa = 9,756.10 10,000
Pb = 9,407.68 10,000
Pc = 9,045.62 10,000

The yield for each zero-coupon bond gives us the corresponding spot rate.

⇒
10,000 10,000
9,756.10 = ya = − 1 = 2.5% = r1
1 + ya 9,756.10

⇒
( 9,407.68 )
1/2
10,000 10,000
9,407.68 = yb = − 1 = 3.1% = r2
(1 + yb )2

⇒
( 9,045.62 )
1/3
10,000 10,000
9,045.62 = yc = − 1 = 3.4% = r3
(1 + yc )3

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 Module 4 – Bond Valuation 4.3 No-Arbitrage Pricing

The Creation of Zero-Coupon Bonds

In practice, zero-coupon bonds are only available for maturities of up to 1 year.

In general, to obtain the term structure for longer maturities, one needs to use
coupon bonds (we will do this on page 4.37).
Alternatively, market participants have created zero-coupon bonds by stripping
the cash flows of coupon bonds.
The resulting bonds are called Strips, an acronym for “Separate Trading of
Registered Interest and Principal of Securities.”
Since Strips are actively traded, it is actually possible to use only zero-coupon
bonds to compute the term structure, as we did on pages 4.34-4.35.
Example: A 3-year bond has a face value of $10,000, a coupon rate of 5%, and
annual coupons. Here is how to create 1-, 2-, and 3-year ZCBs from it.
1 2 3
3-Year Coupon Bond 500 500 500 + 10,000
= Zero-Coupon Bond A 500 0 0
+ Zero-Coupon Bond B 0 500 0
+ Zero-Coupon Bond C 0 0 500
+ Zero-Coupon Bond D 0 0 10,000

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 Module 4 – Bond Valuation 4.3 No-Arbitrage Pricing

Computing the Term Structure: Example

It is possible to use a combination of zero-coupon bonds and coupon bonds to

compute the term structure.

Suppose you observe the following prices for two different bonds, each with a
face value of $100 (recall that T-notes pay semiannual coupons):

Bond Security Coupon Maturity Price

A T-bill – 6 months 97.50
B T-note 8% 1 year 102.20

Determine the 6- and 12-month spot rates.

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 Module 4 – Bond Valuation 4.3 No-Arbitrage Pricing

Computing the Term Structure: Example (cont’d)

First, let us figure out the timing of the bonds’ payments:

6 months 12 months
(0.5 year) (1 year)
Bond A 100 0
Bond B 4 104
Each bond must satisfy the present value formula from page 4.5:
100
97.50 =
(1 + r0.5 )1/2
4 104
102.20 = +
(1 + r0.5 )1/2 1 + r1
We can solve the first equation for r0.5 = 5.2%. We can then use this quantity in
the second equation, which reduces to
104
102.20 = 3.90 +
1 + r1
and leads to r1 = 5.8%.
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 Module 4 – Bond Valuation 4.4 Interest Rate Risk

Section 4.4
Interest Rate Risk

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 Module 4 – Bond Valuation 4.4 Interest Rate Risk

The Interest Rate Risk of Bonds

Treasury bonds are risk-free if you hold them to maturity.

The cash flows are certain (as the U.S. government is not expected to default), and
you know exactly what you will receive up until the bond’s maturity.

However, Treasury bonds are not risk-free if you don’t hold them to maturity.
If you will sell them before maturity, the price that you will receive is uncertain.
Why? Changes in interest rates affect bond prices.
◦ If interest rates have gone up, the price will have decreased.
◦ If interest rates have gone down, the price will have increased.

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 Module 4 – Bond Valuation 4.4 Interest Rate Risk

Effect of Shifts in Interest Rates on Bond Prices

For example, assume the term structure of interest rates is flat at r.

Consider the change in the price of a 30-year zero-coupon bond when interest rates
rise from r = 4% to r = 5%:
100 100
P(r = 4%) = = 30.83, P(r = 5%) = = 23.14.
(1.04)30 (1.05)30
This is a 25.0% drop!
In contrast, the price of a 10-year zero-coupon bond falls from 67.56 to 61.39 when
interest rates rise from 4% to 5%, a 9.1% drop.
Basic pattern: Long maturity bonds are more sensitive to interest rate changes.
Intuition: Because long maturity cash flows must be discounted more to get their
PV, a change in discount rate affects them more.
For example, a rise in interest rates from 4% to 5% has hardly any effect on the PV
of a cash flow to be received tomorrow.

