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ORIE 3150 October 6 2009 notes

ORIE 3150 October 6 2009 notes - ORIE 3150 October 6 2009...

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ORIE 3150 October 6, 2009 Bonds Please submit any Prelim I regrade requests to the instructor in lecture by October 15. A. Bond Basics A bond has four parameters that are predetermined and stated at the time of issue: 1. Face value – the dollar amount the debtor must pay the creditor upon maturity. 2. Face interest rate – used to calculate the amount of cash interest that must be paid to the creditor semi-annually. Also known as the coupon rate or simply coupon. 3. Term – the stated time that elapses between issuance and maturity. 4. Payment dates – the dates on which interest is paid. A bond has two parameters that are not predetermined but are negotiated at the time of issue. However, these two parameters are NOT independent, but merely two different ways to describe the same thing. 1. Price – the dollar amount the creditor pays the debtor upon issuance. The price is almost always between 95% and 105% of the face value. The price is set by market forces at the time of issuance. 2. Yield – the interest rate earned by the bond, given the price, face value, term, and face interest rate. This interest rate is expressed in annual terms. B. The Bond Equation A bond consists of two payment streams: 1. The interest payments made every six months 2. The payment of the face value at maturity. As such, the price of the bond is equal to the sum of the present values of the annuity part (the interest payments) and the single payment part (the payment of the face value).
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The price can be found given the yield, and the yield can be found given the price, by using the following equation. ( 29 ( 29 n n i 1 FV i i 1 1 A PV + + + - = - where PV = price of the bond A = period interest payment (calculated as detailed below) i = periodic interest rate (calculated as detailed below) n = number of six-month periods between issuance and maturity FV = the face value of the bond Parameter Conversion 1. The term is given in years, as n
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ORIE 3150 October 6 2009 notes - ORIE 3150 October 6 2009...

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