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Copyright © 2020 by Xi Yang

All rights reserved.

Published by the Gies College of Business at the University of Illinois

at Urbana-Champaign, and the Board of Trustees of the University of
Illinois

4
Module 1 Introduction to
Finance: The Role of Financial
Markets

5
 Module 1 Overview

Module 1 Overview
Media Player for Video

Corporate Bonds - Slide 1

Simple arrangement
Interest paid to bond holder
Repay principal at the end of term

6
Transcript

In this module, we introduced bonds. First, I want to tell you why

there's a need for bonds. Let's think about big corporations. They
have a lot of financing needs, they need to finance their daily
operations, they need to expand their business to a new market or
create new products. They need to invest in research and
development, or they need to acquire another company. How do
they finance all these activities? One way is to borrow money by
selling bonds to the public. For example, they borrow $1,000 from
each individual bond holders and collectively, they raise enough
money to fund their projects. In fact, the bond is a very simple
arrangement. Companies borrow money from you and promise to
pay you back in the future. Companies borrow money from you and
promise to pay you back in the future. Once the company use the
capital they raise to make investments, they should be able to
generate enough profits to pay the bondholders. They will pay them
some interest payments along the way and also repay the principal
they borrowed at the very end. The good thing about issuing bonds
to the public is that after companies pay back their debt, they can
enjoy all the remaining profits themselves. But this comes at a cost.
If they fail to repay the debt, they will be sued and even go broke.
Besides corporations, another big player in the bond market is the
government. The federal government needs to spend money on food
staffs, unemployment compensation, child's nutrition, student loans,
benefits for Medicare and Medicaid, and among others. Local
governments also need to fund schools, highways construction,
airport construction, and other infrastructure. They can use the
money they collected from taxpayers, but that's far from enough.
They need to issue bonds to raise more money and use the
revenues generated from these projects to pay back in the future.

7
In This Module - Slide 2

Major bond features and bond types

How do we determine bond values?
Why do bond values fluctuate?
What are the risks of bonds?
What is the meaning of bond ratings?

8
Transcript

From the perspective of investors, bonds also represent good

investment opportunities. The future cashflows are pretty stable and
reliable, the return is descent compared with other investment
vehicles. In general, investors will put some bonds in their portfolio
more or less. In this module, we want to introduce you to the basic
bond features and the common bond types. These serve as
foundations to understand how bonds work. We will also address
some important questions about bonds. For example, how to
determine bond values, why bond values fluctuate in the
marketplace, what are the major risks of investing year bond? What
is the meaning of bond rating? After this module, you should be able
to answer all these questions and understand this important financial
instrument.

9
 Bond: Basic Concepts

Bond: Basic Concepts

Media Player for Video

A Bond is a Loan - Slide 3

Borrower: corporations or governments

Lender: investors

10
Transcript

In this lesson, I want to introduce you to some basic concepts about

bonds. In essence, a bond is a loan made by investors to a borrower.
The borrower can either be a corporation or a government. The
investors can either be individual investors or institutional investors
such as pension funds, mutual funds, or endowment funds.

How a Bond Works (1 of 4) - Slide 4

In 2020, a company wants to borrow $100 million by issuing 100,000

bonds. Each bond allows the company to borrow $1000 for 10 years
with an interest rate of 8%.

11
Transcript

Let's use a very simple example to illustrate how bonds work and
explain some key bound terms. In 2020, a Corporation wants to
borrow 100 million dollars by issuing 100,000 pounds. Each bond
allows the company to borrow $1000 for 10 years at an interest rate
of 8%.

How a Bond Works (2 of 4) - Slide 5

The bondholder receives $1,000 × 8% = $80 in interest every year

for 10 years.

Transcript

The investor who buys the bond is called a bondholder. For each
bond he holds, he will receive $80.00 every year as interest
payment, which is calculated by multiplying $1000 principle with the
interest rate 8%.

12
How a Bond Works (3 of 4) - Slide 6

At the end of 10 years, the bondholder will receive the $1,000

principal repayment.

Transcript

At the end of year 10, the company will repay the principle $1000 to
the bondholder.

13
How a Bond Works (4 of 4) - Slide 7

The company is legally obligated to repay the loan.

Transcript

A key feature of the bond is that it represents an obligation of the

company. Meaning, the company must make timely payments in full
and on time. Otherwise, the bondholders conceal the company and
demand it to pay. In most cases this will lead to a bankruptcy.

14
Par (Face) Value - Slide 8

The amount repaid at the end of the loan ($1,000)

Transcript

The first term we will learn is the face value, also called the par
value. Is the principle repaid at the end of the law? In this case, the
face value is $1000. This is very common for corporate bonds.
Government bonds often have higher face values, such as $10,000.

15
Coupon - Slide 9

$80 regular interest payments

Transcript

The $80.00 interest payment is called a coupon. Bondholders

receive their coupon payments once a year or twice a year. If this is
a semi-annual coupon, the bond holder will receive $40 every six
months.

16
Physical Certificate - Slide 10

This slide contains an image of a physical bond certificate.

Transcript

You may wonder, why do we call the interest payment coupons? The
origin comes from the historical bond certificate. The bonds were
printed on the physical certificate, which was a proof of ownership.
When the interest was dual, bondholders clip the coupon, send it to
the issuer to get payments. No one used the physical certificate
anymore. But in the name coupon is still used today.

