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ENGR 390 Lecture 10 Bonds Winter 2007

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?

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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

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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

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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%

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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?

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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 ?

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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 !!!

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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 = ?

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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%

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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

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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%

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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.

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