Valuing Bonds
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| What is a bond? | Security that obligates the issuer (government, corporations) to make specified payments to the bondholder.
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| What is a coupon | The interest payments made to the bondholder.
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| What is Face Value (Par Value or Principal Value) | Payment at the maturity of the bond.
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| What is a coupon rate | Annual interest payment, as a percentage of face value.
WARNING: The coupon rate IS NOT the discount rate used in the Present Value calculations. The coupon rate merely tells us what cash flow the bond will produce.
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| Bond Pricing | The price of a bond is the Present Value of all cash flows generated by the bond (i.e. coupons and face value) discounted at the required rate of return r.
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| 1. What happens when the interest rate is equal to the coupon rate? 2. What happens when the interest rate is higher than the coupon rate? | 1. When interest rate is equal to the coupon rate, the bond price equal face value.
2. When interest rate is higher than the coupon rate, the bond price is lower than its face value, i.e, the bond sells for less than face value.
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| Semi annually vs Annually & its affects on time periods and the discount rate. | Time Periods - Paying coupons twice a year, instead of once doubles the total number of cash flows to be discounted in the PV formula.
Discount rate - when the time periods change to half years, the DR changes from the annual rate to the half year rate.
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| Interest Rate Risk. The value of the 5% bond falls as interest rates rise Explain what happens when to the Bondholder's payments & bond prices when interest rates rise, decline and stay the same. What is the effect on short-term & long-term bonds | Rise in IR – decrs the PV of BH’s payments & bond prices
Decline in IR - incs the PV of payments & result in + prices.
When the IR = the 5.0% coupon rate, both bonds sell at face value
A change in IR has + effect on the prices of LT bonds than ST bon
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| Current Yield | Annual coupon payments divided by bond price. (compare: coupon rate – annual coupon payment divided by face value)
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| Yield To Maturity (YTM=r) | Interest rate for which the present value of the bond’s payments equal the price.
If you are given the price of a bond (PV) and the coupon rate, the yield to maturity can be found by solving for r.
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| Rate of Return | Total income per period per dollar invested.
= (total income)/(investment)
=(coupon income + price change)/(investment)
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| Yield curve | Graph of the relationship between time to maturity and yield to maturity.
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| Credit risk/Default risk | The risk that a bond issuer may default on its bonds.
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| Default premium | The additional yield on a bond investors require for bearing credit risk
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| Investment Grade | Bonds rated Baa or above by Moody’s or BBB or above by Standard & Poor’s Junk bonds – Bond with a rating below Baa or BBB.
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| Corporate bonds: Zero Coupons? | Investors receive face value at the maturity date but do not receive a regular coupon payment, i.e., zero-coupon rate. They are issued at prices below face value.
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| Floating rate bonds | Coupon rate change over time.
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| Convertible bonds | Can be chosen later to exchange for a specified number of shares of common stock.
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