UNIVERSIDADE CATÓLICA PORTUGUESA

Finanças Empresariais

Session 2

Guilherme Almeida e Brito

UNIVERSIDADE CATÓLICA PORTUGUESA
Bond Valuation
Generic Methodology to value real and financial assets
∞
CF1 CF2 CF3 CFt CFt
P0 = PV = V0 = + + + ... + + ... = ∑
(1 + r01 ) (1 + r02 ) 2 (1 + r03 )3 (1 + r0t )t t =1 (1 + r0 t )
t

To value bonds the relevant cash flows are the coupons and the final
payment:
I1 I2 I3 IT RT
B0 = + + + ... + +
(1 + r01 ) (1 + r02 ) 2 (1 + r03 )3 (1 + r0T )T (1 + r0T )T

To value fixed-rate bonds :

I1 = I 2 = I 3 = ... = I T = I
I I I I RT
B0 = + + + ... + +
(1 + r01 ) (1 + r02 ) 2 (1 + r03 )3 (1 + r0T )T (1 + r0T )T

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UNIVERSIDADE CATÓLICA PORTUGUESA
Bond Valuation

Example 1: Consider a Government Bond with a face value of E

100 and a maturity in 5 years with a 6% fixed coupon rate.

How much is it worth if the spot rates are:

r01 = 3%, r02 = 3,5%, r03 = 4%, r04 =4,25% and r05 = 4,5%?

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Yield-to-maturity

I I I I RT
B0 = + + + ... + +
(1 + y ) (1 + y ) (1 + y )
2 3
(1 + y ) T
(1 + y )T

Example 2: Consider a Government Bond with a nominal value of

100 euros. This bond pays an annual coupon of 6% for 5 years.
Estimate this bond yield to maturity if its fair price is 106,90 euros.
Note: r01 = 3%, r02 = 3,5%, r03 = 4%, r04 =4,25% and r05 = 4,5%

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Yield-to-maturity

Example 3:
t 1 2 3 4 5
r0t 5% 6% 7% 8% 9%

B0 CF1 CF2 CF3 CF4 CF5 YTM

A 85,21 5 5 5 5 105
B 105,43 10 10 10 10 110

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UNIVERSIDADE CATÓLICA PORTUGUESA
Interest Rate Risk
Example 4: Consider a Government Bond with a face value of 100
euros, maturity in 5 years and paying an annual coupon of 6%.
Estimate the fair price of this government bond if all spot rates
are equal to 6%? And what if the spot rates were equal to 4%?
What if they were 7%?

Finanças Empresariais 6 Guilherme Almeida e Brito

 Interest Rate Risk
UNIVERSIDADE CATÓLICA PORTUGUESA Bonds with different maturities

Example 5.a.:
B0 B0 Price CF2 CF5 CF10 CF30
(r=10%) (r=8%) Change
A 82,64 85,73 +3,7% 100 - - -
B 62,09 68,06 +9,6% - 100 - -
C 38,55 46,32 +20,1% - - 100 -
D 5,73 9,94 +73,4% - - - 100

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 Interest Rate Risk
UNIVERSIDADE CATÓLICA PORTUGUESA Bonds with different coupon rates

Example 5.b.:

B0 B0 Price CF1 CF2

(r=10%) (r=8%) Change
A (0%) 82,64 85,73 +3,74% - 100
E (5%) 91,32 94,65 +3,64% 5 105
F (10%) 100 103,57 +3,57% 10 110
G (15%) 108,68 112,48 +3,50% 15 115

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 Duration
UNIVERSIDADE CATÓLICA PORTUGUESA
CF1 CF2 CF3 CFT
1× + 2× + 3× + ... + T ×
(1 + r01 ) (1 + r02 ) 2
(1 + r03 ) 3
(1 + r0 T ) T
D=
CF1 CF2 CF3 CFT
+ + + ... +
(1 + r01 ) (1 + r02 ) 2 (1 + r03 ) 3 (1 + r0 T )T

CF1 CF2 CF3 CFT

1× + 2× + 3 × + ... + T ×
(1 + y ) (1 + y ) 2 (1 + y ) 3 (1 + y )T
D=
CF1 CF2 CF3 CFT
+ + + ... +
(1 + y ) (1 + y ) 2
(1 + y ) 3
(1 + y )T

CFt CFt
t× t×
T
(1 + y ) t T
(1 + r0 t ) t
D=∑ D=∑
t =1 B0 t =1 B0

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 Duration
UNIVERSIDADE CATÓLICA PORTUGUESA

Example 6: Estimate the duration of the following bonds. Then

use duration to estimate the price change.

