Financial Institutions , Markets & Money FIN 221

Chapter 5 Summary Prepared By Al Mannaei

The Time Value of Money

The idea that money available at the present time is worth more than the same amount in the future due to its
potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount
of money is worth more the sooner it is received.

The future value(FV):Amount that will be received in the future after investing it in a specific investment

For annual : FV = PV (1+i)nm , For compounding periods FV = PV (1+i/m)nm

PV : The Value of Money now ( in the question PV is usually the amount that will be paid now )

i: Interest rate of the investment ( deposit , loan , bonds …etc)

n : Number of years

m : Compounding periods ( ex. m=2 if semi-annually , m=4 for quarterly compounded , …etc)

The Present Value (PV): The current worth of a future sum of money or stream of cash flows given a specified
rate of return .

Bonds :

Definition : A debt investment in which an investor loans money to an entity (corporate or governmental) that
borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies,
municipalities, states and U.S. and foreign governments to finance a variety of projects and activities.

Further Justification : The indebted entity (issuer) issues a bond that states the interest rate (coupon) that will be
paid and when the loaned funds (bond principal) are to be returned (maturity date). Interest on bonds is usually
paid every six months (semi-annually).

Bonds Quick Facts

- A form of loan—a debt security obligating

- a borrower to pay a lender principal and interest.
- Borrower (issuer) promises contractually to make periodic payments to lender (investor or bondholder)
over given number of years
- At maturity, holder receives principal (or face value or par value).
- Periodically before maturity, holder receives interest (coupon) payments determined by coupon rate,
original interest rate promised as percentage of par on face of bond

Who issue (sell) bonds ?

The issuer (seller) is the party who need the money , Governments & corporations ( ex. BISB , Apple , Nokia …etc)
issue bonds in order to receive money , governments use funds (money) to finance infrastructure projects ( ex.
Building schools , hospitals …etc) , While corporation use fund to finance their investment , to expand or to rise the
capital.
Financial Institutions , Markets & Money FIN 221
Chapter 5 Summary Prepared By Al Mannaei
Is payment guaranteed ?

Yes , almost the payment is guaranteed on agreed time. The issuer fail the repay his obligation the holder (buyer)
of the bonds have the right to claim.

Risk & Return ?

Generally Risk & Return are low , Why?! Because the payment is almost guaranteed .

Government bond ( which called municipal bonds )has lower risk & lower return compared to the corporate bonds
as corporate invest in riskier investments.

Frequency of Payment ?

The frequency of payment can be annually , semi-annually (which is the most popular) , monthly.

Maturity ?

The maturity of bonds start from 1 year to 30 years.

Is it negotiable ?

Yes its tradable in the bonds market ( Capital Market )

How to price a Bond ?

The price of a bond is the present value of the future cash flows (coupons + Face Value ) promised,
discounted at the market rate of interest.

C1 C2 CN + FN
PB = 1
+ 2
+ ... N
(1 + i) (1 + i) (1 + i)
Where PB = price of bond or present value of promised payments;

Ct = coupon payment in period t, where t = 1, 2, 3,…, n;

Fn = par value (principal amount) due at maturity;

i = market interest rate (discount rate or market yield); and

n = number of periods to maturity.

Example 1 : Consider 3 Years Bond with face value of $1000 and Coupon rate 8% , Current market rate
is 10% , Calculate the price of the Bond ?

PB = C 1 + C 2 + ... C N + F N
1 2 N
(1 + i) (1 + i) (1 + i)
80 80 1080
PB  1  2 
1.1 1.1 1.13
PB  72.72  66.15  811  950.289
Financial Institutions , Markets & Money FIN 221
Chapter 5 Summary Prepared By Al Mannaei

Example 2 : Consider 3 Years Bond with face value of $1000 and Coupon rate 5% , Current market rate
is 5% , Calculate the price of the Bond ?

C1 C2 C +F
PB = 1
+ 2
+ ... N NN
(1 + i) (1 + i) (1 + i)
50 50 1050
PB   
1.051 1.052 1.053
PB  47.62  45.35  907.029  1000

Important Rules :

- Increasing i decreases price (PB); decreasing i increases price; thus bond prices and
interest rates move inversely.
- If market rate equals coupon rate, bond trades at par ( Bond price = Face Value )
- If coupon rate exceeds market rate, the bond trades above par—at a premium (Bond
Price > Face Value ).
- If market rate exceeds coupon rate, bond trades below par—at a discount ( Bond price <
Face Value ).