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 Module 4 – Bond Valuation 4.4 Interest Rate Risk

Effect of Shifts in Interest Rates on Bond Prices (cont’d)

But bond maturity is not the only determinant of bond price sensitivity to
interest rate changes: the size and timing of coupons also matter.
Consider the effect of a rise in interest rates from 4% to 5% on the price of a
15-year, 10% annual coupon bond.
We have

0.04 [ (1.04)15 ] (1.04)15

10 1 100
P(r = 4%) = 1− + = 166.71, and

0.05 [ (1.05)15 ] (1.05)15

10 1 100
P(r = 5%) = 1− + = 151.90.

This represents a drop of 8.9%, which is less than that for the 10-year zero-coupon
bond on page 4.41.

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 Module 4 – Bond Valuation 4.4 Interest Rate Risk

Interest Rate Risk and Bond Prices: Example

Let us consider four bonds with different characteristics and see how they
respond to changes in the level of the term structure.
Bond A B C D
Coupon Rate 4% 8% 8% 0%
Face Value $1,000 $1,000 $1,000 $1,000
Maturity (years) 30 30 10 10
Annual Coupon 40 80 80 0
Flat Term Structure Bond Price
7% $628 $1,124 $1,070 $508
8% $550 $1,000 $1,000 $463
9% $486 $897 $936 $422
10% $434 $811 $877 $386
Change in Term Structure % Change in Bond Price
from 7% to 8% -12.4% -11.0% -6.6% -8.9%
from 8% to 9% -11.5% -10.3% -6.4% -8.8%
from 9% to 10% -10.7% -9.6% -6.3% -8.7%
Calculations are on page 4.44.
Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.43
 Module 4 – Bond Valuation 4.4 Interest Rate Risk

Interest Rate Risk and Bond Prices: Example (cont’d)

⋯
Here is the time line for the payments from bond A.
0 1 2 3 29 30

40 40 40 ⋯ 40 1,040
If the term structure is flat at 7% (i.e., if r1 = r2 = ⋯ = r30 = 7% = r), then the
price of this bond is

+⋯+
40 40 40 40 1,040
PA (r = 7%) = + 2
+ 3 29
+ = 628.
1.07 (1.07) (1.07) (1.07) (1.07)30

Notice that this can be written as

0.07 [ (1.07)30 ] (1.07)30

40 1 1,000
PA (r = 7%) = 1− + = 628.

Also, we can use Excel to compute this price: −PV(0.07, 30, 40, 1000) = 628.
We compute the percentage price change when the term structure shifts from
7% to 8% as follows: 550−628
628 = 550
628 − 1 = −12.4%.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.44
 Module 4 – Bond Valuation 4.4 Interest Rate Risk

Interest Rate Risk: Summary

In general, the sensitivity of bond prices to interest rate changes depends on all
bond characteristics. It is higher when
the maturity is longer (for given coupon rate and bond price);
the coupon rate is smaller (for given bond price and maturity);
today’s price is higher (for given maturity and coupon rate).
In practice, the sensitivity of a bond’s price to changes in interest rates is
measured by a quantity called duration.
Intuitively, duration measures the effective maturity of a bond.
See (optional) Appendix for more information on the concept of duration.
If you buy a coupon bond with a yield to maturity of 8%, and market interest
rates subsequently rise, then you suffer a loss.
You have tied up your money earning 8% when alternative investments earn a
higher return.
This is interest rate risk: a form of discount rate risk faced even by owners of
default-free bonds.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.45
 Module 4 – Bond Valuation 4.5 Forward Rates

Section 4.5
Forward Rates

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.46
 Module 4 – Bond Valuation 4.5 Forward Rates

Forward Rates: Numerical Example

Suppose that r1 = 8% and r2 = 10%.

Your client knows that they will have to borrow some money for one year in one
year from now. They approach you.
Your firm agrees (today) to lend the client the money at that time (in one year) at a
rate f2 specified today.
This arrangement is called a forward rate agreement.

Question: Assuming that your client will repay you for sure (i.e., this loan is
risk-free), what is the correct rate f2 ?

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.47
 Module 4 – Bond Valuation 4.5 Forward Rates

Forward Rates: Numerical Example (cont’d)

Notice that, for every dollar that you invest for two years, you now have two
possible investment alternatives:
1) Invest for 2 years at a rate of r2 = 10%. Every dollar invested will grow to

FV2 = (1 + r2 )2 = (1.10)2 = 1.21.

2) Invest for 1 year at a rate of r1 = 8%, and then lend to your client at the
pre-contracted rate of f2 . Every dollar will then grow to

FV2 = (1 + r1 )(1 + f2 ) = (1.08)(1 + f2 ).