17
Coupon Rate - Slide 11

Annual coupon divided by the face value:

$80 ÷ $1,000 = 8%

Transcript

Coupon rate is the annual coupon payment divided by the face

value. In this case, we use $80.00 of annual coupon divided by face
value. $1000 to get the coupon rate 8%.

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Maturity - Slide 12

The number of years until the face value is repaid

Transcript

The number of years until the face value is repaid is called the
bounce time to maturity. In this case it is 10 years. The time to
maturity will shrink with time. For example, in 2022, the time to
maturity will be 8 years. The bond

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Level-Coupon Bond - Slide 13

Coupon is constant and paid regularly

Transcript

in this example is also called level coupon bond or coupon bond

because the coupon payments remain the same every year until
time to maturity. This arrangement is very common for long-term
corporate bonds and long-term government bonds.

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Zero-Coupon Bonds - Slide 14

Pays no coupons

Transcript

Another type of bonds is called 0 coupon bond. They pay no

coupons at all and the coupon rate is 0%. 0 coupon bonds pay the
face value at the maturity date.

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 Bond Valuation

Bond Valuation: Introduction

Media Player for Video

Primary Principle of Bond Valuation -

Slide 15

Value of bond = PV of all future cash flows

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Transcript

In this part we discuss bond valuation. The basic principle of bond

valuation is that the value of the bond is equal to the present value of
all future cash flows. First, let's take a look at the cash flows of a
bond. The bondholder invests in the month because of the
expectation of future cash flows.

Bond Cash Flows - Slide 16

This slide shows an image of a timeline from years 0–T. C is written

above the ticks for years 1–T-1, and C+F is written above year T.

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Transcript

The bondholder receives coupon payments C in each period

throughout the life of the Bond P and also received the face value F.
Add the majority. A remarkable feature of the bomb is that all the
future payments are fixed. And the payment schedule is also fixed.
Because of this, bonds are also called fixed income securities. Worth
the cash flows in hand. We still need one more thing to do the
valuation. Which is the discount rate?

The Yield to Maturity (YTM) - Slide 17

The required market interest rate on the bond

It is also called the bond's yield, for short.

Transcript

We call it yield to maturity or yield for short. The yield to maturity is

the real return required in the market.

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How to Determine Bond Value - Slide
18

1. A coupon of C paid each period

2. Face value F paid at the maturity
3. T periods to maturity
4. A yield to maturity of r per period

Transcript

Given the coupon payment C per period, the face value F and the
number of periods remaining until maturity T and the yield to maturity
r we can value abound. In order to value bonds, we treat the stream
of coupon payments C in each period as annuity. And treat the face
value F as a separate future value.

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Calculate Present Value - Slide 19

C 1 F
Bond value = [1 − T
] + T
r (1+r) (1+r)

Bond Value = PV of the coupons + PV of the face value

Transcript

We calculate the present value of the coupons using the annuity

formula and discount face value to the present. The sum of the
present value of all the future coupons and the present value of the
face value gives us the value of this level coupon bond.

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How to Value a Level-Coupon Bond -
Slide 20

Consider a corporate bond with 8% coupon rate that matures in

December 2030
Face value: $1,000
Coupons are paid out semiannually (June 30 and December 31)

Transcript

Let's use an example to see how to value a level coupon bond.

Suppose a Corporation issued abound with 8% coupon rate that
matures in December 2030. The face value of the bond is $1000.
Which is very typical for corporate bonds. Coupons are paid out
semiannually on June 30th and December 31st of each year. Since
the coupon rate is 8%. Each coupon payment is calculated as the
face value of 1000 times the coupon rate of 8%. And divide it by two
which is equal to $40. Less value the bond. On December 31st,
2020. The cash flows generated by this bond I expressed in this
graph.

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Bond Cash Flows - Slide 21

This slide shows a timeline for bond cash flows at intermittent times
between 12/31/2020–12/31/2030. There are ticks for the following
dates: 12/31/2020, 6/30/2021, 12/31/2021, 6/30/2030, and
12/31/2030. The values above each tick are as follows, respectively:
blank, $40, $40, $40, and $1,040.

Transcript

The bond pays $40 in the middle of the year and at the end of the
year. In addition to that, the face value of $1000 is repaid at maturity.
December 31st, 2030. If the yield to maturity is 6%, the yield to
maturity is also an APR. We need to convert it to the six months
interest rate because the coupons are paid semi annually. The six
month yield is just half of it, which is 3%.

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The Current Value of the Bond - Slide
22

$40 1 $1,000
PV = [1 − 20
] + 20
= $1, 148. 77
3% (1+3%) (1+3%)

Transcript

The current value of the bond is composed of two parts. The first
part is the present value of an annuity of cash flow. Which is $40 last
four 20 purees. Because the bondholder receives 20 coupon
payments in total. The discount rate is 3%. The second part is the
present value of the face value, discounted at 3%. The value of the
bond is $1148.77. In this case, you may notice that the bond value is
higher than the face value, $1000.

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Premium Bond - Slide 23

A premium bond sells for more than the face value.

Transcript

We call it a premium bond. Here, I want you to think about a

question. Why does this bond sell for more than its face value? If you
take a look at the market interest rate. The yield to maturity is 6%.
This bond pays a coupon rate 8%. Which is higher than the market
rate. If the bond sells at par than all the investors would want to buy
the bond. Because it's a better deal than the current market
investment. For each $1000 investment, they will receive $80.00
each year instead of $60.00. The high demand drives up the price of
the bond and pure is yield is in line with the competing market
interest rate. Equilibrium. The bond trades above par value and the
Bond also yields a 6% return, which is no better than the market
return. Now let's take a look at another case.

