3-1

Value of Bond
• Using The Present Value
1 Formula to Value Bonds

• How Bond Prices Vary

2 With Interest Rates

• The Term Structure of

3 Interest Rates

• Real and Nominal Rates of

4 Interest

• Corporate Bonds and the

5 Risk of Default
 3-2

What is a Bond?
➢If they need cash for
long-term investments,
they generally issue
bonds, which are simply
long-term loans
➢Corporations (and
governments) frequently
borrow money by issuing
or selling debt securities
called bonds
 3-3

Bond Features

Par Value
YTM
(FV)

Fixed Price
Coupon (PV)
Bond
 3-4

Valuing a Bond

C1 C2 1,000 + C N
PV = + + ... +
(1 + r ) (1 + r )
1 2
(1 + r ) N

For example, suppose Vinamilk wants to

borrow $1,000 for 5 years. The interest rate
on similar debt issued by similar
corporations is 12 percent. Vinamilk will
thus pay .12 × $1,000 = $120 in interest
every year for 5 years. At the end of 5
years, Vinamilk will repay the $1,000. The
required interest rate in the market on a
bond is called the bond’s yield to maturity
(YTM). What is the price of this bond if
YTM is 8%?
 3-5

Valuing a Bond

Example
➢ If today is October 1, 2010, what is the value of the
following bond? An IBM Bond pays $115 every
September 30 for 5 years. In September 2015 it pays an
additional $1000 and retires the bond. The bond is rated
AAA (WSJ AAA YTM is 7.5%)

Cash Flows
Sept 11 12 13 14 15
115 115 115 115 1115
 3-6

Valuing a Bond

Example continued
➢ If today is October 1, 2010, what is the value of the following bond? An
IBM Bond pays $115 every September 30 for 5 years. In September
2015 it pays an additional $1000 and retires the bond. The bond is rated
AAA (WSJ AAA YTM is 7.5%)

115 115 115 115 1,115

PV = + + + +
1.075 (1.075) (1.075) (1.075) (1.075)5
2 3 4

= $1,161.84
 3-7

Valuing a Bond
Example - France
➢ In December 2008 you purchase 100 Euros of bonds in France which
pay a 8.5% coupon every year. If the bond matures in 2012 and the
YTM is 3.0%, what is the value of the bond?

8 .5 8 .5 8 .5 108.5
PV = + + +
1.03 (1.03) (1.03) (1.03)4
2 3

= 120.44 Euros
 3-8

Valuing a Bond

Another Example - Japan

➢ In July 2010 you purchase 200 Yen of bonds in Japan which pay a 8%
coupon every year. If the bond matures in 2015 and the YTM is 4.5%,
what is the value of the bond?

16 16 16 16 216
PV = + + + +
1.045 (1.045 ) (1.045 ) (1.045 ) (1.045 )5
2 3 4

= 243.57 Yen
 3-9

Discount Vs Premium Bonds

Suppose the EVN were to issue a bond with 10
years to maturity. The EVN bond has an annual
coupon of $80, implying the bond will pay $80
per year for the next 10 years in coupon interest.
In addition, EVN will pay $1,000 to the
bondholder in 10 years.
a) Assuming similar bonds have a yield of 10
percent, what will this bond sell for?
b) Assuming similar bonds have a yield of 6
percent, what will this bond sell for
 3-10

Discount Vs. Premium Bonds

Discount Bonds
• YTM > Coupon Rate
• Sell as discount price (PV < Par Value)

Premium Bonds
• YTM < Coupon Rate
• Investors need to pay EXTRA fee
(Premium) to buy this bond (PV > Par
Value)
 3-11

Valuing a Semi-annual Bond

Example - USA
➢ In February 2009 you purchase a 3 year US Government bond. The
bond has an annual coupon rate of 4.875%, paid semi-annually. If
investors demand a 0.6003% semiannual return, what is the price of the
bond?