Since both investment alternatives involve no risk, they should result in the
same future value in two years.
Otherwise, there would be an arbitrage opportunity.
Thus we must have (1 + r2 )2 = (1 + r1 )(1 + f2 ), which implies

(1 + r2 )2 (1.10)2
f2 = −1= − 1 = 12.04%.
1 + r1 1.08
The rate f2 is known as the forward rate for year 2.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.48
 Module 4 – Bond Valuation 4.5 Forward Rates

Forward Rates: General Case

More generally, suppose you entered a forward rate agreement (FRA) structured
as follows.
Your counterparty knows that they will need to borrow some money for a year at
time t − 1 (i.e., at the end of year t − 1).
However, rather than borrowing at the then prevailing interest rate (which is
uncertain), the counterparty asks you to agree today to lend them money at time
t − 1 at a rate ft contracted today.
What should this rate be?

As before, you have two options if you want to invest money for t years.
1) Invest for t years at a rate rt . This will result in a future value of

FVt = (1 + rt )t .

2) Invest for t − 1 years at a rate rt−1 , and enter into the rate specified in the FRA. This
will result in a future value of

FVt = (1 + rt−1 )t−1 (1 + ft ).

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.49
 Module 4 – Bond Valuation 4.5 Forward Rates

Forward Rates: General Case (cont’d)

Since both strategies are risk-free, we must have

(1 + rt )t = (1 + rt−1 )t−1 (1 + ft ).

This implies that

(1 + rt )t
ft = −1
(1 + rt−1 )t−1

The rate ft is known as the forward rate for year t.

The following figure shows the relationship between spot rates and forward
rates.
(1 + r2 )2 (1 + f3 )

0 1 2 3

(1 + r3 )3

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.50
 Module 4 – Bond Valuation 4.5 Forward Rates

Using Spot Rates and Forward Rates: Example

Consider the following situation.

You know that r3 = 6% and that f3 = 7%.
You are interested in investing $1,000 at the bank for two years.
How much money will you have in your account in two years?
Approach 1. Using the time travel possibilities depicted on page 4.50, you could
proceed as follows.
Bring the $1,000 forward to the end of year 3 using r3 = 6%:

FV3 = 1,000(1.06)3 = 1,191.02.

Discount this quantity back to the end of year 2 using f3 = 7%:

FV2 = 1,191.02 ÷3 1.07 = 1,113.10.

× (1 + r3 )

0 1 2 3
÷ (1 + f3 )

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.51
 Module 4 – Bond Valuation 4.5 Forward Rates

Using Spot Rates and Forward Rates: Example (cont’d)

Approach 2. You could infer r2 from the data you have, and use it to calculate
FV2 .
From page 4.50, we have (1 + r3 )3 = (1 + r2 )2 (1 + f3 ), which implies

[ 1 + f3 ] [ 1.07 ]
1/2 1/2
(1 + r3 )3 (1.06)3
r2 = −1= − 1 = 5.504%.

Therefore, the future value of $1,000 at the end of year 2 is

1,000(1 + r2 )2 = 1,000(1.05504)2 = 1,113.10.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.52
 Module 4 – Bond Valuation 4.6 Nominal and Real Rates

Section 4.6
Nominal and Real Rates

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.53
 Module 4 – Bond Valuation 4.6 Nominal and Real Rates

Nominal versus Real Interest Rates: Numerical Example

Suppose that all you buy are apples, which cost $1 each today. Suppose also
that the money you save will generate 26% interest this year (i.e., r = 26%).
Question: Does that mean that you will be able to buy 26% more apples next
year?
Answer: It will depend on the price of apples in one year.
Example.
Suppose that you have $100 today, and that the price of apples goes up by i = 5%
during the year.
Let us compare how many apples you could buy today vs. in one year.
Today In one year
Money available $100 $126
Price of apples $1.00 $1.05
100 126
Can buy 1.00
= 100 apples 1.05
= 120 apples
Since you can only buy 20% more apples, you are only 20% better off (not 26%). In
other words, your real interest rate is rr = 20%.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.54
 Module 4 – Bond Valuation 4.6 Nominal and Real Rates

Nominal versus Real Interest Rates

The relationship between interest, inflation, and real rates holds in general:

1+r Growth of Money

Growth in Purchasing Power = 1 + rr = =
1+i Growth of Prices
That is, suppose that you invest for one year in the bond market.
Your investment next year is worth 1 + r dollars for each dollar invested.
With an inflation rate of i, prices go up by a factor of 1 + i.
◦ You need more money than before to buy the same goods.
Thus, the quantity of goods that you will be able to buy will go up by a factor of
1 + rr = 1+r
1+i
.

rr is known as the real interest rate, while r is called the nominal interest rate.