Bond Risks :

Credit or default risk: chance that issuer may be unable or unwilling to pay as agreed. For
example if you buy a bond from a corporation which fail to repay their obligation.

Reinvestment risk: The chance that future coupons from a bond will not be reinvested at the
stated interest rate when the bond was purchased.

Price risk: Inverse relationship between bond prices and interest rates. You can figure that from
the formula .

Zero-Coupon Bonds : A Debt security that doesn't pay interest (a coupon) but is traded at a deep
discount, rendering profit at maturity when the bond is redeemed for its full face value. Therefore ,
the main difference between the regular coupon & Zero-coupon is the coupon payment.

- The zero-coupon always issued at discount , therefore the zero-coupon price of

Bond always lower than face value .
- The is NO Reinvestment Risk because there is no coupon payments.
- Default risk is higher because holder of zero-coupon will not receive any coupon
Financial Institutions , Markets & Money FIN 221
Chapter 5 Summary Prepared By Al Mannaei

- Better time to buy zero-coupon when the interest rate is high , Why?! Because the
bond will be issued at very deep discount .

How to calculate Zero-Coupon Bonds ?

F
As the is no coupon payment in zero-coupon bonds , it can be calculated :
PB = mn
i
(1 + )
m
Example : if you want to purchase a Company XYZ zero-coupon bond that has a $1,000 face
value and matures in 3 years compounded semi-annually, and you would like to earn 10% per year on
the investment, using the formula above you might be willing to pay:

F 1000
PB = mn
  746 . 21
i 10 % 2 * 3
(1 + ) ( 1  )
m 2

Common yield measures ( Bond yields )

1. Yield to Maturity : The rate of return anticipated on a bond if held until the end of its lifetime.
YTM is the interest rate an investor would earn by investing every coupon payment from the bond at a
constant interest rate until the bond’s maturity date. The present value of all of these future cash flows
equals the bond’s market price.
- YTM assume that coupon rate will be invested at the same rate
The calculation can be presented as:

C1 C2 CN + F N
PB = 1
+ 2
+ ... N
(1 + i) (1 + i) (1 + i)
In the YTM calculation , the Bond price , Coupon rate & maturity will be given and the I has to be
calculated . The YTM can be calculated through trail & error1 , OR by financial calculator which
better & easier .

Example YTM : Investor buys 5% percent coupon (semiannual payments) bond for $951.90;
bond matures in 3 years. Solve the bond pricing equation for the interest rate (i) such that price
paid for the bond equals PV of remaining payments due under the bond.

YTM & Bond Price relationship

It’s Exactly same to the Market IR

1
Trail & Error : it’s a method which depend on plugging numbers (rates) then checking the answer , if it’s not right
then you have to retry again , this method is easy but time consuming , you can plug numbers depending on the
comparison of the coupon rate & market rate.
Financial Institutions , Markets & Money FIN 221
Chapter 5 Summary Prepared By Al Mannaei

- Increasing YTM decreases price (PB); decreasing YTM increases price; thus bond
prices and YTM move inversely.
- If market rate equals coupon rate, bond trades at par.
- If coupon rate exceeds YTM rate, the bond trades above par—at a premium.
- If YTM rate exceeds coupon rate, bond trades below par—at a discount.

2. Expected Yield2 : Predicted yield for a given holding period , it’s almost the same as YTM the
only difference that the maturity shorter. Expected yield formula ( same as YTM )

C1 C2 C +
PB = 1
+ 2
+ ... N FNN
(1 + i) (1 + i) (1 + i)

3. Realized Yield3 : The actual rate of return earned on a bond over a period of time. Realized yield
might differ from YTM and Expected4 yield because of change in the amount or timing of
promised payments (e.g. default) or change in market interest rates affecting premium or
discount. Realized yield formula ( same as YTM )

C1 C2 C +
PB = 1
+ 2
+ ... N FNN
(1 + i) (1 + i) (1 + i)

The Realized yield can be calculated using the below formula if the following is known P1 (
Market price ), P0 ( purchased price ) & coupon rate .

( P1  P 0 )  C
Re alized 
P0

Problem 1 : Tom purchased a bond last year for $1240, received $60 in interest return, and sold the
bond for $1300 one year later. What is Tom's realized annual rate of return ? Answer : 9.67%

Problem 2 : Calculate the realized return on a $1,000 face value, 9 percent coupon bond (annual)
purchased for $800 and sold one year later for $850. Answer : 17.5%

Example : Investor pays $1,000 for 10-year 8% coupon bond; sells bond 3 years later for $902.63.Solve
for i such that $1,000 (the original investment) equals PV of 2 annual payments of $80 followed by a 3rd
annual payment of $982.63 (the actual cash flows this investor received).

