Valuation of bonds

Definition of a Bond
• A bond is a legally binding agreement between a
borrower and a lender that specifies the:
– Issuer, Par (face) value, Coupon or Discount or
premium, Coupon payment (rate and frequency),
Maturity Date, Currency, Credit Quality, Security,
etc.
– Bond indenture:
http://www.mhhefa.com/documents/bondresolutiondo
cuments/sampleconduitfinancing.pdf
 Why valuation?

• Efficient markets
• Price = value (fairly priced: buy or sell -> normal
returns)….serves as cost of funds

• Inefficient markets
• Price > value (overpriced: sell -> abnormal returns)
• Price < value (underpriced: buy -> abnormal returns)

Abnormal returns are possible only if the prices move towards

your estimated value after you acted.
 Valuation of a bond

• Known cash flows: Value = PV of expected future cash flows

• Prices of bond are highly sensitive to current rates of returns

available on bonds of the same credit quality having the same
duration (Yield to maturity: YTM)
 Bond Concepts
 Bond prices and market interest rates on similar
assets (YTM) move in opposite directions.
 YTM is the discounting rate (current rate on offer
for a similar bond)
 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)
 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.
 The Bond Pricing Equation

 1 
1 -
 (1  R) T  FV
Bond Value  C  
 (1  R)
T
 R
 
 Pure (Deep) Discount 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.
• Sometimes called zeroes, deep discount bonds, or original
issue discount bonds (OIDs)
• Treasury Bills
 Pure (Deep) Discount Bond:
Example
Find the value of a 30-year zero-coupon bond with a $1,000
par value and a YTM of 6%.

$0 $0 $0 $ 1, 0 0 0

0 2 29 30

FV $ 1, 000
PV    $ 174 . 11
(1  R ) T
(1 . 06 ) 30
 Level Coupon Bonds
• Make periodic coupon payments in addition to the maturity
value
• The payments are equal each period. Therefore, the bond is
just a combination of an annuity and a terminal (maturity)
value.
• Coupon payments are typically semiannual.
• Effective annual rate (EAR) =
(1 + R/m)m*t – 1
 Level Coupon Bond: Example
Consider a U.S. government bond with a 6 3/8% coupon that expires
in December 2010.
– The Par Value of the bond is $1,000.
– Coupon payments are made semi-annually (June 30 and
December 31 for this particular bond).
– Since the coupon rate is 6 3/8%, the payment is $31.875.
What is the bond price if On January 1, 2010, the required annual
yield is 5%.
_______________________________________________________
Solution

$ 3 1 .8 7 5 $ 3 1 .8 7 5 $ 3 1 .8 7 5 $ 1,0 3 1 .8 7 5

1 /1 / 06 6 /30 / 06 12 /31/ 06 6 / 30 /10 12 / 31 /10

Level Coupon Bond: Example

• On January 1, 2010, the required annual

yield is 5% or semi annual 2.5% and 10
semiannual periods

$ 31 . 875  1  $ 1, 000
PV  1 10 
 10
 $ 1, 060 . 17
. 05 2  (1 . 025 )  (1 . 025 )
 Consols

• Not all bonds have a final maturity.

• British consols pay a set amount (i.e., coupon) every period
forever.
• These are examples of a perpetuity.

C
PV 
R
 Bond Market
• Primarily over-the-counter transactions with dealers
connected electronically
• Extremely large number of bond issues, but generally low
daily volume
• Makes getting up-to-date prices difficult, particularly on a
small company or municipal issues
• Treasury securities are usually an exception

• http://in.investing.com/rates-bonds/india-10-year-bond-yield-
historical-data
• http://www.nseindia.com/products/content/debt/corp_bonds/c
bmhist_data.htm
• http://www.nse-
india.com/products/content/debt/corp_bonds/cbm_reporting_h
omepage.htm