CHAPTER IV:

BOND VALUATION

Lecturer: Phan Tran Minh Hung

Phone: 0984.240.240
Email: [email protected]
1
 TOPICS COVERED
 Key features of bonds;
 Bond valuation;
 Measuring yield;
 Assessing risk.

2
 OBJECTIVES
Upon successful completion of this lecture,
students should be able to:
Distinguish among the bond’s coupon rate,
current yield, and yield to maturity;
Compute the bond price;
Define interest rate risk-Default risk.

3
 WHAT IS A BOND?
 A bond is a certificate showing that a
borrower owes a specified sum. In order to
repay the money, the borrower has agreed to
make interest and principal payments on
designated dates.
 A long-term debt instrument in which a
borrower agrees to make payments of
principal and interest, on specific dates, to
the holders of the bond.
4
 TERMS RELATED TO BOND
 Coupon: the interest payment paid to the
bondholder, interest payment made on a
bond.
 Coupon rate: annual coupon divided by
the face value of a bond.
 Face value (par value): principal amount
of a bond that is repaid at the end of the
term.
5
 (CONT'D)
 Maturity: a specified date on which
principal amount of a bond is paid.
 Yield to maturity: the rate required in the
market on a bond.
 Features of bond value: number of periods
remaining until maturity, the face value, the
coupon and the market interest rate (YTM).

6
 (CONT'D)

WHAT IS A BOND?

7
 (CONT'D)

WHAT IS A BOND?

8
 (CONT'D)

WHAT IS A BOND?

9
TERMS RELATED TO BOND (CONT'D)
Coupon Rate vs Discount Rate
The is the annual interest payment divided by the
coupon rate face value of the bond.
The interest rate (or discount rate) is the rate at which
the cash flows from the bond are discounted to
determine its present value.
WARNING!
The coupon rate, though a percent, is not the interest rate (or
discount rate).
The coupon rate tells us what cash flows a bond will produce.
The coupon rate does not tell us the value of those cash flows.
To determine the value of a cash flow, you must calculate its
present value. 10
 BOND VALUATION
 Nonzero coupon bond
 What would you be willing to pay right now for
a bond (What is a Bond Worth?) which:
 Pays a coupon of $65 per year for 3 years.
 Has a face value of $1,000.
 The cash flows on this bond would be:
-Price ? $65 $65 $65 + 1000

0 1 2 3
 To determine the price, you must calculate
the present value of these cash flows. 11
 (CONT'D)
Nonzero coupon bond
 What is a Bond Worth?
The coupon rate on this bond is 6.5%.
 To determine the PV of the bond, you need to know the
discount rate for the bond.
 The discount rate is the interest rate which investors
are earning on a similar security.
Assume that similar 3 year bonds offer a return of
5.1%.
12

 5.1% is the discount rate for this bond.

 (CONT'D)
 Nonzero coupon bond
 Todetermine the price of the bond, you would
calculate the PV of the cash flows using a 5.1%
discount rate:
-Price ? $65 $65 $65 + 1000
Bond price = PV today: 0 1 2 3
$65/(1.051) = $61.85
$65/(1.051)2 = $58.84
$1065/(1.051)3 = $917.36
$1,038.05 13
 (CONT'D)
 Nonzero coupon bond
What is a bond worth? Thus, if discount rates
are 5.1%, you would be willing to pay $1,038.05
for a bond with a coupon rate of 6.5% and a
remaining life of three years.
 But, suppose this were a 20 year bond … what
would it be worth?
You could use the same procedure as you used
for the first bond:
 Calculate the PV of each cash flow.
 Add up these present values. 14
 (CONT'D)
Nonzero coupon bond
 What is a bond worth? If the coupon payment(s)
on a bond are an annuity and in the last year of
the bond’s life the holder receives a payment equal
to the face value of the bond.
 Thus you can calculate the PV of the bond:
PV = PV (coupons) + PV (face value)
= (coupon x annuity factor) + (face value x discount
factor)
= $65x[1/0.051–1/(0.051(1+0.051)3)]+1000x[1/(1+0.051)3]
= $176.68 + 861.37 = $1,038.05
15
 (CONT'D)
Nonzero coupon bond
Example: US treasury bond has a face value
$1,000; 9% coupon rate and 25 years to maturity.
Please compute the bond price with discount rate
of 10%/ year.

