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# Sess05 new - Lecture 5 Valuing Bonds Reading RWJ Chapter 7...

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Fin3715 – Fall 07 - Kayhan 1 Lecture 5: Valuing Bonds Reading: RWJ Chapter 7 Outline: Bond Terminology Bond Prices Bond Yields Bond Arbitrage

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Fin3715 – Fall 07 - Kayhan 2 Bond Terminology Bond Security that obligates the issuer to make specified payments to the bondholder (i.e., a loan or IOU). Typical issuers are companies and governments. Maturity Date The promised time to repay the bond. Maturity – # Years between now and the maturity date. A bond’s maturity declines over time. Face Value ( or Par Value , Principle ) The promised payment for the bond on the maturity date. Coupon The annual interest payments made to bondholders, usually stated as a percentage of the face value Coupon Rate: annual coupon payment/face value Coupon Yield : coupon payment/price of the bond Yield to Maturity The discount rate for the bond (more on this later).
Fin3715 – Fall 07 - Kayhan 3 Bond Terminology (II) 0 1 2 T-1 T r % C C C+F C Maturity Date Face Value Value Face Rate Coupon Coupon × = Yield to Maturity

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Fin3715 – Fall 07 - Kayhan 4 WARNING: Coupon vs. Discount Rate The coupon rate IS NOT the discount rate used in the Present Value calculations . The coupon rate merely tells us what cash flows the bond will produce. The discount rate (or required rate of return) is the opportunity cost of capital, i.e., the current rate earned on investments of equal risk, and is determined by market conditions. Since the coupon rate is listed as a %, this misconception is somewhat common.
Fin3715 – Fall 07 - Kayhan 5 Bond Pricing The value of a bond is the PV of all cash flows Coupon payments (an annuity) Principal repayment (a lump sum) t t t r F r r C PV PV PV PV r F C r C r C PV ) 1 ( ) 1 ( 1 1 ) sum - lump ( ) annuity year - t ( ) repayment principle ( ) coupons ( ) 1 ( ) ( .... ) 1 ( ) 1 ( 2 1 + + + - = + = + = + + + + + + + =

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Fin3715 – Fall 07 - Kayhan 6 Example: Bond Pricing (i) What is the price of an 8% annual coupon bond, with a \$1,000 face value and 4 years to maturity? Assume a YTM of 6.8%. (ii) Recalculate the price for YTMs of 6% and 8%.
Fin3715 – Fall 07 - Kayhan 7 Example: Bond Pricing (Sol’n-1) (i) (ii) r = 6%, then PV = \$1,069.30 r = 8%, then PV = \$1,000. 83 . 040 , 1 \$ ) 068 . 1 ( 1000 ) 068 . 1 ( 1 1 068 . 80 ) 1 ( ) 1 ( 1 1 % 8 . 6 years, 4 80 1000 8% C , 1000 4 4 = + + + - = + + + - = = = = × = = t t r F r r C PV r T F

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Fin3715 – Fall 07 - Kayhan 8 Bond Price Dynamics After a bond is issued, interest rates on similar bonds may change, but the cash flows from the bond remain the same. The value of the bond will vary as the PV of the
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## This note was uploaded on 05/06/2008 for the course FIN 3715 taught by Professor Stephens during the Spring '08 term at LSU.

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Sess05 new - Lecture 5 Valuing Bonds Reading RWJ Chapter 7...

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