Lecture 4 -Supplementary Notes (Ch.5 Bonds )-R

Lecture 4 -Supplementary Notes (Ch.5 Bonds )-R - Lecture 4...

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Lecture 4 : Supplementary Notes for Ch.5 – Bonds 1. Description of Bond Terms Bonds securities issued by corporations and governments when they want to raise money. usually a term loan for a fixed number of years i.e. long-term debt Par Value the payment a holder will receive at the maturity of the bond is almost always is $1,000 also referred to as face value , maturity value or principal amount. Maturity Date Date the loan will be paid off Usually 5 , 10, 20 years from issue date Coupons Fixed interest payments that issuer promises to make to bondholders almost always expressed as a percentage of par value (eg. coupon rate of 7% = 0.07 x $1000 = $70 per year) Most Canadian And U.S. bonds pay coupons semi-annually (twice per year) Stated rate is an APR => If semi-annual payment , then Each coupon payment = semi-annual PMT = (Coupon rate x Par Value ) / 2. E.g. Bond with 7% coupon paid semi-annual, then PMT = ( 0.07 x $1000)/2 = $35 every six months (i.e 2 times per year!) Discount Rate Also referred to as market interest rate (or “interest rate”) The current interest rate that the market is demanding of similar securities The rate at which cash flows from the bond are discounted to determine its current price (or present value) i.e. its yield to maturity Also referred to as opportunity cost of funds * Do not mix-up COUPON RATE and MARKET INTEREST RATE They are usually different. If they are the same, (i.e. coupon rate = market interest rate), then bond will sell at par value or $1000) 1
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2. How Do We Value a Bond? (Why do we care?) Important for personal finance or investment reasons as many bonds trade in the secondary market (some are even listed on exchanges); (example: Air Canada bonds) Important for financial managers as they need to know what bond terms the market will demand if their corporation needs to raise money via a bond issue. Valuation of Bonds Current Price = PV bond payments = PV (Coupons) + PV (Face Value) 3 Ways of Solving: 1. Discount each cash flow payment being made to bondholder: P bond = PV = PMT 1 + PMT 2 + PMT t + FV (1 + r) 1 (1 + r) 2 (1 + r) t (1 + r) t 2. Discount Coupons using Annuity formula (and then add PV of maturity value):
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Lecture 4 -Supplementary Notes (Ch.5 Bonds )-R - Lecture 4...

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