16
 (CONT'D)
 Nonzero coupon bond
 Example: A bond which:
 Pays a coupon of $65 per year for 4 years.
 Has a face value of $1,000.
 Assume that similar 4 year bonds offer a return of
5.1%.
 Issue day: 10/10/2010
 Maturity date: 10/10/2014
 What would you be willing to pay at
10/10/2011 and 10/04/2012.
17
 (CONT'D)
 Nonzero coupon bond
0 1 2 3 4
10/10/2010 10/10/2011 10/10/2012 10/10/2013 10/10/2014

65 65 65 65 +1,000

𝟔𝟓
( 𝟏+𝟓.𝟏% ) 𝟏
𝟔𝟓
( 𝟏+𝟓.𝟏% ) 𝟐
𝟏,𝟎𝟔𝟓
( 𝟏+𝟓.𝟏% ) 𝟑 18

 PV = 1,038.05
 (CONT'D)
 Nonzero coupon bond
10/04/2012
0 1 2 3 4
10/10/2011 10/10/2012 10/10/2013 10/10/2014

65 65 65 65 +1,000
𝟔𝟓
( 𝟏+𝟓.𝟏% ) 𝟏
𝟔𝟓
( 𝟏+𝟓.𝟏% ) 𝟐
𝟏,𝟎𝟔𝟓
( 𝟏+𝟓.𝟏% ) 𝟑
 PV = 1012.73 19
 (CONT'D)
 Nonzero coupon with semi-annual
coupons

20
 (CONT'D)
 Nonzero coupon with semi-annual coupons
0 1 2 3 4 5 6
PV0
32.35 32.35 32.35 32.35 32.35 32.35 +1,000
𝟑𝟐.𝟑𝟓
𝟏+𝟐.𝟓𝟓 %
𝟑𝟐.𝟑𝟓
( 𝟏+𝟐.𝟓𝟓%) 𝟐
𝟑𝟐.𝟑𝟓
( 𝟏+𝟐.𝟓𝟓%) 𝟑
𝟑𝟐.𝟑𝟓
( 𝟏+𝟐.𝟓𝟓%) 𝟒
𝟑𝟐.𝟑𝟓
( 𝟏+𝟐.𝟓𝟓%) 𝟓
𝟏𝟎𝟑𝟐.𝟑𝟓 21
( 𝟏+𝟐.𝟓𝟓%) 𝟔
 (CONT'D)
 Nonzero coupon with semi-annual
coupons
C

PV: present value;

C: annual coupon;
 r: period discount interest rate;
 t: annual number of periods;
 n: semi-annual number of periods.
22
 (CONT'D)
Nonzero coupon with semi-annual
coupons
Example: US Government bond has a face value
$1,000; 8% coupon rate; 17 years to maturity;
coupon payment is paid semi-annually. Please
compute the bond price with:
 YTM = 12% =
 YTM = 10% =

23
 (CONT'D)
 Zero coupon bond
 Example: What would you be willing to pay right
now for a bond without paying a coupon for 4 years
and has a face value of $1,000. Assume that the
bond offer a return of 5.1% per year.
1st 2nd 3rd 4th

0 1 2 3 4
r = 5.1%

0 0 0 1,000
Today Face value
Coupon or
 PV= 1,000/(1+5.1%) = ?
4 24

principal
 (CONT'D)
 Zero coupon
bond
1st 2nd 3rd tth

0 1 2 3 t
r%

0 0 0 FV (P)
Today Face value
Coupon or
principal
 PV= FV/(1+r)t
25
 (CONT'D)
 Zero coupon bond
 Example: What would you be willing to pay right
now for a bond without paying a coupon for 4 years
and has a face value of $2,000. Assume that the bond
offer a return of 10% per year.
1st 2nd 3rd 4th