2
In case Realized & Expected yield calculation you should always look for the previous years only !
3
Realized Yield : Remember that it’s a yield for a known : maturity , coupon rate , market rate. Because the bond is
expired or sold, so we are talking about past. That’s why it’s the most accurate (actual)
4
YTM & Expected Yield : Remember that YTM & Expected depend on forecasting the future.
Financial Institutions , Markets & Money FIN 221
Chapter 5 Summary Prepared By Al Mannaei

Bond price volatility

The volatility of the bond is related with price risk which is affected by market interest rate. Bond
volatility can be calculated :
Pt  Pt 1
%PB   100
Pt 1

where %∆PB = percentage change in price

Pt = new price in period t ( current market price )

P t – 1 = bond’s price one period earlier ( purchased price )

Bonds theorems

Bond prices are inversely related to bond yields5.

The price volatility of a long-term bond is greater than that of a short-term bond, holding the coupon
rate constant.6

The price volatility of a low-coupon bond is greater than that of a high-coupon, bond, holding maturity
constant.7

 Price risk and reinvestment risk work against each other.

o As interest rates fall —
- Bond prices rise but
- Coupons are reinvested at lower return.
o As interest rates rise—
- Bond prices fall but
- Coupons are reinvested at higher return.

In other word , Price risk & reinvestment risk are working against each other (offset each other in away )

Duration - a measure of interest rate risk

Definition : A measure of the sensitivity of the price of a bond ( fixed-income investment) to a change in interest
rates. The formula of Duration8 :
n
CFt * t
 (1  i)
t 1
t CF = Coupons , t = years ( 1,2,3..etc)
D n
CFt
5
 (1  i) t
Bonds Yields : Market interest rate , YTM t 1, Expected yield …etc.
6
To see the relationship refer to slides timetable
7
To see the relationship refer to slides timetable
8
Duration calculation should be solved by using the formula only
Financial Institutions , Markets & Money FIN 221
Chapter 5 Summary Prepared By Al Mannaei

i : interest rate

Duration Example : Suppose we have a bond with a 3-year term to maturity, an 8% coupon paid
annually, and a market yield of 10%. Duration is:

Duration Example 2 : Suppose we have a bond with a 3-year term to maturity, an 8% coupon paid
annually, and a market yield of 15%. Duration is:

As you can notice as the yield increasing , the duration decrease , therefore inverse relationship.

Duration concepts

- Higher coupon rates mean shorter duration and less price volatility.
- Duration equals term to maturity for zero coupon securities.
- Longer maturities mean longer durations and greater price volatility.
- The higher the market rate of interest, the shorter the duration.

Test your knowledge :

Which of the following risks will not affect zero coupon bonds?

a. price risk b. reinvestment risk c. credit risk d. default risk

The bond yield to maturity calculation is

a. the guaranteed rate of return to an investor.

b. the same as the coupon rate.

c. the expected rate of return on the bond.

d. the realized rate of return on the bond.

Financial Institutions , Markets & Money FIN 221
Chapter 5 Summary Prepared By Al Mannaei

All of the following are can be fixed except

a. par value b. yield c. maturity d. coupon

A $1000 bond with an 8.2% coupon rate, interest paid semiannually, and maturing in six years is
currently yielding 7.6% in the market. What is the current price of the bond?

a. $1,027.08 b. $1,131.19 c. $1,028.48 d. $972.00

Hint :Recall the Bond price formula

$5,000 invested at 6%, compounded quarterly, will be worth how much after 5 years?

a. $6,691 b. $16,036 c. $6,734 d. $5,386

Hint : Refer to FV formula mentioned earlier in this notes.

Find the yield to maturity on a semiannual coupon bond with a face value of $1000, a 10%
coupon rate, and 15 years remaining until maturity given that the bond price is $862.35.

a. 10% c. 8%
b. 6% d.12%

Hint : This question can be solved by comparing coupon rate & market interest rate

Duration is a measure of

a. a bond's price.

b. a bond's contractual maturity.

c. the length of time it takes to get back the original investment.

d. bond price volatility.

A 3-year zero coupon bond selling at $900 and yielding 12.18 percent has a duration of

a. 3 years. b. 2.78 years. c. 2.50 years. d. 2 years.

Hint : Refer to Duration concept