L03s Mkts FinStmt IntRates

Lecture 4: Bonds and Their Valuation
Learning Objectives
Calculating the bond prices and discuss what the relationship
is between interest rates and bond prices
Understand how a bonds price changes over time as it
approaches maturity.
Calculate a bonds yield to maturity
Understand the component of total return on bonds
Explain the different types of risks that bond investors and
issuers face
1
AB1201:
Financial Management
Lecture 4: Bonds and Their Valuation
By: Chanika Charoenwong

Bonds and their valuation > What is a bond? > Zero coupon bond > Coupon bond > Key features of a bond > LL1 > Bond
valuation > Par, discount and premium bond > LL2 > Calculating yield to maturity > Total return identity > Changes in bond
value over time > Semi-annual coupon bonds > LL3 > Risks of a bond > Interest rate risk > Reinvestment rate risk > Default
risk > LL4 > Conclusion
Bonds and Their Valuation
What is a Bond?
Key Features of Bonds
Bond Valuation
Measuring Yield
Assessing Risk
3
What is a Bond?
A long-term debt instrument in
which a borrower agrees to
make payments of principal
and interest, on specific dates, to the
holders of the bond.
Most basic
Zero coupon bond
Coupon bond
4
Zero Coupon Bond (Bond A)
Company MNO will pay the bearer of this

bond certificate:
S$1,000
on January 31, 2019
5
Question
If you paid $900 for Bond A,
$900
31/1/2015: You Co. MNO
Bond A
Bond A
31/1/2019: You Co. MNO
$1000
How much return would you earn? (Annual

compounding)
6
What Return would You Earn?
Time Line:
0 1 2 3 4
I% = ?
-$900 $1000
7
1000 9001 I
4 In bond
terminology:
Yield = Return
= Interest rate
Solves the equation for I.
I = 2.67% << Yield to Maturity
INPUTS 4 -900 0 1000

N I/YR PV PMT FV
OUTPUT 2.67
8
Coupon Bond (Bond B)
Company MNO will pay the bearer of this

bond certificate:
S$1,000, on January 31, 2019
And the following coupons:
$60 $60 $60 $60

31/1/16 31/1/17 31/1/18 31/1/19
9
What is the return for Bond B if you

paid $900 for it?
Time Line:
0 1 2 3 4
I%= ?
-$900 $60 $60 $60 $1060
10

60 60 60 1000
900
1 I 1 I 2 1 I 4 1 I 4
Solves the equation for I using FC
60 1 1000
900 1 4

I 1 I 1 I 4
INPUTS 4 -900 60 1000

N I/YR PV PMT FV
OUTPUT 9.09
11
Key Features of a Bond

Par value face amount of
the bond, which is paid at
maturity (assume $1,000).
Maturity date date
the bond must be repaid.
Yield to maturity (YTM) nominal rate of return

earned on a bond held until maturity
(also called the promised yield).
(e.g. 2.67%, or 9.09%)
12
Key Features of a Bond

Coupon amount paid by the
issuer regularly.
Coupon interest rate stated
interest rate (generally fixed)
paid by the issuer. Multiply by
par value to get dollar
payment of interest.
Coupon = Coupon interest rate * Par Value
E.g. $60 = 6% * $1000
13
What is fixed on a bond certificate and

what is not?
Fixed on a bond certificate and cannot be
changed:
Par value
Coupon interest rate
Maturity date
Payment frequency
Not fixed
Price of bond
Yield to maturity
14
Lessons Learnt 1
Bond is a long-term debt instrument in which a borrower
agrees to make payments of principal and interest, on specific
dates, to the holders of the bond.
If you purchase a zero coupon bond and hold it until maturity,
you will receive only par value at the maturity date.
If you purchase a coupon bond and hold it until maturity, you
will receive a regular fixed dollar of coupon payment from t=1
until maturity (N) and the par value at maturity date.
Coupon payment = coupon rate par value
Some features of bonds such as par value, coupon interest
rate, maturity date and payment frequency are fixed on the
bond certificate while price and yield to maturity of bond are
not.
15
Bond Valuation
16
The Value of Financial Assets

