Valuing Bonds

Recap of TVM

Back to the Fundamental

Future Value

Compounding and Discounting

Translate $1 today into its

equivalent in the future
Today
(COMPOUNDING).

Future
FV=?

Translate $1 in the future into

Today
its equivalent today
Future
(DISCOUNTING).
PV=?

Future Value
PV =

-100

FV =

106

Future Value (FV) = PV (1 + i) t

= 100 (1+0.06)1 = RM 106
Calculator Solution:
P/Y = 1
I = 6 N = 1 PV =
RM106

-100

FV =
4

Future Value
PV =

-100

FV =

133.82

Future Value (FV) = PV (1 + i) t

= 100 (1+0.06)5 =
133.82
Calculator Solution:
P/Y = 1
I = 6 N = 5 PV =
RM133.82

-100

RM
FV =
5

Future Value
PV = -100
0

FV = 133.82
5

Mathematical Solution:
FV = PV (FVIF i, n )
FV = 100 (FVIF 6%, 5 ) (use FVIF table,
or)
FV = PV (1 + i)n
FV = 100 (1.06)5 = RM133.82

Future Value
PV =

-100

FV =

134.69
20

Future Value (FV) = PV (1 + i/m) mxn

= 100 (1+0.06/4)(4x5) = 134.69
Calculator Solution:
P/Y = 1
I = 1.5 N = 20 PV =
134.69

-100

FV =
7

Future Value
PV =

-100

FV =

134.89

20

Future Value (FV) = PV (1 + i/m) mxn

= 100 (1+0.06/12)(12x5) = 134.89
Calculator Solution:
P/Y = 1
I = 0.005 N = 60 PV =
-100 FV = 134.89

Present Value

Present Value - single sums

If you receive $100 one year from now,
what is the PV of that $100 if your
opportunity cost is 6%?

PV = ??

FV =

100
1

Present Value (PV) = FV/(1+i)t = 100/(1.06)1 = 94.34

Calculator Solution:
P/Y = 1 I = 6 N = 1
PV = -94.34

FV =

100
10

Present Value - single sums

If you receive $100 five years from now,
what is the PV of that $100 if your
opportunity cost is 6%?

PV = ??

FV =

100
5

Present Value (PV) = FV/(1+i)t = 100/(1.06)5 = 74.73

Calculator Solution:
P/Y = 1 I = 6 N = 5

FV =

100

PV = -74.73
11

Mathematical Solution:
PV = FV (PVIF i, n )
PV = 100 (PVIF 6%, 5 ) (use PVIF table)
PV = FV / (1 + i)n
5
PV = 100 / (1.06) = 74.73
12

Present Value of $1
n
1%
1
0.9901
2
0.9803
3
0.9706
4
0.9610
5
0.9515
6
0.9420
7
0.9327
8
0.9235
9
0.9143
10
0.9053
11
0.8963
12
0.8874
13
0.8787
14
0.8700
15
0.8613
16
0.8528
17
0.8444
18
0.8360
19
0.8277
20
0.8195
21
0.8114
22
0.8034
23
0.7954
24
0.7876
25
0.7798
30
0.7419
40
0.6717
50
0.6080
60
0.5504

2%
0.9804
0.9612
0.9423
0.9238
0.9057
0.8880
0.8706
0.8535
0.8368
0.8203
0.8043
0.7885
0.7730
0.7579
0.7430
0.7284
0.7142
0.7002
0.6864
0.6730
0.6598
0.6468
0.6342
0.6217
0.6095
0.5521
0.4529
0.3715
0.3048

3%
0.9709
0.9426
0.9151
0.8885
0.8626
0.8375
0.8131
0.7894
0.7664
0.7441
0.7224
0.7014
0.6810
0.6611
0.6419
0.6232
0.6050
0.5874
0.5703
0.5537
0.5375
0.5219
0.5067
0.4919
0.4776
0.4120
0.3066
0.2281
0.1697

4%
0.9615
0.9246
0.8890
0.8548
0.8219
0.7903
0.7599
0.7307
0.7026
0.6756
0.6496
0.6246
0.6006
0.5775
0.5553
0.5339
0.5134
0.4936
0.4746
0.4564
0.4388
0.4220
0.4057
0.3901
0.3751
0.3083
0.2083
0.1407
0.0951