0 1 2 3 4
r = 5.1%

0 0 0 2,000
Today Face value
Coupon or
 PV= 2,000/(1+5.1%) = ?
4 26

principal
 (CONT'D)
 Perpetual coupon or consol
 Example: What would you be willing to pay right now
for a bond which: pays a coupon of $65 per year forever
and has a face value of $1,000. Assume that the bond
offer a return of 5.1% per year.
1st 2nd 3rd tth

0 1 2 3 t
r = 5.1%

$65 $65 $65 $65

Today
Coupon
 PV= C/r = 65/5.1% = 1,274.51 27
 (CONT'D)
 Perpetual coupon or consol
1st 2nd 3rd tth

0 1 2 3 t
r%

C C C C
Today

=
If t ->  PV= C/r 28

28
 (CONT'D)
 Perpetual coupon or consol
 Example: What would you be willing to pay right
now for a bond which: pays a coupon rate of 10%
per year forever and has a face value of $2,000.
Assume that the bond offer a return of 10% per
year.
0 1 2 3 t
10%
$200 $200 $200 $200

 PV = 200/10% = 2000 29
 RELATIONSHIP(CONT'D)
How bond prices vary with the remaining
life
 When interest rates are 5.1%, a 3 year bond with a
6.5% coupon rate is worth $1,038.05.
 Critical question: What would happen to the value
of this bond if a remaining life was to change?
 You would have to recalculate the PV of the cash
flows to determine its worth.
 Say the remaining life decreases from 3 years to 2
years and 6 months.
What is the value of this bond under each of these30

scenarios?
 RELATIONSHIP(CONT'D)
 How bond prices vary with the remaining
0life 1 2 3 4
10/10/2011 10/10/2012 10/10/2013 10/10/2014

65 65 65 65 +1,000

𝟔𝟓
( 𝟏+𝟓.𝟏% ) 𝟏
𝟔𝟓
( 𝟏+𝟓.𝟏% ) 𝟐
𝟏𝟎𝟔𝟓
( 𝟏+𝟓.𝟏% ) 𝟑
When interest rates are 5.1%, a 3 year bond
31

with a 6.5% coupon rate is worth $1,038.05.

 RELATIONSHIP(CONT'D)
 How bond prices vary with the remaining
life 0 1 2 3 4
10/10/2011 10/10/2012 10/10/2013 10/10/2014
65 65 65 65 +1,000
10/05/2012
𝟔𝟓
( 𝟏+𝟓.𝟏% ) 𝟏 Critical question: What would
happen to the value of this bond if
𝟔𝟓 the remaining life was to change?

( 𝟏+𝟓.𝟏% ) 𝟐 When interest rates are 5.1%,

the remaining life of 2 years and 6 months with a
6.5% coupon rate, What is the value of this bond ?
𝟏,𝟎𝟔𝟓
( 𝟏+𝟓.𝟏% ) 𝟑
 PV = 1012.73 32
 RELATIONSHIP(CONT'D)
 How bond prices vary with the remaining
life
 There is a positive relationship between bond
prices and the remaining life
 If remaining life goes up, bond prices go up
 If remaining life goes down, bond prices go down

33
 RELATIONSHIP(CONT'D)
 How bond prices vary with interest rates
 When interest rates are 5.1%, a 3 year bond
with a 6.5% coupon rate is worth $1,038.05.
 Critical question: What would happen to the
value of this bond if interest rates were to
change?
 You would have to recalculate the PV of the
cash flows to determine its worth.
 Say interest rates rise to 6.5% and then to
15%.
What is the value of this bond under each of these
34
 RELATIONSHIP(CONT'D)
 How bond prices vary with interest rates
If the discount rate is 6.5% then the PV is:
0 1 2 3 4
r = 6.5%
65 65 65 65 +1,000
𝟔𝟓
( 𝟏+𝟔.𝟓%) 𝟏
 PV = $1,000.00 𝟔𝟓
( 𝟏+𝟔.𝟓 %) 𝟐
𝟏,𝟎𝟔𝟓
( 𝟏+𝟔.𝟓%) 𝟑
35
 RELATIONSHIP(CONT'D)
 How bond prices vary with interest rates
If the discount rate is 15% then the PV is:
0 1 2 3 4
r = 15%
65 65 65 65 +1,000
𝟔𝟓
( 𝟏+𝟏𝟓% ) 𝟏

