Lecture 4

Bond Valuation

Objectives:
Bond values and why they fluctuate
Bond ratings and what they mean
The term structure of interest rates and
the determinants of bond yields
Spot and forward rates
Important:

You need your calculator!

Do end-of-chapter problems

Recap: Regular, Immediate and

delayed perpetuity
Regular perpetuity is when the first payment arrives next period(e.g., next year,
month etc)
PMTper period
PV (Perpetuity)
rper period
Immediate perpetuity is when the first payment arrives today
PV (immediate)

PMTper period
rper period

PMTper period

Delayed (or deferred) perpetuity is when the first payment arrives at some
future period t
PMT
1
PV ( Delayed )

per period

rper period

(1 rper period ) t 1

Note: r is the per period interest rate. The formula assumes that r can be used to discount all
future cash flows, and that the first payment arrives next period

Problems

You just won a perpetuity that will pay you $1,000

every three months. What is the present value of this
perpetuity, if you can earn 10% return per year,
compounded quarterly?
A. 1,000
B. 4,000
C. 10,000
D. 40,000
Now say that you want the first payment of $1,000 to
be paid 36 months (or 12 quarters) from today? Did
moving the start of the scholarship back in time
positively or negatively impact the value? WHY?

5-3

General Annuity Formula

Relaxing the assumption about annual compounding:

PV (Annuity) Cper period x

1
rper period

1
(1 rper period )

mn

1.

When we move from annual payments to some other frequency, we

replace r with the per period interest rate (r/m)

2.

Because we are now making more frequent payments, the number of

periods increases by a factor of m (from n to mn).

3.

C is the per period payment. Changing from annual compounding to

more frequent compounding lowers C significantly.

Assume that you are 30 years old today, and that you are planning on
retirement at age 65. To save for your retirement, you plan on making
$3,600 in annual contributions to a retirement account each year until you
reach age 65. Your first contribution will be made on your 31st birthday so
that you make 35 annual contributions. Assume that the rate of interest is
7%.
1. The present value (PV) (at age 30) of your retirement savings is closest to:
a. $46,611
b. $87,000
c. $108,000
d. $126,000
e. $75,230
2. The future value (FV) at age 65 of your retirement savings is closest to:
a. $126,000
b. $497,653
c. $1,000,000
d. $3,788,260

Now to bonds and valuation

Bond is debt contract with

certain standard features
Coupon interest rate:
Stated interest rate
and does not change
during the life of the
bond
Usually = YTM at
issue

Maturity:
Years until
bond must
be repaid
Face amount or
par value which
is re-paid at
maturity
Typically $1,000
for most bonds

Bond Characteristics and Required

Returns
Bond Ratings: Judgments by Moodys and

Standard and Poors about the likelihood of

payment by the bond issuers.
Moodys

S&P

Quality of Issue

Aaa

AAA

Highest quality. Very small risk of default.

Aa

AA

Baa

BBB

Ba

BB

Caa

CCC

Ca

CC

High specullative quality. May be in default.

Lowest rated. Poor prospects of repayment.

In default.

High quality. Small risk of default.

High-Medium quality. Strong attributes, but potentially
vulnerable.
Medium quality. Currently adequate, but potentially
unreliable.
Some speculative element. Long-run prospects
questionable.
Able to pay currently, but at risk of default in the
future.
Poor quality. Clear danger of default .

Bond Markets
Primarily over-the-counter
transactions with dealers connected
electronically
Extremely large number of bond
issues, but generally low daily
volume in single issues
Getting up-to-date prices difficult,
particularly on small company or
municipal issues
Treasury securities are an exception
6-9

Government Bonds
Treasury Securities = government debt
Treasury Bills (T-bills)
Pure discount bonds
Original maturity of one year or less

Treasury notes
Coupon debt
Original maturity between one and ten years

Treasury bonds
Coupon debt
Original maturity greater than ten years
6-10

Valuation of Coupon Bonds:

A typical example: What is the market price of a corporate bond that has a coupon
rate of 9%, a face value of $1,000 and matures exactly 10 years from today if the
interest rate is 10% compounded semiannually?
Timeline of coupons and face value repayment looks like this

