Chapter 7- Bond Valuation

Chapter 7- Bond Valuation - Arizona State University...

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Arizona State University FINANCE 300 Fundamentals of Finance Chapter 7: Bonds and Their Valuation Instructor: Christian Ramirez Date: 04/07/2008 Introduction The goal of this chapter is to introduce you to bonds. Some of the time value of money techniques we learned in the past two lectures will be applied to bond valuation. We begin our lecture with a discussion of the different types of bonds and their characteristics. Then we move on to how bond values are valued using our discounted cash flow procedure, how yields are determined, the effects of changing interest rates on bond prices, and the riskiness inherent in different types of bonds. Bonds Corporations and governments issue bonds to raise capital to finance their day to day operations and/or expansion plans. When you buy a bond, you are loaning your money for a certain period of time to the issuer, be it Coca Cola or the U.S. Government. In return, the borrower or issuer promises to pay you interest every year and to return your principal at "maturity," when the loan comes due, or at "call" if the bond is of the type that can be called earlier than its maturity (more on this later). The length of time to maturity is called the "term." Hence, a bond is a long-term debt contract where a borrower or issuer agrees to make payments of interest and a final principal payment at the end of the life of the bond to the holders of these bonds. Another way to look at bonds is as an interest-only loan, where the borrower will pay the interest every period, but none of the principal will be repaid until the end of the loan. For example, suppose that Wal- Mart issues $1,000 bonds with a maturity or duration of 30 yrs. Say, Wal-Mart offers to pay an interest of 10% per year. In this case, Wal-Mart will pay $1,000 x 10% = $100 in interest to the bond holder every year. At the end of 30 years, Wal-Mart will repay the $1,000 principal amount. Based on the example above, we may think that bonds can be seen as a fairly simple financing instrument, where the borrowers pay interest every year and then repay the principal at the end of the term. However, other variables come into play which affect the value that these bonds have on the secondary market. Types of Bonds When it comes to investment in bonds, the bond investment options are mainly classified into four categories: U.S. Treasury Bonds, Corporate Bonds, Municipal Bonds (aka Munis), and Foreign Bonds. Each different bond option offers a different risk which ultimately determines its expected rate of return.
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2 Treasury Bonds —These bonds are issued by the Federal Government. Since Uncle Sam prints money on a daily basis, the probability of him not paying interest on the bonds is zero and this is why we say that these bonds are default or risk free. However, there is a risk of a decrease in the bond price is interest rates increase. We will discuss this bond price-interest rate relationship later on.
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Chapter 7- Bond Valuation - Arizona State University...

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