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Valuation of Known Cash Flows: Bonds


Consider:
A note that promises $105 by next year (No risk). How much would
you be willing to pay to get that note?
Depends on how much you require the interest rate to be.
If the ongoing market interest rate is 5%, how much would you
be willing to pay to get that note?
Would you pay $110? Would you pay $105? Would you pay
$100? Would you pay $80?
If the ongoing market rate is 10%, how much would you be
willing to pay to get that note?
Would you pay $110? Would you pay $105? Would you pay
$100? Would you pay $80?
If the ongoing market rate is 1%, how much would you be willing
to pay to get that note?
Would you pay $110? Would you pay $105? Would you pay
$100? Would you pay $80?
How does the value of the note changes with the interest rate?

In this chapter we will examine the valuation of fixed income securities


promising a stream of known future cash payments - such as bonds.
Bonds
Type of debt or long-term promissory note issued by a
borrower, promising to pay the holder a fixed amount of
interest per year.

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Types of Bonds
Debentures
Any unsecured long-term debt
Viewed as more risky than secured bonds and provide a
higher yield than secured bonds
Subordinated Debenture
Hierarchy of payout in case of bankruptcy

The claims of subordinated debentures are honored only


after the claims of secured debt and unsubordinated
debentures have been satisfied

Mortgage Bond
A bond secured by a lien on real property

Typically the value of the real property is greater than that


of the bonds issued

Euro Bonds
Securities (bonds) issued in a country different from the
one in whose currency the bond is denominated
Zero Coupon Bonds
Do not make regular interest payments
Issued at a significant discount
Return comes from appreciation of the bond.
Series EE government savings bondspurchase for $500,
payback is $1,000
Junk Bonds
High risk debt with low ratings by Moodys and Standard &
Poors
High yieldtypically pay Three to Five percent more than
AAA grade long-term bonds

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Current Yield
Current yield:
the ratio of the interest payment to the bonds current
market price.

Calculated by dividing the annual interest


payment by the market price of the bond

A $1,000 bond with 10% coupon rate and market


price of $700
Current yield = $100 / $700 = 14.286 %
Bond Ratings
Three agencies rate bonds:
Moodys
Standard & Poors
Fitch Investor Services
The lower the rating, the higher the return demanded in the
market
Bond ratings are favorably affected by:
Greater reliance on equity as opposed to debt financing
Profitable operations
Low variability in past earnings
Large firms size
Little use of subordinated debt
AAA is the highest rating assigned by Standard & Poors
AAA indicates a strong capacity to pay principal and interest

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Definitions of Value
Book value:
value of an asset as shown on a firms balance sheet
Liquidation value:
the dollar amount that could be realized if an asset were
sold individually and not as part of a going concern.
Market value:
the observed value for the asset in the marketplace
Intrinsic or economic value:
also called fair valuethe present value of the assets
expected future cash flows
Efficient Market
The values of all securities at any instant fully reflect all
available public information, which results in the market value
and the intrinsic value being the same
Determinants of Value
The value of an asset is its intrinsic value or the present value of
its expected future cash flows, when these cash flows are
discounted back to the present using the investors required
rate of return
Determinants of Value are:
Amount and timing of expected cash flows
Riskiness of the cash flows
Investors required rate of return for the investment

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Valuation: the Basic Process

V=
V =

OR,

C1
(1+k )1

C2
(1+k )2

+ ........

Cn
(1+k )n

t =1

Ct
(1+ k )t

Bond Valuation
The value of a bond is a combination of:
The present value of the interest payments
Plus
The present value of the par or face value

Vb =

t =1

$ It
(1+k )

$M
(1+ k )n

Bond Valuation
1.

The value of a bond is inversely related to changes in the


investors present required rate of return (the current interest
rate). As interest rates increase, the value of the bond decreases.

2.

The market value of a bond will be less than the par value if the
investors required rate of return is above the coupon interest
rate; the value will be above par value if the investors required
rate of return is below the coupon interest rate.

3.

Long-term bonds have greater interest rate risk than do shortterm bonds.

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Par Value
When the investors required rate of return is equal to the coupon
interest rate, the bond has a market value of par or face value
Discount
The market value of a bond will be below the par or face when the
investors required rate is greater than the coupon interest rate. The
bond will sell at a Discount or below face value.
Premium
The market value of a bond will be above the par or face value when
the investors required rate is lower than the coupon interest rate. The
bond will sell at a Premium or above face value.
EX1:

Calculate the market value of price of a 5-year $1,000 bond with an


8% coupon rate and the investors required rate of return is 8%.
Solution:
N
i
5
8

EX2:

PMT
80

FV
1000

Result: 1000

Calculate the market value of price of a 5-year $1,000 bond with an


8% coupon rate and the investors required rate of return is 6%.
Solution
N
5

EX3:

PV
?

i
6

PV
?

PMT
80

FV
1000

Result: 1084.24

Calculate the market value of price of a 5-year $1,000 bond with an


8% coupon rate and the investors required rate of return is 10%.
Solution:
N
i
5
10

PV
?

PMT
80

FV
1000

Result: 924.18

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Par, premium, and Discount Bonds


A coupon bond with its current price equal to its par value is a par
bond
If it is trading below par it is a discount bond
If it is trading above par it is a premium bond

Reading Bond Listings


There are traditions for reporting yields and computing earned interest
that need to be understood before trading
Coupon bonds are often quoted in terms of the annual rate
compounded semi-annually
T-bills are often quoted on a discount basis
e.g., a 1 year T-bill has 364 days outstanding, but a year has only
360 days(it gets nasty)

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Reading Bond Listings

Take care that the fractional part of a number is understood


Is it 16ths, 32nds, 64ths, 100ths or some other convention?
Ask price: dealers selling price
Bid price: dealers buying price

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The Behavior of Bond Prices Over Time

The expected price of pure discount bonds rises exponentially


to the face value with time, and the actual price never
exceeds par
Coupon bonds are more complex, and their price may exceed
their par value, but at maturity they reach their par value

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Factors that Affect the Bond Price


The Feds monetary policy
When the Fed increases money supply growth, it
increases the supply of funds, and therefore places the
downward pressure on the risk free rate. A simple rule of
demand and supply of funds.. And Bond price increases
Impact of inflation
Inflation tends to discourage savers from saving, because
savers prefer to purchase products now before prices
increase further, reducing the supply of fund, and
therefore places the upward pressure on the risk free rate.
Again a simple rule of demand and supply of funds..
Bond price declines
Impact of economic growth
Economic growth encourages firms to expand, increasing
the demand for funds and therefore places the upward
pressure on the risk free rate. Again a simple rule of
demand and supply of funds.. Bond price declines