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Reading 1CFA L1 FIFull chapter

Bond pricing and yield

In this chapter: Time value of money for bonds · YTM, current yield, realised return

~3 min readLayer 4 · Professional CertificationsFree

Bond price = PV of all future cash flows. Inverse relationship between price and yield. Yield types: current yield, YTM, realised yield. Most-used: YTM.

Foundation

Bond pricing: PV = Σ (Coupon / (1+y)^t) + Face / (1+y)^T • y = yield-to-maturity (YTM) • T = time to maturity Inverse relationship: yields rise → prices fall. Yield types: • Current yield: annual coupon ÷ price • YTM: full discount rate • Realised yield: actual return after reinvesting coupons

Deep Dive

Worked: 5-year, 8% coupon, ₹1,000 face, YTM 7%. Annual coupon = ₹80. Price = 80×[1−(1.07)^−5]/0.07 + 1000/(1.07)^5 = 328 + 713 = ₹1,041 (premium) At 9% YTM: Price = 80×3.890 + 1000/1.539 = 311+650 = ₹961 (discount). Premium/discount converges to face as bond approaches maturity. Indian bond market: • G-Secs (Government securities): most liquid • Corporate bonds: less liquid, wider bid-ask • T+1 settlement • SEBI + RBI as regulators Effective annual yield from semi-annual coupon = (1+y/2)^2 − 1.

Advanced

Subtle CFA tests: • Realised yield depends on reinvestment rate of coupons • If can't reinvest at YTM, realised return < YTM • Critical for retiree planning — declining-rate environments hurt reinvestment Clean price vs dirty price: • Clean: excluding accrued interest • Dirty: including accrued interest • Bond markets quote clean, settle dirty Indian RFQ platforms use dirty for actual settlement. Indian bond yield curve (typical): • 1-year G-Sec: ~6-7% • 10-year G-Sec: ~7-8% (positive slope typical) • Corporate AAA: 30-50 bps premium over G-Sec

Regulatory references
  • SEBI Debt Funds Regulations
  • RBI for sovereign bonds
  • CFA Institute curriculum
Common mistakes & pitfalls
  • Confusing current yield with YTM.
  • Forgetting reinvestment risk.
  • Not understanding clean vs dirty price.

Frequently asked

Why do bond prices fall when yields rise?
Inverse relationship. New bonds offer higher yields; existing bonds with lower yield trade at discount. PV of fixed cash flows falls when discount rate rises.
Indian retail can buy G-Secs?
Yes, via RBI Retail Direct (since Nov 2021). Can also via mutual funds (gilt funds), Sovereign Gold Bonds, etc. Direct retail access easier than corporate bonds.

Practice questions

Click each question to reveal the answer and explanation.

Q 1
Bond price-yield relationship:
  1. (a)Same direction
  2. (b)Inverse: yields rise → prices fall
  3. (c)No relationship
  4. (d)Random
Correct: (b) Inverse: yields rise → prices fall
Inverse: yields rise → prices fall. Fundamental bond pricing principle. Discount factor changes.
Q 2
YTM:
  1. (a)Annual coupon ÷ price
  2. (b)Internal rate of return on bond cash flows
  3. (c)Coupon rate
  4. (d)Face value
Correct: (b) Internal rate of return on bond cash flows
YTM: discount rate that equates PV of all future cash flows to current price. Internal rate of return.
Q 3
Realised yield differs from YTM when:
  1. (a)Coupons reinvested at different rate
  2. (b)Always equal
  3. (c)Only for premium bonds
  4. (d)Random
Correct: (a) Coupons reinvested at different rate
Realised yield depends on actual reinvestment rate of coupons. Only equals YTM if coupons reinvested at YTM rate.
Q 4
Indian retail can buy G-Secs:
  1. (a)No, only institutions
  2. (b)Yes, via RBI Retail Direct (since Nov 2021)
  3. (c)Only via demat
  4. (d)Tax-restricted
Correct: (b) Yes, via RBI Retail Direct (since Nov 2021)
RBI Retail Direct platform: retail can buy G-Secs. Easier access; no commission. Launched Nov 2021.
Q 5
Premium bond is one where:
  1. (a)Price > Face
  2. (b)Price < Face
  3. (c)Price = Face
  4. (d)YTM = 0
Correct: (a) Price > Face
Premium: bond trading above face value. Coupon rate > YTM. Common when interest rates have fallen.
Educational purposes only. The numbers, returns, and examples used in this lesson are illustrative. Past performance does not guarantee future results. Mutual fund and securities investments are subject to market risks. This lesson is not investment advice; for advice tailored to your circumstances, consult a SEBI-registered Investment Adviser. Read our full disclaimer.