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Excel Spreadsheet - Slide 24

Download the Module 5 Excel Sheet Data file

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Transcript

Alternative ways to solve the problem using Excel spreadsheet. The

first input is the settlement date, which is the date that the bond is
purchased. So we put December 31st. 2020 here Because this is the
time we purchased the bond, the maturity date is the date the bond
matures. So we put. December 31st, 2030 here. The annual coupon
rate is 8%. And yield to maturity of the bond is 6%. The redemption
value is the bomb value per 100 face value that is paid back, so we
put 100 over here because we can get 100% of the face value at
maturity and for frequency this frequency is the number of coupon
payments each year. So if the bond pays coupon once a year, we
put one. If they paid twice a year, we put two and four. If bonds pay
quarterly coupon payments. So we put two over here BIH cause the
coupon payments are made semi annually. And for the bond price,
we can use the Excel Price function. So using the price function we
put the settlement date in the first argument and then followed by
maturity date, coupon rate yield to maturity. Redemption value and
the frequency over here. OK and then we got the price so the palm
prices 114.877% of face value and we also need to convert it to
dollar value. So we use 1000 dollar 1000 over here times the bond
price 114.877. 1 / 100 and then we get that dollar value. So this is
the dollar value of the bond $1148.77. The value derived using Excel
spreadsheet should match the result you get from mathematical
formulas. Most people feel Excel is an easier way to compute bond
prices because you just need to figure out the inputs and you get the
result automatically.

32
Bonds Question - Slide 25

Suppose the required yield to maturity is 10% instead.

What would be the bond's price?

Transcript

Where the yield to maturity is 10% instead. How does the bank value
change?

33
Bond Value - Slide 26

$40 1 $1,000
PV = [1 − 20
] + 20
= $875. 38
5% (1+5%) (1+5%)

Transcript

This time the six month interest rate is changed to 5%. And all the
other inputs are exactly the same as before. The value of the bond is
calculated as $875.38.

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Yield to Maturity - Slide 27

Download the Module 5 Excel Sheet Data file

Transcript

We also use the Excel spreadsheet to double check our calculation

and the results from 2 methods match with each other. So here we
want to change the yield to maturity to 10% and we want to keep all
the other inputs constant. So here we change it from 6% to 10% and
everything else keeps equal. And you can see that the bond price
changed automatically. This time is changed to $875.38, which is
smaller than the previous case.

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Discount Bond - Slide 28

Discount bond sells for less than the face value.

Transcript

The bond value here is lower than the face value of $1000. We call
this one a discount bond. The Bond sells for less than the face value
because the coupon rate at 8% is lower than the prevailing market
rate 10%. If the bond sells at par value. No one will be interested in
the bond. In order to attract investors, the bond should be sold at a
discount to make up for the lower coupon rate.

Bond Valuation: Interest Rate

Media Player for Video

36
Bond Interest Rates (1 of 2) - Slide 29

As time passes, interest rates change in the marketplace.

Cash flows from a bond stay the same.
The value of the bond fluctuates.

Transcript

In this lesson, let's explore the impact of interest rate on bond

valuation. When corporations initially issued bonds, they pick a
coupon rate that is equal to market interest rate. So the bonds trade
at face value. As time goes by, the market interest rate changes and
the bond price will also change. The value of the bond depends on
the cash flows. The time to maturity and the year to majority. For any
given time, the cash flows generated from the bond are fixed. If the
market interest rate increases.

37
Bond Interest Rates (2 of 2) - Slide 30

When the market interest rate rises, the PV of cash flows will have
less value, so the bond will have less value as well.

Transcript

The present value of cash flows will be of lower value. And the bond
will be of lower value. If the market interest rate drops. The bonds
worth well increase. So there is an inverse relationship between
interest rates and bond value.

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Analysis - Slide 31

This slide depicts a graph for Bond Price on Interest Rate. The
Interest Rate's axis spans from 0%–10% and the Bond Price's axis
spans from $800–$1,200. There is a downward sloping curve with 3
points. They are labeled C, A, and B, which are at 4%, 8%, and 10%
respectively. The equation YTM < Coupon Rate is written at point C.
The equation YTM = Coupon Rate (8%) is written at point A. Finally,
the equation YTM > Coupon Rate is written at point B

39
Transcript

The relationship can be captured in the graph here. We start our

analysis from point A where yield to maturity is equal to the coupon
rate. Which is 8%. And the bomb trades at par value of $1000. Then
the bond is also called a power bond. In the future, if the market
interest rate increases to Point B, where the yield to maturity is 10%.
The coupon rate is 8%. The bond will trade at a discount. If the yield
to maturity decreases to 4% instead. Like the point see in this graph.
The yield to maturity is lower than the coupon rate 8%. The bomb
value will be higher than the face value of $1000. And the bond is a
premium bond. Let's summarize the relationship between you to
majority and the value of the bond in this table.

Three Conditions - Slide 32

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 Coupon Rate Related to YTM
Coupon rate > YTM Price > par value Premium bond

Coupon rate = YTM Price = par value Par bond

Coupon rate < YTM Price < par value Discount bond

41
Transcript

There are three conditions. Based on the relationship between the

coupon rate and yield to maturity of the bond. We can tell whether a
bond is a premium bond discount, bond, or power bound. Now let's
talk about the interest rate risk. For bondholders, the future cash
flows are fixed. But the interest rate may change.

