L5 - Bond valuation

# L5 - Bond valuation - Financial Management Fall 2010...

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Financial Management Fall 2010 Lecture 5: Bond valuation (I) Professor Erica Li Ross School of Business

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Last class ! APR: by default, the interest rate given in a question is the quoted rate, i.e., the APR ! Let r= APR / # of compounding per year, then the effective rate of a given period = (1+r)^(# of compounding per period) - 1 ! Examples: APR = 12% compounding monthly, r=1%, " the effective quarterly rate = (1+1%)^3 - 1 " the effective semi-annual rate = (1+1%)^6 - 1 " the effective annual rate (EAR) = (1+1%)^12 - 1 " the effective rate of 2-yr period = (1+1%)^24 - 1
Roadmap for Today ! Terminology of bond ! Bond valuation ! Interest rate risk ! Book reading: Chapter 7, section 7.1

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What is bond? ! Bond is a debt security ! Buying a bond is “lending money” to the bond issuer ! Selling a bond is “borrowing money” from the buyer ! You can treat bond as a loan and the price of the bond is the size of the loan ! The issuers of bonds are corporations and governments
Bond terminology ! Coupon: promised interest payments ! Face (par) value: the principal amount that will be repaid at the end of the loan (not necessarily the selling price). The default face value is \$1,000 ! Maturity date: the date when the face value is paid ! Time to maturity (or term): the time remaining until the maturity date ! Yield to maturity (or yield, YTM): the quoted interest rate required in the market on a bond. It is the APR

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Cash flows from a typical bond ! Suppose you bought a bond issued by XYZ Co. at a price p today (t=0) and the bond matures in 2 years ! You will receive \$50 every half year in the next 2 years and you also receive \$1000 at maturity. t=0 1 2 3 4 Coupons \$50 \$50 \$50 \$50 Face value \$1,000
Bond valuation: general formula ! The price of a bond is the present value of all the cash flows that the owner of the bond will receive ! C: coupon payment ! t: # of coupon payments before maturity ! r: = YTM / # of coupons per year Bond value = C 1 " 1 /( 1 + r ) t [ ] r Present value of the coupons ! " # # \$ # # + F 1 + r ( ) t Present value of the face value ! " \$

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! If the market required interest rate on XYZ Co. bond is 8%,
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L5 - Bond valuation - Financial Management Fall 2010...

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