BOND VALUATION

Bond

Bond is a long term contract under which a borrower agrees to make payments of interest and principal,
on specific dates, to the holders of the bond
Key characteristics:
VB = value of a bond/bond price
M = par or maturity value of the bond; it is the stated face value of the bond and this is amount that
must be paid off at maturity and it is often equal to $ 1.000
INT = coupon payment or dollars of interest paid each year; (Coupon rate x Par value)
rk = coupon interest rate; (coupon payment / par value)
rd = the bond's required rate of the return; that is the market rate of interest for that type of bond; it is
also called the yield
N = number of years before the bond matures; maturity date is a date on which the par value must be
repaid
m = number of discounting periods per year

The value of any financial asset - a stock, a bond, a lease, or even a physical asset such as an
apartment building is simply the present value of the cash flows the asset is expected to produce.

Bond Valuation
The cash flows from a specific bond depend on the contractual features meaning the type of the bond.
The following general equation, written in several forms, can be used to find the value of any bond, VB.

= + + ⋯+ +
(1 + ) (1 + ) (1 + ) (1 + )

= + = ∙ + ∙
(1 + ) (1 + )
1 1
= ∙ − +
(1 + ) (1 + )

So, the cash flows consist of an annuity of N years plus a lump sum payment at the end of Year N.

1. Standard coupon-bearing bond

Standard coupon-bearing bond =the cash flows consist of interest payment during the life of the bond,
plus the amount borrowed when the bond matures
Types:
 Bond with a fixed coupon rate
= coupon payments are constant. It can be:
 Floating-rate bond.
= if a bond's coupon payment vary over time, meaning that the coupon rate is set for, say, the
initial six month period, after which it is adjusted every six months based on some market rate

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1.1. Bond with a fixed coupon rate

Bond with a fixed coupon rate = coupon payments are constant. It can be:
a) the bond is selling at a price equal to its par value; required rate of return (rd)=coupon rate (rk)
b) the bond is selling at a price below its par value; required rate of return (rd) coupon rate (rk); it is
called a discount bond
c) the bond is selling at a price above its par value; required rate of return (rd) coupon rate (rk); it is
called a premium bond.

Valuation of bonds on the date of their issue

=valuation of bonds at the beginning of an interest payment dates

Bonds with annual coupons

Example: (Tool Kit 4 Chapter)

A bond has a 15-year maturity, a 10% annual coupon and a $ 1,000 par value. The required rate of
return or the yield to maturity on the bond is 10%, given its risk, maturity, liquidity and other rates in the
economy. What is a fair value for the bond i.e. its market price?

M (or FV)=$ 1,000

rk=10%
rd=10%
INT= $ 100
N=15
VB=?

= 100 ∙ + 1,000 ∙ = 100 ∙ 7.606 + 1,000 ∙ 0.239 = 1,000

or

1 1 1,000
= 100 ∙ − + = 1,000
0.10 0.10 ∙ (1 + 0.10) (1 + 0.10)

The bond is selling at a price equal to its par value.

Example: (Tool Kit 4.3.)

A bond matures in 6 years has a par value of $ 1.000, an annual coupon payment of $ 80 and a market
interest rate of 9%. What is its price?

M (or FV)=$ 1,000

rd=9%
INT= $ 80  rk=8%
N=6
VB=?
= 80 ∙ + 1,000 ∙ = 80 ∙ 4.48592 + 1,000 ∙ 0.59627 = 955.14

The bond is selling at a price below its par value, meaning that the required rate of return (rd) coupon
rate (rk).It is called a discount bond.

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Example: (Tool Kit 4.3.)
A bond matures in 18 years has a par value of $ 1,000, an annual coupon of 10% and a market interest
rate of 7%. What is its price?

M (or FV)=$ 1,000

rd=7%
rk=10%  INT= $ 100
N=18
VB=?

= 100 ∙ + 1,000 ∙ = 100 ∙ 10.05909 + 1,000 ∙ 0.29586 = 1,3011.77

The bond is selling at a price above its par value, meaning that the required rate of return (rd) coupon
rate (rk). It is called a premium bond.

