MGT+3062+-+Bond+Pricing

MGT+3062+-+Bond+Pricing - FinancialManagement...

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1 Financial Management Barry Marchman, Ph.D. Georgia Institute of Technology Atlanta, GA 30332 Ph: 404-894-5110 Email:  [email protected] 
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2 Bond Pricing
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3 Objectives Describe the links between bond price, coupon rate, time to maturity, and   yield to maturity Calculate the price of a bond given the coupon rate, time to maturity, and  the yield to maturity Calculate the yield to maturity given the price of a bond, the time to  maturity, and the coupon rate
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4 Bond Terminology Bond  - Security that obligates the issuer to make specified payments to the  bondholder over a specified time period i.e., a loan or IOU Typical issuers are companies and governments. Face Value  (Also called Par Value or Maturity Value or Principal) - Payment at the  maturity of the bond.  The face value is almost always $1000 Coupon  - The interest payments made to the bondholder. Sometimes we talk about the Coupon Rate  Annual interest payment, as a percentage of face value.   Maturity  – Years until the face value must be repaid.  A bond’s maturity declines  over time.
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5 The fundamental principle of valuation Value of  any  asset is the PV of expected future cash flows Value of a bond = PV Expected value of future coupons Value of a stock = PV Expected value of Future Dividends To value stocks and bonds we need: Size of future cash flows Timing of future cash flows A discount rate
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6 Bond Valuation Two sources of cash flows for bonds: Coupon payments (an annuity) Principal repayment (a lump sum) The value of a bond is the sum of the PVs of these two parts. For bonds the required return (or discount rate) is also called the yield  to maturity (YTM) 0 1 2 T-1 T Cpn Cpn Cpn+Principal Cpn
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7 Bond Pricing Formula We can derive an explicit formula for the price of a bond: r is the yield-to-maturity CPN is the coupon payment T is the time to maturity This gives us the following formula: ( 29 T 2 r) (1 Principal CPN ... 1 r) (1 CPN Price + + + + + + + = r CPN Principal of PV Payments Coupon of PV bond a of Price + = T T r r ) 1 ( Principal ) 1 ( 1 1 r CPN + + + - =
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8 Bond Pricing: example What is the price of an 8% annual coupon bond, with a $1,000 face  value and 4 years to maturity? Assume a required return of 6.8%
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