Lecture5 - LECTURE 5 VALUATION OF BONDS 1 Reading: Chapter...

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L ECTURE 5 V ALUATION OF B ONDS 1 Reading: Chapter 6, Sections 6.1-6.4 plus all the appendices After reading Chapter 6, read Chapter 5, pp. 151-152 on the yield curve. Homework: Online problems, as well as my supplemental problems on the web. Objectives: Explain what a bond is and be able understand its terms Value a bond using a single interest rate Understand the risks that bond investors face Define the Term Structure of Interest rates (or yield curve) and understand the meaning of its shape Value bonds using a Treasury STRIP table Compute the Yield to Maturity (YTM) Use the YTM to approximate prices of bonds with difficult to observe prices Compute the return realized from investing in a bond
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W HAT IS A BOND ? A bond is a long-term loan to a company or government that is made by investors (or bondholders). The borrower (company) receives funds today and in exchange agrees (or enters into a contractual promise) to make a series of coupon payments until the maturity date of the bonds. Example: The US government wants to build a bullet train from Downtown LA to Las Vegas that no one except Harry Reid is likely to ride. It wants you to help pay for it by selling you a bond. Do your part to finance government waste! Buy a bond with $1000 in par value, that pays a 1.1% coupon, semi-annually, and matures in 2 years. Par Value is the principal amount to be paid at maturity, usually $1000 per bond. Coupon is the percentage of par value that is paid every year. (Usually coupons are paid semi-annually, so divide by two to get each payment amount.) Maturity is the amount of time that will pass until the par value is paid.
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S O HOW DO WE V ALUE OUR T RAIN - TO - N OWHERE B OND ? Use the law of one price! What are the market interest rates on comparable loans? The economic value of a bond is the present value of its cash flows. Suppose market the interest rate right now is 1.2% (Semi-Annual APR). We would value our Train to Nowhere Bond as follows: 3 12 4 1234 (1 / 2) CF CF CF CF V rr r r =+++ ++ + + 5.5 5.5 5.5 1000 5.5 (1 0.012/ 2) (1 0.012/ 2) (1 0.012/ 2) (1 0.012/ 2) V + Three kinds of information are required to value a bond: 1) Cash flows 2) Timing of the cash flows 3) The market interest rate
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Valuing Bonds (continued) If there is only 1 interest rate, you can treat a bond like an annuity: 3 12 4 1234 (1 / 2) 5.5 5.5 5.5 5.5 (1 0.012/ 2) (1 0.012/ 2) (1 0.012/ 2) (1 0.012/ 2) CF CF CF CF V rr V =+++ ++ 4 1000 (1 0.012/ 2) + + 44 1 1 1000 5.5 0.012/ 2 (0.012/ 2)(1 0.012/ 2) (1 0.012/ 2) V ⎛⎞ =− + ⎜⎟ ⎝⎠ What are the inputs into the financial calculator?
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Lecture5 - LECTURE 5 VALUATION OF BONDS 1 Reading: Chapter...

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