Exercise: 1
Jackson Corporation's bonds have 12 years remaining to maturity. Interest is paid annually, the bonds
have a $1.000 par value, and the coupon interest rate is 8%. The bonds have a YTM of 9%. What is the
current market price of these bonds?

Bonds with semiannual coupons

∙
/2 ∙ ∙
= + ∙
= ∙ + ∙
(1 + /2) (1 + /2) 2

Example: (Tool Kit 4.6.)

A bond has a 25-year maturity, an 8% annual coupon paid semiannually, and a face value of $1,000. The
going nominal annual interest rate is 6%. What is the bond's price?

M (or FV)=$ 1,000

rd=6%
rk=8%  INT= $ 80
N=25
m=2
VB=?

80
= ∙ + 1,000 ∙ = 40 ∙ 25.72976 + 1,000 ∙ 0.22811 = 1,257.30
2

Exercise: 2
Rentro Rentals has issued bonds that have a 10% coupon rate, payable semiannually. The bonds mature
is 8 years, have a face value of $1,000 and a YTM of 8.5%. What is the price of the bonds?

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Exercise: 3
Suppose HM sold an issue of bonds with a 10-year maturity, a $1,000 par value, a 10% coupon rate, and
semiannual interest payments.

a) two years after the bonds were issued, the going rate of interest on bonds such as these fell to 6%; at
what price would the bonds sell?

b) suppose that 2 years after the initial offering, the going interest rate had risen to 12%; at what price
would the bonds sell?

c) suppose that the conditions in part a existed-2 years after the issue date, interest rates fell to 6%.
Suppose further that the interest rate remained at 6% for the next 8 years. What would happen to the
price of bonds over time?

2. Zero-coupon bond

Zero-coupon bond = bonds that pay no interest but are offered at a substantial discount below their par
values and hence provide capital appreciation rather than interest income. These securities are called
zero coupon bonds (“zeros”), or original issue discount bonds (OIDs).

= ∙

Bond yields
Unlike the coupon interest rate, which is fixed, the bond's yields vary from day to day depending on
current market conditions. The yield can be calculated in three different ways, and three "answers" can
be obtained.

These different yields are described in the following sections.

1. Yield to Maturity (YTM)

The YTM is defined as the rate of return that will be earned if a bond makes all scheduled payments and
is held to maturity. It can be viewed as the bond's promised rate of return which is the return that
investors will receive if all the promised payments are made.

YTM equals to expected rate of return only if the probability of default is zero and the bond cannot be
called. If there is some default risk, or if the bond may be called, then there is some probability that the
promised payments to maturity will not be received, in which case the calculated YTM will differ from
expected return, meaning that the expected rate of return will be less than the promised YTM.
The YTM for a bond that sells at pas consists entirely of an interest yield, but if the bond sells at a price
other than its par value, the YTM will consist of the interest yield plus a positive or negative capital gains
yield.

It cannot be solved for directly. It generally must be determined using trial and error or an iterative
technique.

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Steps:
1. Given that it is difficult to guess the YTM of the first attempt, we are assuming at least two rates: one
that gives a lower price than current market price and the other which results in a higher price of
current market price
2. When we have those two prices we are approaching to the procedure for linear interpolation:

( − )
= +( − )∙
( − )

An Approximation: If you are not inclined to follow the trial-and-error approach, you can employ the
following formula to find the approximate YTM on a bond:

−
+
=
0.4 ∙ + 0,6 ∙

This formula was suggested by Gabriel A. Hawawini and Ashok Vora, in the article published in the
Journal for Finance March 1982 issue.

Example: (Tool Kit 4 Chapter)

Suppose that you are offered a 14-year, 10% annual coupon, $1,000 par value bond at a price of
$1,494.93. What is the YTM of the bond?

M (or FV) =$ 1,000

rk=10%  INT= $ 100
N=14
VB=$ 1,494.93
rd/YTM=?

VB  M  YTM  rk
So, YTM has to be less than a coupon rate, meaning less than 10%.

rd1=8%
P1= 100 ∙ ( %, ) + 1,000 ∙ ( %, ) = 100 ∙ 7.53608 + 1,000 ∙ 0.39711 = 1,150.72
1,150.72  1,494. 93  P1 P  8% is too high rate

rd 2=5%
P2= 100 ∙ ( %, ) + 1,000 ∙ ( %, ) = 100 ∙ 9.89864 + 1,000 ∙ 0.50507 = 1,494.934
1,494.93=1,494.93  P2=P  5% is YTM

Exercise: 4
Wilson Wonders' bonds have 12 years remaining to maturity. Interest is paid annually, the bonds have a
$1.000 par value, and the coupon interest rate is 10%. The bonds sell at price of $850. What is their yield
to maturity?

