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Introduction to compounding… In this section we will • Definite what compounding means • Analyze through an example how the compounding methodology could impact the valuation of our Armani bond • Indroduce the concept of companding through a mathematical equation .

Introduction to compounding… • Let ’s then take our Armani bond and suppose to have another very similar bond avaiable in the market that has a semi-annual coupon frequency 100% * Face Value Face * C / F = $30k $30k $30k $30k $30k $30k + $1mln Bond A: Annual coupon 03/2012 03/2013 03/2014 03/2015 03/2016 03/2017 t Issue Price * Face Value Coupon Period 100% * Face Value Face * C / F = $15k $15k $15k $15k $15k $15k $15k $15k $15k $15k + $1mln 03/12 09/12 03/13 09/13 03/14 09/14 03/15 09/15 03/16 09/17 03/17 t Bond B: SemiAnnual coupon Coupon Period Issue Price * Face Value .

e they would be earning interest on the interst .000 Bond B – S/A Cpn 15. 2012) Date 09/20/2012 03/20/2013 Bond A – Annual Cpn 0 30. they earn additional income by reinvesting these cash-flows.000 $30.000 Tot $30. I.Introduction to compounding… • Cash-flows received after 1 year since we bought the bonds (March 20.000 15. 2012 you were able to reinvest the $15.000 coupon payments in the same bond? • • Compounding is the process by which bondholders reinvest the coupons that they receive to earn additional interest income Bondholders do not “put their coupon payments under the mattress”! Instead.000 • • Which bond would you prefer to have? What about if on Sept 20.

Introduction to compounding… • In order to understand how compouding works we need to start by calculating a bond behaviour / total return when there’s no compounding.000 Bond B – S/A Cpn 15. aka simple interest Date 09/20/2012 03/20/2013 Bond A – Annual Cpn 0 30.e they would be earning interest on the interst .000 Tot $30.000 coupon payments in the same bond? • • Compounding is the process by which bondholders reinvest the coupons that they receive to earn additional interest income Bondholders do not “put their coupon payments under the mattress”! Instead. 2012 you were able to reinvest the $15.000 15.000 $30.000 • • Which bond would you prefer to have? What about if on Sept 20. they earn additional income by reinvesting these cash-flows. I.