210

(2023)
 Learning outcomes
PART1 • Understand basic bond terminology.
Bonds and Bond Valuation • Explain the relationship between the
coupon rate and the yield to maturity.

• Apply the time value of money equation in

pricing bonds.

• Understand the difference between annual

and semiannual bonds and note the key
features of zero-coupon bonds.
 Bond
• Bond is a long-term debt instrument that creates
a liability claim where one party agrees to pay back
the funds with interest on a specific date in the
future.

• It is a promissory note issued by an organization.

• Bonds are also called fixed-income securities

because they pay a set amount on specific future
dates.
• Provide periodic interest income—annuity series.
• Return of the principal amount at maturity—
future lump sum.
• Prices can be calculated by using present value
techniques i.e., discounting of future cash flows.
• Combination of the present value of an annuity
and of a lump sum.
• Corporate bonds are issued by companies, while
Treasury bonds are issued by governments
7-3
 Key Components of a Bond

·I s

O
• Par Value or Face Value: this is the bond
principal amount that the corporation repays
at the bond’s maturity (we quote the price in
relation to $1000).
!: I'd gest

• Coupon rate (%): This is the interest rate

for the coupons, which we express in annual
terms. It normally remains the same
throughout the life of the bond.
969,410 =1,;5:54) s
=

• Coupon ($): This is the bond’s regular –

fixed interest payment. We determine it by
multiplying the coupon rate times the par
value of the bond for a bond paying interest
annually. The interest is usually paid every 6
months, i.e. twice a year.
 Key Components of a Bond

19610;2
• Maturity date: this is the bond’s expiration
date, on which the corporation makes the
final interest payment and repays the
principal.
• Yield or yield to maturity (YTM): This is
the bond’s discount rate or the return the
bondholder receives if he or she holds it to
maturity. You can think of it as an interest
rate that summarizes a bond’s overall
investment value.
 1000
fV 95

-03)3: 2023 202 2025

-

(I r 2022

Bond Rates of Return an

1 ↳ I
& 2 3
emex e -so
50x os
Coupon Payment ($): 0.03
Example:
(1,13
-

If the coupon rate is 6.5% and the bond has a par value of
𝐴𝑛𝑛𝑢𝑎𝑙 c𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 = 𝐶𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 × 𝑝𝑎𝑟 𝑣𝑎𝑙𝑢𝑒 £1,000, what would be the coupon payment for the bond?

-f
£65

1. Coupon Rate (%): Example:

𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 If the annual coupon is £65 and the bond has a par value of
𝐶𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 = £1,000, what is the coupon rate? 6.5%
𝑝𝑎𝑟 𝑣𝑎𝑙𝑢𝑒

2. Current Yield (%): Example:

When the economy changes, the general interest rates (referred to In the previous example, the bond has a coupon rate of 6.5%,
as market interest rates) will also change. but if the market interest rates are now 13%, what will be the
𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 new price of the bond, similarly if market interest rates fall to
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 = 3.25%, what will be the new price of the bond?
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒
- Fall to £500 and rise to £2,000

Note that this example uses a bond that has no maturity date, i.e. it has no fixed date to be repaid although it can be traded during that time

6
Bond Rates of Return
3. Yield to Maturity (%):

We also need to include any changes in the future price in

our return calculation. This final return is referred to as the
yield to maturity. Bond prices will change during their
lifespan, but at maturity, they will converge to the par value.
Therefore, when this loss or profit is factored in, the return
is called the yield to maturity.
Summary of Bond Returns
Coupon Rate (%): Current Yield (%):

The coupon rate depends on the coupon The current yield depends on the coupon
payment and initial par value. In other words, it payment and current market price. In other
represents the initial rate of return when the bond words, it represents the yield assuming that you
was first issued. bought the bond today at its current market price.

Yield to Maturity (%):

The calculation of yield to maturity (YTM)

involves the use of the coupon payment, current
market price, and years to maturity. YTM is
influenced by market, economic, and company-
specific factors.
 Bond Pricing
Since bonds involve a combination of an annuity (coupons) and a lump sum (par value), its price is best
calculated by using the following steps:

01
Layout the timing and
amount of the future
cashflows promised.
02 03 04
Determined the Add the present value of
Find the present value of the lump-sum principal
appropriate discount lump-sum principal and
rate for the cash and the present value of
the annuity stream of coupons to get the price
flows. coupons. or the value of the bond.
 falud etrrt-34

maturita date
-

Bond Pricing
100
-upon to
ParValue:
Example: A bond has a par value of £100, a coupon of £10, a maturity date in 3 years, and the yield to
maturity is 3%. What is the current price?