Interest Rate Risk (1 of 3) - Slide 33

Interest rate risk is the risk for bondholders due to fluctuating interest
rates

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Transcript

Investors may suffer a loss due to the changes in interest rates. This
is called interest rate risk. There is an inverse relationship between
bond prices and interest rate. How much interest rate risk an investor
is exposed to depends on how sensitive the bond prices to the
changes in interest rate.

Interest Rate Risk (2 of 3) - Slide 34

Long-term bonds have more interest rate risk than short-term bonds.

43
Transcript

There are two principles about interest rate risk. That should be
discussed with you. Price of long term bonds are more sensitive to
interest rate changes than short-term bonds. An investor who holds
a 20 year bond will suffer more lost than investor who holds a one
year bond when interest rate increases. For the one year bond, the
$1000 face value is received in one year. So any small change in the
interest rate won't change the present value of cash flows too much.
For a 20 year bond, the face value is received 20 years later. And a
lot of the cash flows from distant future. Even a small change in
interest rate will be compounded for 20 years, which has a big
impact on the bond price.

Interest Rate Risk (3 of 3) - Slide 35

Low coupon rate bonds have more interest rate risk than high
coupon rate bonds.

44
Transcript

Price of low coupon bonds is more sensitive to interest. Rates

change than that of high coupon bonds. The reasoning is very
similar to the previous one. Suppose there are two bonds, one with a
1% coupon while the other carries a 10% coupon. Other things being
equal, the price of 1% coupon bond depends more on its face value.
$1000. Which is paid at maturity. This distend cash flow will be very
sensitive to any changes in interest rate. The 10% coupon bond
generates a lot of near term cash flows. The near term cash flows
won't be heavily affected by that interest rate.

Computing Yield to Maturity - Slide 36

C 1 F
P = [1 − T
] + T
r (1+r) (1+r)

45
Transcript

Another question that should be addressed is how to derive the year

to maturity. When we are facing 2 alternative funds and we want to
know which one is a better investment. We cannot just compare their
current prices. Since the 2 pounds have different maturities,
coupons, even face values. The yield to maturity is a better variable
to evaluate the potential return from the bonds. Normally way would
like to invest in the with a higher yield to maturity. Controlling the
credit risk and other things equal. Worth the information on the
current Bond Price P. The cash flows, including the coupon payment
C and face value F. And their timing, we can solve the yield to
maturity are using the equation here. The equation is pretty
straightforward. We have one question and one unknown. But the
solving is manually is very tedious. I don't want to try that way here.
Instead I would like to show you how to find the answer using Excel
spreadsheet. Take a look at the example here. Suppose a 9%
coupon bond has a face value of 1000. 20 years to maturity. Make
semi annual payments and selling for $1098.96. What is this yield to
maturity?

46
Excel 1 - Slide 37

Download the Module 5 Excel Sheet Data file

47
Transcript

We set up an Excel spreadsheet to solve this problem. One technical

question here is that we only know the yields to maturity is 20 years.
But we don't know the exact settlement date and maturity date of this
bond under this circumstance we can pick a random date say
January first 2020. So we put the general 1st 2020 settlement date
and then we add 20 years on top of it so the maturity date will be
January 1st. 2040 over here. And as long as the distance of these
two days are 20 years apart, good to go. The annual coupon rate of
this bond is 9%, so we put 9% over here. The bond price is
109.896% of par value. Because the bond price is 1098.96 and we
divided by the face value of 1000. So this is the bond price in terms
of percentage of face value. And the redemption value is 100%
because you can get 100% back at majority. So the frequency is 2
over here BIH cause the bond makes semiannual coupons. And in
order to calculate the yield to maturity, we use the function yield and
then followed by the inputs. Over here the first argument settlement
date and then followed by maturity date. Annual coupon rate. Bond
price Redemption value and the last one is the frequency over here.

48
Excel 2 - Slide 38

Download the Module 5 Excel Sheet Data file

Transcript

And then we calculate the yield to maturity equals to 8%. So when

we got the year to maturity, we also need to check whether it makes
sense or not. Because this bond sells for more than the face value,
so you can see over here. So sells for more than 100% of the face
value. So the yield to maturity must be lower than the annual coupon
rate, and here you can see 8% is lower than 9%, so it makes sense.

Bond Valuation: Zero-coupon Bonds

Media Player for Video

49
Zero-Coupon Bond - Slide 39

No coupon payments (coupon rate = 0%).

Also called zeroes, discount bonds, or deep discount bonds

Transcript

In the previous lesson we talked about coupon bonds. Which are

bonds with periodic coupon payments? In this part, we'll cover the
zero coupon bond. 0 coupon bonds without coupon payments. 0
coupon bonds are also called Zeros, discount bound or deep
discount bonds.

50
Cash Flow - Slide 40

This slide depicts a timeline for the years 0–T. Above years 1, 2, and
T - 1, 0 is written. Above year T, F is written.

Transcript

The cash flows of 0 coupon bonds are very simple. A bondholder

received the face value of the bond at maturity and no other cash
flows.

