Lesson Plan

•What’s A Bond?
•Types of Bonds
•Bond Valuation Techniques
•The Bangladeshi Bond Market
•Problem Set
What’s a bond?
What’s a bond?
What’s a bond?
What’s a bond?
 What’s a bond?
•A bond is a long-term debt instrument issued by a
corporation or a government. It is a fixed-income
security.
 What’s a bond?
•A bond is a formal contract to repay borrowed
money with interest at fixed intervals.

•A bond provides the borrower with external funds

to:
– finance long term investments (for corporations)
– finance current expenditures (for municipal, state or
national governments).
 Difference between stocks and bonds

Shares of stock Bond

Equity stake in the firm Creditor stake in the firm

[i.e. owners] [.i.e. lenders]

Undefined term Defined term (maturity)

(outstanding indefinitely)
 Types of bonds
• A non-zero coupon-paying bond/Coupon paying
bond is a coupon-paying bond with a finite life.

•A zero-coupon bond is a bond that pays no

interest but sells at a deep discount from face value.

• A perpetual bond is a bond that never matures. It

has an infinite life.
 The maturity value
•The maturity value (MV) [or face value] of a bond
is the stated value.

– In the case of a U.S. bond, the MV is usually $1,000.

– In the case of a Bangladeshi prize bond, the MV is

usually 100 Taka.
 Coupon rate
•The coupon rate [or coupon yield] of a bond is the
stated rate of interest.

Annual coupon payments (CP)

Coupon rate =
Maturity value (MV)

For example:
Annual coupon payments = $80
Face value = $1,000
Coupon rate = $80/$1,000
= 0.08 = 8%
 Sample problem #1
•If the annual coupon payments are $70 and the face
value of a bond is $1,000, what is its coupon rate?

Annual coupon payments (CP)

Coupon rate =
Maturity value (MV)

Annual coupon payments = $70

Face value = $1,000
Coupon rate = $70/$1,000
= 0.07 = 7%
 Sample problem #2
•If the annual coupon payments are $100 and the
face value of a bond is $1,000, what is its coupon
rate?
Annual coupon payments (CP)
Coupon rate =
Maturity value (MV)

Annual coupon payments = $100

Face value = $1,000
Coupon rate = $100/$1,000
= 0.10 = 10%
 Coupon payment
•The coupon Payment [or coupon yield] of a bond
is the amount of interest.

Coupon payment = Coupon rate X Maturity value (MV)

For example:
Coupon rate = 8%
Face value = $1,000
Annual coupon payments = 8%x$1,000
= $8
 The discount rate
•The discount rate [or capitalization rate] of a bond
is dependent on the risk of the bond.

•The discount rate (k ) is composed of the risk-free

d
rate plus a premium for risk.
 Bond valuation
•Bond value = PV of coupons + PV of MV

•Bond value = PV annuity + PV of lump sum

Remember: as interest rates increase, the PVs

decrease.

So, as interest rates increase, bond prices decrease.

 Bond valuation
•Bond value = PV of coupons + PV of MV

•Bond value = PV annuity + PV of lump sum

V = CP (PVIFA k , n) + MV (PVIF k , n)
d d
 Bond valuation
A bond has a $1,000 face value and provides an 8%
annual coupon for 30 years. The appropriate
discount rate is 10%. What is the value of the bond?

V = CP (PVIFA k , n) + MV (PVIF k , n )
d d
 Bond valuation
A bond has a $ 1,000 face value and provides an 8%
annual coupon for 30 years. The appropriate
discount rate is 10%. What is the value of the bond?

V = CP (PVIFA 10%, 30) + MV (PVIF 10%, 30)

= $80 (9.427) + $1,000 (0.057)
= $754.16 + 57.00
= $811.16
 Sample problem #1
A bond has a $ 1,000 face value and provides a 6%
annual coupon for 20 years. The appropriate
discount rate is 6%. What is the value of the bond?

V = CP (PVIFA 6%, 20) + MV (PVIF 6%, 20)

= $60 (11.4699) + $1,000 (0.3118)
= $688.19 + 311.80
= $999.99
 Sample problem #2
A bond has a $ 1,000 face value and provides a 6%
annual coupon for 10 years. The appropriate
discount rate is 10%. What is the value of the bond?

V = CP (PVIFA 10%, 10) + MV (PVIF 10%, 10)

= $60 (6.1446) + $1,000 (0.3855)
= $368.68 + 385.50
= $754.18
 Semi-annual compounding
•Most bonds pay coupon payments twice a year.

•They pay ½ of the annual coupon payments.

Adjustments needed for semi-annual compounding:

(1) Divide kd by 2
(2) Multiply n by 2
(3) Divide CP by 2
 Semi-annual compounding

A non-zero coupon bond adjusted for semi-annual

compounding:

V = CP/2 (PVIFA kd/2, n*2) + MV (PVIF kd/2, n*2)

 Sample problem #1
A bond has a $ 1,000 face value and provides an 8%
semi-annual coupon for 15 years. The appropriate
discount rate is 10% (annual rate). What is the value
of the coupon bond?

V = CP/2 (PVIFA 10%/2, 15*2) + MV (PVIF 10%/2, 15*2)

= $40 (15.3725) + $1,000 (0.2314)
= $614.90 + 231.40
= $846.30
 Sample problem #2
A bond has a $ 1,000 face value and provides a 6%
semi-annual coupon for 15 years. The appropriate
discount rate is 6% (annual rate). What is the value
of the coupon bond?

