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Engineering Economics 390. Courtesy of Atre, Sundar V Associate Professor, Oregon State University.

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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?

S.V. Atre 1

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

S.V. Atre 2

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

S.V. Atre 3

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

Maturity (2005) Trading volume

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%

S.V. Atre 4

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?

S.V. Atre 5

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 ?

S.V. Atre 6

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 !!!

S.V. Atre 7

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 = ?

S.V. Atre 8

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%

S.V. Atre 9

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

S.V. Atre 10

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

Broader diversification reduces risk

Broader diversification increase expected

return

Broader Diversification Increases 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%

S.V. Atre 11

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.

S.V. Atre 12

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