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Exercise: 5
The BC's bonds have 5 years remaining to maturity and interest is paid annually, the bonds have a
$1,000 par value, and the coupon rate is 9%.
a) what is the YTM at a current market price of $829
b) would you pay $829 for one of these bonds if you thought the appropriate rate of interest was 12%

2.Yield to Call (YTC)

If you purchased a bond that was callable and the company called it, you would not have the option of
holding the bond until it matured. Therefore, the YTM would not be earned.

( )= +
(1 + ) (1 + )

N = the number of years until the company can call the bond
Call price = the price the company must pay in order to call the bond (it is often set equal to the par
value plus 1 year's interest
rd = YTC

The YTC is the rate of return investors will receive if their bonds are called. If the issuer has the right to
call the bonds and if interest rate fall, then it would be logical for the issuer to call the bonds and replace
them with new bonds that carry a lower coupon.
The YTC is find similarly to the YTM. The same formula is used, but years to maturity are replaced with
years to call, and the maturity value is replaced with the call price.

Example: (Tool Kit 4 Chapter)

Suppose you purchase a 15-year, 10% annual coupon, $ 1.000 par value bond with a call provision after
10 years at a call price of $ 1.100. One year later, interest rates have fallen from 10% to 5% causing the
value of the bond to rise to $ 1.494,93. What is the bond's YTC?

Call price =$ 1,100

rk=10%  INT= $ 100
N=10-1=9 (years to call)
VB=$ 1,494.93
rd/YTC=?

VB  Call price  YTC  rk

So, YTC has to be less than a coupon rate, meaning less than 10%.

rd 1=5%
P1= 100 ∙ ( %, ) + 1,100 ∙ ( %, ) = 100 ∙ 7,10782 + 1,100 ∙ 0,64461 = 1,419. 853
1.419,853  1,494.93  P1 P  5% is too high rate

rd 2=4%
P2= 100 ∙ ( %, ) + 1,100 ∙ ( %, ) = 100 ∙ 7,4352 + 1,100 ∙ 0,70259 = 1.516,369

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1.516,369  1.494,93  P2 P  4% is too low rate

YTM=4%+x

−
=
2− 1 −

1,516.369 − 1,494.93
=
0.05 − 0.04 1,516.369 − 1,419.853

21.439
=
0.01 96.516

= 0.01 ∙ 0.222 = 0.00222 → 0.222%

YTM=4%+0.222%=4.22%

Exercise: 6
Thatcher Corporation's bonds will mature in 10 years. The bonds have a face value of $1,000 and an 8%
coupon rate, paid semiannually. The price of the bond is $1,100. The bonds are callable in 5 years at a
price of $1,050.
What is their YTM?
What is their yield to call?

Exercise: 7
AI' bonds have a current market price of $1.200. The bonds have an 11% annual coupon payment, a $1,000
face value, and 10 years left until maturity. The bond may be called in 5 years at 109% of face value (call
price=$1,090).
a)what is the YTM?
b)what is the YTC if they are called in 5 years?
c) which yield might investors expects to earn on these bonds and why?
d) the bond's indenture indicates that the call provision gives the firm the right to call them at the end of
each year beginning in Year 5. In Year 5 they must be called at 109% of face value, but in each of the next 4
years the cal percentage will decline by 1 percentage point. Thus, in Year 6 they may be called at 108% of
face value, in Year 7 they may be called at 107% of face value and so on. If the yield curve is horizontal and
interest rate remains at their current level, when is the latest that investors might expect the firm to call the
bonds?

3. Current Yield

The current yield provides information regarding the amount of cash income that a bond will generate
in a given year, but since it does not take account of capital gains or losses that will be realized if the
bond is held until maturity or call, it does not provide an accurate measure of the bond's total expected
return.

