FINA2303 Topic 04 Bond Valuation

Topic 4: Bond Valuation
Learning Outcomes
discounted
cash flows (DCF) approach

bond terminology
zero-coupon bonds and coupon bonds
interest rate risk
credit risk and bond ratings (extra)
yield curve
Topic 4 Bond Valuation
M K Lai
Page 2
Valuation Model
in
making financial decisions, we have to

estimate the fair value of a financial
instrument/firm in many occasions
mergers and acquisitions, company research
report, expert opinion in court, corporate
restructuring
we can use a valuation model to do so
one of the most commonly used valuation
models is the discounted cash flow (DCF)
approach
M K Lai
Page 3
Discounted Cash Flow Approach

steps
estimate
the future cash flows generated by

the financial instrument
estimate the required rate of return (or known
as the discount rate) based on time value of
money and risk of the financial instrument
(use modern financial theories)
calculate the present value of the future cash
flows and it is the fair value of the financial
instrument
application: bond valuation and stock valuation
M K Lai
Page 4
Example: DCF Approach

A
financial instrument is expected to generate an

annual cash flows of $1, $1.5 and $2 in the
coming three years respectively. Its selling price
is expected to be $30 in three years time. The
required rate of return is 12%. What is its fair
value using the discounted cash flow model?
year
cash income
selling price
cash flows
$1
$1.5
$2
$1.5
$30
$32
$1
M K Lai
Page 5
Example: DCF Model

$1
$1.5
$32
PV =
+
+
2
3
1 + 12% (1 + 12%)
(1 + 12%)
= $24.87
The fair value of the financial instrument is estimated
to be $24.87.
M K Lai
Page 6
Bond
when
a company wishes to borrow money from

investors on a long-term basis, it does so by
issuing debt securities that are generally known
as bonds
contractual
obligation of issuer (borrower) to pay

a specific amount of money to investors (called
bondholders) as creditors at some time in the
future
regular interest/coupon payments
principal repayment at maturity
M K Lai
Page 7
Bond
FV
0
bond
price
CPN
CPN
CPN CPN CPN
N-1
CPN = coupon payment

FV = face value
M K Lai
Page 8
Bond
total
return on bond
1.
2.

(sold before maturity)

(held to maturity)
M K Lai
Page 9
Bond Certificate
bond
certificate: a document states the terms

and conditions of a bond as well as the amounts
and dates of the payments to be made
mostly
scripless trading nowadays
M K Lai
Page 10
Bond Certificate
Bond trading is
scripless with
electronic book entry
in Hong Kong!
M K Lai
Page 11
Bond Indenture/Agreement
bond
indenture: written agreement between the

bond issuer (borrower) and the bondholders
(creditors/lenders)
basic terms of the bond
(term to) maturity/tenor: the specified life of a
bond
term can also refer to the time remaining to
maturity
maturity date: the final repayment date of a
bond
M K Lai
Page 12
interest
payment dates: the specified dates for

making interest payments
face/par/nominal value or principal amount:
notional amount of bond to compute interest
payments and is due at bonds maturity
coupon/nominal rate: specified quoted
interest rate (APR) to determine periodic
interest payments at the time of issue
coupon (payment): the promised interest
payment of a bond, paid periodically until the
maturity date of a bond
M K Lai
Page 13
annual
coupon = face value * coupon rate

periodic coupon = annual coupon/number
of payments per year, e.g. annual coupon/2
for semi-annual coupon payments
description of property used as security/collateral
less risky
secured bond (with collateral) vs. unsecured
(lower market interest rate)
bond (without collateral)
seniority of claims upon companys
liquidation (which is senior?)
other things being equal, which offers a
higher market interest rate?
M K Lai
Page 14
protective
covenant that limits certain actions the

issuing company may otherwise wish to take
during the term of the bond (positive or negative)
credit rating: show credit worthiness of issuer
embedded option: an option-like feature included
in a bond to give a specified right to either the
bond issuer or the bondholder, e.g. a callable
bond allows the bond issuer to redeem the bond
at a specified redemption price before maturity
and it will affect the price and yield of the bond
M K Lai
Page 15
Case Study on Bond Terms
source: Fantasia
M K Lai
Page 16
embedded option
source: Fantasia
M K Lai
Page 17
source: Fantasia
M K Lai
Page 18
source: Fantasia
M K Lai
Page 19
Example: Bond Basics