1+r
rr = −1
1+i

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.55
 Module 4 – Bond Valuation 4.6 Nominal and Real Rates

Nominal versus Real Interest Rates (cont’d)

Notice that

⏟⏞⏞⏞⏞⏞⏟⏞⏞⏞⏞⏞⏟
1 + r = (1 + rr )(1 + i) = 1 + rr + i + (rr × i) ≈ 1 + rr + i,
small
so that
rr ≈ r − i
is a convenient shortcut.

In fact, in practice, people often calculate the real rate of return rr this way, that
is, as the difference between the nominal rate of return r and the inflation rate i.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.56
 Module 4 – Bond Valuation 4.6 Nominal and Real Rates

Interest Rates and Inflation Rates

The following figure shows U.S. interest rates and inflation rates for 1962-2022.
The difference between them reflects the (approximate) real interest rate.
Note that nominal interest rates tend to be high when inflation is high.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.57
 Module 4 – Bond Valuation 4.6 Nominal and Real Rates

Inflation and Discounting

How do we treat inflation and real rates when discounting cash flows?
Discount nominal cash flows at the nominal interest rate, or
discount real cash flows at the real interest rate.

Both methods will produce the same NPV, that is

NPVreal = ∑ =∑ t = NPVnominal .
T T
Ctreal C nominal
(1 + rr ) t (1 + r)t
t=0 t=0

To see this, recall (from page 4.55) that the real rate rr is given by

,
1+r
1 + rr =
1+i

.
so that
Ctnominal Ctreal (1 + i)t Ctreal
t
= t
=
(1 + r) (1 + r) (1 + rr )t
This makes intuitive sense: real and nominal dollars are the same today.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.58
 Module 4 – Bond Valuation 4.6 Nominal and Real Rates

Inflation and Discounting: Example

The nominal rate is 6%, and inflation is expected to be 2% for the long term.

You are 36 and, this past year, you spent $60,000 on rent, food, and
transportation.

You would like to be able to afford the same set of goods in your first year of
retirement at age 66 (i.e., in 30 years).

How much do you need to save now to afford this? Do your calculations in
nominal and in real terms.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.59
 Module 4 – Bond Valuation 4.6 Nominal and Real Rates

Inflation and Discounting: Example (cont’d)

Let us first do the calculations in nominal terms.

Over the next 30 years, prices will go up at 2% a year. This means that, in 30 years,
the same bundle of goods will cost you
nominal
C30 = 60,000(1.02)30 = 108,682.

The amount you need to save today is the present value of this cash flow at the
nominal rate of 6%:
108,682
NPVnominal = = 18,923.
(1.06)30
Let us now do the calculations in real terms.
Since you would like to spend the same amount of money in real terms, we have
real = 60,000.
C30
1+r 1.06
The real rate is given by rr = 1+i
−1= 1.02
− 1 = 3.92%.
The amount you need to save today is therefore
60,000
NPVreal = = 18,923.
(1.0392)30

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.60
 Module 4 – Bond Valuation 4.7 Economics of the Term Structure

Section 4.7
Economics of the Term Structure

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.61
 Module 4 – Bond Valuation 4.7 Economics of the Term Structure

Determinants of the Term Structure

The term structure (a.k.a. yield curve) is a key indicator in finance and
economics.

What determines the shape of the term structure?

Interest rates, in particular long-term rates, are largely determined by investors’
expectations about the macro-economy, future rates, and inflation.
◦ When inflation is expected to be high (low), interest rates tend to be high
(low): r ≈ rr + i.
◦ When economic growth is expected to be high (low), interest rates are
typically high (low).
The U.S. Federal Reserve and central banks in general directly affect short-term
rates by determining the rate at which banks can borrow cash reserves overnight.

The shape of the current U.S. term structure can be seen here.

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 Module 4 – Bond Valuation 4.7 Economics of the Term Structure

The Shape of the Term Structure

As the following figure shows, the term structure usually slopes up: long-term
rates (e.g., 10-year) are above short-term rates (e.g., 3-month).
This is not always the case: the term structure tends to invert before recessions.

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 Module 4 – Bond Valuation 4.7 Economics of the Term Structure

Term Structure as a Leading Indicator

The following graphs are from the Federal Reserve Bank of New York. They are
available here, and described on page 4.65.