𝟔𝟓
( 𝟏+𝟏𝟓% ) 𝟐
 PV = $805.93 𝟏,𝟎𝟔𝟓
( 𝟏+𝟏𝟓% ) 𝟑 36
 RELATIONSHIP(CONT'D)
 How bond prices vary with interest rates
Can you see the relationship between the
coupon rate, the interest (discount) rate and the
price of a bond?
Coupon Rate Interest Rate Price of
Bond
6.5% 5.1%
$1,038.05
6.5% 6.5%
$1,000.00
Check the next slide for a graph!
6.5% 15.0% $37
 RELATIONSHIP(CONT'D)
How bond prices vary with interest rates
Price of 6.5% Coupon Bond vs Discount Rate

$1,100
Price of Bond

$1,000

$900

$800

10.0%

11.0%

12.0%

13.0%

14.0%

15.0%
5.0%

6.0%

7.0%

8.0%

9.0%

Discount Rate

38
 RELATIONSHIP(CONT'D)
How bond prices vary with interest rates
Example: US treasury bond has a face value
$1,000; 8% coupon rate and 15 years to maturity.
Please compute the bond price if:
 YTM = 10%/ year
 YTM= 8%/ year
 YTM = 5%/year

39
 RELATIONSHIP(CONT'D)
 How bond prices vary with interest rates
 There is an inverse relationship between bond
prices and the interest rate:
 If interest rates go up, bond prices go down
 If interest rates go down, bond prices go up
More Precisely:
 When the market interest rate exceeds the coupon
rate, bonds sell for less than face value. (sells at discount)
 When the market interest rate equals the coupon rate,
bonds sell for their face value. (sells at par value)
 When the market interest rate is below the coupon
rate, bonds sell for more than face value. (sells at 40

premium)
 YIELD RATE
Measuring the returns on bonds
 There are three methods used for measuring the
return an investor would receive on an investment in
bonds:
 Current yield.
 Yield to maturity - yield to call
 Rate of return.

 Suppose you could buy a 3 year bond, with a 10%

coupon rate.
If you pay $1,136.16 for this bond,
what is your return? 41
 YIELD RATE (CONT'D)
Current Yield
 Current yield is calculated by dividing the coupon
payment(s) by the bond’s price.
Coupon Payments
Current Yield =
Bond Price
 You are buying a bond with:
 Coupon Payments = $100 per year.
 Price of $1,136.16.

 Current Yield = $100 = 0.088 = 8.8%

$1,136.16 42
 YIELD RATE (CONT'D)
 Current Yield
 The current yield on this bond is 8.8%.
 But, the current yield only takes into account the
interest income earned on the bond.
 It does not include any capital gains or losses on
your investment.
 If you pay $1,136.16 for this bond, will you have a
capital gain, or a loss, when the bond matures?
 In three years, when the bond matures, you will
receive $1,000 for it.
43
 YIELD RATE (CONT'D)
 Current Yield
Thus, you will have a capital loss of $136.16 over
the life of the bond.
 So, your actual return on this bond must be less
than the 8.8% current yield.
 Conclusion:
 Current yield, because it ignores capital gains and
losses, mis-measures the rate of return on a bond.

