CH 09 Bonds Valuation

9-1
CHAPTER 9
Bonds and Their Valuation
 Key features of bonds

 Bond valuation
 Measuring yield
 Assessing risk
Copyright © 2002 Harcourt, Inc. All rights reserved.

9-2
Key Features of a Bond
1. Par value: Face amount; paid

at maturity. Assume $1,000.
2. Coupon interest rate: Stated

interest rate. Multiply by par
value to get dollars of interest.
Generally fixed.
(More…)
9-3
3. Maturity: Years until bond

must be repaid. Declines.
4. Issue date: Date when bond

was issued.
5. Default risk: Risk that issuer

will not make interest or
principal payments.

9-4
How does adding a call provision

affect a bond?
 Issuer can refund if rates decline.

That helps the issuer but hurts the
investor.
 Therefore, borrowers are willing to
pay more, and lenders require more,
on callable bonds.

9-5
Financial Asset Valuation
0 1 2 n
k
...
Value CF1 CF2 CFn
CF1 CF2 CFn

PV = + + ... + .
1+ k 1
1 + k2
1+ k n

9-6
 The discount rate (ki) is the

opportunity cost of capital, i.e., the
rate that could be earned on
alternative investments of equal
risk.
ki = k* + IP + LP + MRP + DRP
for debt securities.

9-7
What’s the value of a 10-year, 10%

coupon bond if kd = 10%?
0 1 2 10
10% ...
V=? 100 100 100 + 1,000
$100 $100 $1,000

VB  1 + . . . + 10 + 10
1 + k d  1 + k d  1+ k d 
= $90.91 + . . . + $38.55 + $385.54
= $1,000.
9-8
The bond consists of a 10-year, 10%

annuity of $100/year plus a $1,000 lump
sum at t = 10:
PV annuity = $ 614.46
PV maturity value = 385.54
Value of bond = $1,000.00
INPUTS 10 10 100 1000

N I/YR PV PMT FV
OUTPUT -1,000

9-9
What would happen if expected

inflation rose by 3%, causing k = 13%?
INPUTS 10 13 100 1000

N I/YR PV PMT FV
OUTPUT -837.21
When kd rises, above the coupon rate,

the bond’s value falls below par, so it
sells at a discount.
9 - 10
What would happen if inflation fell, and

kd declined to 7%?
INPUTS 10 7 100 1000

N I/YR PV PMT FV
OUTPUT -1,210.71
If coupon rate > kd, price rises above

par, and bond sells at a premium.
9 - 11
Suppose the bond was issued 20

years ago and now has 10 years to
maturity. What would happen to its
value over time if the required rate
of return remained at 10%, or at
13%, or at 7%?

9 - 12
Bond Value ($)

1,372 kd = 7%.
1,211
kd = 10%. M
1,000
837
kd = 13%.
775
30 25 20 15 10 5 0
Years remaining to Maturity

9 - 13
 At maturity, the value of any bond

must equal its par value.
 The value of a premium bond would
decrease to $1,000.
 The value of a discount bond would
increase to $1,000.
 A par bond stays at $1,000 if kd
remains constant.

9 - 14
What’s “yield to maturity”?
 YTM is the rate of return earned on a

bond held to maturity. Also called
“promised yield.”

9 - 15
What’s the YTM on a 10-year, 9%

annual coupon, $1,000 par value bond
that sells for $887?
0 1 9 10
kd=?
...
90 90 90
PV1 1,000
.
.
.
PV10
PVM
887 Find kd that “works”!
9 - 16
Find kd
INT ... + INT M
VB  1 + N + N
1 + k d  1 + k d  1 + k d 
90 ... + 90 1,000
887  1 + 10 +
1 + k d  1+ k d  1 + k d 
10
INPUTS 10 -887 90 1000

N I/YR PV PMT FV
OUTPUT 10.91

9 - 17
 If coupon rate < kd, bond sells at a discount.

 If coupon rate = kd, bond sells at its par
value.
If coupon rate > kd, bond sells at a premium.
 If kd rises, price falls.
 Price = par at maturity.

9 - 18
Find YTM if price were $1,134.20.
INPUTS 10 -1134.2 90 1000

N I/YR PV PMT FV
OUTPUT 7.08
Sells at a premium. Because

coupon = 9% > kd = 7.08%,
bond’s value > par.
9 - 19
Definitions
Current yield = Annual coupon pmt

Current price
Change in price
Capital gains yield =
Beginning price
Exp total Exp Exp cap

= YTM = +
return Curr yld gains yld

9 - 20
Find current yield and capital gains

yield for a 9%, 10-year bond when the
bond sells for $887 and YTM = 10.91%.
$90
Current yield = $887
= 0.1015 = 10.15%.

