Comm298-Week5-Pricing_and_valuation_of_bonds-wit

Comm298-Week5-Pricing_and_valuation_of_bonds-wit - Com298:...

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Com298: Week 5 Pricing and Valuation of Bonds Learning Objectives: Focus on the following: Bond definitions and types of bonds. Key characteristics of bonds. Bond valuation and price of bond. Callable bonds and yield to call. Interest rate risk and bond ratings. Bonds: Definition and Types A bond is a long term contract under which a borrower agrees to pay the interest every period 1
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and repays the principal of the loan at the end of the period. Three main types of bonds: government, corporate and foreign bonds. Government bonds are issued by the Canadian Federal and provincial governments; and they have no default risk. Corporate bonds are exposed to default risks or credit risks. The larger the credit risk, the higher the interest rate the issuer must pay. Foreign bonds are exposed to both credit risks and exchange rate risks if they are denominated in a foreign currency. Key Characteristics of Bonds Face value is the principal amount repaid at the end of the term or the maturity date. Maturity date is the specified date at which the principal amount of a bond is to be repaid. 2
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Coupon payment is the stated fixed interest payments made on a bond. Coupon rate is the annual coupon payment divided by the face value of the bond. Yield to maturity is the market interest rate that equates the present values of the bond’s interest payments and principal repayments with its price. Bond Valuation The value of a bond is the present value of the cash flows of the bond. The cash flows from a specific bond depend on its contractual features. For a coupon bearing bond: the cash flows consist of interest payments during the life of the bond, plus the principal when the bond matures. For a zero coupon bond: there are no interest 3
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payments, only the principal amount when the bond matures. For a floating rate bond: the interest payments vary over time. The bond valuation equation: P Bond = PV(coupon payments) + PV(principal). P Bond = PV of annuity + PV of face value. Solving for the Price of a Bond Example: Suppose Nextel issued a 15-year bond with an annual coupon rate of 10% and a face value of $1000. The market interest rate is 8%. Determine the price of this bond. Note: The coupon payment = 10% of $1000 = $100 The yield to maturity = 8% Formula approach: 4
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B = PV of annuity + PV of face value B = 100[1 – 1/(1.8) 15 ] /0.08 + 1000/(1.08) 15 B = 855.95 + 315.24 = 1171.19 Calculator approach: N = 15 I/Y = 8.0 PMT = 100 FV = 1000 CPT PV = -1171.19 Bond Prices: Relationship between YTM and Coupon Rate If YTM = coupon rate, then bond price = par value If YTM > coupon rate, then bond price < par value If YTM < coupon rate, then bond price > par value 5
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Student Exercise When YTM = coupon rate: Coupon rate = 5.6% and face value = $1000 and the bond has 10 years to maturity. YTM = 5.6%. What is the price of the bond?
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This note was uploaded on 01/27/2011 for the course COMM 298 taught by Professor L during the Spring '10 term at Capilano.

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Comm298-Week5-Pricing_and_valuation_of_bonds-wit - Com298:...

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