1
$45

$45

$45

4 ...
$45

20
$1000+ $45

time
payment

Yes, the cash flow from the bond look like:

a) an annuity: 20 identical payments of $45 for 10 years (or 20 semi-annual
payments)
b) Plus a lump-sum amount of $1000 at the end of the period

Bond Value
Bond Value = PV(coupons) + PV(par)
Bond Value = PV(annuity) + PV(lump
sum)
Remember:
As interest rates increase present values
decrease
( r PV )

As interest rates increase, bond prices

decrease and vice versa
6-12

The Bond-Pricing Equation

C
1
F
Bond Value 1
t
t
r
(1 r) (1 r)
PV(Annuity)

PV(lump sum)

C = Coupon payment; F = Face value,

r=discount rate (yield-to-maturity)

Current yield=Coupon/Bond Value

6-13

Example of Coupon Bond

Valuation
You are considering the purchase of a 5 year, 10% coupon bond with a face value
of $1000. The bond pays coupons annually. Your cost of capital (discount rate) is
8%. What is the highest price that are you willing to pay for the bond?

Bond Value

C
1
F
1

r (1 r) t (1 r) t

Example of Coupon Bond

Valuation

You are considering the purchase of a 5 year, 12% coupon bond with a face value of $1000. The bond pays coupons semi-annually. Your cost of capital is 14%. What is the highest price that are you willing to pay for
the bond?

Remember that
1.C is the per period payment. Changing from annual compounding to semi-annual (m=2) means that we divide Annual Coupon C by 2 .
2.When we move from annual payments to semi-annual, we replace r with the semi-annual interest rate (r/2)

C
1
F
Bond Value
1

r/m (1 r/m) tm (1 r/m) tm

Zero Coupon Bonds

Example: You are considering the purchase of a 3 year
Treasury bond with a face value of $1000 and zerocoupons. The market interest rate on similar risk and
maturity bonds is 5%, compounded semi-annually. What
is the highest price that are you willing to pay for the
bond?
Note:
Zero-Coupon Bonds make no interest payments (Coupon=0)
C
1
F
Bond Value 1
r (1 r) t (1 r) t

6-16

The Yield to Maturity (YTM)

The Yield to maturity (YTM) of a bond is
the discount rate that equates the todays
bond price with the present value of the
future cash flows of the bond.
The yield to maturity is the average annual
rate of return that a bondholder will earn if
bond held to maturity
Usually coupon rate at issue equals YTM
We use YTM as the discount rate to value a
bond

Computing Yield-to-Maturity
YTM).
Suppose we know the following information:

current price of a bond=$1,083.17

coupon rate=9%, paid semi-annually
time to maturity=5 years
How do we calculate the YTM?

$90
1
$1,000

$1,083.17
1
25
25
YTM
YTM
YTM
1
1
2
2

We can use the trial and error method trying different yields until we come
across the one that produces the current price of the bond.

If you have a financial calculator it is easy. Otherwise, it is too tedious.

10-18

Computing Yield-to-Maturity (YTM)

Yield to Maturity of a Zero-Coupon Bond
The yield to maturity for a zero-coupon
bond is the return you will earn as an
investor by buying the bond at is current
market price, holding the bond to maturity,
and receiving the promised face value
payment.
Yield to Maturity of an n-Year Zero-Coupon
1/ n
Face Value
Bond

1 YTM n

Price

Example: Yield-to-Maturity
(YTM)
If the Price of 3 year maturity risk-free,
zero-coupon bond is $91.83, what is its
yield to maturity? Assume that Face
Value=100 and annual compounding.

Price

Face Value

1 YTM n

Face Value
YTM
Price

1/ n

Bond Prices:
Relationship Between Coupon and Yield
Coupon rate = YTM
Price =
Par
Coupon rate < YTM
Price <
Par
Discount bond Why?
Coupon rate > YTM
Price >
Par
Premium bond Why?
6-21

Bond Price

Graphical Relationship
Between Price and Yield-tomaturity

Yield-to-maturity
6-22

Problem 15 and 17, page 233

6-23

Interest Rate Risk

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
6-24

Bond Value ($) vs Years

remaining to Maturity
Premium

CR>YTM
YTM = CR

1,000

CR<YTM

Discount
30

25

20

15

10

0
6-25

Treasury Quotations
2020 Feb 15 8.5 145.12 145.15 +64
3.4730
Maturity = Feb 15, 2020
Coupon rate = 8.5% per year
Bid price = 145:12 = 145 12/32 % of par
Price at which dealer is willing to buy from you

