Lecture 07A – Valuation of Bonds The value of any asset is given by the present value of the expected cash

flows received from that asset during the holding period. This means that to value any asset the investor needs an estimate of: • An estimate of the cash flows. • The timing of the cash flows (for time value purposes). • The opportunity cost of funds or discount rate. The difficulty in valuing different types of assets is related principally to the ease with which the different pieces of information are known prior to purchasing these assets. For example, bonds are easier to value than common stock because bonds promise specific payments at specific times. This means that the expected cash flows and their timing are known. Common stock on the other hand makes no explicit promise to pay anything. So neither the expected cash flows nor their timing is known ahead of time. Bonds have two types of cash flows, periodic interest payments, and the face value at maturity. Bond Valuation: The value of a bond is equal to the present value of its future cash flows, discounted at the rate of return the financial markets expect for the risk of the bond. Where P = Price of the bond C = Coupon (Annual) R = Yield or Discount Rate N = Number of periods to Maturity M = Face Value of the Bond. The value of the bond is given by:
P=

(1 + R )

C1

1

+ .... +

(1 + R )

CN

N

+

(1 + R ) N

M

Since the coupon payments are the same each year, they could be treated as an annuity. Thus the value of a bond could also be written as: P = C (PVIFAR,N) + M (PVIFR,N) Consider an 8% coupon, 10 year bond with $1000 face value. What would be its value today?

At 8% discount the value of the bond is P = 80(PVIFA8.10) P = 80(6. The value however depends on the market rate. Principles • • Bond prices move inversely to bond yields. the longer the term to maturity.000.We know that this bond will make interest payments of $80 per year. Consider two $1. the value of this bond is P = 80(PVIFA10.10) = 1. percentage changes in bond prices are greater.10) = 1. Holding the coupon rate constant.000 bonds with 12% coupon rates. If the discount rate is 10%. or the discount rate. and will pay $1000 at the end of year ten. the value of the bond is P = 80(PVIFA 5.10 ) + 1000(PVIF5. the bond sells at par (its face value). PA = $931 PB = $877 • The percentage price change described above increases at a decreasing rate as maturity increases. the bond value is lower than the face value (it sells at a discount). for a given change in market yields.1446) + 1000(. Bond A has 5 years to maturity. .10) + 1000(PVIF8.07 If the discount rate is 5%.10) + 1000(PVIF10. the bond sells at a premium (greater than its face value).231. and B has 15 years.3855) = 877.65. Let rates change to 14%. Assume they are both currently selling at par. • When the discount rate is less than the coupon rate. Note: • When the discount rate is greater than the coupon rate. • When the discount rate is equal to the coupon rate.

.107. the higher the coupon rate. portfolios heavily invested in long-term securities have greater price fluctuations than portfolios concentrated on short-term securities.. a fall of 9. That will take too much time. Portfolios heavy in low coupon instruments are more affected by changes in interest rates than portfolios of high coupon instruments. Price change effects are asymmetric with respect to changes in yield.000 par value bond at a price of $877. P = $877.3%. + (1 + R ) CN N + (1 + R ) N M Thus for our bond. equal yield changes up. . an increase of 10. + (1 + k ) 80 10 + (1 + k ) 10 1.. so it is easier to use the smart machines. 8 year bond selling at par. 12%. $1.. Implications: • Changes in market interest rates will not affect all fixed income portfolios in the same way..000.• Holding maturity constant and starting from the same market yield. 8% annual coupon. • Holding maturity constant and starting from the same market yield. the smaller the percentage change in price for a given change in yield. • Bond Yields: Suppose you were offered a 10 year. They will give us a value k = 10%.07. or down do not result in equal percentage changes in prices. We know that the value of a bond is given by: P= (1 + R ) C1 1 + .000 It is possible to find k by trial and error.07 = (1 + k ) 80 1 + .. What rate of interest would you earn on your investment if you bought the bond and held it to maturity? This is called the yield to maturity. If yield rises to 14% the price will fall to $907.7%. • In periods of high volatility. Consider a $1. If yield falls to 10% the price will rise to $1.

Case 2.As we shall see later. and the interest earned on the coupons. The total accumulated at the end of 5 years will be: Face value 1. Price or Market Value Risk is the potential variation from unexpected changes in market prices of securities.610. Rates fall to 5% immediately after the bond was purchased and stay there for 5 years. the yield to maturity is not the effective yield on a bond. Your total accumulation at the end of 5 years will consist of the face value of the bond. Consider a bond that currently sells at par (1. you will reinvest the coupon payments over the course of time. So you can invest the coupon payments at 10%. Case 1. The interest rate stays at 10% during the life of the bond. The total accumulated at the end of year 5 will be: Face value 1. There are two components to interest rate risk.51 Total 1.000 Coupons plus reinvestment 610. In other words.000 Coupons plus reinvestment 552. Interest Rate Risk is defined as the variation in returns caused by unexpected changes in interest rates. .56 This produces a yield over five years that is less than 10%. You will only male 10% on this bond if you invest all the interim cash flows at 10%.56 Total 1. It is important to note that the bond is exposed to reinvestment risk even when it is not sold before maturity. the coupon payments. differences in the way interest rate risk affects securities will occur because of: • types of instruments • maturity • size and timing of cash flows • planned holding period relative to maturity of security.000) and has a 10% coupon rate with a 5 year maturity. We explore this below as we talk about interest rate risk. As we see from the above principles.51 This produces a yield over five years of 10%.552. Assume that you were investing in this bond in order to accumulate a sum of money at the end of 5 years. Reinvestment Risk is the potential variation from unexpected changes in the rate at which intermediate cash flows can be reinvested.

Interest rates have declined since the bond was issued.165. 2002.090). 2004. You want to determine both the yield to maturity and the yield to call for this bond. at 109 percent of par. • Suppose the bond had sold at a discount.75. There is a 5 year call protection (until December 31. The bond has a 9. which return do you think you would actually earn? Explain your reasoning. • What is the yield to maturity in 2004 for the bond? What is the yield to call? • If you bought this bond. after which time the bond can be called at 109 (that is. Would the yield to maturity or yield to call have been more relevant? . 2031). 2006). and the bond is now selling at $116. or $1. or $1.75 percent of par.5% annual coupon and a 30 year original maturity (it matures in December 31.Assignment It is now January 1. and you are considering the purchase of an outstanding RDC bond that was issued on January 1.

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