5%
0.9524
0.9070
0.8638
0.8227
0.7835
0.7462
0.7107
0.6768
0.6446
0.6139
0.5847
0.5568
0.5303
0.5051
0.4810
0.4581
0.4363
0.4155
0.3957
0.3769
0.3589
0.3418
0.3256
0.3101
0.2953
0.2314
0.1420
0.0872
0.0535

6%
0.9434
0.8900
0.8396
0.7921
0.7473
0.7050
0.6651
0.6274
0.5919
0.5584
0.5268
0.4970
0.4688
0.4423
0.4173
0.3936
0.3714
0.3503
0.3305
0.3118
0.2942
0.2775
0.2618
0.2470
0.2330
0.1741
0.0972
0.0543
0.0303

7%
0.9346
0.8734
0.8163
0.7629
0.7130
0.6663
0.6227
0.5820
0.5439
0.5083
0.4751
0.4440
0.4150
0.3878
0.3624
0.3387
0.3166
0.2959
0.2765
0.2584
0.2415
0.2257
0.2109
0.1971
0.1842
0.1314
0.0668
0.0339
0.0173

8%
0.9259
0.8573
0.7938
0.7350
0.6806
0.6302
0.5835
0.5403
0.5002
0.4632
0.4289
0.3971
0.3677
0.3405
0.3152
0.2919
0.2703
0.2502
0.2317
0.2145
0.1987
0.1839
0.1703
0.1577
0.1460
0.0994
0.0460
0.0213
0.0099

9%
0.9174
0.8417
0.7722
0.7084
0.6499
0.5963
0.5470
0.5019
0.4604
0.4224
0.3875
0.3555
0.3262
0.2992
0.2745
0.2519
0.2311
0.2120
0.1945
0.1784
0.1637
0.1502
0.1378
0.1264
0.1160
0.0754
0.0318
0.0134
0.0057

10%
0.9091
0.8264
0.7513
0.6830
0.6209
0.5645
0.5132
0.4665
0.4241
0.3855
0.3505
0.3186
0.2897
0.2633
0.2394
0.2176
0.1978
0.1799
0.1635
0.1486
0.1351
0.1228
0.1117
0.1015
0.0923
0.0573
0.0221
0.0085
0.0033
13

The Time Value of

Money
Compounding and
Discounting
Cash Flow Streams
0

4
14

Annuities
Annuity: a sequence of equal
cash flows, occurring at the
end of each period.

4
15

Examples of
Annuities:

If you buy a bond, you will

receive equal semi-annual
coupon interest payments
over the life of the bond.
If you borrow money to buy
a house or a car, you will pay
a stream of equal payments.

16

Future Value annuity

If you invest $1,000 each year at 8%, how
much would you have after 3 years?
FV?

0
FV

=
3,246.40

1000

1000

1000

(PMT)

(1 + i)n - 1
i
(1,000) (1.08)3 - 1
.08

=
17

:FV

PMT (FVIFA

i, n

FV =
1,000 (FVIFA .08, 3 )
(use FVIFA table)
=
1,000
x
3.2464
=
RM
Sum of an Annuity of $1 for n years
n 3,246.40
1%
2%
3%
4%
5%
6%
7%
8%
9%
1
1.0000
1.0000
1.0000
1.0000
1.0000
1.0000
1.0000
1.0000
1.0000
2
3
4
5

2.0100
3.0301
4.0604
5.1010

2.0200
3.0604
4.1216
5.2040

2.0300
3.0909
4.1836
5.3091

2.0400
3.1216
4.2465
5.4163

2.0500
3.1525
4.3101
5.5256

2.0600
3.1836
4.3746
5.6371

2.0700
3.2149
4.4399
5.7507

2.0800
3.2464
4.5061
5.8666

2.0900
3.2781
4.5731
5.9847

10%
1.0000
2.1000
3.3100
4.6410
6.1051

Calculator Solution:
P/Y = 1
I = 8 N = 3 PMT =
-1,000
Solve for FV = RM 3,246.40

18

Sum of an Annuity of $1 for n years

n
1%
2%
1
1.0000
1.0000
2
2.0100
2.0200
3
3.0301
3.0604
4
4.0604
4.1216
5
5.1010
5.2040
6
6.1520
6.3081
7
7.2135
7.4343
8
8.2857
8.5830
9
9.3685
9.7546
10
10.4622 10.9497
11
11.5668 12.1687
12
12.6825 13.4121
13
13.8093 14.6803
14
14.9474 15.9739
15
16.0969 17.2934
16
17.2579 18.6393
17
18.4304 20.0121
18
19.6147 21.4123
19
20.8109 22.8406
20
22.0190 24.2974

