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-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.
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.
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.
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
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)
WHY?
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)
1,372
1,211
kd = 7%.
kd = 10%.
1,000
837
775
kd = 13%.
30
25
20
15
10
Years
to Maturity
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.
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*
Junk Bonds
Moodys
Aaa Aa A Baa
Ba B Caa C
S&P
AAA AA A BBB
BB B CCC D
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 !!!
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!!!