BOND VALUATION

All bonds have the following characteristics:

1. A maturity date- typically 20-25 years.
2. A coupon rate- the rate of interest that the issuing
company pays to the holder. 8 1 8 %
3. A face value- usually $1000 or $5000.
 BOND VALUATION

The value of a bond is the sum of the present value of the

annual interest payments plus the present value of the face
value;
Interest Face
pv  
(1  r ) n
(1  r ) n

Where; interest = coupon rate x face value

r = discount rate
n = years to maturity
 BOND VALUATION

1 1
PV  Coupon  Face
(1  r ) n
(1  r ) n

Where 1/(1+r) = discount rate

 BOND VALUATION
EXAMPLE
Find the value of a 20 year, 10%, $1000 face value bond.
The interest payment is given by: .10 x $1000 = $100/year

THE FORMULA IS:

20
$100 $1000
PV = 
N 1 (1  r )
N

(1  r ) 20

PV = $100(6.145) + $1000(.386) = $614.50 + $386 = $1000

 BOND VALUATION
if the coupon rate is 8%, then the formula for the value of
the bond is;
20
$80 $1000
PV   
n 1 (1  r ) n
(1  r ) 20

PV = $80(6.145) + $1000(.386) = $877.60

THE BOND SELLS AT A DISCOUNT

 BOND VALUATION
if the coupon rate is 12%, then the formula for the value of
the bond is;
20
$120 $1000
PV   
n 1 (1  r ) n
(1  r ) 20

PV = $120(6.145) + $1000(.386) = $1123.40

THE BOND SELLS AT A PREMIUM

 BOND THEOREMS

In this section we will look at the relationship between

changes in bond prices and changes in term to maturity,
coupon rate, and discount rates (market yields).
7 1/4 %, due 1995, $1000 Face 8/8
7
72.50 1000
$886.25   
T 1 1  y T
1  y 7

 y  9.55%

10 3/8 %, due 1995, $1000 Face 8/8

7
103.75 1000
$1032.50   
T 1 1  y T
1  y 7

 y  9.71%
7 1/4 %, due 1995, $1000 Face 8/8
7
72.50 1000
$882.50   
T 1 1  y T
1  y 7

 y  9.63%

10 3/8 %, due 1995, $1000 Face 8/8

7
103.75 1000
$1027.50   
T 1 1  y T
1  y 7

 y  9.81%
 Change in Bond Prices
• Price of 7 1/4 bond fell by $3.75 or .42%
• Price of 10 3/8 bond fell by $5.00 or .48%
• When market yields fall unexpectedly, the
prices of financial assets rise and vice-versa

Theorem I
Consider two Bonds with 12% coupon of
equal risk, one 5 year term, the other 15
year term
5
120 1000
$931   
T 1 114
. 
T
114
. 
5

15
120 1000
$877   
T 1 114
. 
T
114
. 
15
 1000  931
% in 5 year bond is : .069
1000
1000  877
% in 15 year bond is : .123
1000

If yields fall to 11%:

1037  1000
% in 5 year bond is : .037
1000
1072  1000
% in 15 year bond is : .072
1000
 Theorem II

Holding coupon rate constant, for a

given change in market yields,
percentage changes in bond prices
are greater the longer the term to
maturity.
 15
120 1000
$1151.72   T 

T 1 110
.   110
.  15

10
120 1000
$1123.40   T 
T 1 110
.  110
. 
10

15
120 1000
$1242.32   T 
T 1 109
.  109
. 
15

10
120 1000
$1192.16   T 
T 1 109
.  109
. 
10
 1242.32  115172
.
% in 15 year bond is : .0787
115172
.
1192.16  1123.4
% in 10 year bond is : .0612
1123.40

 .0787.0612 .0175
(% change in 15 - % change in 10)
 5
120 1000
$1075.92   T 
T 1 110
.  110
. 
5

5
120 1000
$1116.80   T 
T 1 109
.  109
. 
5

1116.80  1075.92
% in 5 year bond is : .0380
1075.92

 .0612 .0380 .0232

(% change in 10 - % change in 5)
 Theorem III
The percentage price changes described in
Theorem II increase at a decreasing rate
as N increases.

- Slopes are percentage changes.

Consider: 12%, 8 year, $1000 coupon bond

If yields move from 12% to 14%, price falls to 907.

1000  907
% = .093
1000

If yields fall to 10%, price is 1107

1107  1000
% = .107
1000
 Theorem IV
Holding N constant and starting from same market
yield, equal yield changes up or down do not result
in equal percentage price changes. A decrease in
yield increases prices more than an equal increase in
yield decreases prices. Price changes are
asymmetric with respect to changes in yield.
 10
120 1000
$1123.40   T 
T 1 110
.  110
. 
10

10
100 1000
$1000.00   T 
T 1 110
.  110
. 
10

10
120 1000
$1192.16   T 
T 1 109
.  109
. 
10

10
100 1000
$1063.80   T 
T 1 109
.  109
. 
10
 1192.16  1123.40
% in 12% coupon = .061
1123.40

% .  1000
106380
in 10% coupon = .0638
1000

Theorem V
Holding N constant and starting from the same
yield,the greater the coupon rate, the smaller the
percentage change in price for a given change in yield.
 DURATION AND BOND
PRICES
The relationship between duration and the expected
percentage price change expected from a change in market
yield is closely approximated by:

%  P0 =
P0
 -DUR Y 
(1  Y )
P0
Percentage price changes accompanying the change
in market yields between August 8th and August
10th can be estimated:
 0.08
% P71/ 4 = -5.6409 X = -.41%
1.0955

010
% P103/ 8 = -5.3366 X = -.49%
1.0971
 ESTIMATING INTEREST
RATE ELASTICITY
Y
E = -DUR
(1  Y )
 P0
% P0 P0
E= =
% Y  Y 
Y

 P0 Y 
 Dur 
P0 1Y  Y  Y Y
= =  DUR    DUR
Y  1  Y  Y  1Y 
Y 
Y
Y