Chapter 6 - Chapter 6 Valuing Bond The Application of the...

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1 Chapter 6 Valuing Bond The Application of the Present Value Concept
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2 Topics Covered Bond Characteristics Interest Rates and Bond Prices Current Yield and Yield to Maturity Bond Rates of Return The Yield Curve Corporate Bonds and the Risk of Default
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3 Bond Characteristics Bond - Security that obligates the issuer to make specified payments to the bondholder. Coupon - The interest payments made to the bondholder. Face Value - (Par Value, Principal or Maturity Value) - Payment at the maturity of the bond. Coupon Rate - Annual interest payment as a percentage of face value.
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4 Bond Characteristics A bond also has (legal) rights attached to it: If the borrower doesn’t make the required payments, bondholders can force bankruptcy proceedings In the event of bankruptcy, bond holders get paid before equity holders
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5 An Example of A Bond Example A coupon bond that pays coupon of 5% annually, with a face value of $1000, has a discount rate of 2.15% and matures in three years. The coupon payment is $50 annually In the third year, the bondholder is supposed to get $50 coupon payment plus the face value of $1000. The discount rate is different from the coupon rate.
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6 Bond Cash Flows
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7 Coupon Rate vs. Discount Rate WARNING WARNING The 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.
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8 Bond Pricing – Zero Coupon Bonds Zero coupon bonds are the simplest type of bond (also called stripped bonds, discount bonds) You buy a zero coupon bond today (cash outflow) and you get paid back the bond’s face value at some point in the future (called the bond’s maturity ) PV Face value Time=t Time= 0
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9 Bond Pricing – Zero Coupon Bonds Example How much is a 10-yr zero coupon bond worth today if the face value is $1,000 and the effective annual rate is 8% ? P0=1000/1.08 10 =$463.2 So for the zero-coupon bond, the price is just the present value of the face value paid at the maturity of the bond.
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10 Bond Pricing – Coupon Bonds The price of a coupon bond is the Present Value of all cash flows generated by the bond (i.e. coupons and face value) discounted at the required rate of return.
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