44
 YIELD RATE (CONT'D)
 Yield to maturity
 We need a measure of return which takes account of
both
 Current yield (interest income);
 Changes in the bond’s value over its life (capital gains and
losses).
 This measure is called Yield to maturity.
 Yield to maturity is defined as “the discount rate
which makes the PV of the bond’s cash flows equal to
its price.”
45
 YIELD RATE (CONT'D)
 Yield to maturity
 For the 3-year bond in the previous example, we
know that it’s price is $1,136.16.
 To calculate the YTM, we must solve for the
discount rate “r” in the price equation:
$1,136.16 = 100
 We use interpolation method to solve for the
unknown r.

46
 YIELD RATE (CONT'D)
 YTM approximation formula

47
 YIELD RATE (CONT'D)
When Price = $1,136.16 the discount rate = 5% (YTM is
5%)
Price of 10% Coupon Bond vs Discount Rate

$1,250

$1,200
Price

$1,150
Paid Price=$1,136.16
$1,100

$1,050

$1,000
3.0% 4.0% 5.0% 6.0% 7.0%

Discount Rate
48
 YIELD RATE (CONT'D)
Yield to maturity
 Note that yield to maturity depends on
 The coupon payments;
 The current price of the bond;
 The final repayment.
 Thus, it is a measure of your return if you buy
the bond today and hold it until maturity.
 But what if you wanted to hold this bond for only
one year … now how would you calculate your
return?
49
 YIELD RATE (CONT'D)
Yield to call (YTC)
 For the 3-year bond in the previous example, we
know that it’s price is $1,136.16 and the issuer
announces repurchase their bond at the second
year.
 To calculate the YTC, we must solve for the
discount rate “r” in the price equation:
$1,136.16 = 100
We use interpolation method to solve for the
unknown r. 50
 YIELD RATE (CONT'D)
 Rate of Return
Let’s continue with our previous example:
 You buy a 3 year bond with a 10% coupon for
$1,136.16.
 One year later, you sell it for $1,130.
For this example we need to calculate the
bond’s rate of return:
Rate of return = coupon income + price change
investment
= $100 + ($1,130 - $1,136.16)
$1,136.16
= 0.083 = 8.3% 51
 YIELD RATE (CONT'D)
 Yield to maturity vs rate of return
 Note that the rate of return over a particular
holding period is not the same as the yield to
maturity.
 But, is there a relationship between yield to
maturity and rate of return?
 Yes: If the bond’s yield to maturity is
unchanged over the holding period, then the
yield to maturity will equal the rate of return.
52
 YIELD RATE (CONT'D)
 Yield to maturity vs rate of return
 Continuing with our previous example, suppose the
yield to maturity stays at 5% for one year, then at
the end of the holding period, its price would be:
PV = PV(coupons) + PV(face value)
= $100x[1/0.05–1/(0.05(1 + 0.05)2)]+1000x[1/(1+ 0.05)2]
= $185.94 + 907.03 = $1,092.97
Rate of return= coupon income + price change
investment
= 100 + (1,092.97 - 1,136.16) = 0.05 = 5%
53

1,136.16
 YIELD RATE (CONT'D)
 Suppose that you bought a 8 % coupon
rate bond, 3 years to maturity with YTM
10%; what is the price for that bond?
 Suppose you hold it for 1 year and sell it.
Pl compute the new price of the bond and
your rate of return if:
 YTM 10%
 YTM 12%
54
 RETURN
 How do you calculate the rate of return if the investment lasts for
longer than 1 year? For example:
 You buy a 3 year bond with a 6.5% coupon for $1,038.05.
 Two years later, you sell it for $1,015.25.
 You will receive two coupon payments on this bond: $65 at the end
of the first year and $65 at the end of the second year. Assume that
you reinvest the first coupon payment at 4% for one year.
 Your coupon income for this investment will be:
 Coupon Income = ($65 x 1.04) + $65 = $132.60
 Rate of return = coupon income + price change
investment
= $132.60 + ($1,015.25 - $1,038.05) = 0.1058=10.58%
$1,038.05
However, this is a two year rate of return. You must annualize it:
Annual Rate of return = (1.1058)1/2 – 1 = 0.052 = 5.2% 55
 INTEREST RATE RISK
 We have seen that:
 Bond prices fall when interest rates rise.
 Bond prices rise when interest rates fall.
 Interest rate risk: the risk in bond prices
due to fluctuations in interest rates
 Interest rate risk depends on 2 things:
time to maturity and coupon rate
56
 (CONT'D)
 All other things being equal, the longer
time to maturity, the greater the interest
rate risk
 All other things being equal, the lower the
coupon rate, the greater the interest rate
risk

