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Review Questions
Can you add rates of return (or interest rates)?
Bond Valuation
x a = b x = b1 / a
ax = b x =
log b
log a
2
Bond Valuation
Valuation Fundamentals
Present Value of Future Cash Flows
Expected
Return on Assets
Valuation
1/18/2011
Bond Valuation
CF 1
CF 2
CF n
+
+ . . .+
1
2
(1 + r )
(1 + r )
(1 + r ) n
Bond Valuation
Bond Valuation
Valuation questions
the price is right?
what is return and borrowing cost?
how to compare returns across instruments?
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Bond Valuation
Learning objectives:
pricing simple bonds and introduction to risk
inherent in different bonds
FT and bond reporting
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Bond Valuation
Bond Types
Bonds: standardized fixed income security
generally tradable, long term (10+ or 15+ years)
standardized: same conditions for all owners of security
Bond Valuation
Loan Types
Bank loan: terms are not standardized
negotiable, flexible: what does this mean for price?
Bond Valuation
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Coupon:
Principal:
Par (Face) Value:
Coupon Rate:
Maturity:
Price/Proceeds:
Current Yield:
Yield-to-Maturity:
All-in Cost:
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Bond Valuation
Interest Payment
Amount Borrowed
Amount Repaid at End of Loan
Coupon / Face Value
Years Until Repayment
Amount Raised
Coupon / Current Price
Lifetime return of the bond
Lifetime cost of the bond
Robert B.H. Hauswald
11
Bond Example
Consider a U.S. government bond listed as 6 3/8 of
December 2009.
The Par Value of the bond is $1,000.
Coupon payments are made semi-annually (June 30 and
December 31 for this particular bond).
Since the coupon rate is 6 3/8 the payment is $31.875.
On January 1, 2002 the size and timing of cash flows are:
$31.875
$31.875
$31.875
$1,031.875
6 / 30 / 09
12 / 31 / 09
L
1 / 1 / 02
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6 / 30 / 02
12 / 31 / 02
Bond Valuation
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Bond Valuation
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$0
$0
$0
$F
T 1
L
0
PV =
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Bond Valuation
F
(1 + r )T
14
$0
$0
$1,000
L
L
0
PV =
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30
29
F
$1,000
=
= $174.11
(1 + r )T (1.06) 30
Bond Valuation
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Bond Pricing
Information needed to value level-coupon bonds:
Coupon payment dates and time to maturity (T)
Coupon payment (C) per period and Face value (F)
Discount rate: YTM = r
$C
$C
$C
$C + $ F
T 1
L
0
PV =
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C
1
F
1
+
r (1 + r )T (1 + r )T
Bond Valuation
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$31.875
$31.875
$31.875
$1,031.875
6 / 30 / 09
12 / 31 / 09
L
1 / 1 / 02
PV =
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6 / 30 / 02
12 / 31 / 02
$1,000
$31.875
1
1
+
= $1,089.75
16
.05 2 (1.025) (1.025)16
Bond Valuation
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T
Ct
1,000
y : P0 t =1
+
=0
t
T
(
)
(
)
1
+
y
1
+
y
20
Bond Valuation Robert B.H. Hauswald
Bond Valuation
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Bond Valuation
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Bond Valuation
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$1400
1300
1200
1100
1000
800
0
0.01
0.02
0.03
0.04
0.05
0.06
0.07
6 3/8
0.08
0.09
0.1
Discount Rate
Bond Valuation
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Bond Valuation
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Bond Valuation
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DISCOUNT
PREMIUM
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Bond Valuation
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3.
4.
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Bond Valuation
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Semi-Annual Coupons
Semi-annual coupons: Halve the p.a. coupon amount and
the quoted p.a. YTM, and double number of years
Example: A $1,000 bond with an 8% coupon rate maturing
in 10 years will have what price if the market quoted YTM
is 10%?
Present value of face value
= $1,000/(1.05)20 = $376.89
Annuity present value of coupons
= $40 x (1-l/(1.05)20)/.05
= $40 x 12.4622 = $498.49
Adding the discounted face value and coupons together:
= 376.89 + $498.49 = $875.38
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Bond Valuation
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Bond Risks
A Quick Pass at Duration Analysis
Interest rate risk: changes in bond prices arising from
fluctuating interest rates (varying YTMs).
Ceteris paribus, the longer the time to maturity, the
greater the interest rate risk. Ceteris paribus, the lower
the coupon rate, the greater the interest rate risk.
Bond Valuation
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Bond Value
Par
Short Maturity Bond
C
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Bond Valuation
Discount Rate
Long Maturity
Bond
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Bond Value
Bond Valuation
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Summary
Bond valuation: focus on the Cash Flows
Split valuation problem into 2 parts
the PV of the coupon payments
the PV of the final payment: redemption
Bond Valuation
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