51
Valuing Zero-Coupon Bonds - Slide 41

Time to maturity (T)

Face value (F)
Yield to maturity (r)

Present value of a zero-coupon bond at time 0:

F
PV = T
(1+r)

Transcript

To value 0 coupon bonds, we just need to discount the face value F

by T pillars and the discount rate R and the present value will serve
as the price. From this formula, we discovered that the price of the
bond should always be lower than the face value. And this is also
why the zero coupon bonds are also called discount bonds. The
yield to maturity comes from the difference between the purchase
price and the face value.

52
Zero-Coupon Bonds - Slide 42

Find the value of a 10-year zero-coupon bond with a $1,000 par

value and a YTM of 6%.
Assume semiannual compounding.

Transcript

Let me show you an example of 0 coupon bond and see how to

value it. Our aim is to find the value of a 10 year zero coupon bond
with $1000 face value and yield to maturity of 6%.

Here we adopt the semi annual compounding. Even if the zero

coupon bonds. We still assume semiannual compounding to be
consistent with coupon bonds.

53
Cash Flow - Slide 43

This slide shows a timeline for years 0–20. Above the ticks for years
1–19, 0 is written. Above year 20, $1,000 is written.

Transcript

The cash flows from this bond looks like this. There's no cash flows
throughout the life of the bond. And at the end of 10 years or 20
years. There's cash inflow of $1000.

54
Price of Bond - Slide 44

F $1,000
PV = T
= 20
= $553. 68
(1+r) (1+3%)

Transcript

The price of this bond is calculated as the face value of $1000

discounted the six month interest rates 3% for 20 Perez. The zero
coupon bonds. $553.68

55
How to Value the Bond - Slide 45

56
 Bond Price Calculation 1
Settlement date: 1/1/2020

Maturity date: 1/1/2030

Annual coupon rate: 0.00%

Yield to maturity: 6.00%

Redemption value (% of the face value): 100

Frequency:
Bond price (% of face value):
Bond price ($)

57
Download the Module 5 Excel Sheet Data file

Transcript

Let me use Excel spreadsheet to show you how to value this bond.
First we pick a random settlement date. January 1st 2020 Then we
set the mature date. 10 years after that January 1st. 2030 Because
the bond has a time to maturity of 10 years, you can pick a different
settlement date and maturity date then this example, as long as the
difference between these two days at exactly 10 years apart, then
you are good to go. The annual coupon rate is 0%. Because this
bond doesn't pay any coupons. The yield to maturity is 6% and the
redemption value is 100% of their face value. We put frequency
equals 2 two because of the semi annual compounding and now we
compute the bond price.

Bond Prices - Slide 46

58
 Bond Price Calculation 2
Settlement date: 1/1/2020

Maturity date: 1/1/2030

Annual coupon rate: 0.00%

Yield to maturity: 6.00%

Redemption value (% of the face value): 100

Frequency: 2

Bond price (% of face value): 55.368

Bond price ($) $553.68

59
Download the Module 5 Excel Sheet Data file

Transcript

So in order to calculate the bond price we use the price function. So

this is the function price and then followed by the 1st argument,
settlement date, maturity date. Annual coupon rate yield to maturity,
redemption value and frequency, and then we close the parenthesis.
And the bond price is expressed as 55.368% of face value. But we
are also interested in the dollar value. So in order to get the bound
price in terms of dollars, we need to use the face value $1000 and
then times the percentage bound price. Now we got the bond price
equals to all $553.68.

Zero-Coupon Bonds (1 of 2) - Slide 47

Original-issue zero-coupon bonds

STRIPS Bonds (Separate Trading of Registered Interest and
Principal of Securities)

60
Transcript

Some 0 coupon bonds are originally issued as zero coupon bonds

are generated from coupon bonds. One example is called STRIPS.
Separate trading of registered interest and principle of securities. In
the works like this. Suppose investment banks or dealers buy
coupon bonds and sell each cash flow as a standalone 0 coupon
bond. A 20 year coupon bond will generate 40 coupon payments.
The first coupon payment will be sold to an investor as if it is an
independent six month 0 coupon bond. And the second payment will
be sold as a one year zero coupon bond and so on and so forth. The
face value at maturity will also be sold as a separate 20 year zero
coupon bond. I would like to use this example to show you the
relationship between coupon bonds and zero coupon bonds. They
are not totally independent of each other. 0 coupon bonds. From
coupon bonds. Combining several 0 coupon bonds together, we can
also synthesize coupon bonds. The lesson here is to understand the
size and timing of cash flows as well as the impact of interest rate
risk. 0 coupon bonds carry more interest rate risk than coupon bonds
because their values depend solely on the face value paid that
majority. Coupon bonds have more early cash flows. Which are less
sensitive to the changes in interest rate?

61
Zero-Coupon Bonds (2 of 2) - Slide 48

Why do investors prefer a bond without coupon payments?

Transcript

Another question that I would like to address is why do some

investors wish to invest in zero coupon bonds? 0 coupon bonds are
sold at a discount. The yield to maturity is also the market interest
rate comparable with other investments. For investors who have
certain obligations to pay at a future date. 0 coupon bond provides a
perfect tool for them to meet their obligations. For example, you plan
to pay your child's college tuition 10 years from now. You can invest
in a 10 year zero coupon bond. That uses the face value payment 10
years later to cover the expense. By matching the maturity of 0
coupon bonds. Eight of the obligation you don't need to worry about
Reinvestment risk. Suppose you invest in coupon month instead.
You should reinvest the coupons you received each period. But there
may not be any attractive reinvestment opportunities at that time.