3%
1.0000
2.0300
3.0909
4.1836
5.3091
6.4684
7.6625
8.8923
10.1591
11.4639
12.8078
14.1920
15.6178
17.0863
18.5989
20.1569
21.7616
23.4144
25.1169
26.8704

4%
1.0000
2.0400
3.1216
4.2465
5.4163
6.6330
7.8983
9.2142
10.5828
12.0061
13.4864
15.0258
16.6268
18.2919
20.0236
21.8245
23.6975
25.6454
27.6712
29.7781

5%
1.0000
2.0500
3.1525
4.3101
5.5256
6.8019
8.1420
9.5491
11.0266
12.5779
14.2068
15.9171
17.7130
19.5986
21.5786
23.6575
25.8404
28.1324
30.5390
33.0660

6%
1.0000
2.0600
3.1836
4.3746
5.6371
6.9753
8.3938
9.8975
11.4913
13.1808
14.9716
16.8699
18.8821
21.0151
23.2760
25.6725
28.2129
30.9057
33.7600
36.7856

7%
1.0000
2.0700
3.2149
4.4399
5.7507
7.1533
8.6540
10.2598
11.9780
13.8164
15.7836
17.8885
20.1406
22.5505
25.1290
27.8881
30.8402
33.9990
37.3790
40.9955

8%
1.0000
2.0800
3.2464
4.5061
5.8666
7.3359
8.9228
10.6366
12.4876
14.4866
16.6455
18.9771
21.4953
24.2149
27.1521
30.3243
33.7502
37.4502
41.4463
45.7620

9%
1.0000
2.0900
3.2781
4.5731
5.9847
7.5233
9.2004
11.0285
13.0210
15.1929
17.5603
20.1407
22.9534
26.0192
29.3609
33.0034
36.9737
41.3013
46.0185
51.1601

10%
1.0000
2.1000
3.3100
4.6410
6.1051
7.7156
9.4872
11.4359
13.5795
15.9374
18.5312
21.3843
24.5227
27.9750
31.7725
35.9497
40.5447
45.5992
51.1591
57.2750
19

Present Value - annuity

What is the PV of RM 1,000 at the end of
each of the next 3 years, if the opportunity
cost is 8%?

PV?

1000

Present Value (PV) =

1000

1000

C1
C2
C3

(1 i )1
(1 i ) 2
(1 i ) 3
1,000
1,000
1,000
=

(1 0.08)1
(1 0.08) 2
(1 0.08) 3
RM 2, 577.10

20

Mathematical Solution:
PV = PMT (PVIFA i, n )
PV
= 1,000 (PVIFA 8%, 3 ) (use PVIFA
table)
Present Value of=
an Annuity
of $1 for n x
years
1,000
2.5771 = RM 2,577.10
n
1
2
3
4
5

1%
0.9901
1.9704
2.9410
3.9020
4.8534

2%
0.9804
1.9416
2.8839
3.8077
4.7135

3%
0.9709
1.9135
2.8286
3.7171
4.5797

4%
0.9615
1.8861
2.7751
3.6299
4.4518

5%
0.9524
1.8594
2.7232
3.5460
4.3295

6%
0.9434
1.8334
2.6730
3.4651
4.2124

7%
0.9346
1.8080
2.6243
3.3872
4.1002

8%
0.9259
1.7833
2.5771
3.3121
3.9927

9%
0.9174
1.7591
2.5313
3.2397
3.8897

10%
0.9091
1.7355
2.4869
3.1699
3.7908

Calculator Solution:
P/Y = 1 I = 8 N = 3 PMT =
Solve for PV = RM 2,577.10

-1,000
21

Present Value of an Annuity of $1 for n years

n
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

1%
0.9901
1.9704
2.9410
3.9020
4.8534
5.7955
6.7282
7.6517
8.5660
9.4713
10.3676
11.2551
12.1337
13.0037
13.8651
14.7179
15.5623
16.3983
17.2260
18.0456

