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Bond definition

Infinance, a bond is an instrument of

indebtedness of the bond issuer to the


holders
It is a debtsecurity , under which the
issuer owes the holders a debt and,
depending on the terms of the bond, is
obliged to pay theminterest (thecoupon)
and/or to repay the principal at a later
date, termed thematurity.

Bond Valuation
Bond valuationis the determination of thefair

priceof abond.
As with any security or capital investment, the
theoretical fair value of a bond is thepresent
value of the stream of cash flows it is expected to
generate

Bond Valuation
Bonds are valued using time value of

money concepts.
Their coupon, or interest, payments are

treated like an equal cash flow stream


(annuity).
Their face value is treated like a lump sum.
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Factors that Affect Bond Prices


Par or Face Value

The amount of money that is paid to the bondholders at


maturity. For most bonds this amount is Rs.1,000. It also
generally represents the amount of money borrowed by
the bond issuer.

Coupon Rate

The coupon rate, which is generally fixed, determines the


periodic coupon or interest payments. It is expressed as a
percentage of the bond's face value. It also represents the
interest cost of the bond to the issuer.
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Factors that Affect Bond Prices


Coupon Payments

The coupon payments represent the periodic interest


payments from the bond issuer to the bondholder. The
annual coupon payment is calculated by multiplying the
coupon rate by the bond's face value. Since most bonds
pay interest semiannually, generally one half of the annual
coupon is paid to the bondholders every six months.

Maturity Date

The maturity date represents the date on which the bond


matures, i.e., the date on which the face value is repaid.
The last coupon payment is also paid on the maturity date.

Factors that Affect Bond Prices


Original Maturity

The time from when the bond was issued until its maturity
date.

Remaining Maturity

The time currently remaining until the maturity date.

Call Date

For bonds which are callable, i.e., bonds which can be


redeemed by the issuer prior to maturity, the call date
represents the earliest date at which the bond can be called.
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Factors that Affect Bond Prices


Call Price

The amount of money the issuer has to pay to call a


callable bond (there is a premium for calling the bond
early). When a bond first becomes callable, i.e., on the
call date, the call price is often set to equal the face
value plus one year's interest.

Required Return

The rate of return that investors currently require on a


bond.

Factors that Affect Bond Prices


Yield to Maturity

The rate of return that an investor would earn if he bought


the bond at its current market price and held it until
maturity. Alternatively, it represents the discount rate which
equates the discounted value of a bond's future cash flows
to its current market price.

Yield to Call

The rate of return that an investor would earn if he bought a


callable bond at its current market price and held it until the
call date given that the bond was called on the call date.

The bond's price will differ from its par value

r > Coupon Interest Rate

r < Coupon Interest Rate

P0 < par value

P0 > par value

= DISCOUNT
= PREMIUM

Different Types of
A perpetual
bond is a bond that
Bonds

never matures. It has an infinite


life.
I

V=

(1 + kd)

t=1

(1 + kd)t

V = I / kd

(1 + kd)

or

[Reduced Form]

+ ... +

(1 + kd)

I (PVIFA kd, )

Perpetual Bond
Bond PExample
has a Rs.1,000 face value and provides an
8% annual coupon. The appropriate discount rate
is 10%. What is the value of the perpetual bond?
bond

= 1,000 ( 8%)

kd

= 10%.
10%

= I / kd

= Rs.80.
Rs.80

[Reduced Form]

= 80 / 10% = Rs.800.
Rs.800

Coupon Bond
Example
Bond
C has a Rs.1,000
face value and
Rs.

provides an 8% annual coupon for 30 years.


The appropriate discount rate is 10%. What
is the value of the coupon bond?
V

= 80 (PVIFA10%, 30) + 1,000 (PVIF10%, 30)


(9.427) + 1,000 (.057)
= 754.16 + 57.00
= Rs.811.16.
Rs.811.16

= 80

zero coupon bond


A zero coupon bond is a bond that
pays no interest but sells at a deep
discount from its face value; it
provides compensation to investors
in the form of price appreciation.
V=

MV

(1 + kd)n

= MV (PVIFk , n
d

Zero-Coupon
Bond
BondExample
Z has a Rs.1,000
face value and
Rs.
a 30 year life. The appropriate
discount rate is 10%. What is the
value of the zero-coupon bond?
V

= 1,000 (PVIF10%, 30)


= 1,000 (0.057)
= Rs.57.00

Bonds coupon rate:

Annual coupon
Coupon rate
Par value
Bonds current yield:

Annual coupon
Current yield
Bond price
Straight bond prices:

C
1
Bond price
1
YTM
YTM

FV

2M

YTM

2M

Straight bond prices:


Bond price

C
1
1
YTM
YTM

FV

2M

YTM

2M

C
= annual coupon
FV
= face value
M
= maturity (years)
YTM = Yield to maturity
Assume a bond has 15 years to maturity, a 9% coupon,
and the YTM is 8%. What is the price?

90
1
Bond price
1

.08
.08

1000

30

.08

30

Rs.1,086.4 6

C
1
FV

Bond price
1
2M
2M
YTM
YTM
YTM
1

2
2

Now assume a bond has 25 years to maturity, a 9% coupon,


and the YTM is 8%. What is the price? Is the bond selling at
premium or discount?

90
1
1000

Bond price
1
Rs.1,107.4 1
50
50

.08
1 .08
1 .08

2
2

Now assume the same bond has a YTM of 10%. (9% coupon &
25 years to maturity) What is the price? Is the bond selling at
premium or discount?

90
1
1000

Bond price
1
Rs.908.72
50
50

.10
1 .10
1 .10

2
2

10-17

Now assume the same bond has 5 years to maturity (9% coupon
& YTM of 8%) What is the price? Is the bond selling at
premium or discount?

90
1
1000
Bond price
1
Rs.1,040.5 5
10
10

.08
.08
1

1 .08
2
2

Now assume the same bond has a YTM of 10%. (9% coupon &
5 years to maturity) What is the price? Is the bond selling at
premium or discount?

90
1
1000
Bond price
1
Rs.961.39
10
10

.10
1 .10
1 .10

2
2

Where does this leave us? We found:


Coupon Years
9%
9%
9%
9%

YTM
25
25
5
5

Price
8%
10%
8%
10%

$1,107
$ 908
$1,040
$ 961

25 years
5 years

10-19

Figure 10.1: Premium, par, and discount bond prices


140

Bond prices (% of par)

130
120
110
100
90
80
70
30

25

20

15

10

Time to maturity (years)

10-20

Calculating Yields
The formula:

C
1
FV

Bond price
1

2M
2M

YTM
YTM
YTM

1

1

2
2

Use the same formula, but solve for YTM


How?
Trial and error . . .
Financial calculator

Prices versus yields

C
1
FV

Bond price
1

2M
2M

YTM
YTM
YTM
1
1

2
2

Assume a bond has 15 years to maturity,


a 9% coupon, and the bond is selling for is Rs.1,080.
What is the YTM?
Rs.1,080

90
1
1000

1
30
30

YTM
YTM
YTM
1
1

2
2

YTM = 4.0354% x 2 = 8.07%

C
1
CP

Callable bond price


1

2T
2T

YTC
YTC
YTC
1
1

2
2

Assume the previous bond has 5 years until it can be


called with a Rs.90 call premium. (9% coupon & selling
for Rs.1,080.) What is the YTM?

90
1
1090

Rs.1,080
1

10
10

YTC
YTC
YTC
1
1

2
2

YTC = 4.243% x 2 = 8.49%

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