Chapter 3: Valuing Bonds

Using the PV formula to value bonds

P = PV =

C F ! + n (1 + i ) n , t =1 (1 + i )

F is the face value, or the principal C (usually) = F x j (where j is the coupon rate) Yield to maturity (=i) Rate of return of a bond The interest ate that equates the PC to the value of the nancial instrument Yield to maturity is reported annually T-x T-Bonds==>20-30 years T-Notes==> <10 years T-Bills==> <1 year Traded by a network of Bond Dealers Accrued Interest: The interest that has been accrued since the last coupon payment AI = T x P x R (T is the fraction of the year, P the principal, R the annualised interest rate) Dirty Price = Clean Price (the quoted Price) + AI

Bond Dealers All measurements are in 32nds. E.g. 104:01 = 104 + (1/32), +5 = +5/32

Asked Price: The price you need to pay to buy from a dealer Bid Price: The price investors receive if they sell to a dealer Asked Yield to Maturity: The yield to maturity calculated with the asked price Chg: Change in price from the previous day

Bond Properties Premium/Discount/Par (i=yield, j=coupon rate) Premium: if i < j. You will have to pay more than face value Par: if i = j. You will pay the face value Discount: if i > j. You will have to pay less than face value Duration: Is the bonds average maturity

Modied Duration: measures the percentage change in bond price for a 1 percentage-point change in yield

Term Structure of Interest Rates The term structure of interest rates is the relationship between short- and long-term interest rates. This is used because a single discount rate is not accurate enough The series of spot rates r1, r2, , rt traces out the term structure of interest rates The t-year spot rate rt is the discount rate such that

Arbitrage Premises: r1 = 20%, r2 = 7% If Tintin buys a one-year Treasury STRIP, he will pay 833 (1000/(1.2)) Thus he is certain that he will have AT LEAST 1000$ at the end of year 2 He can either re-invest the 1000 paid-out FV or put it in a checking account He then goes to the bank to take out a two-year loan with single nal payment =1000 Since r2=7%, she will receive 873 (1000/1.07^2) She does both of the above on the same day, so on that day she will make a prot of 40$ Therefore, a dollar tomorrow cannot be worth less than a dollar after-tomorrow. There must be some extra gain from lending for two periods rather than one (1+r2)^2 > (1+r1) FORCEFULLY Expectation Theory

it + ite+1 2 ! States that in equilibrium investment in a series of short-maturity bonds must offer the same expected return as an investment in a single long-maturity bond. Therefore, the yield curve slopes upwards only if investors expect short term interests to rise Problems Risk: You are not sure of forecasts, therefore you opt for less risk at the cost of return Volatility of long-term bonds does create extra risk for investors who have longterm obligaitons Ination You do not know future short-term interest rates, but you do know that future interest rates will adapt to ination. (1 + it )(1 + ite+1 ) = (1 + i2t )(1 + i2t ) i2t
Real and Nominal Rates of Interests Measurements of Ination CPI: measures the number of dollars that it takes to pay for a typical familys purchases. The change in the CPI from one year to the next measures the rate of ination. Converting nominal cash ows to real cash ows:

Converting the nominal rate of return to the real rate of return:

 What determines the real rate of interest? The real rate of interest depends on peoples willingness to save (the supply of capital) and the opportunities for productive investment by governments and businesses (the demand for capital) Willingness to save can also be indirect (e.g. taxes or retained earnings) Ination and nominal interest rates Fishers Theory (i is the expected ination rate) A change in the expected ination rate causes the same proportionate change in the nominal interest rate; it has no effect on the required real interest rate Contentious, not all economist agree with Fisher that the real interest rate is unaffected by the ination rate. Corporate Bonds The yield to maturity of different corporations depends on: Probability of default Liquidity Classication of bonds by rating agencies Above the line are Investment grade Below the line are Junk Bonds, Speculative Grade or High-Yield

STRIPS: Separate Trading of Registered Interest and Principal Securities TIPS: Treasury Ination Protected Securities