62
 Types of Bonds and Ratings

Types of Bonds
Media Player for Video

Treasury Securities - Slide 49

Issued by the US Treasury Department

Treasury Bills
Treasury Notes
Treasury Bonds

63
Transcript

In this video. Let me introduce you to some common types of bonds.

The first group is Treasury securities. Treasury securities can be
divided into three categories. Treasury bills, Treasury nose and the
Treasury bonds. The main difference between them is time to
majority.

Treasury Bills (T-Bills) - Slide 50

Discount bonds with original maturity less than one year (4, 8, 13,
26, and 52 weeks)

64
Transcript

Treasury bills, also called T-bills. Our short-term, you ask

government that worth common denomination of $1000. There are
zero coupon bonds with face value paid at maturity. They have the
shortest. The majority we should last from 4 weeks 2 or 52 weeks.
Treasury bills are considered as safe investments. And there are the
qualities are high. Whenever you want to invest your money for a
short period of time, even for a few days, is a good choice to add
treasure bills into your portfolio.

Treasury Notes (T-Notes) - Slide 51

Coupon debt with original maturity between one and ten years (2, 3,
5, 7, and 10 years)

65
Transcript

Treasury nose, also called Tinos. I issued with maturity of two 357
and 10 years. It pays coupon payments every six month until
maturity date and the face value at maturity.

Treasury Bonds (T-Bonds) - Slide 52

Coupon debt with original maturity greater than 10 years (between

10 and 30 years)

Transcript

Treasury bonds, also called as T bonds. Have maturity time between

10 and 30 years. They also pay semi annual coupon payments
throughout the life of the bound and the re pay the face value at
maturity. Normally the interest rates are higher for long maturities
because investors need to be compensated for the money tide up in
the bonds.

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Advantages of Treasury Securities (1
of 2) - Slide 53

They have virtually no default risk.

Transcript

The greatest advantage of Treasury Securities is that they have no

default risk. Because they are backed by the US government. The
government can always increase taxes to make sure investors are
paid in full.

67
Advantages of Treasury Securities (2
of 2) - Slide 54

Treasury issues are exempt from state and local income taxes, but
subject to federal income taxes.

Transcript

Another attractive feature of the Treasury Securities is that interest

income is exempt from state and local income taxes. That is to say, if
you buy Treasury notes and Treasury bonds. The coupon payments
you received only taxed at the federal level.

68
Disadvantages of Treasury Securities
- Slide 55

Returns are low compared to corporate bonds.

Transcript

The downside of the investing in Treasury Securities is that their

returns are relatively low compared to corporate bonds. For most
investors. They will have tool at least the devote a portion of their
assets in Treasury securities. Because the future payments are
scheduled and they are safe investments. The second group of
bonds are called agency bonds. There are two categories of agency
bonds. Federal government agency bonds and government
sponsored enterprise bonds.

69
Federal Government Agency Bonds -
Slide 56

Issued by federal government agencies, such as the Federal

Housing Administration (FHA), Small Business Administration (SBA),
and the Government National Mortgage Association (GNMA).

Transcript

Federal government agency bonds are issued by federal agencies

such as GNMA. They are backed by the full faith and credit of US
government. And so federal government agency bonds are pretty
safe investment choices. But they are not as liquid as Treasury
Securities, and so they provide a higher interest rate than Treasury
bonds.

70
Government-Sponsored Enterprise
Bonds - Slide 57

Issued by government-sponsored enterprises, such as, the Federal

National Mortgage Association (Fannie Mae), Federal Home Loan
Mortgage (Freddie Mac), Federal Farm Credit Banks Funding
Corporation. and the Federal Home Loan Bank.

Transcript

Government sponsored enterprise bonds are issued by government

sponsored corporations such as Fannie Mae and Freddie Mac.
These corporations created by Congress to promote a public
purpose such as affordable housing. These corporations buy
mortgages from financial institutions that make loans. And then they
group them to create a pool. They divide the pole into small units
and sell them to investors as bonds. Since government sponsored
enterprise bonds don't have the backing from US government.
These bonds carry some degree of default risk.

71
Municipal Securities (Munis) - Slide 58

Debt of local governments

General obligation bonds
Revenue bonds

Transcript

Another category of the bonds is the municipal bonds. Which is also

called munis. There are bonds issued by local governments. Some
are general obligation bonds that pay investors using tax revenue of
local governments. Revenue bonds make payments using the
revenues collected from specific projects, such as highways, airports
or water utilities.

72
Municipal Securities (1 of 3) - Slide 59

Interest received is tax-exempt on a federal level.

Transcript

One big advantage of investing in municipal bonds is that the interest

is tax fray a federal level. What's more, if you live in the state where
the bonds have been issued, you also don't need to pay state taxes.
Because of the favorable tax treatment. The municipal bond is very
attractive to those investors who are in a high income tax bracket.

73
Municipal Securities (2 of 3) - Slide 60

Risk of default

Transcript

When you invest in municipal bonds. You also need to pay attention
to default risks. The municipal bonds are also redid, just like
corporate bonds. We'll talk more about bond rating later.

74
Municipal Securities (3 of 3) - Slide 61

Risk of default
In 2013, the city of Detroit, Michigan, filed for the largest
municipal bankruptcy in United States history.

Transcript

One recent example is the City of Detroit. On July 18th, 2013, the
City of Detroit used bankruptcy to default on its general obligation
bonds. Because it had no income to pay those bonds. Bondholders
suffered billions of dollars losses from the default.

