Chapter 7 - BA 3341 Business Finance Nataliya...

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1 BA 3341 Business Finance Nataliya Polkovnichenko, Senior Lecturer
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2 • Bond Definitions • Valuation of Bonds • Yield to Maturity (YTM) • Rate of Return • Interest Rate Risk • Default Risk
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3 • A Bond is an agreement ( or financial asset ) in which an issuer is required to repay to the investor the amount borrowed plus interest over a specified period of time. Principal borrowed by government(corporation) from investor Principal returned to investor Principal Regular interest payments
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4 In the beginning of 1994 U.S. government borrowed $100 million at 9% yearly rate by issuing 100,000 bonds for $1,000 each. Each bond promised to pay its holder $90 (9% of $1,000) at the end of year for 10 years and repay $1,000 at the end of 2003. $90 $90 $90 Years 1994 1995 2002 2003 You pay price of the bond coupons principal+ last coupon $1,000+ $90= $1,090
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5 Issuer The organization responsible for ensuring that interest and principal payments are made to bondholder. Principal The amount of money denominated in a specific currency that the issuer wishes to borrow and agrees to repay the investor. ( Face Value , Par value , Maturity value ) Coupon (rate) The rate of interest the issuer agrees to pay the investor. Usually stated as a percentage of the FaceV . Maturity date The date on which the issuer of a bond must repay the principal due and the final interest rate payment.
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6 Pricing a bond is a simple two step process: 1. Define the cash flows. 2. Calculate the aggregate present value of the cash flows using appropriate discount rate (r). Note: Generally discount rate IS NOT EQUAL to coupon rate!!! c c c Years 1 2 t-1 t You pay price of the bond coupons principal+ last coupon FaceValue+ c
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7 • It is an interest rate on similar bonds on financial markets. • What does similar mean? • Similar features!!! (ALL) • Similar risk!!!
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8 Yield to Maturity (YTM) - The single discount rate (internal rate of return) used to calculate the market price of the bond. – Reflects the required market interest rate for the bond. – Assumes the bond is held to maturity . – Different than the coupon rate.
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9 In other words: If you plan to hold the bond until maturity n years from today : The yield to maturity is the discount rate at which the bond’s price is the present value of the bond’s payments (coupons and face value). YTM is the required return on the bond assuming it will be held until maturity.
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10 c c c Years 1 2 t-1 t You pay price of the bond coupons principal+ last coupon FaceValue+ c
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Five year 9% coupon bond offers these cashflows. Discount rate (YTM) is 9% .
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This note was uploaded on 11/24/2009 for the course BA 3341 taught by Professor Polkovnichenko during the Fall '08 term at University of Texas at Dallas, Richardson.

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Chapter 7 - BA 3341 Business Finance Nataliya...

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