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ENGR 390 Lecture 10 Bonds Winter 2007

Chapter 6
Principles of Investing
 Investing in Financial
Assets
 Investing in Stocks
 Investing in Bond
 Investment Strategies

Investment Basics

 Liquidity – How accessible is your
money?
 Risk – What is the safety involved?
 Return – How much profit will you
be able to expect from your
investment?

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ENGR 390 Lecture 10 Bonds Winter 2007

Investing in Bond

 Bonds: Loans that
investors make to
corporations and
governments.
 Face (par) value: Principal
amount
 Coupon rate: yearly
interest payment
 Maturity: the length of the
loan

Types of Bonds and How They Are Issued in the Financial Market

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ENGR 390 Lecture 10 Bonds Winter 2007

No meaning,
Spacing Maturity date
Coupon rate
2005

AT&T 7s05
Closing price: 108 1/ 4
\$1,082.50
Market price

Bond Price Notation Used in Financial Markets

Corporate Bonds Treasury Bonds
1/8=\$1.25 5/8=\$6.25 1/32=\$0.3125 17/32=\$5.3125
2/32=\$0.6250 18/32=\$5.6250
3/32=\$0.9375 19/32=\$5.9375
4/32=\$1.25 20/32=\$6.25
1/4=\$2.50 3/4=\$7.50 6/32=\$1.5625 21/32=\$6.5625
7/32=\$1.8750 22/32=\$6.8750
7/32=\$2.1875 23/32=\$7.1875
8/32=\$2.50 24/32=\$7.50
3/8=\$3.75 7/8=\$8.75 9/32=\$2.8125 25/32=\$7.8125
10/32=\$3.1250 26/32=\$8.1250
11/32=\$3.4375 27/32=\$8.4375
12/32=\$3.75 28/32=\$8.75
1/2=\$5.00 1=\$10 13/32=\$4.0625 29/32=\$9.0625
14/32=\$4.375 30/32=\$9.3750
15/32=\$4.6875 31/32=\$9.6875
16/32=\$5.00 32/32=\$10

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ENGR 390 Lecture 10 Bonds Winter 2007

How Do Prices and Yields Work?

 Yield to Maturity: The actual interest (%)
earned from a bond over the holding period

 Current Yield: The annual interest (%) earned
as a percentage of the current market price

Bond Quotes

AT&T 7s05 6.5% 5 million 108 1/4

Coupon rate of 7% Closing
Current yield Market price

\$70/108.25 \$1,082.50
= 6.47%

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ENGR 390 Lecture 10 Bonds Winter 2007

BOND TERMINOLOGY
1. Face Value, Par Value, Maturity Value
– How much the borrower will pay the
holder when it matures.
2. Coupon Rate, Nominal Annual Interest Rate
– Paid yearly on face value.
3. Frequency of Interest Payments
4. Maturity Date
– Date at which you receive the face value
5. Current Price, Market Value
– What someone is willing to pay for the
future cash flows.
6. Yield to Maturity
– Actual interest earned over holding period

Problem 1
You desire to make an investment in
bonds provided you can earn 12% per
year, compounded monthly on your
investment.

How much can you afford to pay for a
bond with a face value of \$10,000 that
pays a coupon rate of 10% in quarterly
payments, and will mature in 20 years?

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ENGR 390 Lecture 10 Bonds Winter 2007

Problem 1
GIVEN:
FACE VALUE = \$10,000
COUPON RATE = 10% (APR) PAID QUARTERLY
MATURITY = 20 YEARS
DESIRED YIELD RATE = 12%/YR, CPD MONTHLY

FIND MAXIMUM MARKET PRICE TO BUY BOND:

DIAGRAM: \$10,000

AB
0
1 2 3 4 80 QUARTERS
P?

Problem 1
DIAGRAM: \$10,000

AB
0
1 2 3 4 80 QUARTERS
P?

1. How much is quarterly interest rate, iB currently ?
C = 1; K = 4; r = 0.1
C
⎛ r ⎞
i = ⎜1 + ⎟ −1 AB = \$10,000 (0.025)
⎝ CK ⎠
1 = \$250 / QUARTER
⎛ 0.10 ⎞
= ⎜⎜1 + ⎟ −1
⎝ (1)4 ⎟⎠
= 2.5% PER QUARTER

2. How much is quarterly interest amount, AB currently ?

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ENGR 390 Lecture 10 Bonds Winter 2007

Problem 1
DIAGRAM: \$10,000

\$250
0
1 2 3 4 80 QUARTERS
P?
3. How much is ieff for your expectation?