24.375 24.375 24.375 24.375 24.375 1024.375

PV = + + + + +
1.006003 (1.006003)2 (1.006003)3 (1.006003)4 (1.006003)5 (1.006003)6

= $1,107.95
 3-12

Valuing a Semi-annual Bond

Example continued - USA

➢ Take the same 3 year US Government bond. If investors demand a 4.0%
semiannual return, what is the new price of the bond?

24.375 24.375 24.375 24.375 24.375 1024.375

PV = + + + + +
1.04 (1.04 ) (1.04 ) (1.04 ) (1.04 ) (1.04 )6
2 3 4 5

= $918.09
 3-13

Bond Prices and Yields

115.00

110.00

105.00
Bond Price, %

100.00

95.00

90.00

85.00

80.00
0

10
Interest Rates, %
 3-14

Interest Rate Risks

➢ The risk that arises for bond owners from fluctuating
interest rates is called interest rate risk.
➢ How much interest rate risk a bond has depends on
how sensitive its price is to interest rate changes.
1. All other things being equal, the longer the time to
maturity, the greater the interest rate risk
2. All other things being equal, the lower the coupon
rate, the greater the interest rate risk.
 3-15

Interest Rate Risks

 3-16

Duration Formula

1  PV (C1 ) 2  PV (C 2 ) 3  PV (C 3 ) T  PV (C T )
Duration = + + + ... +
PV PV PV PV

duration
Modified Duration = volatility (%) =
1 + yield
 3-17

Duration Calculation

Proportion of Total Value Proportion of Total

Year Ct PV(Ct) at 5.0% [PV(Ct)/V] Value Time
1 100 95.24 0.084 0.084
2 100 90.7 0.08 0.16
3 1100 950.22 0.836 2.509
V = 1136.16 1 Duration= 2.753 years
 3-18

Duration
Example)
Given a 5 year, 9 % Coupon, Par value is $1000, with a 8.5%
YTM, what is this bond’s duration?

Year CF PV@YTM % of Total PV % x Year

1 90 82.95 .081 0.081
2 90 76.45 .075 0.150
3 90 70.46 .069 0.207
4 90 64.94 .064 0.256
5 1090 724.90 .711 3.555
1019.70 1.00 Duration= 4.249
 3-19

Bond Duration Example

A bond of $1000 was issued five years ago at a coupon
rate of 6%. The bond had a maturity period of 10 years to
be redeemable at par. The market interest rate currently is
10%.
a. Determine the value of the bond.
b. Calculate the Modified Duration.
c. Calculate the expected price change if tomorrow interest
rates increases from 10% to 11.5%
d. Calculate the expected price change if next year the
interest rates will increase from 10% to 12%
 3-20

Duration & Bond Prices

Bond Price, percent

Interest rate, percent

 3-21

Interest Rates
➢ Short- and long-term interest rates do not always move in parallel.
Between September 1992 and April 2000 U.S. short-term rates rose
sharply while long term rates declined.
 3-22

Law of One Price

➢All interest bearing instruments are priced
to fit the term structure
➢This is accomplished by modifying the asset
price
➢The modified price creates a New Yield,
which fits the Term Structure
➢The new yield is called the Yield To
Maturity (YTM)
 3-23

Yield to Maturity
Example
➢A $100 treasury bond expires in 5 years. It
pays a coupon rate of 10.5%. If the market
price of this bond is 107.88, what is the
YTM?
 3-24

Yield to Maturity
Example
➢A $1000 treasury bond expires in 5 years. It pays
a coupon rate of 10.5%. If the market price of this
bond is 107.88, what is the YTM?

C0 C1 C2 C3 C4 C5
-1078.80 105 105 105 105 1105

Calculate YTM (or IRR) = 8.5%

 3-25

Term Structure
What Determines the Shape of the Term Structure?