1 1
1−(1+𝑟)𝑛 1−
1+0.03 3
• Present value of coupons = PMT × = £10 × = 10 × 2.829 = 28.29
𝑟 0..03
1 1
• Present Value of Par Value = FV × = £100 × = £100 x 0.915 = 91.51
1+𝑟 𝑛 1+0.03 3

• Price of bond = 28.29 + 91.51 = £ 119.8

Bond Pricing
Example: Calculating the price of a corporate bond.
Calculate the price of an AA-rated, 20-year, 8% coupon (paid annually) corporate bond (Par value = $1,000)
which is expected to earn a yield to maturity of 10%.

Year 0 1 2 3 18 19 20

$80 $80 $80 … $80 $80 $80

$1,000

Annual coupon = PMT = Coupon rate x Par value = ?

Annual coupon = PMT = Coupon rate x Par value = .08 * $1,000 = $80
YTM = r = 10%
Maturity = n = 20
Par Value = FV = $1,000
Price of bond = Present Value of coupons + Present Value of par value
 Bond Pricing
Example: Calculating the price of a corporate bond

1 1
1− 1−
(1+𝑟)𝑛 1+0.10 20
Present value of coupons = PMT × = $80 ×
𝑟 0.10
= $80 × 8.51359 = $681.09

1 1
Present Value of Par Value = FV × = $1,000 ×
1+𝑟 𝑛 1+0.10 20
=$1,000 x 0.14864 = $148.64

Price of bond = $681.09 + $148.64= $829.73

Bond Pricing
Problem Five years ago, Thompson Tarps Inc. issued twenty-five-year 10% annual coupon bonds with a
$1,000 face value each. Since then, interest rates in general have risen, and the yield to maturity on the
Thompson Tarps bonds is now 12%. Given this information, what is the price today for a Thompson Tarps
bond?

Solution
YTM = r = 12%
Maturity = n = 20
Par Value = FV = $1,000
Annual coupon = PMT = Coupon rate x Par value = 10% × $1,000 = $100

Bond Price = Present Value of coupons + Present Value of par value

1
1− 1
(1 + 12%)20
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 = $100 × + $1,000 × = $𝟖𝟓𝟎. 𝟔𝟏
12% (1 + 12%)20
Semiannual Bonds

• Most corporate and government bonds pay coupons on a semiannual basis.

• For computing price of these bonds, the values of the inputs have to be adjusted
according to the frequency of the coupons (or absence thereof).

➢ For example, for semiannual bonds, the annual coupon is divided by 2, the
number of years is multiplied by 2, and the YTM is divided by 2.

➢ The price of the bond can then be calculated by using the TVM equation, a
financial calculator, or a spreadsheet.
 Semiannual Bonds

• Example: Calculating the price of a

semiannual corporate bond.

Calculate the price of an A-rated, 30-year, 8.5%

coupon (paid semiannually) COCA COLA bond
(Par value = $1,000) which is expected to earn a
yield to maturity of 8.8%.

12 =0.0425
Semiannual Bonds

Using TVM Equation, YTM is 8.8%

Semiannual Bonds
Problem Endicott Enterprises Inc. has issued thirty-year semiannual coupon bonds
with a face value of $1,000. If the annual coupon rate is 14% and the current yield
to maturity is 8%, what is the firm’s current price per bond?

Solution

YTM = r = 8% ⇢ 8% ÷ 2 = 4%
Maturity = n = 30 ⇢ 30 × 2 = 60
Par Value = FV = $1,000
Annual coupon = PMT = Coupon rate x Par value = 14% × $1,000 = $140 ⇢ $140 ÷ 2 = $70

Bond Price = Present Value of coupons + Present Value of par value

1
1− 1
(1 + 4%)60
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 = $70 × + $1,000 × = $1,583.64 + $95.06 = $𝟏, 𝟔𝟕𝟖. 𝟕𝟎
4% (1 + 4%)60
A Zero-Coupon Bond

• A zero-coupon bond is a debt security that does not pay interest but
instead trades at a deep discount, rendering a profit at maturity, when
the bond is redeemed for its full-face value

• Known as “pure” discount bonds and sold at a discount from face

value.

• Do not pay any interest over the life of the bond.

• At maturity, the investor receives the par value, usually $1,000.