B0 B0 Price CF1 CF2

(r=10%) (r=8%) Change
A (0%) 82,64 85,73 +3,74% - 100
E (5%) 91,32 94,65 +3,64% 5 105
F (10%) 100 103,57 +3,57% 10 110

∆B0 ∆ (1 + r ) D
≈ −D ≈− ∆r
B0 1+ r 1+ y

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 Prices change with time
UNIVERSIDADE CATÓLICA PORTUGUESA

CF1 +( P1 − P0 )
Market returns: r0/1 =
P0
Example 7:

B0 B1 r0,1
A (0%) 82,64 90,91
E (5%) 91,32 95,45
F (10%) 100 100
G (15%) 108,68 104,55

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UNIVERSIDADE CATÓLICA PORTUGUESA
Bonds: Institutional Aspects

Accrued interest: Total cost = bond price + accrued interest

Zero Coupon Bonds

Fixed Rate Bonds
Floating Rate Bonds: Index + Spread

Default Risk, Bond Ratings (Moody’s, S&P, Fitch, …)

AAA, AA, A, BBB, BB, B, CCC, CC, C, D; A+, A-
Investment Grade Bonds, Junk or High Yield Bonds

Derivatives: Callable Bonds, Convertible Bonds, ….

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Explaining the Yield Curve

• The Expectations Theory

• The Market Segmentation Theory

•The Liquidity-Preference Theory

Finanças Empresariais 13 Guilherme Almeida e Brito

 Loan Reimbursement: Constant Cash
UNIVERSIDADE CATÓLICA PORTUGUESA Flows

Year Beginning- Year-end Total Amortiza- End-of-

of-Year Interest Year-end tion of Year
Balance Payment Loan Balance
1 5000,00 300,00 1186,98 886,98 4113,02
2 4113,02 246,78 1186,98 940,20 3172,82
3 3172,82 190,37 1186,98 996,61 2176,20
4 2176,20 130,57 1186,98 1056,41 1119,79
5 1119,79 67,19 1186,98 1119,79 0,00

5000=CF×a5; 6% CF = 5000 = 5000 =1186,98

a5; 6% 4,212

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 Loan Reimbursement: Constant
UNIVERSIDADE CATÓLICA PORTUGUESA Amortization

Year Beginning- Year-end Amortiza- Total End-of-

of-Year Interest tion of Year-end Year
Balance Loan Payment Balance
1 5000,00 300,00 1000,00 1300,00 4000,00
2 4000,00 240,00 1000,00 1240,00 3000,00
3 3000,00 180,00 1000,00 1180,00 2000,00
4 2000,00 120,00 1000,00 1120,00 1000,00
5 1000,00 60,00 1000,00 1060,00 0,00

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 Loan Reimbursement: Other
UNIVERSIDADE CATÓLICA PORTUGUESA alternatives

Year Beginning- Year-end Amortiza- Total End-of-

of-Year Interest tion of Year-end Year
Balance Loan Payment Balance
1 5000,00 300,00 0,00 300,00 5000,00
2 5000,00 300,00 0,00 300,00 5000,00
3 5000,00 300,00 2000,00 2300,00 3000,00
4 3000,00 180,00 0,00 180,00 3000,00
5 3000,00 180,00 3000,00 3180,00 0,00

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UNIVERSIDADE CATÓLICA PORTUGUESA
Solutions

Ex 1: B0 = 106,90 Ex 2: y = 4,43%

Ex 3: yA = 8,78%; yB = 8,62% Ex 4: B0 = 100,00 y = 6,00%;

Ex 4: B0’ = 108,90 y’ = 4,00%; B0’’ = 95,90 y’’ = 7,00%

Ex 6: DA = 2; DB = 5; DC = 10; DE = 1,95; DF = 1,91;
Price changes: A: ~3,64%; B: ~9,09%; C: ~18,18%;
E: ~3,54%; F: ~3,47%
Ex 7: r0/1A = 0% + 10% = 10%; r0/1E = 5,48% + 4,52% = 10%;
r0/1F = 10% + 0% = 10%; r0/1G = 13,8% - 3,8% = 10%

Finanças Empresariais 17 Guilherme Almeida e Brito