Fundamentals of Bond Valuation

Bonds are debt instruments used by business and government to raise large sums of money Most bonds share certain basic characteristics
1.bond promises to pay investors a fixed amount of interest, called bonds coupon. 2.bonds typically have a limited life 3.bonds coupon rate = bonds annual coupon pay.t /par value. 4. bonds coupon yield = coupon pay.t /bonds current market price

Fundamentals of Bond Valuation

Bond Valuation described in terms of dollar values Present value model which computes a specific value for the bond using a single discount value Yield model which computes the promised rate of return based on the bonds current price.

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The value of the bond equals the present value of its expected cash flows

Pp Ci 2 Pm t 2n (1 i 2) t 1 (1 i 2)
2n
where:
Pm = the current market price of the bond

n = the number of years to maturity

Ci = the annual coupon payment for Bond I i = the prevailing yield to maturity for this bond issue Pp = the par value of the bond

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Example By using an 8 percent coupon bond that matures in 20 years with a par value of $1,000. And If we assume a prevailing yield to maturity for this bond of 10 percent. the current market Value of the bond is as follows

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first term is the present value of an annuity of$40 every 6 months for 40 periods at 5 percent, while the second term is the present value of $1,000 to be received in 40 periods at 5 percent.

markets required rate of return of 10 percent is greater than the bonds coupon rate, that is $828.36 or 82.836 percent of par.

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The price yield curve for a 20 year, 8% coupon bond

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1. When the yield is below the coupon rate,

the bond will be priced at a premium to its par Value

2. When the yield is above the coupon rate,

the bond will be priced at a discount to its par value.

3. The price-yield relationship is not a straight line; rather, it is u-shaped.

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The Yield Model Instead of determining the value of a bond in dollar terms, price bonds in terms of yields

Pp Ci 2 P m t 2n 1 (1 i 2) t 1 ( i 2)
2n

i = the discount rate that will discount the cash flows to equal the current market price of the bond

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Yield Measure
Nominal Yield
Current yield Promised yield to maturity

Purpose
coupon rate current income rate expected rate of held to maturity

Promised yield to call expected rate of return to first call date

Realized yield

measure the actual rate of return on a bond during some past period of time.