• Price of a zero-coupon bond is calculated by merely discounting its par

value at the prevailing discount rate or yield to maturity.
A Zero-Coupon Bond
A zero-coupon bond is a debt security that does not pay interest but instead trades at a deep
discount, rendering a profit at maturity, when the bond is redeemed for its full-face value

The price of a zero-coupon bond can be calculated as:

𝑀
𝑝𝑟𝑖𝑐𝑒 =
(1 + 𝑟)𝑛
where
M = Maturity value or face value of the bond
r = required rate of interest
n = number of years until maturity

Example: If an investor wishes to make a 6% return on a bond, with $25,000 par value,
that's due to mature in three years, he will be willing to pay the following:

$25,000
The 𝑝𝑟𝑖𝑐𝑒 = (1+6%)3 = $20,991
Malkiel’s Theorems

1. YTM and bond prices move in different directions.

2. A change in YTM causes a bigger change in price for a longer maturity.

3. A change in YTM changes price at a decreasing rate for a longer maturity.

4. A change in YTM causes a bigger change in price if the coupon is smaller

and vice versa

5. A fall in YTM increases price by a greater amount than the decrease in

price caused by a rise in YTM
Malkiel’s Theorems

A bond has a par value of £100, matures in 3 years’ time and pays a coupon of
£6 annually; the current market price is £90.05:
a) What is the coupon rate and current yield?
Coupon rate = 6 /100 = 6%. Current yield = 6 / 90.05 = 6.7%
b) Bond price and yield move in opposite directions (Malkiel’s theorem 1),
therefore is the yield to maturity higher or lower than the coupon rate?

Bond price has fallen therefore yield to maturity (YTM) is higher than the
coupon rate
 to find curret price:
- final arsen value of coupons:Om 4x(miring
NMT=coupon -
I

↑ Yieldfomaturity
:

10X(-)
0.03
H =

feas
Or of coupon:20,28
-
find presen value of Nar value - oux
(1
bond has par value at=0U
a

rym
I
100x 100x
=

mo

-
price of bond
2141,41
114,8
=

PMT: coupontutex parvalue.

annual coupon:
0.08 x 1000

not trin) 80
-
x (s)
PU of of coupons:
881,0,8
Du of ParValue:1000x oloo:
I
price of bond-&81,08 +148,84
824,74
=
 - -

Ovesult name ofcopons-Unter (

120x(yrg
Men 1000x 0,12
=

=120
->

848,38
prsentwheafwarvane: fNx-
[I re
- +

I
=1000 x
6,12) 20

Bond,
o
price of
848,33 102, d d +

=
949,99

.To calculate the price of a bond, we need to discount the future cash flows (interest payments and principal) back to their present values using the current yield to maturity

:For the Thompson Tarps bond, we know the following information

Face value (FV) = $1,000 -
Coupon rate (C) = 10% -
Number of years to maturity (N) = 25 -
Yield to maturity (YTM) = 12% -

:First, we can calculate the annual coupon payment (PMT) as

PMT = C * FV = 0.10 * $1,000 = $100

:Next, we can calculate the present value of each coupon payment using the formula
PV of coupon payment = PMT / (1 + YTM)^n
.where n is the number of years until the coupon payment is received

:For example, the present value of the first coupon payment (received at the end of year 1) would be
PV of first coupon payment = $100 / (1 + 0.12)^1 = $89.29

We can repeat this calculation for each of the 25 coupon payments and add up the present values to get the total present value of the coupon payments. Alternatively, we can use
:the formula for the present value of an annuity to simplify the calculation

PV of annuity = PMT * (1 - 1 / (1 + YTM)^N) / YTM

:Using this formula, we can calculate the present value of the coupon payments as
PV of annuity = $100 * (1 - 1 / (1 + 0.12)^25) / 0.12 = $872.37

:Finally, we need to calculate the present value of the principal payment (the face value of the bond) by discounting it back 25 years using the yield to maturity
PV of principal payment = FV / (1 + YTM)^N = $1,000 / (1 + 0.12)^25 = $91.85

:The total price of the bond today is the sum of the present values of the coupon payments and principal payment
Price = PV of annuity + PV of principal payment = $872.37 + $91.85 = $964.22

.Therefore, the price of the Thompson Tarps bond today is $964.22

years, do
coupon:4,5 I
fV 1000
=

80))
y + m 4,4
=

C1000x0ons x 1000x any ot

x

price