Ask price = 145:15 = 145 15/32 % of par

Price at which dealer is willing to sell to you

Bid-Ask Spread = Dealers profit

Change = 64/32nds
Tick Size = 1/32

Asked Yield = 3.4730%

6-26

Problems
1. What is the yield to maturity of a one-year,
risk-free, zero-coupon bond with a $10,000 face
value and a price of $9600 when released?
2. A risk-free, zero-coupon bond with a face value
of $1,000 has 15 years to maturity. If the YTM is
5.8%, what is the price this bond will trade at?
3. What must be the price of a $10,000 bond
with a 6.5% coupon rate, semiannual coupons,
and two years to maturity if it has a yield to
maturity of 8% APR?

6-27

Say Hello to the Yield Curve

http://finance.yahoo.com/bonds/composite_bond_rates
US Treasury Bonds
Maturity

Yield

Yesterday

Last Week

Last Month

3 Month

0.05

0.07

0.02

0.04

6 Month

0.05

0.05

0.05

0.05

2 Year

0.30

0.30

0.29

0.38

3 Year

0.63

0.63

0.62

0.73

5 Year

1.47

1.47

1.44

1.62

10 Year

2.67

2.69

2.58

2.86

30 Year

3.65

3.68

3.53

3.80

Possible Term Structure Shapes

What do each of these shapes say about the relation between
current and future interest rates?

r = interest rate

Rising Term Structure

Flat Term Structure

Declining (Inverted)
Term Structure
Term to maturity

Three Theoretical Explanations

1.

Unbiased expectations hypothesis: Which shape do you

expect if interest rates are expected to
Increase?
Decrease?

2.

Liquidity Preference: You take on additional risk when

you purchase long term bonds. For example, there is the
additional volatility in prices that we saw earlier.

3.

Market Segmentations (Preferred Habitat): Some

investors face legal restrictions or personal preferences
which limit investment choices to certain maturity
ranges. These demand effects influence rates of return.

Why Does the Term Structure

of Interest Rates Matter?
The term structure of interest rates tells us what interest rate
we could earn over different investment horizons
How can we use this information?

CF1
CF2
CF3
CF4
CFN
PV

...
1
2
3
4
(1 r1) (1 r2 ) (1 r3 ) (1 r4 )
(1 rN ) N
4

CFn

n
(1
r
)
i
n1
If were going to calculate the PV of cash flows occurring in
the future, we should use the discount rate that applies to
cash flows arriving in that period

Forward Rates and Expectations

Theory
Suppose Mary has $100 to invest for two years. She has two choices:
1.
2.

She can invest $100 at the 2-year spot rate and earn 6.05%
She can invest $100 at the 1-year spot rate and earn 5.33% between
years 0 and 1 and then reinvest $105.33 at the new 1-year spot rate
between years 1 and 2

If expectations are unbiased about the one year spot rate one year from
now, Mary should expect to earn the same amount of money from
either investment strategy
Year
Option 1
Option 2

$100.00
$100.00

$106.05
$105.33

$112.47
x

Forward Rates and Expectations

Theory
Define 1r2 as the forward rate between year 1 and year 2; it is the rate
which equates the returns from the two options
In this case:

100(1 0 r 2 ) 2 100(1 0 r1)(11r 2 )

100(1.0605) 2 100(1.0533)(11r 2 )

(1 0 r 2 ) 2 1.1247
(11r 2 )

1.0678
(1 0 r1) 1.0533

Therefore the one year forward rate 1r2 equals 6.78%. If the expectations
theory
of the term structure is correct this implies that the market
believes that the one year spot rate one year from now will be
6.78%.

Forward Rate Practice Problem

#1
Suppose the one year spot rate is 5% and the two year spot rate is 8%.
Assuming the expectations theory of the term structure is correct,
what is the one year forward rate expected to be one year from now?

(1 0 r 2 ) 2
(11 r 2 )
(1 0 r 1)

Therefore the one year forward rate 1r2 is expected to equal