Bond Valuation

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 Outline
Bond features and bond types
Bond Valuation
Zero coupon bonds
Coupon bonds
Bond values and why they fluctuate
The impact of inflation on interest rates

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 Bonds
A security that obligates the issuer to make
specified payments to the holder over a period of
time.

Bonds are also called “ fixed income securities” .

Government Bonds ( Bonds issued by governments:
Treasury bonds, T-bills..)
Corporate Bonds ( Bonds issued by corporations)

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 Sample Corporate Bond

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 Bond Valuation – Bond features
Face or par value
Coupon rate
Maturity date
Discount Rate
PRICE!!!

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 Bonds Valuation
Present Value of all Future Payments!
Yield to Maturity (YTM)
Interest rate that equates the PV of Bond’s
future payments with current price.
Assumptions:
Bond is held to maturity
Coupons are reinvested at YTM
The discount factor (YTM) remains constant
over the life of the bond.

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 Bond Pricing - Zero Coupon Bonds

P B 
Par Value T

(1 r )
T

Zero coupon bond simply pays the face value at maturity.

Make no periodic interest payments (coupon rate = 0%)
Entire yield-to-maturity comes from the difference between the purchase price and the par value
(capital gains)
Cannot sell for more than par value

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 The Price of a Zero-Coupon Bond over Time

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 Bond Valuation
T

P B  t 1
Ct t
(1  r )
 ParValue
(1 r )
T
T

PB = Price of the bond

Ct = coupon payment at time t
T = number of periods to maturity
r = discount rate
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 Bond Valuation

Bond Value = PV(coupons) + PV(Face Value)

Bond Value = PV(annuity) + PV(lump sum)
Remember:
 As interest rates increase present values decrease ( r → PV  )
 As interest rates increase, bond prices decrease
and vice versa
 Use the same interest rate (YTM) across the valuation formula

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 Bond Valuation-Example

Example
If today is October 2004, what is the value of the following bond?
 An IBM Bond pays $115 every Sept for 5 years. In Sept 2009 it

pays an additional $1000. Assume that the discount rate on the

bond is 7.5%.

115 115 115 115 1,115

Pr ice     
1.075 1.075 2
1.075 1.075 1.075
3 4 5

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 $1,161.84
 What is the price of 8% (semiannual), 10-yr.
bond with a yield of 6%?

P0 = PV(annuity) + PV(lump sum)

P 0  1,148 .77
Coupon = 4%*1,000 = 40 (Semiannual)
Discount Rate = 3% (Semiannual)
Maturity = 10 years or 20 periods
12 Par Value = 1,000
 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
13 When the YTM > coupon, the bond trades at a discount.
 Bond Concepts
 Bond prices and market interest rates move in
opposite directions.
 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)

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 Premium and Discount Bonds over Time

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