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18BUSI408 - Bond Valuation

18BUSI408 - Bond Valuation - BUSI 408 Corporate Finance...

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Chip Snively [email protected] Interest Rates & Bond Valuation BUSI 408 Corporate Finance Fall 2011
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Warren Buffett “Value is defined simply: it is the sum total of the discounted cash that can be taken off of a project or business over its remaining life.” We can apply this thinking to bonds: Our focus today: intro to interest rates & bond math
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3 Bonds and Loans A bond is a legal claim on a specified set of cash flows. Bond buyers are lending money to issuers; Issuers are borrowing from buyers. Bonds and loans are identical! Bonds/loans are capital investments; Lenders receive returns on investment through interest and principal payments. Bond valuation is all about the tradeoff of cash today for cash in the future
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4 Zero-Coupon Bonds / T-Bills Pure discount bonds, also known as zero-coupon bonds, are promises of a lump sum of cash at a single future point in time. Examples: $1 million, 20-year zero T-Bills; sold at a discount to face value
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Valuing Zero-Coupon Bonds / T-Bills What is the price of a 20-year, $1 million US government zero if the market rate of interest is 4%? If the quoted price of a 1-year T-bill is 97.56, what is one-year risk-free market rate of interest?
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6 Coupon Bonds The buyer of a coupon bond trades money today (the bond’s market price ) for money in the future (promised periodic coupon interest plus the par value of the bond at the bond’s maturity) The market price may be different from the bond’s par value The discount rate that equates the PV of the bond’s future cash flows with its market price is called the bond’s yield-to-maturity (YTM, or simply yield )
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Coupon Bonds
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8 Example Consider a $1,000 par bond that promises 10% coupon interest, paid annually, and has exactly five years remaining to maturity (a coupon was just paid minutes ago) If the yield-to-maturity on similar-risk bonds is 10%, what would we predict this bond’s price to be?
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