Bond Valuation

A long term contract under which borrower promises to pay interest on specific dates and principle
on maturity.
Par Value - Face Value which is paid at matuirty
Coupon Rate - Interest Rate on Face value not purchase value. Generally fixed.
Maturity - Years untill bond must be repaid.
Issue Date - Date when bond is issued.
Default Risk - Risk that issuer will not make interest payment or principle payment.
Reinvestment Risk - The risk that CFs will have to be reinvested in the future at lower rates,
reducing income.

Call Option - Buy Back - Issuer can refund if rates decline. That helps the issuer but hurts the
investor. Therefore, borrowers are willing to pay more, and lenders require more, on callable
bonds.

Yield To Maturity - YTM is the rate of return earned on a bond held to maturity. Also called
“promised yield.”
YTM = Current Yield + Capital Gain Yield
Current Yield = Annual Coupon(Interest) Return/Purchase Price x 100
Capital Gain Yield = Capital Gain(Buy Back Price - Purchase Price)/ Purchase Price x 100
Find current yield,capital gains and YTM when bond yield for a 9%, 10-year bond when the bond
sells for $887.
Current Yield (1000*0.09)/887 10.15%
Capital Gain Yield (1000-887)/887 12.74%
Yield To Maturity 22.89%
Reinvestment Risk - The risk that CFs will have to be reinvested in the future at lower rates,
reducing income.

Suppose you just won $500,000 playing the lottery. You’ll invest the money and live off the interest.
You buy a 1-year bond with a YTM of 10%.

Year 1 income = $50,000. At year end get back $500,000 to reinvest.

If rates fall to 3%, income will drop from $50,000 to $15,000. Had you bought 30-year bonds,
income would have remained constant.

Long-term bonds: High interest rate risk, low reinvestment rate risk.
Short-term bonds: Low interest rate risk, high reinvestment rate risk.
Nothing is riskless!
Types of Bonds:
Treasury Bond,Corporate Bond,Junk Bond,Mortgage Bond,Municipal Bond,Foreign Bond & Zero
Rated Bond

Find current yield,capital gains and YTM when bond yield for a 9%, 10-year bond when the bond
sells for $887. It's a zero rated bond
Current Yield 0.00% 0.00%
Capital Gain Yield (1000-887)/887 12.74%
 Yield To Maturity 12.74%

Find current yield,capital gains and YTM when bond yield for a 9%, 10-year bond when the bond
sells for $1040. It's a corporate bond.
Current Yield (1000*0.09)/1040 8.65%
Capital Loss Yield (1000-1040)/1040 -3.85%
Yield To Maturity 4.81%

Price of a Bond

$1000 bond yield a coupon of 11% per annnum. YTM of the bond is 10%. Bond will mature in three
years time. Currently bond is valued at $1100 in the market, what will be the buyer and seller
prospective.

Years CF DF(10%) PV
1 110 0.9090909 100.00
2 110 0.8264463 90.91
3 1110 0.7513148 833.96
Price of a Bond 1024.87

Buyer will hold and Seller will sell because it is over priced.

$1000 bond yield a coupon of 14% per annnum. YTM of the bond is 12%. Bond will mature in four
years time. Currently bond is valued at $1020 in the market, what will be the buyer and seller
prospective.

Years CF DF(12%) PV
1 140 0.8928571 125.00
2 140 0.7971939 111.61
3 140 0.7117802 99.65
4 1140 0.6355181 724.49
Price of a Bond 1060.75

Buyer will buy and Seller will hold because it is under priced.

Bond yield a coupon of 17% per annnum. YTM of the bond is 15%. Bond will mature in five years
time. Currently bond is valued at $1080 in the market, what will be the buyer and seller
prospective.

Years CF DF(15%) PV
1 170 0.8695652 147.83
2 170 0.7561437 128.54
3 170 0.6575162 111.78
4 170 0.5717532 97.20
5 1170 0.4971767 581.70
Price of a Bond 1067.04
Buyer will hold and Seller will sell because it is over priced.