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Lecture07_student - Anintroductiontobonds Decisiontrees...

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    An introduction to bonds Decision trees Today: More on risky decision making
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Bad returns for US  government bonds continue Mid-September annual returns 3-month bonds at 0.01% $1,000,000 invested for 3 months at 0.01% will  get about $25 in interest 1-year bonds between 0.08 and 0.11% 5-year bonds between 0.81 and 0.95% 20-year bonds between 2.82 and 2.97%
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Why so low? Remember that there are few safe  investments with any reasonable return People want to earn some interest on their  money Most bank interest rates are very low Even with a $25,000 balance, you may only get  0.25-0.30% effective annual interest rate (also  referred to as APY)
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How do bonds work? Consider a bond to be a loan from a  firm to a bondholder The firm can offer two types of  paybacks Pay interest each year Pay all of the interest when the life of the  bond is over
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Coupons The amount of the yearly interest  payment is called the bond’s coupon Example: A yearly interest payment of  $500 Bonds with zero coupons will pay all of  the interest at the end of the bond’s life
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Two simple examples A bond with a coupon Yearly interest paid out A zero coupon bond No yearly interest paid
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A bond with a coupon In theory, a bond can have a life of any  length In reality, bonds rarely last for more than  30 years In our example here, we will assume a  bond sells for $5,000 (face amount) with  a yield of 12%, for 20 years Yearly coupon interest of $600
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A bond with a coupon What are the cash flows? The bondholder lends $5,000 in year 0 to  the firm The bondholder receives $600 in yearly  interest in years 1-20 The bondholder receives an additional  $5,000 in year 20, since the bond’s life is  over
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A bond with a coupon There are two ways to think about this A bond as a loan Present value analysis
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A bond as a loan Notice that the cash flows of a loan  could be treated with the following  explanation You deposit $5,000 in a bank You receive $600 in yearly interest that you  do NOT reinvest After 20 years, you withdraw your $5,000
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Present value analysis You could also value the future payments  using present value analysis If you give up $5,000 today, you want $5,000 back  (PV) in the future Annuity present value $600   (1 – 1/1.12 20 )/.12 = $600   7.4694 = $4482 Value of $5,000 paid back 20 years from now $5,000 / 1.12 20  = $518 $5,000 total in PV
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With a zero coupon bond, the interest 
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Lecture07_student - Anintroductiontobonds Decisiontrees...

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