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Example: (Tool Kit 4.4.)
A bond currently sells for $850. It has an 8-year maturity, an annual coupon of $80 and a par value of
$1,000. What is its YTM? What is its current yield?
A bond currently sells for $1,250. It pays a $110 annual coupon and has a 20-year maturity, but it can be
called in 5 years at $ 1,100. What is its YTM and its YTC?

M (or FV) =$ 1,000

rk=8%  INT= $ 80
N=8
VB=$ 850
rd/YTM=?

80
= = = 0.09419.41%
850

M (or FV) =$ 1,000

rk=11%  INT= $ 110
N=20
VB=$ 1,250
rd/YTM=?

VB  M  YTM  rk

So, YTM has to be less than a coupon rate, meaning less than 11%.

rd1=9%
P1= 110 ∙ ( %, ) + 1,000 ∙ ( %, ) = 110 ∙ 9.12855 + 1,000 ∙ 0.17843 = 1,182.57
1,182.57  1,250.00  P1 P  9% is too high rate

rd 2=8%
P2= 110 ∙ ( %, ) + 1,000 ∙ ( %, ) = 110 ∙ 9.81815 + 1,000 ∙ 0.21455 = 1,294.5465
1,294.54651,250.00  P2P  8% is too low rate

YTM=8%+x

−
=
2− 1 −

1,294.5465 − 1,250.00
=
0.09 − 0.08 1,294.5465 − 1,182.57

44.5465
=
0.01 111,9765

= 0.01 ∙ 0.39782 = 0.0039782 → 0.39782%

YTM=8%+0.39782%=8.39%

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Call price =$ 1,100
rk=10%  INT= $ 100
N=5 (years to call)
VB=$ 1,250.00
rd/YTC=?

VB  Call price  YTC  rk

So, YTC has to be less than a coupon rate, meaning less than 11%.

rd 1=8%
P1= 110 ∙ ( %, ) + 1,100 ∙ ( %, ) = 110 ∙ 3.99271 + 1,100 ∙ 0.68058 =1,187.84
1,187.84  1,250.00  P1 P  8% is too high rate

rd 2=6%
P2= 110 ∙ ( %, ) + 1,100 ∙ ( %, ) = 110 ∙ 4.21236 + 1,100 ∙ 0.74726 = 1,285.35
1,285.35 1,250.00  P2 P  6% is too low rate

YTM=6%+x

−
=
2− 1 −

1,285.35 − 1,250.00
=
0.08 − 0.06 1,285.35 − 1,187.84

35.35
=
0.02 97.51

= 0.02 ∙ 0.3625 = 0.007251 → 0.725%

YTM=6%+0.725%=6.725%

Exercise: 8
Heath Foods's bonds have 7 years remaining to maturity. The bonds have face value of $1.000 and a
yield to maturity of 8%. They pay interest annually and have a 9% coupon rate. What is the current
yield?

Exercise: 9
A bond that matures in 7 years sells for $1,020. The bond has a face value of $1,000 and a YTM of
10.5883%. The bonds pay coupons semiannually. What is the bond's current yield?

Exercise: 10
A 10 year, 12% semiannually coupon bond with a par value of $1,000 may be called in 4 years at a call
price of $1,060. The bond sells for $ 1,100. Assume that the bond has just been issued.
a) what is the bond's yield to maturity?
b) what is the bond's current yield?
c) what is the bond's capital gain or loss yield
d) what is the bonds' yield to call?

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Exercise: 11
A 10 year, 12% semiannually coupon bond with a par value of $1,000 may be called in 4 years at a call
price of $1,060. The bond sells for $ 1,100. Assume that the bond has just been issued.
a) what is the bond's yield to maturity?
b) what is the bond's current yield?
c) what is the bond's capital gain or loss yield
d) what is the bonds' yield to call?

Exercise: 12
You just purchased a bond that matures in 5 years. The bond has a face value of $1,000 and has an 8%
annual coupon. The bond has a current yield of 8.21%. What is the bond's YTM?