0 r% 1 2 N
...
Value CF1 CF2 CFN
CF1 CF2 CFN
Value 1
2
...
(1 r) (1 r) (1 r)N
Given future CFs you will receive from the asset, if

you pay a high price for the asset at P0, you will get
low return of r% from this investment. But if you want
high return (high r), you are willing to pay low price
for the asset today.
17
The Value of a Bond
0 r% 1 2 N
...
Value CF1 CF2 CFN
CF1 CF2 CFN
Value 1
2
...
(1 r) (1 r) (1 r)N
For bonds, CF would be the coupon payments

and payment of par value at maturity
For bonds, what is r?
18
What is the opportunity cost of debt

capital?
The discount rate (r) is the opportunity cost of debt
capital, and is the rate that could be earned on
alternative investments of equal risk.
The discount rate is also known as the required rate of return
Also, it can be referred as yield to maturity
For annual bonds, the discount rate is given by
Implications: Two annual bonds with the same maturity and same risks
must have the same r!
19
What is the value of a 10-year, 13% annual coupon

bond, if rd = 10%? Assume par = $1,000.
0 1 2 N
rd=10% ...
VB = ? 130 130 130 + 1,000
$130 $130 $1,000

VB 1
... 10

(1.10) (1.10) (1.10)10
VB $1184.34
20
Using a Financial Calculator to Value

a Bond
This bond has a $1,000 lump sum (the par value)
due at maturity (t = 10), and annual $130 coupon
payments beginning at t = 1 and continuing through
t = 10, the price of the bond can be found by
solving for the PV of these cash flows.
INPUTS 10 10 130 1000
N I/YR PV PMT FV
OUTPUT -1184.34
21
The same company also has 10-year

bonds outstanding with the same risk
but a 7% annual coupon rate
Since the risk is the same, the bond has the
same yield to maturity as the previous bond
(10%).
INPUTS 10 10 70 1000
N I/YR PV PMT FV
OUTPUT -815.66
22
The same company also has 10-year

bonds outstanding with the same risk
but a 10% annual coupon rate
This bond has an annual coupon payment of
$100. Since the risk is the same, the bond
has the same yield to maturity as the
previous bonds (10%).
INPUTS 10 10 100 1000
N I/YR PV PMT FV
OUTPUT -1000
23
Par, Discount, Premium Bond

If yield = coupon rate, then bond price = par
value par bond.
If yield < coupon rate, then bond price > par
value premium bond.Investors pay higher than par
value because coupon rate is
higher than their required yield.
If yield > coupon rate, then bond price < par

value discount bond.
24
Lessons Learnt 2
If you hold a bond until maturity, the value of
bond is PV of all future coupon payments and par
value at maturity
The discount rate for bond valuation is the
required rate of return on bonds
Opportunity cost of debt
Yield to maturity
If yield = coupon rate, then bond price = par
value.
If yield < coupon rate, then bond price > par
value.
If yield > coupon rate, then bond price < par 25
Measuring Yield
26
What is the YTM on a 10-year, 9% annual
coupon, $1,000 par value bond, selling for
$887?
Must find the rd that solves this model.
INT INT M
VB 1
... N

(1 rd ) (1 rd ) (1 rd )N
90 90 1,000
$887 1
... 10

(1 rd ) (1 rd ) (1 rd )10
INPUTS 10 - 887 90 1000
N I/YR PV PMT FV
OUTPUT 10.91
27
What is the YTM on a 10-year, 9%

annual coupon, $1,000 par value bond,
selling for $1,134.20?
Solving for I/YR, the YTM of this bond is
7.08%. This bond sells at a premium,
because YTM < coupon rate.
INPUTS 10 -1134.2 90 1000
N I/YR PV PMT FV
OUTPUT 7.08
28
What is fixed on a bond certificate and

what is not?
Fixed on a bond certificate and cannot be
changed:
Par value
Coupon interest rate
Maturity date
Payment frequency
Not fixed
Price of bond
Yield to maturity
29
The Total Return Identity

