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Several Assumptions:
Chapter 11
Bond pricing
Time path of bond prices
Bond yields
Term structure of interest rates
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Bond Pricing - 2
Bond Pricing - 3
c
c
1
P= (1 + i) + (1 + i) 2
c
+ (1 + i) 3
c
+ (1 + i) n
M
+ (1 + i) n
where:
c = semi-annual coupon payment
i = semi-annual yield
n = number of semi-annual periods
M = maturity value (or face value)
1
(1 + i ) n
i
P=c[
1
1
(1 + i ) n
i
]+
M
(1 + i ) n
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$45
40
$1,000
6%
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Bond Pricing - 4
Bond Pricing - 5
The cash flows are unchanged, but the semi-annual yield is now
3.5%.
The cash flows are unchanged, but the semi-annual yield is now
4.5%.
45
1
1000
P=
[1
]+
= $1,213.55
40
(1 + 3.5%)
(1 + 3.5%) 40
3 .5 %
P=
PMT
N
FV
INT
$45
40
$1,000
3.5%
PMT
N
FV
INT
Compute PV:
PV = $1,213.55
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45
1
1000
[1
]+
= $1,000
40
4 .5 %
(1 + 4.5%)
(1 + 4.5%) 40
$45
40
$1,000
4.5%
Compute PV:
PV = $1,000
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Bond Pricing - 6
Bond Pricing - 7
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Price
$2,800.00
$2,446.89
$2,149.21
$1,897.48
$1,683.89
$1,502.06
$1,346.72
$1,213.55
$1,098.96
$1,000.00
$914.20
$839.54
$774.31
$717.09
$666.71
$622.17
$582.64
$2,500
$2,000
Bond price
Yield to maturity
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
16%
$1,500
$1,000
$500
$0
0%
2%
4%
6%
8%
10%
12%
14%
Yield to maturity
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16%
Bond Pricing - 8
Bond Pricing - 9
Zero-coupon bond:
For a straight bond, the coupon rate and term to maturity are fixed.
Consequently, as yield in the marketplace changes, the only variable
that can change to compensate for the new yield is the price of the
bond.
M
= (1 + i)n
Where
i = semi-annual yield
n = number of semi-annual periods = 2 x N.
M= maturity value
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Bond Pricing - 10
Zero-coupon bond:
The following table shows the relation between the bond price and
time to maturity for a 9% coupon bond with a face value of $1,000,
assuming the yield to maturity stays the same over the life of the
bond:
n = 2 x 10 = 20
Years remaining
to maturity
20
Discount Bond
$774.30
(YTM=12%)
Premium Bond
$1346.72
(YTM=6%)
15
10
$793.53
$827.95
$889.60
$1,000
$1294.01
$1223.16
$1127.95
$1,000
Assuming the required yield does not change, we have the following
conclusion:
M = $100,000
i = 0.049
P = $100,000/(1.049)14 = $51,185.06
n = 2 x 7 = 14
For a bond selling at par, the bond price will not change.
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Bond Yield - 1
Current Yield:
The following graph shows the relation between the bond price and
time to maturity of the bond mentioned above.
$1,400.00
$1,300.00
$1,200.00
Discount Bond
Premium Bond
P rice
$1,100.00
$1,000.00
$900.00
$800.00
$700.00
$600.00
22
20
18
16
14
12
10
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Bond Yield - 2
Bond Yield - 3
Yield to Maturity:
Yield to Maturity:
CF
t
P =
(
1
+
y
)t +
t =1
M
(1 + y ) n
Note:
1. n is number of semi-annual periods.
2. y is semi-annual rate of return.
3. Market convention is to use 2y as the yield to maturity.
4. The yield to maturity computed this way is called the
bond-equivalent yield.
1
2
Total
cash flows PV at 8%
PV at 7%
PV at 6%
8
108
7.48
94.33
101.81
7.55
96.12
103.67
7.41
92.59
100.00
PV at
6.625%
7.50
95
102.50
= IRR (range);
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Bond Yield - 4
Bond Yield - 5
Yield to Maturity:
Example 2: Compute the yield to maturity of an 18-year 6% coupon
bond selling at $700.89.
Two sources of cash flows:
1. 36 coupon payments of $30 every six months.
2. $1,000 36 six-month periods from now.
Using IRR function, the range is [-700.89, 30, 30, ..., 1030]
Therefore, the semi-annual yield is: y = IRR (range) = 4.75%,
YTM = 2y = 9.5%.
Using the financial calculator, we can find YTM with the following
input:
N
PMT
PV
FV
36
$30
-$700.89
$1,000
20
$40
-$1100
$1,000
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Bond Yield - 6
Bond Yield - 7
= 1,000
= 1,000/274.78
= (1,000/274.78)1/30
= 0.044
(Ans: 6%).
Bond-equivalent yield is the same as yield-to-maturity.
where
Future value
per dollar =
invested
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maturity value
Price
19
(Ans: 6.09%).
Effetive annual yield takes into account semi-annual compounding
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Bond Yield - 8
Bond Yield - 9
Yield to Call:
Yield to Call:
Mathematically,
c
P= (1 + y )1
c
+ (1 + y ) 2
c
+ (1 + y ) 3
c
+ (1 + y ) n*
M*
+ (1 + y ) n*
If the bond is called in 13 years, the two sources of cash flows are:
1. 26 coupon payments of $55 every six months.
2. $1,055 due in 13 years.
Using financial calculator, we input the following:
N
PMT
PV
FV
where:
M* = call price
n* = number of periods until first call date
26
$55
-$1,168.97
$1,055
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Bond Yield - 10
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