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Bond Valuation_1

# Bond Valuation_1 - EC150 FINANCIAL ECONOMICS Slide Set 4...

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EC150: FINANCIAL ECONOMICS Slide Set 4: Basic Approaches to Stock and Bond Valuation (Based on RWJ Chapter 5.)

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The Discounted Cash Flow Approach to Valuation Estimate The Size And Timing Of Future Cash Flows Determine The Required Rate Of Return or Discount Rate For Each Cash Flow. Based on current interest rates, and the riskiness of the cash flow; Different Discount Rates May Be Appropriate For Different Cash Flows Discount Each Cash Flow To Present Sum The Present Values Of The Cash Flows.
First, Bond Valuation. The terminology: Par or Face Value (F); The Bond promises to pay its face value at the Par or Face Value (F); The Bond promises to pay its face value at the Maturity Date. Maturity Date. Coupon Interest. The bond makes interest payments at a rate of C per Coupon Interest. The bond makes interest payments at a rate of C per year, with actual payments of C/2 every six months. C/F is defined as year, with actual payments of C/2 every six months. C/F is defined as the coupon interest rate. Note that the coupon rate is constant over the the coupon interest rate. Note that the coupon rate is constant over the life of the bond. life of the bond. Call Provision; Call Protection; Call Premium Call Provision; Call Protection; Call Premium Default Risk Default Risk Discount Rate, r. Discount Rate, r. This changes day to day. This changes day to day. Yield to maturity. The discount rate that equates the bond’s promised Yield to maturity. The discount rate that equates the bond’s promised payments to its observed price, PV. payments to its observed price, PV. Current yield: C/PV. Current yield: C/PV.

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First, Bond Valuation. The terminology (contd): Call Provision: buying back bonds at pre-determined price Call Provision: buying back bonds at pre-determined price (or Call price) over a specified period. (or Call price) over a specified period. Why? calls can be used to make profits during interest Why? calls can be used to make profits during interest rates fluctuations rates fluctuations Call premium = (Call price) minus (Face value) Call premium = (Call price) minus (Face value) (see page 530 of RWJ) (see page 530 of RWJ) Call Protection: used to descrfibe a bond that is protected Call Protection: used to descrfibe a bond that is protected from a call for from a call for x x number of years number of years
Valuing a semiannual coupon bond Valuation of a semiannual coupon bond with annual coupon payment C, maturity value of F, N years to maturity, and annual discount rate r. Two components. - The coupon payments comprise an annuity . - Lump sum payment of face value at maturity

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Value of a semiannual coupon bond 1 2 N-1 N C/2 C/2 C/2 C/2 C/2 C/2 C/2 C/2 F 0 ) 2 / r + (1 F ) 2 / r 1 )( 2 / r ( 1 2 / r 1 2 / C = P 2N N 2 0 + + - Two Pieces: Annuity of C/2 for 2N periods. Lump sum of F received at the end of 2N periods.
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Bond Valuation_1 - EC150 FINANCIAL ECONOMICS Slide Set 4...

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