75
Corporate Bonds - Slide 62

Higher default risk than United States government bonds

Transcript

Corporate bonds are bonds issued by corporations. Since business

operations are riskier than governments, the corporate bonds carry
more risk than government securities. Therefore they need to
promise a higher return to compensate investors.

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Bond Types - Slide 63

Secured bonds
Unsecured bonds (debenture)

Transcript

Let's talk about the concepts of secured bond, an unsecured bond.

Secured bond means the issuer used some assets, such as building
equipment, vehicle or income stream as collateral on the loan. Once
the company could not make scheduled interest and principle
payments. The bondholders will seize the collateral. To repay the
debt. Unsecured bonds are not backed up by some form of
collateral. These bonds are also called the ventures. Some
companies issue unsecured bonds because they do not have
enough assets to pledge as collaterals. Other businesses are well
established and the investors trust their ability to pay their debt. In
the case of default, investors have to sue the company to get their
money back. Since unsecured bonds are riskier than secured bonds.
Unsecured bonds issuers must promise a higher interest rate to the
bondholders than secured bonds. Otherwise, investors won't be
interested in unsecured bonds.

77
Bond Ratings
Media Player for Video

Bond Rating - Slide 64

Evaluate the credit worthiness of corporate or government bonds.

Transcript

Bond rating is an evaluation of the creditworthiness of corporate or

government bonds. Companies or governments planning to issue a
security need to pay a rating agency to reap their debt. Based on the
reading, investors decide whether they want to invest in the bonds or
not.

78
"Big Three" Credit Rating Agencies -
Slide 65

Fitch Ratings
Moody's
Standard & Poor's (S&P)

Transcript

There are three major credit rating agencies in the world. Fitch
Ratings Moody's and Standard and Poor's. They collectively control
around 95% of global market share. Their job is to provide investors
with reliable information about the riskiness of bonds. After the 2008
financial crisis. They also received a lot of criticism. Because they
gave favorable ratings for insolvent financial institutions such as
Lehman Brothers. After that, regulators also reflect how to make
reading agencies more transparent and faster. More competition.

79
Bond Ratings Chart - Slide 66

80
 Bond Ratings 1
Moody's Standard & Poor's and Fitch

Aaa AAA

Aa AA
Investment-grade
A A

Baa BBB

Ba BB

B B

Caa CCC
Junk Bond
Ca CC

C C

81
Transcript

Bond ratings are represented by letter grades. With AAA as the

highest rating, then followed by AA an A, so on and so forth. D is the
lowest rating. Reading agencies also use 123 or plus or minus to
indicate the relative strength of the bond within that category. The
Rings show how large the default risk is and the financial stability of
the issuer.

Bond Ratings Example - Slide 67

82
 Bond Ratings 2
Moody's Standard & Poor's and Fitch

Aaa AAA

Aa AA

A A

Baa BBB

83
Transcript

For example, abound rated AAA or AA means the company's

capacity to pay is pretty strong. For bonds in the A and Triple B
category, their capacity to pay also rely on the economic conditions.
They can repay their debt if the economy is booming. But they may
have trouble paying their debt in an economic downturn. Worth
double B or B ratings? Bonds are considered speculative with
respect to capacity to pay interest and repay principle. For bonds
with C or D ratings. Their repayments are highly uncertain. Some of
them are already in default.

Bonds How They're Rated - Slide 68

84
 Investment Grade Bonds
Moody's Standard & Poor's and Fitch

Aaa AAA

Aa AA
Investment-grade
A A

Baa BBB

85
Transcript

Bonds rated Triple B or higher by standard poor and Fitch Ratings or

BA or higher by Moody's are considered investment grade bonds.
They carry a lower yield because. They represent attractive
investment opportunities for investors. The story here is very similar
to a person's credit score. Suppose you have a high credit score.
You can borrow money from a bank at a low interest rate. Bonds with
readings below that are called speculative grade. High yield bonds or
junk bonds. They have to promise a higher yield to investors as a
compensation because their default probability is greater. A lot of
institutional investors such as banks and pension funds are
prohibited in their bylaws from holding junk bonds. Therefore,
sometimes it's difficult to sell those bonds to other investors. The
liquid it in junk bond market pretty low compared to investment grade
bonds.

Bond Rating Process - Slide 69

Upgraded when financial strength improves

86
 Downgraded when financial situation deteriorates

Transcript

The bond rating is a dynamic process. Suppose the bond gets an A

rating initially an when the company's financial situation improves.
The bond may be upgraded to AA. This is great news for
Corporation because the upgrade will lead to a lower cost of capital.
On the other hand, the bond may be downgraded to a triple B rating
if the company's financial situation deteriorates, or macro economic
situations gets worse. This downgrade will drive down the price of
the bond because a lot of institutional holders may sell the bond.