Updated: Aug 10, 2022

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.64
 Module 4 – Bond Valuation 4.7 Economics of the Term Structure

Term Structure as a Leading Indicator (cont’d)

The slope of the Treasury yield curve (r10 − r0.25 ), plotted in the first graph, is a
predictor of future real economic activity.
A high slope means good times ahead.
A low (negative) slope forecasts a recession.
Why does a downward sloping yield curve predict recessions?
We can use forward rates to gain some intuition:

(1 + r2 )2 = (1 + r1 )(1 + f2 ).

Thus, a negative slope (r2 < r1 ) implies that f2 is low.

This means that the demand for borrowing is expected to be low in year 2; this
happens when economic conditions are expected to weaken.

The second graph shows recession probabilities over time, as estimated by the
New York Fed.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.65
 Module 4 – Bond Valuation 4.8 [Optional] Appendix: Duration

Section 4.8
[Optional] Appendix: Duration

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.66
 Module 4 – Bond Valuation 4.8 [Optional] Appendix: Duration

[Optional] Measuring Interest Rate Risk: Duration

A key tool for measuring interest rate sensitivity is duration.

Duration is a measure of the effective maturity of a security.
It is the value-weighted average of the maturity of the cash flows.

The duration of a security with cash flows Ct at time t = 1, … , T is

×2+⋯+
PV (C1 ) PV (C2 ) PV (CT )
Duration = ×1+ ×T
P P P

=∑
T
PV (Ct )
× t,
t=1
P

where P denotes the price of the security.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.67
 Module 4 – Bond Valuation 4.8 [Optional] Appendix: Duration

[Optional] Calculating Duration for a Bond: Example

Question: Consider a 2-year 3% annual coupon bond with face value $100 and
suppose the yield curve is flat at 4%. What is the duration of this bond?
Solution.
Let us first compute the price of the bond:
3 103
P= + = 2.88 + 95.23 = 98.11
1.04 (1.04)2

Of the total value of the bond,

◦ a fraction 2.88/98.11 = 2.94% has a maturity of 1 year, and
◦ a fraction 95.23/98.11 = 97.06% has a maturity of 2 years.
The duration is therefore

Duration = 2.94% × 1 + 97.06% × 2 = 1.97

The durations of the bonds on pages 4.41-4.42 are 30, 10, and 9.85, respectively.
Notice this is the same ranking as the ranking of their sensitivity to a rise in
interest rates we found there.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.68
 Module 4 – Bond Valuation 4.8 [Optional] Appendix: Duration

[Optional] Duration and Interest Rate Sensitivity

Duration is useful as a measure of a bond’s interest rate sensitivity.
The percentage change in the bond price is proportional to the duration times the
change in the interest rate.
Specifically, for a bond with duration D,
D
%-Change in Price ≈ − × Change in r.
1+r
In practice, people at times simplify by defining the modified duration Dmod ≡ D
1+r
to
get
%-Change in Price ≈ −Dmod × Change in r
The predicted price changes of the bonds on pages 4.41-4.42 are
30
− × 1% = −28.8% (actual change: − 25.0%)
1.04
10
− × 1% = −9.6% (actual change: − 9.1%)
1.04
9.85
− × 1% = −9.5% (actual change: − 8.9%)
1.04

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.69
 Module 4 – Bond Valuation

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.70
 Module 4 – Bond Valuation

Module 4: Main Takeaways

The term structure of interest rates — the yield curve — reflects interest rates
for different maturities.
We construct the term structure using market prices of U.S. Treasury bonds.
We assume that these bonds are default-free and thus provide the correct discount
rates for risk-free cash flows.
We can infer the spot rates directly using ZCBs / Treasury Strips.
The spot rate rt is the appropriate rate at which to discount a cash flow occurring
at time t back to time 0.

The yield (or yield to maturity) of a bond is the IRR of a bond and discounts all
the cash flows of the bond at the same rate.
Given the yield we can compute the price, and vice versa.
Practitioners often quote yields instead of prices.

The shape of the yield curve reflects expectations about economic growth,
inflation, and future interest rates.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.71
 Module 4 – Bond Valuation

Module 4: Formulas

Present Value with Term Structure: PV = ∑

T
Ct
t=1
(1 + rt )t

Bond Yield: Rate y such that P = ∑

T
C F
+
t=1
(1 + y)t (1 + y)T

Price of a Bond.
Given the yield y and equation above solve for P

Given term structure r1 , r2 , … , rT : P = ∑

T
C F
+
t=1
(1 + rt )t (1 + rT )T

(1+rt )t
(1+rt−1 )t−1 − 1
× (1 + f2 ) × ⋯ × (1 + ft )
Forward Rates: ft =
(1 + rt )t = (1 + f1 )
1+r
Real Rate: rr = 1+i − 1 or approximately rr ≈ r − i

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 4.72