2%
0.9804
1.9416
2.8839
3.8077
4.7135
5.6014
6.4720
7.3255
8.1622
8.9826
9.7868
10.5753
11.3484
12.1062
12.8493
13.5777
14.2919
14.9920
15.6785
16.3514

3%
0.9709
1.9135
2.8286
3.7171
4.5797
5.4172
6.2303
7.0197
7.7861
8.5302
9.2526
9.9540
10.6350
11.2961
11.9379
12.5611
13.1661
13.7535
14.3238
14.8775

4%
0.9615
1.8861
2.7751
3.6299
4.4518
5.2421
6.0021
6.7327
7.4353
8.1109
8.7605
9.3851
9.9856
10.5631
11.1184
11.6523
12.1657
12.6593
13.1339
13.5903

5%
0.9524
1.8594
2.7232
3.5460
4.3295
5.0757
5.7864
6.4632
7.1078
7.7217
8.3064
8.8633
9.3936
9.8986
10.3797
10.8378
11.2741
11.6896
12.0853
12.4622

6%
0.9434
1.8334
2.6730
3.4651
4.2124
4.9173
5.5824
6.2098
6.8017
7.3601
7.8869
8.3838
8.8527
9.2950
9.7122
10.1059
10.4773
10.8276
11.1581
11.4699

7%
0.9346
1.8080
2.6243
3.3872
4.1002
4.7665
5.3893
5.9713
6.5152
7.0236
7.4987
7.9427
8.3577
8.7455
9.1079
9.4466
9.7632
10.0591
10.3356
10.5940

8%
0.9259
1.7833
2.5771
3.3121
3.9927
4.6229
5.2064
5.7466
6.2469
6.7101
7.1390
7.5361
7.9038
8.2442
8.5595
8.8514
9.1216
9.3719
9.6036
9.8181

9%
0.9174
1.7591
2.5313
3.2397
3.8897
4.4859
5.0330
5.5348
5.9952
6.4177
6.8052
7.1607
7.4869
7.7862
8.0607
8.3126
8.5436
8.7556
8.9501
9.1285

10%
0.9091
1.7355
2.4869
3.1699
3.7908
4.3553
4.8684
5.3349
5.7590
6.1446
6.4951
6.8137
7.1034
7.3667
7.6061
7.8237
8.0216
8.2014
8.3649
8.5136
22

Chapter
6
Valuing Bonds

23

Chapter Outline
6.1
Bond Cash Flows, Prices, and Yie
lds
6.2
Dynamic Behavior of Bond Prices
6.3 Corporate Bonds

24

Learning Objectives
1. Identify the cash flows for both coupon bonds and
zero-coupon bonds, and calculate the value for
each type of bond.
2. Calculate the yield to maturity for both coupon
and zero-coupon bonds, and interpret its meaning
for each.
3. Given coupon rate and yield to maturity,
determine whether a coupon bond will sell at a
premium or a discount; describe the time path the
bonds price will follow as it approaches maturity,
assuming prevailing interest rates remain the
same over the life of the bond.
25

Learning Objectives
4. Illustrate the change in bond price that will occur
as a result of changes in interest rates;
differentiate between the effect of such a
change on long-term versus short-term bonds.
5. Calculate the price of a coupon bond using the
Law of One Price and a series of zero-coupon
bonds.

26

Learning Objectives
8. Discuss the relation between a corporate bonds
expected return and the yield to maturity; define
default risk and explain how these rates
incorporate default risk.
9. Assess the creditworthiness of a corporate bond
using its bond rating; define default risk.

27

Recap: The Law of One Price

In competitive markets, securities or
portfolios with the same (future)cash flows
must have the same price.
Price of a security = PV of CFs
The value of an asset to the firm or its
investors is determined by its competitive
market price. The benefits and costs of a
decision should be evaluated using these
market prices to increase the market value
of the firm.
28

Bond
A financial security (investment
opportunity) sold be governments
and corporations to raise money
from investors today in exchange for
the promised future payments.
Fixed income securities
Pay fixed interest

29

6.1 Bond Cash Flows, Prices,

and Yields
Bond Terminology
Bond Certificate
States the terms of the bond

Maturity Date
Final repayment date

Term
The time remaining until the repayment date

Coupon/coupon interest
Promised interest payments
30

6.1 Bond Cash Flows, Prices,

and Yields (cont'd)
Bond Terminology
Face Value
Notional amount used to compute the
interest payments, AKA par value or
maturity value.