Consider
a 3-year 5% $50,000 par bond at a

prevailing market interest rate of 4%. The coupon
are made on a semi-annual basis.
coupon rate: 5%
par/face/nominal value: $50,000
annual coupon = $50,000*5% = $2,500
semi-annual coupon = $2,500/2 = $1,250
term to maturity or tenor: 3 years
yield (to maturity): 4% (to be discussed later)
M K Lai
Page 20
Types of Bonds
government
bond: bond issued by government

short-term: Treasury bill
long-term: Treasury note and bond
corporate bond: bond issued by a company
coupon bond: receive both regular coupons and
face value at maturity
zero-coupon (pure discount) bond: receive face
value of bond at maturity only; coupon rate = 0%
(what to earn?)
perpetual bond: bond without a maturity date
M K Lai
Page 21
Zero-Coupon Bond
source: HKMA
M K Lai
Page 22
Bond Valuation Model

application
of discounted cash flow approach

cash flows to bondholders
periodic coupon payments CPN
par value at maturity FV
discount rate = market interest rate y (not the
same as coupon rate what is the difference
between them?)
term to maturity = N years
M K Lai
Page 23
Bond Valuation Model

coupon bond
N
CPN
FV
bond price =
+
t
N
(1 + y )
t =1 (1 + y )
zero - coupon bond
FV
bond price =
(1 + y)N
M K Lai
Page 24
Example: Coupon Bond

Consider
a 5%, 3-year, $50,000 par bond with

annual coupon payments. If the market interest
rate on the bond is 4%, what is its value now?
$2,500
$2,500
$52,500
bond price =
+
+
2
3
(1 + 4%) (1 + 4%)
(1 + 4%)
= $51,387.55.
When the bond price is higher than the face value,
the bond trades at a premium.
M K Lai
Page 25
Example: Zero-Coupon Bond

Consider
a 2-year, $50,000 par zero-coupon bond.

If the market interest rate on the bond is 3%,
what is its value now?
$50,000
bond price =
= $47,129.80
2
(1 + 3%)
When the bond price is less than the face value,
the bond is said to trade at a discount.
M K Lai
Page 26
Yield to Maturity
yield
(to maturity) is a measure of the average

rate of return on a bond under two conditions
reinvest the coupons in the bond
1. 2.1. hold
the bond to maturity
2.
calculated
average rate of return that makes the

present value of future cash flows generated by a
bond equal to its bond price
M K Lai
Page 27
Yield to Maturity
coupon bond
N
CPN
FV
+
bond price =
t
N
(1 + YTM)
t =1 (1 + YTM)
zero - coupon bond
FV
bond price =
N
(1 + YTM)
M K Lai
Page 28
Yield to Maturity
for
a zero-coupon bond with term-to-maturity of N

years, the yield to maturity must be equal to Nyear market interest rate
FV
bond price =
N
(1 + YTM )
FV
bond price =
N
(1 + y)
M K Lai
Page 29

A
bond has a price of $1,030.42. It has a par

value of $1,000, an annual coupon of $30, and a
maturity of two years. What is its yield to
maturity?
$60
$1,060
$1,030.42 =
+
2
(1 + YTM) (1 + YTM)
YTM = 4.38%
M K Lai
Page 30

Consider

The current bond price is $48,000. What is its
yield to maturity?
$50,000
$48,000 =
3
(1 + YTM)
YTM = 1.37%
M K Lai
Page 31
Risk-Free Interest Rates

spot
(risk-free) interest rates: default-free, zerocoupon yields of risk-free bond
yield
curve: a graph to show the bond yields (YTM)

(a measure of the market interest rates) as a
function of the bonds term to maturity (TTM)
(usually upward-sloping)
M K Lai
Page 32

zero-coupon
yield curve: a plot of the yield of riskfree zero-coupon bonds (STRIPS Separate
Trading of Registered Interest and Principal of
Securities) as a function of the bonds maturity
date
can also plot coupon-paying yield curve by
using on-the-run coupon bonds
M K Lai
Page 33

yield to maturity
zero-coupon yield curve
term to maturity
M K Lai
Page 34
Market Practice
many
bond professionals use the yield to

maturity to represent the market interest rate,
e.g. they use the yield to determine the bond
price (instead of the other way around)
M K Lai
Page 35

