Bonds and their Valuation

bond is a legally binding agreement

between a borrower and a lender that
specifies the:
Par (face) value
Coupon rate
Coupon payment
Maturity Date

The

yield to maturity is the required

market interest rate on the bond.
8-2

 Primary

Principle:

Value of financial securities = PV of

expected future cash flows

Bond

value is, therefore, determined

by the present value of the coupon
payments and par value.
Interest rates are inversely related to
present (i.e., bond) values.
8-3

1
1
T

(1 r)
Bond Value C
r

F

T
(1 r)

8-4

Consider a government bond with as 6

3/8% coupon that expires in December
2013.
The Par Value of the bond is $1,000.
Coupon payments are made semiannually

(June 30 and December 31 for this particular

bond).
Since
rate is 6$31
3/8%,
.875 the payment
$31.875
$31the
.875coupon
$1,031.875
is $31.875.

On January 1, 2009 the size and timing of

12 / 31 / 09
12 / 31 / 13
1 / 1 / 09
6 / 30
/ 09 are:
6 / 30 / 13
cash
flows
8-5

 On

January 1, 2009, the required

yield is 5%.
The current value is:

$31.875
1
$1,000
PV
1

$1,060.17

10
10
.05 2
(1.025) (1.025)

8-6

 Now

assume that the required yield

is 11%.
How does this change the bonds
price?

$31.875
1
$1,000
PV
1

$825.69

10
10
.11 2
(1.055) (1.055)

8-7

When the YTM < coupon, the bond

trades at a premium.

Bond Value

1300

1200

When the YTM = coupon, the

bond trades at par.

1100

1000

800
0

0.01

0.02

0.03

0.04

0.05

0.06
0.07
6 3/8

0.08

0.09

0.1

Discount Rate

When the YTM > coupon, the bond trades at a discount.

8-8

Bond prices and market interest

rates move in opposite directions.
When coupon rate = YTM, price =
par value
When coupon rate > YTM, price >
par value (premium bond)
When coupon rate < YTM, price <
par value (discount bond)

8-9

Price Risk
Change in price due to changes in interest rates
Long-term bonds have more price risk than short-term

bonds
Low coupon rate bonds have more price risk than high
coupon rate bonds.

Reinvestment Rate Risk

Uncertainty concerning rates at which cash flows can be

reinvested
Short-term bonds have more reinvestment rate risk than
long-term bonds.
High coupon rate bonds have more reinvestment rate risk
than low coupon rate bonds.
8-10

Bond Value

Consider two otherwise identical bonds.

The long-maturity bond will have much more
volatility with respect to changes in the
discount rate.

Par
Short Maturity Bond

Discount Rate
Long Maturity
Bond

8-11

 Maturity

value of long term bond and

interest payments are all future cash
flows that are very distant points in
future.
If interest rates rise, those distant
cash flows of long term bond are
discounted in value significantly.
The price of the long term bond falls
in the market abruptly.
8-12

Bond Value

Consider two otherwise identical bonds.

The low-coupon bond will have much
more volatility with respect to changes in
the discount rate.

Par
High Coupon Bond

Low Coupon Bond Discount Rate

8-13

A higher coupon bond means that more cash in

the future in the form of interest payments
flows to investor before maturity than in the
case of lower coupon bond.
When interest rates rise and future cash flows
are discounted at a higher rate, the lower
coupon bond has relatively more cash inflow in
the future which cause the maturity value of
the bond represents a greater portion of total
cash flow.
The bonds value today will fall relatively more.

8-14

 Yield

to maturity is the rate implied by

the current bond price.
Finding the YTM requires trial and error
if you do not have a financial calculator
and is similar to the process for finding
r with an annuity.
If you have a financial calculator, enter
N, PV, PMT, and FV, remembering the
sign convention (PMT and FV need to
have the same sign, PV the opposite
sign).
8-15

 Consider

a bond with a 10% annual

coupon rate, 15 years to maturity,
and a par value of $1,000. The
current price is $928.09.
Will the yield be more or less than 10%?
N = 15; PV = -928.09; FV = 1,000; PMT

= 100
CPT I/Y = 11%

8-16

 Suppose

a bond with a 10% coupon

rate and semiannual coupons has a
face value of $1,000, 20 years to
maturity, and is selling for $1,197.93.
Is the YTM more or less than 10%?
What is the semi-annual coupon payment?
How many periods are there?
N = 40; PV = -1,197.93; PMT = 50; FV =
1,000; CPT I/Y = 4% (Is this the YTM?)
YTM = 4%*2 = 8%

8-17

Current Yield = annual coupon / price

Yield to maturity = current yield + capital
gains yield
Example: 10% coupon bond, with semiannual coupons, face value of 1,000, 20
years to maturity, $1,197.93 price
Current yield = 100 / 1197.93 = .0835 = 8.35%
Price in one year, assuming no change in YTM =

1,193.68
Capital gain yield = (1193.68 1197.93) / 1197.93
=
-.0035 = -.35%
YTM = 8.35 - .35 = 8%, which is the same YTM
computed earlier
8-18

Make no periodic interest payments

(coupon rate = 0%)
The entire yield to maturity comes from the
difference between the purchase price and
the par value
Cannot sell for more than par value
Sometimes called zeroes, deep discount
bonds, or original issue discount bonds
(OIDs)
Treasury Bills and principal-only Treasury
strips are good examples of zeroes
8-19

Information needed for valuing pure discount bonds:

Time to maturity (T) = Maturity date - todays date
Face value (F)
Discount rate (r)

$0

$0

$0

$F

T 1

Present value of a pure discount bond at time 0:

F
PV
T
(1 r )

8-20

Find the value of a 15-year zerocoupon semi-annual bond with a

$1,000 par value and a YTM of 12%.
$0

$0

$0

$1,000
$ 0$0,1$

10 22930

29

30

F
$1,000
PV

$174.11
T
30
(1 r )
(1.06)
8-21