lect56 - 7-1By Donglin LiCHAPTER 7 & 6Bonds and...

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Unformatted text preview: 7-1By Donglin LiCHAPTER 7 & 6Bonds and Their ValuationKey features of bondsBond valuationMeasuring yield, yield curveAssessing default risk7-2By Donglin LiWhat is a bond?A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond.7-3By Donglin LiBond marketsPrimarily traded in the over-the-counter (OTC) market with dealers connected electronically.Most bonds are owned by and traded among large financial institutions.Full information on bond trades in the OTC market is not published, but a representative group of bonds is listed and traded on the bond division of the NYSE.Information on small company or municipal issues is difficult to get, treasury securities are an exception.7-4By Donglin LiKey Features of a BondPar value face amount of the bond, which is paid at maturity (assume $1,000).Coupon rate stated interest rate (generally fixed) paid by the issuer. Multiply by par to get dollar payment of interest.Maturity date years until the bond must be repaid.Current Yield - Annual coupon payments divided by bond price. 7-5By Donglin LiWARNINGWARNINGThe coupon rate IS NOT the discount rate used in the Present Value calculations. The coupon rate merely tells us what cash flow the bond will produce. Since the coupon rate is listed as a %, this misconception is quite common. 7-6By Donglin LiYTMYield to maturity (YTM) - rate of return earned on a bond held until maturity.It is the interest rate (discount rate) for which the present value of the bonds payments equal the bond price.typarcpnycpnycpnP)1()(....)1()1(21+++++++=7-7By Donglin LiWait a minute, isnt yield to maturity just the discount rate? If the discount rates (interest rates) remain same from year to year, YTM=discount rate (interest rate).Discount rates (interest rates) may be different in different periods. In that case, YTM is some average of the discount rates.7-8By Donglin LiThe value of financial assetsNN2211r)(1CF ... r)(1CF r)(1CF Value++++++=12Nr%CF1CFNCF2Value...7-9By Donglin LiBond price changes as Rates ChangeBond Value = PV of coupons + PV of par= PV annuity + PV of lump sumAs interest rate (discount rate, yields to maturity) increases, the PVs decrease, so bond prices decrease and vice versa.7-10By Donglin LiWhat is the value of a 10-year, 10% annual coupon bond, if rd = 10%?...
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lect56 - 7-1By Donglin LiCHAPTER 7 & 6Bonds and...

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