Consider

semi-annual coupons. If the yield to maturity is
3%, what is the bond price?
3%
= 1.5%
semi - annual YTM =
2
$1,000 * 2%
semi annual coupon =
= $10
2
$10
$10
$10
bond price =
+
+
2
$1 + 1.5% (1 + 1.5%)
(1 + 1.5%) 3
$1,010
+
= $980.73
4
(1 + 1.5%)
M K Lai
Page 36

Consider

If the yield to maturity 5%, what is the bond price?
$1,000
bond price =
= $783.53
5
(1 + 5%)
M K Lai
Page 37
Valuing a Coupon Bond with ZeroCoupon Prices and Yields

consider

annual coupon payments
0
-bond price
$50
$1,050
year
STRIPS*
equivalent to a
1-year $50 par
zero-coupon
bond
M K Lai
equivalent to a
2-year $1,050
par zerocoupon bond
Page 38

in
the bond market

1-year zero-coupon bond trades at 96.62 (% of
face value) at a yield of 3.5% (YTM1)
2-year zero-coupon bond trades at 92.45 at a
yield of 4% (YTM2)
assume all bonds have the same risk
M K Lai
Page 39

bond price = $50 * 96.62% + $1,050 * 92.45% = $1,019.04
$50
$1,050
bond price =
+
= $1,019.09
2
(1 + 3.5%) (1 + 4%)
(difference due to rounding error)
$50
$1,050
$1,019.09 =
+
(1 + YTM) (1 + YTM)2
YTM = 3.99%
M K Lai
Page 40

if
the bond price deviates from $1,019.04, it

gives rise to an arbitrage opportunity
for example, the bond price is $1,000
buy the bond and sell (issue) $50 par 1-year
zero-coupon bond at 96.62 and sell (issue)
$1,050 par 2-year zero-coupon bond at 92.45
P&L = $50*96.62%+$1,050*92.45%-$1,000
= $19.04 (arbitrage profit)
You receive $50 from the bond in year 1 and
pay off 1-year zero-coupon bond and $1,050 in
year 2 to pay off 2-year zero-coupon bond
M K Lai
Page 41

yield
to maturity is a weighted average of the

zero-coupon yields (remember that they are the
same as the market interest rates)
if zero-coupon yield curve is upward-sloping,
yield-to-maturity decreases with coupon rate
(why?)
if zero-coupon yield curve is downward-sloping,
yield to maturity increases with coupon rate
(why?)
with a flat zero-coupon yield curve, same yield
to maturity for all coupon rates
M K Lai
Page 42
Why Bond Prices Change?

most
issuers choose to set a coupon rate close to

the market interest rate so that the bonds will
initially issued at par (not for zero-coupon bonds
which must be issued at a discount)
relationship between bond price and market

interest rate/yield (why?)
market
and
interest rate usually increases with

term to maturity of a bond
M K Lai
risk
Page 43

subsequently,
market interest rate changes and

bond price is not necessary equal to the face
value
when coupon rate is higher than market
and
interest rate/yield, bond trades at a
bond price is
than face value (why?)
when coupon rate is equal to market interest
rate/yield, bond trades at
and bond price
is
face value
when coupon rate is lower than market
interest rate/yield, bond trades at a
and
bond price is
than face value
M K Lai
Page 44

change
in interest rate leads to bond price

volatility (interest rate risk)
interest
rate risk can be measured through

duration which is the sensitivity of bond price
to interest rate changes
e.g.
if the duration of a bond is 5.5 years, it

means that a 1% increase in the interest rate
will lead to a 5.5% decrease in the bond price
M K Lai
Page 45
Example: Premium, Par and Discount