Coupon Rate
Determines the amount of each coupon
payment, expressed as an APR
Coupon Rate
Coupon
Payment
CPN

Face Value
Number of Coupon Payments per Year
31

Zero-Coupon Bonds
Zero-Coupon Bond
Does not make coupon payments
Always sells at a discount (a price
lower than face value), so they are also
called pure discount bonds
Treasury Bills are U.S. government
zero-coupon bonds with a maturity of up
to one year.
32

Zero-Coupon Bonds (cont'd)

Suppose that a one-year, risk-free, zerocoupon bond with a $100,000 face value
has an initial price of $96,618.36. The cash
flows would be:

Although the bond pays no interest, your

compensation/opportunity cost is the difference
between the initial price and the face value.
33

Zero-Coupon Bonds (cont'd)

Yield to Maturity
The discount rate that sets the present
value of the promised bond payments/
cash flows equal to the current market
price of the bond.
Price of a Zero-Coupon bond

FV
P
(1 YTM n ) n

34

Zero-Coupon Bonds (cont'd)

Yield to Maturity
For the one-year zero coupon bond:
96,618.36
1 YTM 1

100,000
(1 YTM 1 )

100,000

96,618.36

1.035

Thus, the YTM is 3.5%.

What does this mean?
35

Zero-Coupon Bonds (cont'd)

Yield to Maturity
Under the law of one price,
For the one-year zero coupon bond:
the competitive market
_______________is 3.5%,
hence all 1-yr ___________
investment must earn 3.5%.

100,000
96,618.36
(1 YTM 1 )
1 YTM 1

100,000
96,618.36

1.035

Thus, the YTM is 3.5%.

What does this mean?

Given the expected future cash flows as
$100,000 in a year time, the 3.5% represents
the __________ of the investment in this bond!
36

Zero-Coupon Bonds (cont'd)

Yield to Maturity
Yield to Maturity of an n-Year ZeroCoupon Bond 1
YTM n

FV

37

Textbook Example 6.1

38

Textbook Example 6.1

(cont'd)

YTM1 = (P1-P0)/P0

Or ____________/96.62 =
3.50%

39

Alternative Example 6.1

Problem
Suppose that the following zero-coupon
bonds are selling at the prices shown
below per $100 face value. Determine
the
corresponding yield to maturity for
Maturit
y
1 year 2 years 3 years 4 years
each
bond.
Price

$98.04 $95.18 $91.51 $87.14

40

Alternative Example 6.1

(cont'd)
Solution:
YTM (100 / 98.04) 1 0.02 2%
YTM (100 / 95.18)1/2 1 0.025 2.5%
YTM (100 / 91.51)1/3 1 0.03 3%
YTM (100 / 87.14)1/4 1 0.035 3.5%

41

Zero-Coupon Bonds (cont'd)

Risk-Free Interest Rates
A default-free zero-coupon bond that
matures on date n provides a risk-free
return over the same period. Thus, the
Law of One Price guarantees that the
risk-free interest rate equals the yield to
maturity on such a bond.
Risk-Free Interest Rate with Maturity n

rn YTM n

42

Zero-Coupon Bonds (cont'd)

Risk-Free Interest Rates
Spot Interest Rate
Another term for a default-free, zero-coupon
yield

Zero-Coupon Yield Curve

A plot of the yield of risk-free zero-coupon
bonds as a function of the bonds maturity
date

43

Coupon Bonds
Coupon Bonds
Pay face value at maturity
Pay regular coupon interest payments

Treasury Notes
U.S. Treasury coupon security with
original maturities of 110 years

Treasury Bonds
U.S. Treasury coupon security with
original maturities over 10 years
44

Textbook Example 6.2

45

Textbook Example 6.2

(cont'd)

46

Coupon Bonds (cont'd)

Yield to Maturity
The YTM is the single discount rate that
equates the present value of the bonds
remaining cash flows to its current price.

