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Unformatted text preview: 1 Chapter 4 Bond Valuation 2 Topics in Chapter Key features of bonds Bond valuation Measuring yield Assessing risk 3 Key Features of a Bond Par value: Face amount; paid at maturity. Assume $1,000. Coupon interest rate: Stated interest rate. Multiply by par value to get dollars of interest. Generally fixed. (More…) 4 Maturity: Years until bond must be repaid. Declines. Issue date: Date when bond was issued. Default risk: Risk that issuer will not make interest or principal payments. 5 Call Provision 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. 6 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. 7 Sinking funds are generally handled in 2 ways Call x% at par per year for sinking fund purposes. Call if r d is below the coupon rate and bond sells at a premium. Buy bonds on open market. Use open market purchase if r d is above coupon rate and bond sells at a discount. 8   PV = CF . . . + CF 1 N 2 (1 + r) 2 CF . 1 2 N r CF 1 CF N CF 2 Value ... + + Financial Asset Valuation (1 + r) 1 (1 + r) N 9 Value of a 10year, 10% coupon bond if r d = 10% V B = $100 $1,000 . . . + $100 100 100 1 2 10 10% 100 + 1,000 V = ? ... = $90.91 + . . . + $38.55 + $385.54 = $1,000. + + (1 + r d ) 1 (1 + r d ) N (1 + r d ) N 10 10 10 100 1000 N I/YR PV PMT FV1,000 $ 614.46 385.54 $1,000.00 PV annuity PV maturity value Value of bond = = = INPUTS OUTPUT The bond consists of a 10year, 10% annuity of $100/year plus a $1,000 lump sum at t = 10: 11 When r d rises, above the coupon rate, the bond’s value falls below par, so it sells at a discount. 10 13 100 1000 N I/YR PV PMT FV837.21 INPUTS OUTPUT What would happen if expected inflation rose by 3%, causing r = 13%? 12 What would happen if inflation fell, and r d declined to 7%? If coupon rate > r d , price rises above par, and bond sells at a premium. 10 7 100 1000 N I/YR PV PMT FV1,210.71 INPUTS OUTPUT 13 Suppose the bond was issued 20 years ago and now has 10 years to maturity. What would happen to its value over time if the required rate of return remained at 10%, or at 13%, or at 7%? 14 M 1,372 1,211...
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This note was uploaded on 10/23/2009 for the course MGMT 340 taught by Professor Clarkson during the Spring '09 term at Indiana Institute of Technology.
 Spring '09
 clarkson

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