Consider

annual coupon payments. What is the bond price
if the yield to maturity is (a) 6%; (b) 5% and (c)
4%?
$50
$1,050
(a) bond price =
+
= $981.67 (discount)
2
(1 + 6%) (1 + 6%)
$50
$1,050
(b) bond price =
+
= $1,000 (par)
2
(1 + 5%) (1 + 5%)
$50
$1,050
(c) bond price =
+
= $1,018.86 (premium)
2
(1 + 4%) (1 + 4%)
M K Lai
Page 46
Time and Bond Prices

as
the next coupon from a bond grows nearer, the

bond price increases to reflect the increasing
present value of the cash flow
it will peak right before the coupon is made and
will drop when coupon is made (buyer cannot
receive the coupon any more)
convergence property: bond price moves
gradually to the face value and it is equal to the
face value on the maturity date when the last
coupon is made (why?)
M K Lai
Page 47
Time and Bond Prices

yield = 5%
M K Lai
Page 48
Example: Time and Bond Prices

Consider

If the yield of 5% is constant over time, what is
the bond price in year 0, year 1, year 2 and year 3
right after the coupon is made.
$1,000
= $863.84
bond price in year 0 =
3
(1 + 5%)
$1,000
= $907.03
2
(1 + 5%)
$1,000
= $952.38
(1 + 5%)
bond price in year 3 = $1,000
M K Lai
Page 49
Interest Rate Risk and Bond Prices

interest
rate risk: the risk that arises for

bondholders from fluctuating interest rates
the longer the term to maturity, the higher the
interest rate risk (why?)
the lower coupon rate, the higher the interest
rate risk (why?)
M K Lai
Page 50
Example: Interest Rate Risk and Term to

Maturity
consider
two bonds (5-year and 10-year) with 5%

annual coupons and a par value of $100
bond price
$160
$140
$120
$100
$80
$60
$40
$20
5% 5-year bond
5% 10-year bond
yield
0%
5%
10%
M K Lai
15%
20%
Page 51
Example: Interest Rate Risk and Term to

Maturity
yield
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
bond price
5% 10-year bond
5% 5-year bond
150.00
125.00
137.89
119.41
126.95
114.14
117.06
109.16
108.11
104.45
100.00
100.00
92.64
95.79
85.95
91.80
79.87
88.02
74.33
84.44
69.28
81.05
64.66
77.82
60.45
74.77
56.59
71.86
53.05
69.10
49.81
66.48
46.83
63.98
44.10
61.61
41.58
59.35
39.25
57.19
37.11
55.14
change in bond price for 5%

10-year bond = ($92.64$100)/$100 = -7.36%
5-year bond = ($95.79$100)/$100 = -4.21%
M K Lai
Page 52
Example: Interest Rate Risk and Coupon

Rate
consider
two 5-year bonds with 1% and 10%

annual coupons and a par value of $100
bond price
$160
$140
$120
$100
$80
$60
$40
$20
10% 5-year bond
1% 15-year bond
yield
0%
5%
10%
M K Lai
15%
20%
Page 53
Example: Interest Rate Risk and Coupon

Rate
yield
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
bond price
10% 5-year bond
1% 5-year bond
150.00
105.00
148.53
100.00
147.13
95.29
145.80
90.84
144.52
86.64
143.29
82.68
142.12
78.94
141.00
75.40
139.93
72.05
138.90
68.88
137.91
65.88
136.96
63.04
136.05
60.35
135.17
57.79
134.33
55.37
133.52
53.07
132.74
50.89
131.99
48.81
131.27
46.84
130.58
44.96
129.91
43.18

5-year bond = ($142.12$143.29)/$143.29 = -0.82%
5-year bond = ($78.94$82.68)/$82.68 = -4.53%
M K Lai
Page 54
Bond Prices and Accrued Interest

dirty/invoice/settlement
price: a bonds actual
cash price
accrued
interest: amount of the next coupon

payment that has already accrued, i.e. accrued
interest = coupon * (days since last coupon
payment up to that day/days in current coupon
period)
calculated based on day count convention, e.g.
Actual/360, Actual/365, Actual/Actual,
30/360
M K Lai
Page 55

clean
price: a bonds cash price less an

adjustment for accrued interest, i.e. clean price =
dirty price accrued interest, and dealers usually
quote this price (as a percentage of face value)
from the perspective of an investor, we
observe the clean price and calculate the
accrued interest; hence, dirty price = clean
price + accrued interest
M K Lai
Page 56
M K Lai
Page 57
face value =
$10,000
source: HKEx
clean price =
$10,000*106.3%
= $10,630
dirty price =
$10,630 +
$105.86 =
$10,735.86
M K Lai
Page 58
Example: Bond Prices and Accrued

