WK 7.1 - Bonds and Bond Valuation

Bonds and Bond Valuation
K. Stephen Haggard, Ph.D.

What is a bond?
the payments are on interrest
• A bond is an interest-only loan.
and principle is returned at the
end of the life
• Borrowers (bond issuers) sell bonds to lenders

(bond buyers, bondholders).
• Borrowers pay interest periodically
throughout life of bond.
• Borrowers pay remaining interest and all of
principal at the end of the bond’s life.
Bond Vocabulary
• Coupons periodic
payments made
• Face/Par value
• Coupon rate the rate: coupoun rate x face value= ANNUAL coupon paid
• Maturity
Price the bond. the price fluctuates
how much people would pay today to buy
•
the current interest rate. the coupoun rate remains
• Yield-to-maturity (YTM) fixed from the beginign but the YTM fluctuates. if
company becomes more risky the YTM will increase
but the coupoun rate will remain fixed
What’s a bond worth?
• Recall our earlier definition for the price or
value of anything.
• A bond’s value is the present value of its
future cash flows discounted at YTM. bonds value is the PV
disocunted at risk rate
which is the YTM
• Future cash flows
– Coupons
– Face value
Bond pricing example (1)
A bond with a face value of $1000 has a coupon
rate of 6% and 10 years to maturity. Interest is
paid annually. The market requires a 6% return
on this bond. What is the market price of this
bond?
[2nd][FV]10[N]6[I/Y]60[PMT]1000[FV][CPT][PV]
Why is the payment (coupon) 60? 6% x 1000
Why is the PV negative? because the coupoun rate = required YTM
Why is the market price same as face value?

We call this type of bond a “par” bond.
bond?
because the risk
Why is the market price less than face value? (YTM) is

greater than the
coupoun rate
We call this type of bond a “discount” bond.
bought at a dcisount to make it worht it in the future.
bond?
Why is the market price more than face value?
We call this type of bond a “premium” bond.
paid semi-annually. The market requires a 5%
return on this bond. What is the market price of
this bond?
[2nd][FV]20[N]2.5[I/Y]30[PMT]1000[FV][CPT][PV]
Why is N doubled, and I/Y and PMT cut in half?
N dobled for 2 payments per year
YTM is per year we are dealing with semi-annual
PMT is per year we are recieving that payment in 2 half payments
paid semi-annually. The bond is selling for
$864.10. What is the YTM for this bond?
beacuae its a discount
Is it going to be higher or lower than 6%? bond we know

YTM > Coupon rate
[2nd][FV]20[N] 30[PMT]1000[FV]
-864.10[PV][CPT][I/Y]
Why is PV entered as a negative?
Is I/Y the same as YTM? Why not?
A bond has a coupon rate of 6%. Interest is paid
semi-annually. The bond yields 7% and is selling for
$973.36. How many years until this bond matures?
Do I have to tell you what the face value is?
[2nd][FV]30[PMT]1000[FV]-973.36[PV]3.5[I/Y][CPT][N]
Is N the same as number of years to maturity?
Why not?
divide by 2 to get the # of years
you are calculting in semi annual so more payments and periods

A bond is selling for $1,071.70 and has 4 years left to
maturity. Interest is paid semi-annually. The bond
yields 5%. What is the bond’s coupon rate?
Is it going to be higher or lower than YTM?
[2nd][FV] 8[N]1000[FV]-1071.70[PV]2.5[I/Y][CPT][PMT]
Why does PMT come out positive?
Do I merely divided PMT by face value to get coupon
rate?
this is a premium bond.
market value is gretaer than furure value because the oupoun rate is enouh satisfy the risk (YTM)
coupoin > YTM
Why not?
Pricing Zero Coupon Bonds
• Unless told otherwise, we price zero coupon
bonds as semi-annual coupon bonds, even
though they pay no coupon.
• Why? Most bonds pay semi-annual coupons.
• Impacts bond price because the effective
annual rate of semi-annual pattern is higher
due to compounding.
no coupon means all payments paind at the very end. therefore PMT is 0
Bond value vs. Bond age
both will be worth the same amount at maturity
premium bonds are wrth more therfor thet have to reduce in value during their life
and vice versa for a discount bond
Current Yield
current yeild is not not current yeild to maturity YTM
• Current yield = annual coupon / bond price

• Not the same as yield-to-maturity
• For discount bonds, current yield is lower than
YTM because it ignores the capital gain as
bond price rises to face value.
• For premium bonds, current yield is higher
than YTM because it ignores the capital loss as
bond price falls to face value.
Interest Rate Risk (1)
• This is the risk that changing interest rates will
change bond values. As interest rates go up,
bond prices go down.
• Ceteris paribus, bonds with longer times to
maturity are more sensitive to these changes.
• Ceteris paribus, bonds with smaller coupons
are more sensitive to these changes.
small coupouns menas the value of the bond is closer to the end of its life.
zero coupouns entire value is a the maturity date
Interest Rate Risk (2)
10% is the coupoun rate. because the bond value is 1000 (the defaukt vaue) at 10%
if IR falls below 10% its a premium bond; if above 10% its a discount bond
if IR is cut in half, the 1year only increase by 4% while the 30yr increses by 77% and the
same discrepency when IR increases
bond IR are mean reverting. we expecting

them to revert to thieer histrorical mean
Interest rate risk in the real world
Maturity Coupon Price on Price on % change Price on % change

Rate 12/31/95 7/31/96 in price 9/26/07 in price
95-96 96-07
2095 7.00% 1,000 800 -20.0% 1020.29 +27.5%
Reinvestment Risk
• Reinvestment risk is the risk that future
proceeds will have to be reinvested at a lower
rate of return.
• Bond reinvestment risk sensitivity is opposite
of interest rate risk sensitivity. Ceteris paribus,
– Shorter time to maturity means greater
reinvestment risk
– Larger coupons mean greater reinvestment risk.
a 0 coupoin bond mens there is no reinvestment risk becuse you’ll get none of the proceeds till the very end

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Bonds and Bond Valuation

K. Stephen Haggard, Ph.D.

• Borrowers (bond issuers) sell bonds to lenders

Why is the market price same as face value?

Why is the market price less than face value? (YTM) is

Is it going to be higher or lower than 6%? bond we know

you are calculting in semi annual so more payments and periods

• Current yield = annual coupon / bond price

bond IR are mean reverting. we expecting

Maturity Coupon Price on Price on % change Price on % change

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