Yield to Maturity of a Coupon Bond

(computing the YTM)

1
1
FV
P CPN

1
N
y
(1 y )
(1 y ) N
47

Using Formula:

Bond valuation

PV =

t=1

CPN

CPN + FV

(1 + YTM)t

(1 + YTM)n

Using Financial Tables:

Vb = $I x PVIFAR ,n + $M x PVIFR ,n
b

48

Bond valuation
1. Estimate the expected future CFs;
2. Determine the required rate of
return (discount rate, reflects risk);
3. Compute the PV of the future CFs.
(how much the asset is worth?)

49

6.2 Dynamic Behavior of Bond

Prices
Discount
A bond is selling at a _________ if the price
is less than the face value.

Par
A bond is selling at ______ if the price is
equal to the face value.

Premium
A bond is selling at a premium if the
price is greater than the face value.
50

Discounts and Premiums

If a coupon bond trades at a
discount, an investor will earn a
return both from receiving the
coupons and from receiving a face
value that exceeds the price paid for
the bond.
If a bond trades at a discount, its yield
to maturity will exceed its coupon rate.
51

Discounts and Premiums

(cont'd)

If a coupon bond trades at a premium it will

earn a return from receiving the coupons but
this return will be diminished by receiving a
face value less than the price paid for the
bond.
Most coupon bonds have a coupon rate so
that the bonds will initially trade at, or very
close to, par.

52

Discounts and Premiums

(cont'd)
Table 8.1 Bond Prices Immediately After a Coupon Payment

53

Interest Rate Changes and

Bond Prices
There is an inverse relationship between
interest rates and bond prices.
As interest rates and bond yields rise, bond
prices fall.
As interest rates and bond yields fall, bond
prices rise.
A bond's price would increase (decrease) if
prevailing interest rates were to drop (move
up).
54

Valuing a Coupon Bond

Using Zero-Coupon Yields
The price of a coupon bond must equal
the present value of its coupon payments
and face value.
Price of a Coupon Bond

PV PV (Bond Cash Flows)

CPN
CPN

L
2
1 YTM 1
(1 YTM 2 )

CPN FV
(1 YTM n ) n

100
100
100 1000
P

$1153
2
3
1.035
1.04
1.045
55

Coupon Bond Yields

Given the yields for zero-coupon
bonds, we can price a coupon bond.
100
100
100 1000
P 1153

2
(1 y )
(1 y )
(1 y )3
100
100
100 1000
P

$1153
2
3
1.0444
1.0444
1.0444

56

6.4 Corporate Bonds

Corporate Bonds
Issued by corporations

Credit Risk
Risk of default

57

Corporate Bond Yields

Investors pay less for bonds with credit
risk than they would for an otherwise
identical default-free bond.
The yield of bonds with credit risk will
be higher than that of otherwise
identical default-free bonds.

58

Corporate Bond Yields

(cont'd)

No Default

Consider a 1-year, zero coupon Treasury

Bill with a YTM of 4%.
What is the price?
1000
1000
P

$961.54
1 YTM 1
1.04

59

Corporate Bond Yields

(cont'd)
Certain Default
Suppose now bond issuer will pay 90%
of
the obligation.
900price? 900
What
is
the
P

$865.38
1 YTM 1
1.04

60

Corporate Bond Yields

(cont'd)
Certain Default
When computing the yield to maturity
for a bond with certain default, the
promised rather than the actual cash
FVused.
1000
flows
are
YTM
1
1 15.56%
P

865.38

900
1.04
865.38

61

Corporate Bond Yields

(cont'd)
Certain Default
The yield to maturity of a certain default
bond is not equal to the expected return
of investing in the bond. The yield to
maturity will always be higher than the
expected return of investing in the bond.

62

Are U.S. Treasuries and FD

really Default-free
securities?

Risk free = ________ chance of

default;
How certain that the investors
expectation are met in the past?
In the late 2011, Standard & Poor
downgraded the rating of U.S.
government bonds.
Can bank(s) fails?

63

Bond Ratings
Investment Grade Bonds
Speculative Bonds
Also known as Junk Bonds or High-Yield
Bonds

64

Table 6.4 Bond Ratings

65

Table 6.4 Bond Ratings (contd)

66