The Determinants of Market Interest Rates (rd)

The quoted/nominal interest rate on a debt security, rd, is composed of a real risk-free rate of interest
r*, plus several premiums that reflect inflation, the risk of the security and the security's marketability or
liquidity.

rd = r*+IP+DRP+LP+MRP = rRF + DRP + LP + MRP

rd = quoted or nominal rate of interest

r*= real risk-free rate of interest - the rate that would exist on a riskless security if zero inflation were
expected ; inflation-indexed Treasury bond (TIPS) is a good estimate of the real interest rate

IP = inflation premium - it is equal to the average expected inflation rate over the life of the security
In inflation rate built into a 1-year bond is expected inflation rate for the next year, but the inflation rate
built into a 3-year bond is average rate of inflation expected over the next 30 years.
If It is the expected inflation during the year t, then the inflation premium for an N-year bond's yield
(IPN) can be approximated as:

+ +⋯+
=

DRP = default risk premium - this premium reflects the possibility that the issuer will not pay interest or
principal at the stated time and in the stated amount.
Bond's rating as an indicator of its default risk; the rating has a direct, measurable influence on the
bond's yield. A bond spread is the difference between a bond's yield and the yield on some other
security of the same maturity, mostly a similar maturity T-bond.

LP = liquidity or marketability premium - a premium charged by lenders to reflect the fact that some
securities cannot be converted to cash on short notice at a "reasonable" price
MRP = maturity risk premium - all bonds, even T-bonds, are exposed to two additional sources of risk:
interest rate risk and reinvestment risk; the net effect of these two sources of risk upon a bond's yield is
called the maturity risk premium

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Example: (Tool Kit 4.13.)
Assume that the real risk-free rate is r* = 3% and the average expected inflation rate is 2.5% for the
foreseeable future. The DRP and LP for a bond are each 1%, and the applicable MRP is 2%.What is the
bond's yield?

rd = r*+IP+DRP+LP+MRP = 3+2.5+1+1+2=9.5%

Example:
In investors expect inflation to average 3% during Year 1 and 5% during Year 2. Then the inflation
premium built into a 2-year bond's yield can be approximated by:

3% + 5%
= = 4%
2
Example:
In March 2008 the yield on a 5-year non-indexed T-bond was 2.46% and the yield on 5-year TIPS was -
0.05%.

IP5=2.46%-(-0.05%)=2.51%

This implies that investors expected inflation to average 2.51% over the next 5 years.

Example: (Tool Kit 4.9.)

The yield on 15-year TIPS is 3% and the yield on a 15-year Treasury bond is 5%. What is the inflation
premium for a 15-year security?

IP15=5%-2%=3%

rRF=r*+IP ( it is either quoted U.S. T-bill rate or the quoted T-bond rate)

Example: (Tool Kit 4.11.)

A 10-year T-bond has a yield of 6%. A corporate bond with a rating of AA has a yield of 7.5%. If the
corporate bond has excellent liquidity, what is an estimate of the corporate bond's default risk
premium?

Yield on T-Bond 6.0%

- Yield on corporate bond 7.5%
= Default risk premium 1.5%

Exercise: 13
A T-bond that matures in 10 years has a yield of 6%. A 10-year corporate bond has a yield of 9%. Assume
that the liquidity premium on the corporate bond is 0.5%. What is the default risk premium on the
corporate bond?

Exercise: 14
The real risk-free rate is 3% and inflation is expected to be 3% for the next 2 years. A 2-year Treasury
security yields 6.3%. What is the maturity risk premium for the 2-year security?

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Exercise: 15
Assume that the real risk-free rate r* is 3% and that inflation is expected to be 8% in Year 1, 5% in Year 2
and 4% thereafter. Assume also that all Treasury securities are highly liquid and free of default risk. If 2-
year and 5-year Treasury notes both yield 10%, what is the difference in the maturity risk premiums
(MRPs) on the two notes, that is, what is MRP5 minus MRP2?

Exercise: 16
The real risk-free rate of interest is 4%. Inflation is expected to be 2% this year and 4% during the next 2
years. Assume that he maturity risk premium is zero.
What is the yield on 2-year Treasury securities?
What is the yield on 3-year Treasury securities?

Exercise: 17
The real risk-free rate is 2%. Inflation is expected to be 3% this year, 4% next year and then 3.5%
thereafter. The maturity risk premium is estimated to be 0.0005 x (t-1), where t = number of years to
maturity. What is the nominal interest rate on a 7-year Treasury security?

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