Lecture 2

Bond Valuation
Contact: Natt Koowattanatianchai
 Email:
 fbusnwk@ku.ac.th
 Homepage:
 http://fin.bus.ku.ac.th/nattawoot.htm
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8-1
Outline
1 Bonds and Bond Valuation
2 Calculating Bond Yields

8-2
References
 Ross, S., Westerfield, R. and Jaffe, J.
(2013), Corporate Finance (10th Edition),
McGraw Hill/Irvin. (Chapter 8)
 Moyer, R.C., McGuigan, J.R., and Rao,
R.P. (2015), Contemporary Financial
Management (13th Edition), Cengage
Learning. (Chapter 6)

8-3
Bonds and Bond Valuation
 A bond is a legally binding agreement between
a borrower and a lender that specifies the:
 Par (face) value
 Coupon rate
 Coupon payment
 Maturity Date

 The yield to maturity is the required market

interest rate on the bond.

8-4
Bond Valuation
 Primary Principle:
 Value of financial securities = PV of expected
future cash flows
 Bond value is, therefore, determined by the
present value of the coupon payments and par
value.
 Interest rates are inversely related to present
(i.e., bond) values.

8-5
The Bond-Pricing Equation

 1 
1 -
 (1  r) T  F
Bond Value  C  
 (1  r)
T
 r
 

8-6
Bond Example
 Consider a U.S. government bond with as 6 3/8%
coupon that expires in December 2013.
 The Par Value of the bond is $1,000.
 Coupon payments are made semiannually (June 30 and
December 31 for this particular bond).
 Since the coupon rate is 6 3/8%, the payment is $31.875.
 On January 1, 2009 the size and timing of cash flows are:
$31.875 $31.875 $31.875 $1,031.875

1 / 1 / 09 6 / 30 / 09 12 / 31 / 09 6 / 30 / 13 12 / 31 / 13
8-7
Bond Example
 On January 1, 2009, the required yield is 5%.
 The current value is:

$31.875  1  $1,000
PV  1 10 
 10
 $1,060.17
.05 2  (1.025)  (1.025)

8-8
Bond Example
 Now assume that the required yield is 11%.
 How does this change the bond’s price?

$31.875  1  $1,000
PV  1 10 
 10
 $825.69
.11 2  (1.055)  (1.055)

8-9
 YTM and Bond Value
When the YTM < coupon, the bond
1300 trades at a premium.
Bond Value

1200

1100 When the YTM = coupon, the

bond trades at par.
1000

800
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
6 3/8 Discount Rate
When the YTM > coupon, the bond trades at a discount. 8-10
Bond Concepts
 Bond prices and market interest rates move
in opposite directions.
 When coupon rate = YTM, price = par
value
 When coupon rate > YTM, price > par
value (premium bond)
 When coupon rate < YTM, price < par
value (discount bond)

8-11
Computing Yield to Maturity
 Yield to maturity is the rate implied by the
current bond price.
 Finding the YTM requires trial and error if you
do not have a financial calculator and is similar
to the process for finding r with an annuity.
 Interpolation:
lower rate −YTM lower price −market price
 =
upper rate −lower rate upper price −lower price

8-12
YTM with Annual Coupons
 Consider a bond with a 10% annual coupon
rate, 15 years to maturity, and a par value of
$1,000. The current price is $928.09.
 Will the yield be more or less than 10%?

8-13
YTM with Semiannual Coupons
 Suppose a bond with a 10% coupon rate and
semiannual coupons has a face value of
$1,000, 20 years to maturity, and is selling for
$1,197.93.
 Is the YTM more or less than 10%?
 What is the semi-annual coupon payment?
 How many periods are there?

8-14
Bond Pricing Theorems
 Bonds of similar risk (and maturity) will be
priced to yield about the same return,
regardless of the coupon rate.
 If you know the price of one bond, you can
estimate its YTM and use that to find the price
of the second bond.
 This is a useful concept that can be transferred
to valuing assets other than bonds.

8-15
Zero Coupon Bonds
 Make no periodic interest payments (coupon rate =
0%)
 The entire yield to maturity comes from the
difference between the purchase price and the par
value
 Cannot sell for more than par value
 Sometimes called zeroes, deep discount bonds, or
original issue discount bonds (OIDs)
 Treasury Bills and principal-only Treasury strips are
good examples of zeroes
8-16
Pure Discount Bonds
Information needed for valuing pure discount bonds:
 Time to maturity (T) = Maturity date - today’s date
 Face value (F)
 Discount rate (r)

$0 $0 $0 $F

0 1 2 T 1 T

Present value of a pure discount bond at time 0:

F
PV 
(1  r ) T
8-17
Pure Discount Bonds: Example
Find the value of a 15-year zero-coupon bond
with a $1,000 par value and a YTM of 12%.
$0 $0 $0 $1,000

0 1 2 29 30

F $1,000
PV    $174.11
(1  r ) T
(1.06) 30

8-18
Questions?