chap07 - Chapter 7 Bonds and Their Valuation Chapter 7...

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Bonds and Their Valuation Chapter 7
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Chapter 7 Topic Overview 2 Bond Characteristics Annual and Semi-Annual Bond Valuation Reading Bond Quotes Finding Returns on Bonds Bond Risk and Other Important Bond Valuation Relationships
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Bond Characteristics 3 Par (or Face) Value ( M ) = stated face value that is the amount the issuer must repay, usually $1,000 Coupon Interest Rate Coupon ( INT ) = Coupon Rate x Face Value Maturity Date = when the face value is repaid. A legal contract called the bond indenture specifies these values. This makes a bond’s cash flows look like this:
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Bond Valuation Discount the bond’s cash flows at the investor’s required rate of return. the coupon payment (INT) stream (an annuity). the par (M) value payment (a lump sum). 4 0 0 1 1 2 . . . 2 . . . n n INT INT INT INT INT+M INT+M
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Bond Valuation Example #1 5 Duff’s Beer has $1,000 par value bonds outstanding that make annual coupon payments. These bonds have a 7.5% annual coupon rate and 15 years left to maturity. Bonds with similar risk have a required return of 9%, and Moe Szyslak thinks this required return is reasonable. What’s the most that Moe is willing to pay for a Duff’s Beer bond?
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0 1 2 3 . . . 15 1000 ? 75 75 75 . . . 75 r = 9%
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Let’s Play with Example #1 7 Homer Simpson is interested in buying a Duff Beer bond but demands an 7.5 percent required return. What is the most Homer would pay for this bond?
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0 1 2 3 . . . 15 1000 ? 75 75 75 . . . 75 r = 7.5%
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Let’s Play with Example #1 some more. 9 Barney (belch!) Gumble is interested in buying a Duff Beer bond and demands on a 6 percent required return. What is the most Barney (belch!) would pay for this bond?
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0 1 2 3 . . . 15 1000 ? 75 75 75 . . . 75 r = 6%
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Lesson from Example 1: Bond Prices and Interest Rates have an inverse relationship! Bond Values for 7.5% Annual Coupon Bond 0 200 400 600 800 1000 1200 1400 0% 2% 4% 6% 8% 10% Required Return ($)M arket Value 15-yr Bond 11
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Another Example 1 Lesson: Bond Premiums and Discounts 12 What happens to bond values if required return is not equal to the coupon rate? The bond's price will differ from its par value P 0  < par value r > Coupon Interest Rate DISCOUNT  = P 0   > par value r < Coupon Interest Rate PREMIUM    = P 0  = par value r = Coupon Interest Rate PAR  =
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13 Double the number of years, and divide required return and annual coupon by 2. V
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This note was uploaded on 02/27/2009 for the course FIN 221 taught by Professor Dyer during the Fall '08 term at University of Illinois at Urbana–Champaign.

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chap07 - Chapter 7 Bonds and Their Valuation Chapter 7...

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