Interest
The
dirty price of a 5%, 5-year $1,000 par bond

with semi-annual coupon payments is $985. The
number of days from the last coupon payment up
to the settlement date of the bond trade is 45
days. The number of days between the last
coupon payment to the next coupon payment is
182. Calculate the accrued interest and the clean
price.
accrued interest = ($1,000*5%/2)*45/182 =
$6.18
clean price = $985 - $6.18 = $978.82
M K Lai
Page 59
Credit Risk and Bond Rating

corporate
bonds are risky because there is a

chance that the issuer may not be able to settle
the debt obligations
credit risk: the risk of default by the issuer of any
risky bond that the bonds cash flows are not
known with certainty
investors pay
for a bond with higher credit
risk
lower
yield to maturity is
for a bond with higher
credit risk
M K Lai
Page 60

yield
for yield to maturity--> we expect no credit risk
to maturity (based on promised cash

flows) is higher than the expected return (based
on expected cash flows) because of the chance
of default (why?)
bond/credit rating: an assessment to show the
possibility of default by the bond issuer
different yield curves for bonds with different
bond ratings
credit rating agencies: Standard and Poors,
Moodys and Fitch
M K Lai
Page 61

Moody's
S&P
Fitch
Aaa
Aa1
Aa2
Aa3
A1
A2
A3
Baa1
Baa2
Baa3
Ba1
Ba2
Ba3
B1
B2
B3
Caa1
Caa2
Caa3
Ca
C
AAA
AA+
AA
AAA+
A
ABBB+
BBB
BBBBB+
BB
BBB+
B
BCCC+
CCC+
CCCCC
C
D
AAA
AA+
AA
AAA+
A
ABBB+
BBB
BBBBB+
BB
BBB+
B
BCCC+
CCC+
CCCCC
C
D
investment
grade bonds
if you buy these, you are subjected a low

credit risk
non-investment
grade, speculative,
junk or high yield
bonds
M K Lai
Page 62
Challenging Questions
1. Give two examples of a positive covenant in a
bond indenture.
A. put up collateral to back up the bond
B. make regular interest payments and principal repayment at maturity
2. Give two examples of a negative covenant in a
bond indenture.
A. cannot issue a new bond with a claim priority than the old one
B. cannot announce a dividend higher than a specified level before principal repayment
3. Explain the difference between the coupon rate,
the yield to maturity and the market interest
rate.
upward sloping yield to maturity(calculated number)
M K Lai
Page 63
4. Why is the yield curve upward-sloping more
often than not?
5. What is the implication of an upward-sloping
yield curve?
M K Lai
Page 64
6. Other things being equal, which of the following
bonds should have the highest yield?
A. a term to maturity of 10 years and a credit
rating of AA
B. a term to maturity of 10 years and a credit
rating of BB
C. a term to maturity of 5 years and a credit
rating of AA
D. a term to maturity of 5 years and a credit
rating of BB
M K Lai
Page 65
7. A very important concept in finance is the riskfree rate, i.e. the rate of return of a risk-free
financial instrument. Which of the following is
likely to be used as a proxy for the risk-free rate?
Explain why.
A. Hong Kong Interbank Offered Rate, HIBOR
B. total return on stock of Tracker Fund (an
index fund replicating Hang Seng Index)
C. yield on bond issued by HKSAR Government
D. yield on bond issued by AAA-rated company
M K Lai
Page 66
8. Other things being equal, which of the following
bonds should have the highest interest rate risk?
A. a term to maturity of 10 years and a
coupon rate of 10%
B. a term to maturity of 10 years and a
coupon rate of 5% face value will constitute a higher rate
C. a term to maturity of 5 years and a coupon
rate of 10%
D. a term to maturity of 5 years and a coupon
rate of 5%
M K Lai
Page 67
9. Other things being equal, if the interest rate is
expected to fall and you have to buy a bond, is it
better to buy a bond with a shorter maturity or
one with a longer maturity? Explain. bond price
10.Is the price calculated from the bond valuation
model the clean price or the dirty price? Explain.
11.If a bonds yield to maturity does not change,
how does its price change between coupon
payments? bond price rise, coupon payments
12.Explain why the expected return of a corporate
bond does not equal its yield to maturity.
M K Lai
Page 68
13.The market interest rate increases when
lower
the credit standing of the bond issuer is
;
the term to maturity of the bond is longer ; and
lower
the demand for the bond is
in the
market. bond price lower
bond price and market interest rate (inverse)
14.Explain what is meant by credit risk and interest
rate risk.
demand and supply for short period of time
15.If short-term interest rates are lower than longshort term is more fluctuate
term rates, why might a borrower still choose to
finance with long-term debt?
1. stable source of funds
M K Lai
Page 69
16.The price-yield relationship of a bond is a convex
curve (as shown). The impact on the size in the
bond price change will not be symmetrical for
an increase and a decrease of 1% change in
interest rate. If the bond price effect from a 1%
higher
decrease in the interest rate is usually
than
that from a 1% increase in the interest rate. This
is known as positive convexity.
M K Lai
Page 70
bond price
positive
convexity
yield
i
M K Lai
Page 71
17.Nowadays, a bond issuer tends to include an
option-like feature to a bond. For example, it
may include a redemption provision in the bond
indenture to allow it to redeem the bonds at a
specified redemption price before maturity of
the bond. The bond is called a callable bond. If
an investor buys a callable bond, he effectively
buys a straightsellbond (without any option-like
to the issuer
features) and buys an embedded option. Other
things being equal, as compared to a straight
bond, the callable bond tends to have a lower
price and a higher yield. Explain.
M K Lai
Page 72
18.Most bonds are traded over-the-counter through
a dealer market where large financial
institutions (especially banks) act as the dealers.
In the dealer quotation of the bond price, which
price is likely to be higher, the bid price or the
ask price? Which yield is likely to be higher, the
bid yield or the ask yield?
dealer: for profit
thus ask price must be higher
the bid yield
if ask price is higher
ask yield is lower
M K Lai
Page 73

