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MGNT3125_chapter7_notes - MGNT3125 Fall 2010 Dr Amine...

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MGNT3125 Fall 2010 Dr. Amine Khayati Chapter 7 Notes I- Bonds and bond valuation: Bonds are long-term debt securities issued by corporations and by federal, state, and local governments. A bond is normally an interest-only loan: the borrower will pay the interest every period and the principal will be repaid at the end of the loan. It is commonly called level-coupon bond . Bond Features: Example: ABC Corporation wants to borrow $1,000 for 30 years. The interest rate on similar debt issued by similar corporations is 12%. So, ABC corp. will pay 1,0000.12= $120 every year for 30 years and at the end of the 30 years, it will repay the $1,000. - Coupon: the stated interest payment made on a bond: $120 - Coupon rate: the annual coupon divided by the face value of a bond: 12% - Face value: also called the par value is the principal amount of a bond that is repaid at the end of the term: $1,000. - Maturity date: is the date on which the principal amount of a bond is paid and is also the day of the last coupon payment. - Time to maturity is the number of years until the face value is paid. Once the bond has been issued, the number of years to maturity declines as time goes by. Bond Values and Yields: - The cash flows from a bond stay the same during the life of the bond. However, as time passes, interest rates change in the markets which affect the present value of the bond. When interest rates increase, the present value of the bond decrease and when interest rates fall, the bond is worth more. - There is an inverse relationship between interest rates and bond prices. - The value of a bond is the present value of the future coupon payments plus the present value of the principal payment, discounted at the appropriate opportunity rate for bonds of similar characteristics (Yield to maturity). - To estimate the bond current market value we need to know the face value, the coupon, the number of periods remaining until maturity and the market interest rate for bonds with similar features (maturity and risk). This interest rate required in the market on a bond is called the bond’s Yield to maturity (YTM). YTM is also defined as the rate implied by the current bond price. - Notice that the yield to maturity, the required return, and market rate are used synonymously; the coupon rate is set by the issuer at the time of the issuance to simply determine the size of the dollar coupon payment. - Current yield of a bond is defined as the annual coupon divided by the market price. 1
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Example 1: consider a bond with a coupon rate of 10% and coupons paid annually. The par value is $1,000 and the bond has 20 years to maturity. The yield to maturity is 11%. What is the value of the bond? PV = ……………………………………………. Example 2: same as example 1 except that the yield to maturity is 9%. PV = ……………………………………………………………… Bond prices: Relationship between coupon rate and yield to maturity.
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