V = CP/2 (PVIFA 6%/2, 15*2) + MV (PVIF 6%/2, 15*2)

= $30 (19.6004) + $1,000 (0.4120)
= $588.01 + 412.00
= $1,000.01
 Zero-coupon bond valuation

•A zero-coupon bond is a bond that pays no

interest but sells at a deep discount from its face
value.

V = MV (PVIF k , n)
d
 Zero-coupon bond example

A bond has a $1,000 face value and a 30-year life.

The appropriate discount rate is 10%. What is the
value of the zero-coupon bond?

V = MV (PVIF k , n)
d
 Zero-coupon bond example

A bond has a $1,000 face value and a 30-year

30 life.
The appropriate discount rate is 10%. What is the
value of the zero-coupon bond?

V = MV (PVIF 10%, 30)

= $1,000 (0.057)
= $57.00
 Zero-coupon bond example #2

A bond has a $1,000 face value and a 30-year

30 life.
The appropriate discount rate is 6%. What is the
value of the zero-coupon bond?

V = MV (PVIF 6%, 30)

= $1,000 (0.1741)
= $174.10
 Zero-coupon bond example #3

A bond has a $1,000 face value and a 10-year

10 life.
The appropriate discount rate is 6%. What is the
value of the zero-coupon bond?

V = MV (PVIF 6%, 10)

= $1,000 (0.5584)
= $558.40
 Perpetual bond valuation

•A perpetual bond is a bond that never matures. It

has an infinite life.

V = CP / kd
 Perpetual bond example

A bond has a $1,000 face value and provides an 8%

coupon. The appropriate discount rate is 10%. What
is the value of the perpetual bond?

V = CP / kd
 Perpetual bond example

A bond has a $1,000 face value and provides an 8%

coupon. The appropriate discount rate is 10%. What
is the value of the perpetual bond?

CP = $1,000 * (8%) = $80

kd = 10% = 0.10
V = CP / kd
= $80 / 0.10
= $800
 Perpetual bond example #2

A bond has a $1,000 face value and provides a 6%

coupon. The appropriate discount rate is 20%. What
is the value of the perpetual bond?

CP = $1,000 * (6%) = $60

kd = 20% = 0.20
V = CP / kd
= $60 / 0.20
= $300
 Perpetual bond example #3

A bond has a $1,000 face value and provides a 5%

coupon. The appropriate discount rate is 8%. What
is the value of the perpetual bond?

CP = $1,000 * (5%) = $50

kd = 8% = 0.08
V = CP / kd
= $50 / 0.08
= $625
 Yield to maturity (YTM)
•The yield to maturity (YTM) of a bond is the discount
rate which returns the market price of the bond.
– YTM is often used to price a bond.
– Bond prices are often quoted in terms of YTM.

• It is interest rate on the bond that is implied by the market price of

the bond. It represents what the bond market thinks is a "fair" return
if you were to hold the bond till maturity.

• Thus, one would, expect this rate to change as the market interest
rates change.
 YTM calculations
YTM: The expected rate of return on a bond if bought at
current market price and held to maturity.

Formula for finding YTM:

YTM =Annual Payment+ (Face value - Price)/ No. of year

0.6* Price + 0.4 * Face Value

Problem: Current market price of a bond, having 12

years remaining maturity, is Tk 761. The face value of the
bond is Tk 1000 and coupon rate is 8% which is paid
annually. Find out YTM of the bond.
 YTM calculations
•You want to determine the YTM for an issue of
outstanding bonds at your firm.

•Your firm has an issue of 10% annual coupon

bonds with 15 years left to maturity.

•The bonds have a current market value of $1,250.

What is the YTM?

 YTM solution (9%)
$1,250 = $100 (PVIFA 9%, 15) +
$1,000 (PVIF 9%, 15)
$1,250 = $100 (8.061) +
$1,000 (.275)
$1,250 = $806.10 + $275.00
= $1,081.10

[Rate is too high]

 YTM solution (7%)
$1,250 = $100 (PVIFA 7%, 15) +
$1,000 (PVIF 7%, 15)
$1,250 = $100 (9.108) +
$1,000 (.362)
$1,250 = $910.80 + $362.00
= $1,272.80

[Rate is too low]

YTM solution (interpolate)

.07 $1,273
$23
.02 X IRR $1,250 $192
.09 $1,081

X $23
.02
= $192
YTM solution (interpolate)

.07 $1,273
$23
.02 X IRR $1,250 $192
.09 $1,081

X $23
.02
= $192
 YTM solution (interpolate)

.07 $1,273
$23
.02 X YTM $1,250 $192
.09 $1,081

($23)(0.02)
X= $192 X = .0024

YTM = .07 + .0024 = .0724 or 7.24%

 YTM problem #1
•Your firm has an issue of 8% annual coupon bonds
with 10 years left to maturity.

•The bonds have a current market value of $1,100.

What is the YTM?

 YTM problem #2
•Your firm has an issue of 9% annual coupon bonds
with 12 years left to maturity.

•The bonds have a current market value of $1,310.

What is the YTM?

 Premium vs. discount bond

•A bond selling for more than its face value is called

a premium bond.

•A bond selling for less than its face value is called a

discount bond.
 Current vs. coupon yield
The current yield is the coupon payment (CP) as a
percentage of the current bond price (V).

Current yield = CP / V

•The coupon yield of a bond is the stated rate of

interest.

Annual coupon payments (CP)

Coupon yield =
Maturity value (MV)
YTM, current & coupon yield

•When a bond sells at a discount

YTM > current yield > coupon yield

•When a bond sells at a premium

Coupon yield > current yield > YTM

•When a bond sells at par

YTM = current yield = coupon yield