Expected Expected
Expected total return YTM
CY CGY
Annual coupon payment

Current yield (CY)
Price
t
Price Price
Capital gains yield (CGY) t 1 t
Price
t
30
An Example on Expected Current

and Capital Gains Yield
Find the expected current yield and the
expected capital gains yield for a 10-year,
9% annual coupon bond that sells for $887,
and has a face value of $1,000.
$90
E(CY)
$887
0.1015 10.15%
31
Calculating Expected Capital Gains Yield
Find the bond price in the next year.

N = 10, PV = -$887, PMT = $90, FV =
$1000. We get I/YR = 10.91%
N = 9, I/YR = 10.91%, PMT = $90, FV =
$1000. We get PV = -$893.79
893.79 887
E(CGY ) 0.7651%
887
32
Calculating Expected Capital Gains

Yield (Another Method)
YTM = E(Current yield) + E(Capital gains
yield)
E(CGY) YTM E (CY)
10.91% 10.15%
0.76%
Hence using the YTM identity gives the same

answer.
33
Changes in Bond Value over Time

What would happen to the value of par,
premium and discount bonds if the
required rate of return, rd, remained at
V
10%?
B
1,184
13% coupon rate
10% coupon rate

1,000
816 7% coupon rate

Years
to Maturity
10 5 0
34
Semi-annual Bonds
1.Multiply years by 2: Number of periods = 2N
2.Divide nominal rate by 2: Periodic rate (I/YR)
= rd/2
3.Divide annual coupon by 2: PMT = Annual
coupon/2
INPUTS 2N rd/2 OK Cpn/2 OK
N I/YR PV PMT FV
OUTPUT
35
Lessons Learnt 3
Unlike the coupon interest rate, which is fixed, the bonds
yield varies from day to day depending on current market
condition.
An investor who purchases a bond and hold it until it
matures will receive the YTM that existed on the purchase
date
Expected total return (YTM) = E(CY) + E(CGY)
At maturity, the value of any bond (i.e. par, premium and
discount bond) must equal its par value.
To value semi-annual coupon bond, number of periods is
2N, coupon is annual coupon/2 and periodic rate is rd/2.
36
Risks of a Bond
Investment Risk:
Interest Rate Risk (Price Risk)
Reinvestment Risk
Default Risk
37
What is Interest Rate (or Price) Risk?

Interest rate risk is the concern that rising
rd will cause the value of a bond to fall.
All else being equal, bonds with longer
maturity have higher interest rate risk.
Longer maturity bonds are more sensitive to
interest rate changes
Recall: Maturity Risk

Premium (MRP)
38
What is interest rate (or price) risk? Does a

1-year or 10-year bond have more interest
rate risk?
Interest rate risk is the concern that rising rd will
cause the value of a bond to fall.
rd 1-year Change 10-year Change
5% $1,048 $1,386
+ 4.8% +38.6%
10% $1,000 $1,000
4.4% 25.1%
15% 956 749
The 10-year bond is more sensitive to interest

rate changes, and hence has more interest rate
risk.
39
What is Reinvestment Risk?

