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Valuation of Securities

-bond valuation

BONDS
A bond is a tradable instrument that
represents a debt owed to the owner by the
issuer. Most commonly, bonds pay interest
periodically (annually, semiannually) and
then return the principal at maturity.

Calculating the Value of a Bond

Bond valuation : terminology


1. Par value : it is the value stated on the face of
the bond. It represents the amount the firm
borrows & promises to repay at the time of
maturity.
2. Coupon rate & Interest:
Interest a bond carries a
specific IR which is called the coupon rate. The
interest payable to the bondholder is
= (par value of the bond * coupon rate)

Bond valuation
3. Maturity Date - This is the date after which
the bond no longer exists. It is also the date
on which the loan is repaid and the last
interest payment is made.

There are two types of cash flows that are


provided by a bond investments:
Periodic interest payments (usually every six
months, but any frequency is possible)
Repayment of the face value (also called the
principal amount) at maturity

The Value of a Bond

Valuation Model
Determining the value of a bond requires :
(i) An estimate of expected cash flows
(ii) An estimate of the req. returns.
To simplify the analysis of bond valuation we make
the following assumption:
(i) The coupon interest rate is fixed for the term
of the bond.
(ii) The coupon payments are made every year &
the next payment is receivable exactly a year
from now.

Calculating the Value of a Bond


The value of the bond can be expressed as :

Where,
INT = annual coupon payment
Kd = req. rate of return/discount rate
N = time period.
VB = INT *PVAFn,i + M* PVFn,i

Bond Yield

Commonly applied yield measures are:(i) Current yield (CY) : the CY relates the
annual coupon rate to the market price.
CY = INT/Price
Eg : the current yield of a 10 Yr, 12%
coupon bond with a par value of Rs
1000 and selling at Rs 950 is _____ ?

Bond Yield
Sol: 120/950 = 12.63%
Note : Cy only reflects the current int. rate. It doesnt

consider capital gain (or loss) that an investor will


realize if the bond is purchased at a discount (or
premium) and hold till maturity.
(ii) Yield to maturity (YTM) : rate of return earned on
bond held until maturity (also called the promised
yield).
the yield to maturity of a bond is the interest rate that
makes the present value of the cash flow receivable
from owning the bond equal to the price of the bond.

Yield To Maturity
The IR when:
Price of the bond = PV of all cash flow receivables
Eg : par value : Rs 1000, CI = 9%,time to maturity = 8 Yrs
and currently priced at Rs 800. what will be the yield to
maturity?
sol: An appox.
= INT + (M-P)/n
0.4M + 0.6 P
= 13.06%(CAUTION)

Relationship Between Coupon


Bond Prices and Interest Rates
Bond prices are inversely related to
interest rates (or yields).
A bond sells at par only if its interest rate
equals the coupon rate
A bond sells at a premium if its coupon
rate is above the interest rate.
A bond sells at a discount if its coupon
rate is below the interest rate.

Bond Prices and Interest Rates

WHY?

What is the value of a 10-year, 10%


annual coupon bond, if kd = 10%?The
par value is $1000?
0

k
VB = ?

...
100

100

100 + 1,000

$100
$100
$1,000
VB
...

1
10
(1.10)
(1.10)
(1.10)10
VB $90.91 ... $38.55 $385.54
VB $1,000

An example:
Increasing inflation and kd
Suppose inflation rises by 3%, causing k d
= 13%. When kd rises above the coupon
rate, the bonds value falls below par,
and sells at a discount. (837.21)
Suppose inflation falls by 3%, causing k d
= 7%. When kd falls below the coupon
rate, the bonds value rises above par,
and sells at a premium. (1210.71)

A bond was issued 20 years


ago and now has 10 years to
maturity. What would happen
to its value over time if the
required rate of return
remained at 10%, or at 13%,
or at 7%?

The price path of a bond


What would happen to the value of this bond if its
required rate of return remained at 10%, or at 13%,
or at 7% until maturity?
VB

1,372
1,211

kd = 7%.
kd = 10%.

1,000
837
775

kd = 13%.
30

25

20

15

10

Years
to Maturity

The price path of a bond

Bond yield of GOI bonds

Types of Bonds
Bonds differ in several respects:
Repayment type
Issuer
Maturity
Security

Types of Bonds
Repayment type
Bonds with a balloon payment
Pure discount or zero-coupon bonds
Pay no coupons prior to maturity.

Coupon bonds
Pay a stated coupon at periodic intervals prior to maturity.

Floating-rate bonds
Pay a variable coupon, reset periodically to a reference rate.

Bonds without a balloon payment


Perpetual bonds
Pay a stated coupon at periodic intervals.

Annuity or self-amortizing bonds


Pay a regular fixed amount each payment period.
Principal repaid over time rather than at maturity.

Types of Bonds
Issuer
Government: central , State
PSU
Corporate etc.

examples
#1: the govt. is proposing to sell a 5-year
bond of Rs 1000 @ 8% IR per annum.
The bond amount will be amortized
equally over its life. If an investor has a
minimum required rate of return of 7%,
what is the bonds present value for him?

solution
Sol #1:the amt of interest will go on reducing
because of amortization. The amount of
interest for five years will be :
Rs 1000 * 0.08 = Rs 80
Rs (1000 200)*.08 = Rs 64
P = 280/(1+0.07) +264/(1+0.07) 2 +216/
(1+0.07)5
= Rs 1025.66

examples
#2: A 10 year bond of Rs 1000 has an
annual rate of interest of 12%. The interest
is paid half-yearly. If the required rate of
return is 16%,what is the value of the
bond?

solution
#2: Rs 804.08

Corporate bonds*

Evaluating default risk*:


Bond ratings
Investment Grade

Junk Bonds

Moodys

Aaa Aa A Baa

Ba B Caa C

S&P

AAA AA A BBB

BB B CCC D

Bond ratings are designed to reflect the


probability of a bond issue going into
default.

Expected ratios*

summary
Bonds can be valued by discounting their
future cash flows
Bond prices change inversely with yield
Price response of bond to interest rates
depends on term to maturity.

Important !!!

Group A Money Market in India (**)


Group B Indian F/O Market ()
Group C Trading & Exchange (*)
Group D listing in foreign Exchanges ()
Group E - FOREX Market (**)
Group F financial Institutions- developmental/NBFC
(***)
Group G Function of RBI (***)
Group H financial sector reforms (***)
Group I Indian Banking System (***)

Test # 1
Analytical
Topics to be covered:
(i) Introduction
(ii) TVM
(iii) equity valuation
Marks : 10 marks.
marks
D-day : next Tuesday , Time duration :50
min
No retakes!!!