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Money Markets and Finance Lecture 4 The Time Value of Money: Valuing Debt Instruments 1. Lecture Overview Last week we discussed the characteristics of shares and learnt how to calculate their value. We saw that the value of a share is simply equal to the present value of all its cash flows. Today, we will see that we can apply the same approach to calculating the value of debt instruments. 1. Lecture Overview In discussing how to calculate the value of a debt instrument, we will consider the following questions: What are debt instruments and what different types of debt instruments are there?; What characteristics do debt instruments exhibit?; What cash flows are associated with debt instruments?; and, How do we go about calculating the price of a debt instrument? 2. What are Debt Instruments? Debt instruments allow firms and governments to borrow money from investors and, therefore, they are issued in order to raise funds for operations. Further, debt instruments have contractually agreed upon terms for: Interest payments; and, The repayment of the debt. 2.1 Types of Debt Instruments In this lecture, we will focus two types of debt instruments, namely: Coupon-paying bonds ; and, Zero-coupon bonds ( types of discount securities ): Note that instruments such as bills are examples of short-term zero- coupon bonds. We will now discuss the characteristics of each type of instrument as well as work through examples of how to price them. In doing this, remember that the price of any of these instruments is simply equal to the present value of all cash flows associated with the instrument. 2.1 Types of Debt Instruments Coupon-Paying Bonds: A coupon-paying bond is a contract under which the borrower agrees to: • Pay the lender periodic interest ( c ) for a pre- defined number ( n ) periods. More specifically: • The periodic interest payment is known as a coupon payment (C ), which is equal to the coupon rate multiplied by the face value (or cF ) ; and, • Coupons are almost always paid on a semi-annual basis. •R e p a y ±t h e ± principal (or face value , F) of the instrument at a pre-defined maturity date.
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2.1 Types of Debt Instruments Cash Flows Associated with Coupon-Paying Bonds: The cash flows associated with a bond that pays semi-annual coupons of $C for n periods can be represented as follows: C+F C C C Cash Flow ($) n 1.5 1.0 0.5 Time (Years) 2.1 Types of Debt Instruments Zero-Coupon Bonds: A zero coupon bond does not pay coupons during its life.
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This note was uploaded on 10/13/2011 for the course FINM 1001 taught by Professor Miss during the Three '10 term at Australian National University.

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