Reinvestment risk is the concern that rd
will fall, and future CFs will have to be
reinvested at lower rates, hence reducing
income.
Example: Suppose you just won

$500,000 playing the lottery. You intend
to invest the money and live off the
interest.
40
Reinvestment Rate Example

You may invest in either a 10-year bond or
a series of ten 1-year bonds. Both the 10-
year and 1-year bonds currently yield 10%.
If you choose the 1-year bond strategy:
After Year 1, you receive $50,000 in income
and have $500,000 to reinvest. But, if 1-year
rates fall to 3%, your annual income would fall
to $15,000.
If you choose the 10-year bond strategy:
You can lock in a 10% interest rate, and earn
$50,000 in annual income for 10 years.
41
Conclusions about Interest Rate and

Reinvestment Rate Risk
Short-term Long-term
bonds bonds
Interest
Low High
rate risk
Reinvestme
High Low
nt risk
Conclusion: Nothing is riskless!
42
Default Risk
If an issuer defaults, investors receive less
than the promised return.
Influenced by the issuers financial strength
and the terms of the bond contract.
Bond ratings reflect the probability of a bond
issue going into default.
Investment Grade Junk Bonds
Moodys Aaa Aa A Baa Ba B Caa C
S&P AAA AA A BBB BB B CCC C
43
Lessons Learnt 4
Risks of a bond
Investment Risk
Interest Rate Risk (Price Risk)
Reinvestment Risk
Default Risk
All else being equal, bonds with longer

maturity have higher interest rate risk.
All else being equal, short-term bonds have
higher reinvestment risk.
Bond ratings reflect the probability of a bond
issue going into default.
44
Where Do We Stand?
Bond Instrument to borrow money
Bond valuation
Coupon Coupon Par Value
VB ...
(1 rd )1
(1 rd ) N
(1 rd ) N
rd = opportunity cost of debt capital = discount rate =

required rate of return = yield to maturity = (capital
gains yield + current yield) determined by market
conditions
rd = coupon rate unless bond price is at par
Risks of bonds
Interest rate risk
Reinvestment risk
Default risk 45

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Lecture 4: Bonds and Their Valuation

Lecture 4: Bonds and Their Valuation

By: Chanika Charoenwong

Bonds and Their Valuation

Zero Coupon Bond (Bond A)

Company MNO will pay the bearer of this

How much return would you earn? (Annual

What Return would You Earn?

What Return would You Earn?

INPUTS 4 -900 0 1000

Coupon Bond (Bond B)

Company MNO will pay the bearer of this

$60 $60 $60 $60

What is the return for Bond B if you

-$900 $60 $60 $60 $1060

What Return would You Earn?

INPUTS 4 -900 60 1000

Key Features of a Bond

Yield to maturity (YTM) nominal rate of return

Key Features of a Bond

What is fixed on a bond certificate and

The Value of Financial Assets

Given future CFs you will receive from the asset, if

The Value of a Bond

For bonds, CF would be the coupon payments

What is the opportunity cost of debt

What is the value of a 10-year, 13% annual coupon

VB = ? 130 130 130 + 1,000

$130 $130 $1,000

Using a Financial Calculator to Value

INPUTS 10 10 130 1000

The same company also has 10-year

The same company also has 10-year

INPUTS 10 10 100 1000

Par, Discount, Premium Bond

If yield > coupon rate, then bond price < par

INPUTS 10 - 887 90 1000

What is the YTM on a 10-year, 9%

INPUTS 10 -1134.2 90 1000

What is fixed on a bond certificate and

The Total Return Identity

Annual coupon payment

An Example on Expected Current

Calculating Expected Capital Gains Yield

Find the bond price in the next year.

Calculating Expected Capital Gains

Hence using the YTM identity gives the same

Changes in Bond Value over Time

10% coupon rate

816 7% coupon rate

INPUTS 2N rd/2 OK Cpn/2 OK

What is Interest Rate (or Price) Risk?

Recall: Maturity Risk

What is interest rate (or price) risk? Does a

The 10-year bond is more sensitive to interest

What is Reinvestment Risk?

Example: Suppose you just won

Reinvestment Rate Example

Conclusions about Interest Rate and

Conclusion: Nothing is riskless!

All else being equal, bonds with longer

rd = opportunity cost of debt capital = discount rate =

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