57
 (CONT'D)
 You have also seen that the rate of return on your bond
investments will vary as interest rates change.
 This is why we say that bonds are subject to interest rate
risk.
 It is the risk in bond prices due to fluctuations in interest
rates.
 Bond investors worry that if interest rates go up, they will
have losses on their bonds.
 But bonds are not equally affected by changes in interest
rates:
 Some bonds have big price changes in response to int. rate
changes.
 Some bond prices react very little to a change in interest rates.
 Bonds with larger maturity are more affected by int. rate 58

changes than bonds with shorter maturity.

 (CONT'D)
Compare the two curves on the next slide.
The blue curve shows how the price of a 30 year bond varies
according to interest rates.
 Notice how steep the curve is.
 Notice that a change in rates results in a large change in price.
The red curve shows how the price of a 3 year bond varies
according to interest rates.
 Notice how flat the curve is.
 Notice that a change in rates results in a small change in price.
Which bond would you rather own, the 30 year or the 3 year,
if you expected interest rates to go up? Why?
Which bond would you rather own, the 30 year or the 3 year,
if you expected interest rates to go down? Why?
59
 (CONT'D)
 Price change in response to interest rate changes
(30 year bond vs 3 year bond):

60
 DEFAULT RISK
 Both corporations and the Government of Canada
borrow money by issuing bonds.
 There is an important difference between corporate
borrowers and government borrowers:
 Corporate borrowers can run out of cash and default
on their borrowings.
 The Government of Canada cannot default – it just
prints more money to cover its debts.
 Default risk (or credit risk) is the risk that a bond
issuer may default on its bonds.
 To compensate investors for this additional risk,
corporate borrowers must promise them a higher rate
of interest than the Canadian government would pay.
61
 DEFAULT RISK (CONT'D)
 Key issues in the pricing of debt securities
Why do debt securities with identical terms to
maturity, but which are issued by different firms
have different rates of return/yield?
 Answer Default Risk
Why do debt securities with same terms issued by
the same firm differing only in maturity have
different rates of return/yield?
Answer is given by the Term Structure of Interest
Rates
62
 (CONT'D)
 Bond ratings
Moody’s S&P Quality of Issue
Highest quality. Very small risk of default.
Aaa AAA
High quality. Small risk of default.
Aa AA
High-Medium quality. Strong attributes, but potentially
A A
vulnerable.
Baa BBB Medium quality. Currently adequate, but potentially unreliable.
Ba BB Some speculative element. Long-run prospects questionable.
B B Able to pay currently, but at risk of default in the future.
Poor quality. Clear danger of default .
Caa CCC
Highly speculative. May be in default.
Ca CC
Lowest rated. Poor prospects of repayment.
C C
In default.
D -

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 BONDS
 Zero coupon bond
 Investors receive the face value at the maturity date but do
not receive a regular coupon payment.
 Floating-rate Bonds:
The coupon rate can change overtime.
Convertible Bonds
 Convertible bonds may be exchanged at the option of the
holder for a specified amount of another security, usually
common shares.
 The convertible bondholder hopes that the price of the
shares will rise significantly so that s/he can convert at a
big profit.
 But if the shares don’t go up, there is no obligation to
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convert, so the investor keeps the bond and collects interest

 VARIATIONS IN CORPORATE BONDS
(CONT'D)
 Example: Us treasury bond has a
10%coupon rate and a $1,000 face value.
Interest is paid semi-annually and the bond
has 20 years to maturity. If investors require
12% yield, what is the bond value?

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Thank You!

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