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Unformatted text preview: Chapter 3: Valuing Bonds ECO389, Spring 2010 1 Bond Characteristics 1. Bond : A debt security that obligates the borrower or issuer to make specified payments (periodic interest payments and return of principal) to the lender or investor or bondholder. Bond is a certificate showing that the borrower owes a specified sum. The borrower agrees to make interest and principal payments on designated dates. 2. Coupon: The promised periodic interest payments made to the bondholder. 3. Face Value (Par Value or Maturity Value): Payment at the maturity of the bond. 4. Coupon Rate : Annual interest payment as a percentage of face value, it is a contract rate. For a fixed coupon rate bond, the coupon rate stays the same throughout the life of the bond. The coupon rate is the market rate, or discount rate, at the time the bond is issued. Thereafter, the market rate may vary; the coupon rate, which determines the periodic interest payment, stays the same. Attention: The coupon rate IS NOT the discount rate used in the Present Value calculations. The coupon rate merely tells us what cash ow the bond will produce. 1 Since the coupon rate is listed as a%, this misconception is quite common. Bond prices are quoted in the financial press as a percentage of their face value. Government bonds are quoted in 32nds after the decimal; corporate bonds are quoted in eights. All are eventually switching to decimal quotes. 5. Example (how do bonds work?): We first introduce U.S. Treasury bonds with- out risks. As long as there is competition, corporation bonds have risks. Several years ago, the U.S. Treasury raised money by selling 5.5 percent coupon, 2008 maturity, Treasury bonds. Each bond has a face value of $1,000. Because the coupon rate is 5.5 percent, the government makes coupon payments of 5.5 per- cent of $1,000, or $55 each year. When the bond matures in Feb 2008, the government must pay $1,000 face value of the bond in addition to the final coupon payment $55. Suppose in 2005 you decided to buy the 5.5s of 2008, that is, the 5.5 percent coupon bonds maturing in 2008. The initial cash ow is negative and equal to the price you have to pay for the bond. Thereafter, the cash ows equal the annual coupon payment, until the maturity date in 2008, when you receive the $1,000 face value of the bond plus the final coupon payment. In the United States, these coupon payments typically would come in two semiannual installments of $27.50 each. To keep things simple for now, we will assume one coupon payment per year. The Treasury announced in late 2001 that it would no longer issue bonds with maturities beyond 10 years. In 2005, to help the U.S. government finance its huge deficit and debt at longer terms, the government brought back 30-year Treasury bonds....
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- Spring '08