Table of Cumulative Historical Results

- Slide 70

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 Cumulative Historic Default Rates (in percent)
Rating Moody's Moody's S&P S&P
categories Municipal Corporate Municipal Corporate

Aaa/AAA 0.00 0.52 0.00 0.60

Aa/AA 0.06 0.52 0.00 1.50

A/A 0.03 1.29 0.23 2.91

Baa/BBB 0.13 4.64 0.32 10.29

Ba/BB 2.65 19.12 1.74 29.93

B/B 11.86 43.34 8.48 53.72

Caa-C/CCC-
16.58 69.18 44.81 69.19
C
Investment
16.58 69.18 44.81 69.19
Grade
Non-Invest
4.29 31.37 7.37 42.35
Grade

All 0.10 9.70 0.29 12.98

88
Transcript

Here is a table of cumulative historical default rates for bonds in

different reading categories. You can tell non investment grade
bonds have significantly higher default probability than investment
grade bonds. Meanwhile, the default rate of municipal bonds is much
lower than comparable rated corporate bonds. Even if, in the event
of default. Bondholders recover more debt from municipal bonds
than corporate bonds. You may wonder. How do reading agencies
decide whether to read about the AAA or triple B? Bond rating
agencies determine the reading mainly based on financial ratios.

Bond Ratings Ratios - Slide 71

Coverage ratios
Liquidity ratios
Leverage ratios

89
Transcript

There are several commonly used financial ratios. One category is

coverage ratios, such as interest coverage ratio. Is a ratio of
earnings before interest and taxes to interest obligation. A high
interest coverage ratio means the company has no problem paying
its interest obligations. The equivalency ratios such as current ratios
and quick ratios evaluate a company's ability to pay its short-term
obligations. Leverage ratios measure the company's capacity to pay
is total obligations. A company should keep its leverage ratio within a
reasonable range. Commonly used probability ratios include the
return on assets and return on equity. They are indicators of the
overall performance of the company. Reading agencies will combine
these financial ratios and also take into consideration the trend of
these ratios and make a judgment. Credit rating is important.
Because it promotes the development of the bond market. The
reading delivers clear information to investors. So that they
understand the underlying risks of bond securities. Equipped with the
information, investors should be able to make well informed
decisions.

90
 Module 1 Wrap Up

Module 1 Wrap Up
Media Player for Video

Sole Proprietorship - Slide 72

Simplest way to start a business

Owners keep all profits
Pro: No need to pay corporate taxes
Con: Lots of liabilities and debts
Ex. Small businesses

91
Transcript

In this module. We covered the basics of finance. We got introduced

to three legal forms to organize a business. So pre partnership is the
simplest way to start a business. The owners can keep all the profits
to themselves, and there's no need to pay corporate taxes. But this
comes at a cost. They have unlimited liabilities for business debts
and obligations. For small businesses this is a good choice.

Corporation - Slide 73

Complicated and expensive to form

Con: Double taxation
Pro: Limited shareholder liability
Ex. Large businesses

92
Transcript

The second form to organize a business is through partnership. In

the refers to a business organized by several owners. The
advantages and disadvantages of partnerships are very similar to
the sole proprietorship. The last form is Corporation. Corporations
are complicated and expensive to form. The big downside of the
Corporation is double taxation. But the good news is that
shareholders of corporations have limited liability. Meaning they are
not personally responsible for the debts and obligations of the
Corporation. Most large businesses are organized as corporations.
The second form to organize a business is through partnership. In
the refers to a business organized by several owners. The
advantages and disadvantages of partnerships are very similar to
the sole proprietorship. The last form is Corporation. Corporations
are complicated and expensive to form. The big downside of the
Corporation is double taxation. But the good news is that
shareholders of corporations have limited liability. Meaning they are
not personally responsible for the debts and obligations of the
Corporation. Most large businesses are organized as corporations.

93
Limited Liability Company (LLC) -
Slide 74

A combination of the three basic forms

Offers liability protection to owners
Doesn't pay corporate taxes
Fastest growing out of all options

Transcript

Besides these three basic structures, businesses can also be

organized using hybrid forms, such as a limited liability company C.
All else combines a lot of benefits of three basic forms. All else offers
personal liability protection to its owners. And it doesn't need to pay
corporate taxes. Therefore, the number of limited liability companies
are growing faster than three basic structures.

94
The Goal of Financial Management -
Slide 75

Public co: maximize current value per share of existing stock

Employee safety, customer satisfaction, social responsibility

Transcript

Then we focused our attention on corporations. We discussed the

goal of financial management. For public companies, the goal is to
maximize the current value per share of the existing stock. We also
discussed whether this goal conflict with other goals. Such as
employees, safety, customer satisfaction and social responsibility.

95
Corporate Governance - Slide 76

Shareholders role, the board of directors, and managers

Paves way for future development

Transcript

Another topic is corporate governance. We discussed the role of

shareholders, the board of directors and managers. Good corporate
governance will pave the way for future development.

96
The Agency Problem - Slide 77

Conflict of interest between management and shareholders

Want to mitigate and have regulations to protect shareholders

Transcript

A unique question for corporations is the agency problem. It refers to

the conflict of interest between our companies, management and
shareholders. Corporations come up with multiple ways to mitigate
this problem, and the regulators also tighten regulations to protect
shareholders. This module is just a start of a journey. Let's work
together to explore more about finance in the following modules.

97
Table of Contents
1. Preface
2. Module 1 Introduction to Finance: The Role of Financial Markets
1. Module 1 Overview
1. Module 1 Overview
2. Bond: Basic Concepts
1. Bond: Basic Concepts
3. Bond Valuation
1. Bond Valuation: Introduction
2. Bond Valuation: Interest Rate
3. Bond Valuation: Zero-coupon Bonds
4. Types of Bonds and Ratings
1. Types of Bonds
2. Bond Ratings
5. Module 1 Wrap Up
1. Module 1 Wrap Up

98