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Unformatted text preview: Introduction Bond Valuation Stock valuation Ch6. How to value bonds and stocks JHT Kim ActSc 371 October 2, 2009 1/42 Introduction Bond Valuation Stock valuation Backgrounds First principle in valuation If we ignore all the frictions (e.g., taxes, transaction costs, other market unbalance), Principle Value of financial securities = PV of expected future CFs This applies to both bonds and stocks It remains to decide the followings 1 Size (how much) of the CFs 2 Timing (when) of the CFs 3 Discount rate for these CFs; The rate should be appropriate to the risk presented by the security. 2/42 Introduction Bond Valuation Stock valuation Backgrounds Bond: definition A bond is a legally binding agreement between a borrower (bond issuer) and a lender (bondholder) Bond certificate shows that a borrower owes a specified amount of money To repay the money, the issuer agrees to pay interest (coupon) and principal payments on designated future dates The last payment date is called the maturity. At maturity the issuer pays the last coupon and the principal (face amount). Usually issued by corporations or governments to raise money 3/42 Introduction Bond Valuation Stock valuation Level coupon bond valuation Zeros and consols Properties Level coupon bonds The coupon payments are typically made periodically e.g., semiannually or annually Coupon amount does not have to be fixed over time in theory. e.g., it can be increasing, decreasing, variable, or no coupons at all However, level coupon (fixed amount) is the standard form in many bonds In this case the bond is just a combination of an annuity and a face value. The bond price is the PV of these CFs: P = C a n  r + F v t where C is the coupon amount and F face amount. 4/42 Introduction Bond Valuation Stock valuation Level coupon bond valuation Zeros and consols Properties Valuation of level coupon bonds This equation involves 5 variables: P , C , n , r , and F . If any 4 variables are given, we should know the 5th one Often you are asked to compute r when the other four variables are specified (why r ?) The resulting r is typically converted to APR. In the bond world this APR is called the YTM (yield to maturity) YTM is the rate implied by the current bond price 5/42 Introduction Bond Valuation Stock valuation Level coupon bond valuation Zeros and consols Properties YTM convention Since all bonds in North America have semiannual coupons (except for zeros), the YTM is understood as an APR compounded semiannually in North America Computing the YTM often requires trial and error if you do not have a financial calculator. Example Consider a bond with a 10% coupon rate and semiannual coupons has a face value of $1,000, 20 years to maturity, and is selling for $1,197.93....
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