C = 3; K = 4; r = 0.12
C
⎛ r ⎞
i = ⎜1 + ⎟ −1
⎝ CK ⎠
3
⎛ 0.12 ⎞
= ⎜⎜1 + ⎟⎟ − 1
⎝ (3)4 ⎠
= 3.0301% PER QUARTER

Problem 1
DIAGRAM: \$10,000

\$250
0
1 2 3 4 80 QUARTERS
P?

4. How much are you willing to offer ?
P
P = \$250(P|A, 3.0301%, 80) + \$10,000(P|F, 3.0301%, 80)
= \$250(29.9635) + \$10,000(0.0918)
= \$7,491 + \$918
= \$8,409

NOTE: IF ieff ROUNDED OFF TO 3%/QUARTER, PRICE IS \$8,490 !!!

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ENGR 390 Lecture 10 Bonds Winter 2007

Problem 2
A \$1000 face value bond will mature
in 10 years. The annual rate of
interest is 6% payable semi-annually.

If compounding is semi-annual and
the bond can be purchased for \$870,
what is the yield to maturity in terms
of the effective annual rate earned?

Problem 2
GIVEN:
FACE VALUE = \$1,000
COUPON RATE = 6% (APR) PAID SEMI-ANNUALLY
MATURITY = 10 YEARS
MARKET PRICE = \$870

FIND YIELD TO MATURITY (ANNUAL EFFECTIVE RATE):

DIAGRAM: \$1,000

AB
0
1 2 3 4 20 PERIODS
\$870
ia = ?

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ENGR 390 Lecture 10 Bonds Winter 2007

DIAGRAM:
Problem 2 \$1,000

AB
0
1 2 3 4 20 PERIODS
\$870
ia = ?
1. How much is semi-annual interest rate, iB currently ?
C = 1; K = 2; r = 0.06
C
⎛ r ⎞
i = ⎜1 + ⎟ −1
⎝ CK ⎠ AB = \$1,000 (0.03)
⎛ 0.06 ⎞
1 = \$30 SEMI-ANNUALLY
= ⎜⎜1 + ⎟ −1
⎝ (1)2 ⎟⎠
= 3% SEMI − ANNUALLY

2. How much is semi-annual interest amount, AB currently ?

DIAGRAM:
Problem 2 \$1,000

\$30
0
1 2 3 4 20 PERIODS
\$870
ia= ?

3. How much is effective semi-annual interest rate, iEFF ?
\$870 = \$30(P|A, i, 20) + \$1,000(P|F, i, 20)
TRY 3% = \$30(14.8775) + \$1000(0.5537)
= \$1000
TRY 4% = \$30(13.5903) + \$1,000(0.4564)
= \$864
INTERPOLATE (OR APPROXIMATE) iEFF = 3.96%

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ENGR 390 Lecture 10 Bonds Winter 2007

Problem 2
DIAGRAM: \$1,000

\$30
0
1 2 3 4 20 PERIODS
\$870
ia = ?

2. How much is effective annual interest rate, ia ?

iA = [1 + 0 .0396 ]2 − 1
= 8 .08 % / YEAR

Yield

(a) Yield to maturity:
\$996.25 = \$48.13( P / A, i,20) + \$1,000 ( P / F , i,20)
i = 4.84% per semiannual period
ia = (1 + 0.0484 ) 2 − 1 = 9.91%
(b) Current yield:
\$48.13
= 4.83% per semiannual period
\$996.25

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ENGR 390 Lecture 10 Bonds Winter 2007

Investment Strategies

 Trade-Off between Risk and Reward
 Cash: the least risky with the lowest returns
 Debt: moderately risky with moderate returns
 Equities: the most risky but offering the greatest
payoff
return

Amount Investment Expected Return

\$2,000 Buying lottery tickets -100% (?)

\$2,000 Under the mattress 0%

\$2,000 Term deposit (CD) 5%

\$2,000 Corporate bond 10%

\$2,000 Mutual fund (stocks) 15%

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ENGR 390 Lecture 10 Bonds Winter 2007

Option Amount Investment Expected Value in 25
Return years
1
1 \$10,000 Bond 7% \$54,274
\$2,000 Lottery tickets -100% \$0

\$2,000 Mattress 0% \$2,000

2 \$2,000 Term deposit (CD) 5% \$6,773

\$2,000 Corporate bond 10% \$21.669

\$2,000 Mutual fund 15% \$65,838
(stocks)
\$96,280

Summary
 The three basic investment objects are: growth,
income, and liquidity.
 The two greatest risks investors face are
inflation and market volatility.
 Diversification by combining assets with
different patterns of return, it is possible to
achieve a higher rate of return without
increasing significant risk.
 Investing in stocks and bonds is one of the
most common investment activities among the
American investors.

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