FINA2303 Topic 04 Bond Valuation

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FINA2303 Topic 04 Bond Valuation

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Topic 4: Bond Valuation

cash flows (DCF) approach

Topic 4 Bond Valuation

making financial decisions, we have to

Discounted Cash Flow Approach

the future cash flows generated by

Example: DCF Approach

financial instrument is expected to generate an

Example: DCF Model

Topic 4 Bond Valuation

a company wishes to borrow money from

obligation of issuer (borrower) to pay

Topic 4 Bond Valuation

CPN CPN CPN

CPN = coupon payment

(sold before maturity)

Topic 4 Bond Valuation

certificate: a document states the terms

scripless trading nowadays

Topic 4 Bond Valuation

Topic 4 Bond Valuation

indenture: written agreement between the

payment dates: the specified dates for

coupon = face value * coupon rate

covenant that limits certain actions the

Case Study on Bond Terms

Topic 4 Bond Valuation

Case Study on Bond Terms

Topic 4 Bond Valuation

Case Study on Bond Terms

Case Study on Bond Terms

Topic 4 Bond Valuation

Example: Bond Basics

a 3-year 5% $50,000 par bond at a

Topic 4 Bond Valuation

bond: bond issued by government

Topic 4 Bond Valuation

Bond Valuation Model

of discounted cash flow approach

Topic 4 Bond Valuation

Bond Valuation Model

Topic 4 Bond Valuation

Example: Coupon Bond

a 5%, 3-year, $50,000 par bond with

Example: Zero-Coupon Bond

a 2-year, $50,000 par zero-coupon bond.

Topic 4 Bond Valuation

(to maturity) is a measure of the average

average rate of return that makes the

Topic 4 Bond Valuation

Topic 4 Bond Valuation

a zero-coupon bond with term-to-maturity of N

Topic 4 Bond Valuation

Example: Coupon Bond

bond has a price of $1,030.42. It has a par

Topic 4 Bond Valuation

Example: Zero-Coupon Bond

a 3-year, $50,000 par zero-coupon bond.

Topic 4 Bond Valuation

Risk-Free Interest Rates

(risk-free) interest rates: default-free, zerocoupon yields of risk-free bond

curve: a graph to show the bond yields (YTM)

Topic 4 Bond Valuation