bonds - Finance 254 Bonds Characteristics Pricing Returns...

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Finance 254 Bonds: Characteristics, Pricing, Returns, Risks, and Relationships Bond Characteristics Indenture: The contract between the issuer and the bondholder, which defines the obligations of the issuer. Type of Issuer: Federal government (includes government agencies), municipalities, and corporations all issue bonds. Term to Maturity: The number of years until the maturity date of the bond. The maturity date is the date when the debt will cease to exist, at which time the issuer redeems the bond by paying the principal to the bondholder, fulfilling the final requirement of the indenture. Principal: The amount that the issuer agrees to repay the bondholder at maturity. Bonds usually have $1,000 principals. This is also referred to as the Par Value or Face Value. Coupon Rate: The interest rate that the issuer agrees to pay the bondholder each year. Coupon: The coupon rate multiplied by the “par” value of the bond equals a bond’s coupon. If a bond pays semiannual coupons, the semiannual coupon payments are equal to one half of the coupon rate multiplied by the par value. Current Yield: The current yield on a bond is defined as the coupon (annual dollars paid) divided by the price at which the bond is currently trading. Note the current yield and the coupon rate have the same numerator but have different denominators. It is very important that you know the difference! Yield to Maturity: Like the “yield” on any investment, the yield to maturity of a bond is the interest rate that will make the present value of the cash flows from the investment equal to the price (or cost) of the investment. Bond Pricing How do we price any asset? We discount the future cash flows to their present value using the appropriate discount rate. Bonds are no different. The nice thing about bonds though, or at least the bonds we will consider in this class, is that the indenture clearly defines the timing and magnitude of the future cash flows. Since we know the timing and size of each cash flow, we can write the following bond pricing equation for a bond paying annual coupons for N years: () () = + + + = N t N t y ParValue y CPN P 1 1 1 (1) Note in the above equation that CPN, representing the annual dollars of coupon the bond pays, is calculated as Coupon Rate * Par Value . The yield to maturity is abbreviated y. If a bond pays semiannual coupons instead of annual coupons, we change (1) to the following: = + + + = N t N t y ParValue y CPN P 2 1 2
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Thus, the above formula prices a bond when we know the yield on that bond. For example, consider a 2- year bond issued by Ford motor company with a 5% coupon rate, making semiannual coupon payments, $1,000 par value, and a yield to maturity of 4.5%. We can price this bond using formula (2) from the previous page: () () () () () () () 4 4 3 2 4 1 4 0225 . 1 000 , 1 0225 . 1 25 0225 . 1 25 0225 . 1
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bonds - Finance 254 Bonds Characteristics Pricing Returns...

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