9 - 21
YTM = Current yield + Capital gains yield.
Cap gains yield = YTM - Current yield

= 10.91% - 10.15%
= 0.76%.
Could also find values in Years 1 and 2,

get difference, and divide by value in
Year 1. Same answer.
9 - 22
What’s interest rate (or price) risk?

Does a 1-year or 10-year 10% bond
have more risk?
Interest rate risk: Rising kd causes

bond’s price to fall.
kd 1-year Change 10-year Change
5% $1,048 $1,386
10% 1,000 4.8% 1,000 38.6%
15% 956 4.4% 749 25.1%

9 - 23
Value
1,500 10-year
1,000 1-year
500
0 kd
0% 5% 10% 15%

9 - 24
What is reinvestment rate risk?
The risk that CFs will have to be

reinvested in the future at lower rates,
reducing income.
Illustration: Suppose you just won
$500,000 playing the lottery. You’ll
invest the money and live off the
interest. You buy a 1-year bond with a
YTM of 10%.
9 - 25
Year 1 income = $50,000. At year-

end get back $500,000 to reinvest.
If rates fall to 3%, income will drop

from $50,000 to $15,000. Had you
bought 30-year bonds, income
would have remained constant.

9 - 26
 Long-term bonds: High interest rate

risk, low reinvestment rate risk.
 Short-term bonds: Low interest rate
risk, high reinvestment rate risk.
 Nothing is riskless!

9 - 27
True or False: “All 10-year bonds

have the same price and
reinvestment rate risk.”
False! Low coupon bonds have less

reinvestment rate risk but more
price risk than high coupon bonds.

9 - 28
Semiannual Bonds
1. Multiply years by 2 to get periods = 2n.

2. Divide nominal rate by 2 to get periodic
rate = kd/2.
3. Divide annual INT by 2 to get PMT =
INT/2.
INPUTS 2n kd/2 OK INT/2 OK

N I/YR PV PMT FV
OUTPUT

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9-1

 Key features of bonds

Copyright © 2002 Harcourt, Inc. All rights reserved.

Key Features of a Bond

1. Par value: Face amount; paid

2. Coupon interest rate: Stated

3. Maturity: Years until bond

4. Issue date: Date when bond

5. Default risk: Risk that issuer

Copyright © 2002 Harcourt, Inc. All rights reserved.

How does adding a call provision

 Issuer can refund if rates decline.

Copyright © 2002 Harcourt, Inc. All rights reserved.

Financial Asset Valuation

CF1 CF2 CFn

Copyright © 2002 Harcourt, Inc. All rights reserved.

 The discount rate (ki) is the

for debt securities.

Copyright © 2002 Harcourt, Inc. All rights reserved.

What’s the value of a 10-year, 10%

$100 $100 $1,000

The bond consists of a 10-year, 10%

INPUTS 10 10 100 1000

Copyright © 2002 Harcourt, Inc. All rights reserved.

What would happen if expected

INPUTS 10 13 100 1000

When kd rises, above the coupon rate,

What would happen if inflation fell, and

INPUTS 10 7 100 1000

If coupon rate > kd, price rises above

Suppose the bond was issued 20

Copyright © 2002 Harcourt, Inc. All rights reserved.

Bond Value ($)

Years remaining to Maturity

 At maturity, the value of any bond

Copyright © 2002 Harcourt, Inc. All rights reserved.

What’s “yield to maturity”?

 YTM is the rate of return earned on a

Copyright © 2002 Harcourt, Inc. All rights reserved.

What’s the YTM on a 10-year, 9%

INPUTS 10 -887 90 1000

Copyright © 2002 Harcourt, Inc. All rights reserved.

 If coupon rate < kd, bond sells at a discount.

Copyright © 2002 Harcourt, Inc. All rights reserved.

Find YTM if price were $1,134.20.

INPUTS 10 -1134.2 90 1000

Sells at a premium. Because

Current yield = Annual coupon pmt

Exp total Exp Exp cap

Copyright © 2002 Harcourt, Inc. All rights reserved.

Find current yield and capital gains

Copyright © 2002 Harcourt, Inc. All rights reserved.

YTM = Current yield + Capital gains yield.

Cap gains yield = YTM - Current yield

Could also find values in Years 1 and 2,

What’s interest rate (or price) risk?

Interest rate risk: Rising kd causes

15% 956 4.4% 749 25.1%

Copyright © 2002 Harcourt, Inc. All rights reserved.

What is reinvestment rate risk?

The risk that CFs will have to be

Year 1 income = $50,000. At year-

If rates fall to 3%, income will drop