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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:
Do end-of-chapter problems
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
5-3
1
rper period
1
(1 rper period )
mn
1.
2.
3.
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
Maturity:
Years until
bond must
be repaid
Face amount or
par value which
is re-paid at
maturity
Typically $1,000
for most bonds
S&P
Quality of Issue
Aaa
AAA
Aa
AA
Baa
BBB
Ba
BB
Caa
CCC
Ca
CC
In 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
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
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 )
PV(lump sum)
6-13
Bond Value
C
1
F
1
r (1 r) t (1 r) t
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
6-16
Computing Yield-to-Maturity
YTM).
Suppose we know the following information:
$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.
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
6-23
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
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
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
r = interest rate
Declining (Inverted)
Term Structure
Term to maturity
2.
3.
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
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
(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%.
(1 0 r 2 ) 2
(11 r 2 )
(1 0 r 1)