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ñ Valuing a bond is very similar to valuing an
annuity.
ñ As before, we care about the size, timing,
and risk of the cash flows.
ñ The basic idea in bond valuation is
discounting a stream of level cash flows with
return of principal at the end of the bond¶s
life.
ñ Most of what is new is terminology.

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ñ A bond is a loan, typically made by investors
to a corporation or government.
ñ The indenture spells out the terms of the
loan:
Coupon
Maturity
Seniority
ñ A corporation can deduct the interest
payments on bonds (dividends paid on stock
are not deductible).
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ñ The US Treasury is the largest security issuer in the
world, with £5.2 trillion in debt in 1996.
ñ It issues three basic kinds of securities:
Bills (maturities less than one year at issuance)
Notes
Bonds (up to 30 year maturity)
ñ There are other hybrid securities such as STRIPS
and inflation-indexed bonds.
ñ Treasury securities are important ³benchmark´
instruments (e.g., ³riskless´ interest rate).

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ñ åenerally have £1000 par value, semiannual
coupons.
ñ Default risk is rated by agencies such as
Moody¶s and S&P.
ñ Other features may include:
call provision
convertibility
floating rate
option features

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ñ Aunk bonds are high-yield instruments with a

significant probability of default.
ñ Made popular by Michael Milken of Drexel
Burnham Lambert in the 1980¶s.
ñ Often used in ³leveraged´ transactions such
as LBOs, mergers, acquisitions.

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ñThe cash flows on a bond are constant (³fixed
income´).
ñA bond¶s market price changes in response to
the market interest rate.
When market rates increase, the fixed payments
from the bond are worth less so the price falls.
If rates decrease, the fixed payments are now
worth more.

[A bond¶s price also changes in response to changes in the risk

of the cash flows, but we are not quite ready for that discussion.]
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ñ The bond pricing equation consists of two
components
PV of Coupons
PV of Face Value
ñ The price of a bond (these PVs) depends on:
Discount Rate (r)
Number of Periods (N)
Size of Cash Flows (C and PN)


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ñ The ’

’ is an important number in bond
valuation.
ñ It is the rate which equates the market price of the
bond with the value of the discounted cash flows.
ñ That is, YTM is the r such that the bond equation
holds.
ñ Finding the YTM requires a financial calculator, a
goal-seeking solver, or trial and error.

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ñ £1000 10 year bond paying a 10% annual coupon

What is the value when the interest rate is 10%?

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ñ Now the coupon is split semiannually
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ñ Relationship between YTM and Coupon Rate
YTM = Coupon € bond is selling 
(P0 = PN).
YTM > Coupon € bond is at a     (P0 < PN).
YTM < Coupon € bond is at a 

  (P0 > PN).

ñ Why does the YTM differ from the coupon?

The coupon is set when the bond is issued.
The YTM is the market¶s required interest rate. It
may change as economic fundamentals shift.

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ñ ero Coupon Bonds

Pays no coupon so interest comes in the form of a
discount from the repayment (P0 < PN).
Since Coupon = 0, YTM must be greater than
Coupon.
Putting these pieces together gives the answer.
ñ Capital åains
If the YTM is greater than the Coupon, the extra
return must be coming from somewhere.
The extra return comes from capital gains (P0 < PN).

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ñ Consider a £1000 5 year bond with a 8%
coupon
What is the YTM if it is selling for £1000?

If it is selling for £900?

If it is priced at £1100?

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ñ As we have seen, bonds have value from two

sources: coupons and return of principal.
ñ Intuitively, bonds with high coupon rates or short
maturities will return value more quickly than those
with low coupons or long maturities.
ñ At the extreme is a zero coupon bond, which returns
all value at maturity.

ñ Duration is a measure of how quickly the (present)

value of a bond is returned.
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ñ To calculate duration:
Find the present value of each cash flow individually
Sum these to get the present value of all cash flows (price)
Calculate the proportion of the total value from each
individual cash flow
Multiply each proportion by the corresponding number of
periods and sum
ñ The answer will give a measure of the average life of
the bond in a present value sense.
ñ A bonds with a low duration gets most of its value
from cash flows occurring early.

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ñ Price and interest rates move inversely.
ñ A decrease in interest rates raises bond
prices by more than a corresponding
increase in rates lowers price.
ñ Price volatility is inversely related to coupon.
ñ Price volatility is directly related to maturity.
ñ Price volatility increases at a diminishing rate
as maturity increases.

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ñ A decrease in interest rates raises bond prices by
more than a corresponding increase in rates lowers
price. This is known as 
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$3,000
30 yr, 15%
30 yr, 10%
20 yr, 10%
$2,500 10 yr, 10%
30 yr, 5%

$2,000
 

$1,500

$1,000

$500

$0
4% 6% 8% 10% 12% 14% 16%

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ñ Price volatility is inversely related to coupon.



 

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ñ Price volatility is directly related to maturity.
ñ Price volatility increases at a diminishing rate as
maturity increases.
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30 yr, 10%
20 yr, 10%
80% 10 yr, 10%



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50%

40%

30%

20%

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ñ Price volatility is directly related to maturity.
ñ Price volatility increases at a diminishing rate as
maturity increases.

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200%
5% Interest Rate
10% Interest Rate
180%
15% Interest Rate

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140%

120%

100%

80%

60%

40%

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ñ So far we have ignored risk in valuing the bonds.

ñ We will now discuss qualitatively the types of risk a
bondholder faces.
ñ Quantification of the price impact due to risk is still
coming.
ñ In all cases,   
 
   

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ñ This implies that  


 

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ñ Interest Rate Risk
The risk of a bond changing in value when interest rates
change. This affects all bonds regardless of credit quality,
but is more severe for longer maturity bonds.
ñ Reinvestment Risk
The risk that investors will be unable to reinvest the coupon
payments at the coupon rate. This is more important for
high coupon bonds.
ñ Default (Credit) Risk
The risk that the firm will go bankrupt and not make all
payments to bondholders.
ñ Other Risks: Inflation, Call, Liquidity

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ñ Inflation is the increase in the   (or cash) cost of goods
and services over time.
ñ Put differently, it is the decrease in purchasing power over time.
ñ In the end, we are generally concerned with consumption in
finance (and in life). The amount of dollars you have is really
much less important than their purchasing power.
ñ Nominal rates are the rates observed in the market and quoted
in contracts.
ñ Real rates are actually very illusive since measuring inflation
accurately is difficult.

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ñ A graph of interest rates on securities of

various maturities.
ñ åenerally constructed using riskless zero
coupon bonds (i.e., Treasuries).
ñ Serves as a measure of the Time Value of
Money.
ñ åenerally upward sloping, but can also be
downward sloping, inverted, or humped.

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