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Unformatted text preview: Chapter 6 1 CHAPTER 6 Bond Primer This chapter explores the basis of bond pricing and portfolio management. This chapter is organized into the following sections: 1. Yield Concepts 2. Bond Market Instruments 3. Principles of Bond Price Movements 4. Duration 5. Term Structure of Interest Rates 6. Bond Portfolio Immunization Chapter 6 2 Yield Concepts Pure Discount Bond (Zero Coupon Bond) A pure discount bond promises to pay a certain amount at a specified time in the future (par value). The instrument is sold for less than this promised future payment. There is no payment between the original issue of the bond and the maturity of the bond. The investors return is the difference between the amount that he/she paid for the bond and the promised future value (yield). The general bond pricing formula for all bonds can be stated as: ) r + (1 C = P t i t M 1 = t i where: P i = the price of the bond I C t = cash flow from the bond I at time m r i = the annualized yield to maturity on bond I t = the time in years until the bond matures Chapter 6 3 Yield Concepts Bond Discount The bond discount is the difference between the par value and the selling price. Yield to Maturity The yield is the promised payment that the bond holder will realize after buying and holding the bond until maturity. The appropriate current price of a bond is determined by calculating the present value of the par value. In order to calculate the present value of the par value, we must first know the appropriate interest rate. The interest rate is dependent upon general interest rate levels in the economy, and the riskiness of the bond. That is, the probability that the investor receives the par value as promised. Chapter 6 4 Pure Discount Bond Suppose you have a pure discount bond that agrees to pay $1,000 five years from today. The bond discount rate is 12%. What is the appropriate price for this bond? 43 . 567 $ 12 . 1 1000 $ 5 = ) ( = P 5 ?? $1,000 ) r + (1 C = P t i m i Chapter 6 5 Pure Discount Bond Bond Discount = Face Value Current Price Bond Discount = $1,000$567.43 Bond Discount = $432.57 5$567.43 $1,000 Price Par Value Chapter 6 6 Coupon Bonds Coupon bonds are longer term bonds making regularly scheduled payments between the original date of issue and the maturity date. Suppose you have a bond with a $1,000 face value that matures 1 year from today. The coupon rate is 12% and the bond makes semiannual coupon payments of $60. The bond yield is 13%. 1 ?? $1,000 $60 $60 Chapter 6 7 Coupon Bonds Par Value = $1,000 Yield = 13% annual (13/2 =6.5% semiannual) Coupon = 12% with semiannual payment of $60 Maturity = 1 year ) r + (1 C = P t i t M 1 = t i $990.90 = 934.56 + 56.34 = 065 1....
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 Spring '10
 DPG
 Management, Pricing

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