Expectations Theory

Term Structure & Capital Budgeting

➢ CF should be discounted using Term Structure info
➢ Since the spot rate incorporates all forward rates, then you
should use the spot rate that equals the term of your project.
➢ If you believe in other theories take advantage of the
arbitrage.
 3-26

Debt & Interest Rates

Classical Theory of Interest Rates (Economics)
➢ developed by Irving Fisher

Nominal Interest Rate = The rate you actually pay when you
borrow money

Real Interest Rate = The theoretical rate you pay when you
borrow money, as determined by supply and demand
r
Supply

Real r

Demand

$ Qty
 3-27

Inflation Rates
Annual rates of inflation in the United States from 1900–2008.

25

20
Annual Inflation (%)

15

10

0
1900

1906

1912

1918

1924

1930

1936

1942

1948

1954

1960

1966

1972

1978

1984

1990

1996

2002

2008
-5

-10

-15
 Average Inflation, %

Sw
itz
Ne erla

0.00
2.00
4.00
6.00
8.00
10.00
12.00

th nd
erl
an
ds
US
Ca A
na
Sw da
ed
e
No n
rw
Au ay
str
De alia
nm
ark

UK
So Irel
G uth and
er
m Af
ric
an a
y(
ex Ave
19 rag
22 e
/2
3)
Be
lgi
um
Averages from 1900-2006

Sp
a
Fr in
an
Global Inflation Rates

ce
Ja
pa
n
Ita
ly
3-28
 3-29

Debt & Interest Rates

Nominal r = Real r + expected inflation (approximation)

Real r is theoretically somewhat stable

Inflation is a large variable

Q: Why do we care?
A: This theory allows us to understand the Term Structure of
Interest Rates.

Q: So What?
A: The Term Structure tells us the cost of debt.
 3-30

Debt & Interest Rates

Actual formula

1+rnominal=(1+rreal)*(1+rinflation)
 Interest rate (%)

0
2
4
6
8
14
16
18
20

10
12
1-Jan-84
1-Apr-85
1-Jul-86
1-Oct-87
1-Jan-89
1-Apr-90
1-Jul-91
1-Oct-92
10 year real interest rate

1-Jan-94
1-Apr-95
1-Jul-96
1-Oct-97
1-Jan-99
10 year nominal interest rate

1-Apr-00
UK Bond Yields

1-Jul-01
1-Oct-02
1-Jan-04
1-Apr-05
1-Jul-06
1-Oct-07
1-Jan-09
3-31
 3-32

Homework
Given a 6-year annual coupon bond with a face value of
$1000, coupon rate of 8.5% and a yield to maturity of 7%.
a. Calculate the Macaulay duration of this bond.
b. If tomorrow yield to maturity increases from 7% to 11%,
calculate the price of bond after yield to maturity changes.
c. If next years YTM decreases from 7% to 5%, calculate the
price of the bond after YTM changes
 3-33

HOMEWORK
EX1: A government bond issued in Germany has
a coupon rate of 7%, face value of euros 100 and
maturing in five years. The interest payments are
made annually. Calculate the price of the bond
(in euros)if the yield to maturity is 4.5%.

EX2: A 3-year bond with 10% coupon rate and

$1000 face value yields 8%, compound semi-
annually. Assuming semi annual coupon
payment, calculate the price of the bond
 3-34

HOMEWORK
➢EX3: A 4-year bond with 10% coupon rate
and $1000 face value is selling for $1223.
Calculate the yield to maturity on the bond
assuming semi-annual interest payments.
➢EX4: A 5-year bond with 10% coupon rate
and $1000 face value is selling for $1223.
Calculate the yield to maturity on the bond
assuming annual interest payments.
 3-35

HOMEWORK
A 15-year bond with a 5.5% coupon and a
$1,000 par value is currently priced at $940.
a. If the current market interest rate is 7.5%.
Should you buy the bond? Why or why not?
b. Assuming you buy and hold this bond for
10 years. What price must you sell the bond
for if you want to earn a 8% rate of return on
this investment?