FM8e- ch04 - 4-1 CHAPTER 4 Bonds and Their Valuation Key...

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4 - 1 CHAPTER 4 Bonds and Their Valuation Key features of bonds Bond valuation Measuring yield Assessing risk
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4 - 2 Key Features of a Bond 1. Par value: Face amount; paid at maturity. Assume $1,000. 2. Coupon interest rate: Stated interest rate. Multiply by par value to get dollars of interest. Generally fixed. (More…)
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4 - 3 3. Maturity: Years until bond must be repaid. Declines. 4. Issue date: Date when bond was issued. 5. Default risk: Risk that issuer will not make interest or principal payments.
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4 - 4 How does adding a call provision affect a bond? Issuer can refund if rates decline. That helps the issuer but hurts the investor. Therefore, borrowers are willing to pay more, and lenders require more, on callable bonds. Most bonds have a deferred call and a declining call premium.
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4 - 5 What’s a sinking fund? Provision to pay off a loan over its life rather than all at maturity. Similar to amortization on a term loan. Reduces risk to investor, shortens average maturity. But not good for investors if rates decline after issuance.
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4 - 6 1. Call x% at par per year for sinking fund purposes. 2. Buy bonds on open market. Company would call if r d is below the coupon rate and bond sells at a premium. Use open market purchase if r d is above coupon rate and bond sells at a discount. Sinking funds are generally handled in 2 ways
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4 - 7 Financial Asset Valuation ( 29 ( 29 ( 29 PV = CF 1+r ... + CF 1+r 1 n 1 2 2 1 CF r n . 0 1 2 n r CF 1 CF n CF 2 Value ... + + +
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4 - 8 The discount rate (r i ) is the opportunity cost of capital , i.e., the rate that could be earned on alternative investments of equal risk. r i = r * + IP + LP + MRP + DRP for debt securities.
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4 - 9 What’s the value of a 10-year, 10% coupon bond if r d = 10%? ( 29 ( 29 V r B d = $100 $1,000 1 1 10 10 . . . + $100 1 + r d 100 100 0 1 2 10 10% 100 + 1,000 V = ? ... = $90.91 + . . . + $38.55 + $385.54 = $1,000. + + + 1 r + ( 29 d
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4 - 10 10 10 100 1000 N I/YR PV PMT FV -1,000 The bond consists of a 10-year, 10% annuity of $100/year plus a $1,000 lump sum at t = 10: $ 614.46 385.54 $1,000.00 PV annuity PV maturity value Value of bond = = = INPUTS OUTPUT
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4 - 11 10 13 100 1000 N I/YR PV PMT FV -837.21 When k d rises, above the coupon rate, the bond’s value falls below par, so it sells at a discount. What would happen if expected inflation rose by 3%, causing r = 13% ? INPUTS OUTPUT
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4 - 12 What would happen if inflation fell, and r d declined to 7% ?
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