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Unformatted text preview: Interest Rates and Bond Valuation Lecture 8 Myung Joo Song ECON 393 Fall 2011 Myung Joo Song (ECON 393) Interest Rates and Bond Valuation Fall 2011 1 / 43 Chapter Outline Bonds and Bond Valuation More about Bond Features Term Structure of Interest Rate Inflation and Interest Rates Bond Ratings Some Different Types of Bonds Bond Markets Myung Joo Song (ECON 393) Interest Rates and Bond Valuation Fall 2011 2 / 43 Definitions: Bond Bond is a debt security, a class of financial asset. Bond issuer is a borrower and has to pay to the bond holder: Coupon payments: Periodic interests (periodic equal payments) The Principal or Par Value or Face Value Coupon rate: similar to interest rate which is the percentage of the principal (usually semiannually). Maturity date: The date that the bond finishes and paid off. Yield or Yield to maturity: The rate required in the market on a bond (Market Discount Rate). Myung Joo Song (ECON 393) Interest Rates and Bond Valuation Fall 2011 3 / 43 Bond Valuation and PV Model Bond is a financial asset which is bought and sold. Why buys bond? Why do you want to own bond? A reminder: Financial Asset generates future income. Bond is a typical example: Owner of bond owns the future cash flows. What are they? Asset Pricing: How much is this asset valued? Market Value? If bond market value = PV of future cash flows: Bond Value = PV of coupons + PV of par Bond Value = PV of annuity + PV of lump sum Myung Joo Song (ECON 393) Interest Rates and Bond Valuation Fall 2011 4 / 43 The Bond Pricing Equation If we know discount rate r then we have the formula. If this is market value, r is the key in pricing. We call it Yield to Maturity (YTM) or Yield. Myung Joo Song (ECON 393) Interest Rates and Bond Valuation Fall 2011 5 / 43 Valuing a Discount Bond with Annual Coupons Consider a bond with a coupon rate of 10% and annual coupons. The par value is $1,000, and the bond has 5 years to maturity. The yield to maturity is 11%. What is the value of the bond? Using the formula: B = PV of annuity + PV of lump sum B = 100[1 1 / (1 . 11) 5 ] /. 11 + 1 , 000 / (1 . 11) 5 B = 369.59 + 593.45 = $963.04 Price of the bond is lower than its face value, so called discount bond. Myung Joo Song (ECON 393) Interest Rates and Bond Valuation Fall 2011 6 / 43 Valuing a Premium Bond with Annual Coupons Suppose you are reviewing a bond that has a 10% annual coupon and a face value of $1000. There are 20 years to maturity, and the yield to maturity is 8%. What is the price of this bond? Using the formula: B = PV of annuity + PV of lump sum B = 100[1 1 / (1 . 08) 20 ] /. 08 + 1000 / (1 . 08) 20 B = 981.81 + 214.55 = $1196.36 Price of the bond is higher than its face value, so called premium bond....
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 Spring '10
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 Interest Rates, Myung Joo Song, Myung Joo

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