Bond Valuation

Dr. Satish Kumar

 Valuation
• The process that links risk and return to determine the worth of
an asset.

• Key inputs to valuation are expected returns in terms of their

cash flows together with their timings; and risks in terms of
required return.

• What is the relation between value and risk?

 Forms of value
• Book value vs market value

• Liquidation value vs going concern value

• Replacement value

• Intrinsic or fundamental value

 Bond
• It is a contract under which a borrower promises to pay
interest and principal on specific dates to the holders of the
bonds

• Face value or par value

• Coupon rate or the interest rate

• Maturity

• Redemption value
 Basic bond valuation
• The value of a bond is equal to the present value of all the
future cash flows it would generate.

• The coupon rate is assumed to remain fixed for the term of the
bond.

• The coupon payments on the bond are made annually.

• The bond is expected to be redeemed at par.

Consider a bond having a maturity of 5 years, face value of Rs. 1000 and
paying a coupon rate of 10%. Assume the bond will be redeemed at par.
The cash flows generated from the bond will look as follows:

0 1 2 3 4 5

100 100 100 100 100

1000

The present value of this bond is given as

When the required rate of return is equal to the coupon rate, the bond value
is equal to the par value
• The required rate of return on a bond is called yield to maturity if it is held till
maturity.

• YTM is that rate which makes the present value of the cash flows receivable from
owning the bond equal to the price of the bond.

• Consider a bond having a maturity of 5 years, face value of Rs. 1000 and paying a
coupon rate of 10%. What would be the value of the bond if the YTM is 12%?

• Consider a bond having a maturity of 5 years, face value of Rs. 1000 and paying a
coupon rate of 10%. What would be the value of the bond if the YTM is 8%?
Consider a bond having a face value of Rs. 1000, coupon rate of 9% and number of
years to maturity as 8 years. If the bond is currently selling at a price of Rs. 800, what
is its YTM?

At r = 12%, P0 = 851

At r = 14%, P0 = 768.1

Interpolation formula
Approximation formula

Current Yield
CY is equal to the annual interest divided by the bond’s current price
What will happen if the bond is making the coupon payments semi annually?

Simple – make the time double; and coupon rate and YTM half

Consider an 8 year bond with 12% coupon rate and par value of Rs. 100. If
the bond pays coupons semi annually, what will be current price of the bond if
YTM is 14%?
 Bond value theorems
1. Relationship between required rate of return and coupon
rate

I. When the YTM = CR; P0 = F

II. When the YTM > CR; P0 < F

III. When the YTM < CR; P0 > F

Price

Yield
 Bond value theorems
2. Effect of number of years to maturity
(i) When the required rate of return is greater than the coupon rate, the
________on
discount the bond ________as
declines the maturity approaches

Face value = 1000

Coupon rate = 11% N Price
N= 5 4 Rs. 940.14
YTM = 13% 3 Rs. 952.71

2 Rs. 966.48

1 Rs. 982.35
0 Rs. 1000.0
 Bond value theorems
2. Effect of number of years to maturity
(ii) When the required rate of return is less than the coupon rate, the
_________
premium on the bond declines
_______ as the maturity approaches

Face value = 1000

Coupon rate = 11% N Price
N= 5 4 Rs. 1064.40
YTM = 9% 3 Rs. 1050.41

2 Rs. 1035.49

1 Rs. 1017.87
0 Rs. 1000.00
 Bond value theorems
3. Yield to maturity
(i) For a given difference between YTM and coupon rate of the bonds, the
greater
longer the term to maturity, the _______will be the change in price with
a given change in YTM

Bond A Bond B

Face value 1000 1000

Coupon rate 10% 10%

N 3 6

Price at YTM =10% 1000 1000

Price at YTM =11% 975 958

% change in Price 2.5% 4.2%

 Bond value theorems
3. Yield to maturity
(ii) Given the maturity, the change in the bond price will be ________with
greater a
decrease in bond’s YTM than the change in the bond’s price with an
equal increase in the bond’s YTM

Face value = Rs. 1000 N=5

Coupon rate = 10% YTM =10%

Current Price = Rs. 1000

P2
Price at a YTM of 12% = Rs. 927.90 P0
P1
% decrease in Price = 7.21%

Price at a YTM of 8% = Rs. 1079.85

Y2 Y0 Y1
% increase in Price = 7.98%
 Bond value theorems
3. Yield to maturity
(iii) For a given change in YTM, the percentage price change in case of
smaller than in case of bonds of low
bonds of high coupon rate will be _______
coupon rates, other things remaining the same.

Bond A Bond B

Face value 1000 1000

Coupon rate 10% 12%

N 4 4

Price at YTM =10% 1000 1063.4

Price at YTM =12% 939.7 1000

% change in Price 6.03% 5.96%