Subject: SS-BF-II-12 BUSINESS FINANCE

Week: 11
Topic: Interest Rates and Bond’s Prices Part 1

A bond represents a stream of future payments. Once the bond has been issued, the
price the bond will trade at in secondary markets is the present value of the future stream
of payments. To find its price, we need to compute the present value of each coupon
payment and the present value of the final repayment of the face value on the maturity
date. The appropriate formula is:
P = C1 / (1 + i)1 + C2 / (1+ i)2 +……+ Cn / (1+ i)n + F / (1 + i)n

P= Price of the bond

C = coupon payment
F = Par Value
i = market interest rate
n= number of years

Notice that this formula is a descendant in the time value of money, with P = V0 and Vn
= C or F. The only difference is that we use to compute the present value of a number of
future payments, such as occurs with a bond, and to compute the present value of a
single future payment.
A discount from par and raises the yield on the bond, called the yield to maturity, example
from 6 percent to 8 percent. In sum, as the market interest rate rises, the price of existing
bonds falls. In sum, as the market interest rate rises, the price of existing bonds falls. The
yield to maturity on previously issued bonds must somehow rise to remain competitive
with the new higher level of prevailing interest rates.
Suppose Jane is about to buy a bond that will mature in one year, has a face value of P
1,000, and carries a coupon payment of P 60, and the prevailing interest rate in the
market is 6 percent. What is Jane willing to pay for this bond?
P = 60 / (1 + .06) + 1,000 / (1+.06)
P = 56.60 + 943.40
P = 1,000
This tells Jane that the price of the bond or its present value is P 1,000. In other words, if
the interest rate is 6 percent, the present value of receiving $P,060 in one year is P1,000,
and this is what Jane (or anybody else) will pay for the bond. Because the coupon
payment is P60, the coupon rate is 6 percent (6 percent = P60/P1,000). You might also
note that when the price of a bond is equal to its par value (P1,000), the coupon rate is
equal to the current interest rate.
Continuing with this example, Jane buys the bond for P1,000, and the next day the
prevailing interest rate in the market rises to 7 percent. What effect does this have on the
value (price) of Jane’s bond? Remember that Jane’s bond will pay her P1,060 in one
year. Imagine yourself with P1,000 to invest. How much would you pay for Jane’s bond?
Would you pay P1,000? We hope your answer is “no!” You could go out in the market
and buy another bond yielding 7 percent for P 1,000! Alternatively, you could buy Jane’s
bond. But you would do this if and only if it too was somehow made to yield 7 percent.
How could this happen? The maturity of the bond (one year), the coupon payment (P 60
per P 1,000 of par value), and the par value (P 1,000) are all fixed. They represent the
contractual arrangements entered into by the bond issuer (borrower) at the time the bond
was initially issued. What’s left? The price of the bond! You and other investors would be
willing to pay a price for the bond that, given the receipt of P 1,060 at maturity, would
represent a yield over the year of 7 percent.
P= 60 / (1+.07) + 1000 / (1+.07)
P= 56.07 + 934.58
P= 990.65