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Characteristics of Bonds
•Key Features of Bonds
•Bond Valuation
•Measuring Yield
•Assessing Risk
What is a bond?
• A long‐term debt instrument in which a borrower agrees to make
payments of principal and interest, on specific dates, to the holders
of the bond.
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Key Features of a Bond
• Par value: face amount of the bond, which
is paid at maturity (assume $1,000).
• Coupon interest rate: stated interest rate (generally
fixed) paid by the issuer. Multiply by par value to get
dollar payment of interest.
• Maturity date: years until the bond must be repaid.
• Issue date: when the bond was issued.
• Yield to maturity: rate of return earned on
a bond held until maturity (also called the “promised
yield”).
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Valuation
• A systematic process through which the price at which a security
should sell is established ‐ Intrinsic value
• THE BASIS OF VALUE
• Real assets (houses, cars) have value due to services they provide
• Financial assets (paper) represent rights to future cash flows
• Value today is PV
• Different opinions about securities’ values come from different
assumptions about cash flows and interest rates
• Stocks are hardest to value because future dividends and prices are never
guaranteed.
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The Basis of Value
• Any security’s value is the present value of the cash flows expected
from owning it.
• A security should sell for close to that value in financial markets
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The Value of Financial Assets
0 1 2 N
r% ...
Value CF1 CF2 CFN
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The Basis of Value
• Investing
• Return
• Using a resource to benefit the
future rather than for current • What the investor receives for
satisfaction making an investment
• Putting money to work to earn • 1 year investments return = $
more money received / $ invested
• Common types of investments • Debt investors receive interest.
• Debt Equity investors get dividends +
• Equity price change
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Definition
• The rate of return on an investment is the interest rate that equates
the present value of its expected cash flows with its current price
• Return is also known as
• Yield, or
• Interest
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Return On One Year Investment
Return is what the investor receives
Can be expressed as a dollar amount or as a rate
Rate of return is what the investor receives divided by what was invested
For debt investments: the interest rate
In terms of the time value of money:
Invest PV at rate k and receive future cash flows of
principal = PV, and
interest = kPV
at the end of a year, so
FV1 = PV + kPV
FV1 = PV(1+k)
FV1
PV =
(1 + k)
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The Basis for Value
• Discount Rate
• The term discounted rate is often
used for interest rate
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Returns on Longer‐Term Investments
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Bonds
• Bonds represent a debt relationship in which an
issuing company borrows and buyers lend.
• A bond issue represents borrowing from many lenders at one time
under a single agreement
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Bond Terminology and Practice
• A bond’s term (or maturity) is the time from the present until the
principal is returned
• A bond’s face (or par) value represents the amount the firm intends
to borrow (the principal) at the coupon rate of interest
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Coupon Rates
• Coupon Rate – the fixed rate of interest paid by a bond
• In the past, bonds had “coupons” attached, today they are
“registered”
• Most bonds pay coupon interest semiannually
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Bond Valuation—Basic Ideas
• Adjusting to Interest Rate Changes
• Bonds are originally sold in the primary market and trade subsequently
among investors in the secondary market.
• Although bonds have fixed coupons, market interest rates constantly change.
• How does a bond paying a fixed interest rate remain salable (secondary
market) when interest rates change?
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Bond Valuation—Basic Ideas
• Bonds adjust to changing yields by changing their prices
• Selling at a Premium – bond price above face value
• Selling at a Discount – bond price below face value
• Bond prices and interest rates move in
opposite directions
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Determining the Price of a Bond
• The value (price) of a security is equal to the present value of the
cash flows expected from owning it.
• In bonds, the expected cash flows are predictable.
• Interest payments are fixed, occurring at regular intervals.
• Principal is returned along with the last interest payment.
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Determining the Price of a Bond
Figure 7‐1 Cash Flow Time Line for a Bond
This bond has 10 years until maturity, a par value of
$1,000, and a coupon rate of 10%.?
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Determining the Price of a Bond
• The Bond Valuation Formula
• The price of a bond is the present value of a stream of interest payments plus
the present value of the principal repayment
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Determining the Price of a Bond
• Two Interest Rates and One More
• Coupon Rate
• k ‐ the current market yield on comparable bonds
• “Current yield” ‐ annual interest payment divided by bond’s current price
• Not used in valuation
• Info for investors
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Figure 7‐2 Bond Cash Flow and
Valuation Concepts
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Concept Connection Example 7‐1
Finding the Price of a Bond
Emory issued a $1,000, 8%, 25‐year bond 15 years ago.
Comparable bonds are yielding 10% today.
What price will yield 10% to buyers today?
What is the bond’s current yield?
Assume the bond pays interest semiannually.
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Concept Connection Example 7‐1
Finding the Price of a Bond
Must solve for present value of bond’s expected cash flows at today’s
interest rate. Use Equation 7.4 :
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Concept Connection Example 7‐1
Finding the Price of a Bond
Substituting :
PB $40[PVFA 5%, 20 ] + $1,000[PVF5%, 20 ]
$40[12.4622] + $1,000[0.3769]
$498.49 $376.90
$875.39
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Maturity Risk Revisited
• Related to the term of the debt
• Longer term bond prices fluctuate more in response to changes in interest
rates than shorter term bonds
• AKA price risk and interest rate risk
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Table 7‐1 Price Changes at Different Terms Due to an Interest
Rate Increase from 8% to 10%
in the bond in Example 7‐1
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Figure 7.3 Price Progression with
Constant Interest Rate
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Finding the Yield at a Given Price
• Calculate a bond’s yield assuming it is selling at a given price
• Trial and error – guess a yield – calculate price – compare to price
given
• Benson issued a $1,000, 8%, 30‐year bond 14 years ago.
• Bond is now selling for $718.
• What is yield to an investor buying it today?
• Semiannual interest.
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Concept Connection Example 7‐3
Finding the Yield at a Price
As interest rates rise, bond prices fall, so yield must
be above 8%.
Guess 10% and apply Equation 7.4
PB PMT PVFA k, n + FV PVFk, n
$40 PVFA 5, 32 + $1,000 PVF5, 32
$40 15.8027 + $1,000 0.2099
$842.01
Next guess must be lower to drive price further down.
Answer is just below 12%
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