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18
Valuation of Debt Contracts
and Their Price Volatility
Characteristics
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Learning Objectives
The cash flow characteristics of a bond
How the price of a bond is determined
Why the yield to maturity is used as a
measure of a bonds return
The importance of the reinvestment rate
in realizing the yield to maturity
Why the price of a bond changes
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Learning Objectives
(continued)
Learning Objectives
(continued)
Features of Debt
Contracts
Bullet maturity means that the entire
principal is due at the maturity date
When the principal is paid variously
throughout the life of the loan, then the
last remaining payment at maturity is the
balloon payment
Features of Debt
Contracts (continued)
A special type of debt contract is a bond,
and the amount paid at maturity is called
par value, maturity value, or face value
A debt contracts coupon is the periodic
interest payment made to owners during
the life of the contract
The coupon is coupon rate or the rate of
interest
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Features of Debt
Contracts (continued)
When both the principal and interest are
paid at maturity, the debt is call zerocoupon instruments
Typically, but not universally, for bonds
issued in the United States the coupon
payments are made every 6 months
The price of most debt contracts are
quoted as percentages of par value
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Basic Valuation
Principles
The cash flow from a bond consists of
each period coupon payments and the
repayment of the principal
The price of a debt instrument must equal
the sum of the stream of discounted
payments the debtor is required to make
until maturity. The discounted value of the
debt is
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Basic Valuation
Principles (continued)
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Price of an Option-Free
Bond
The yield to maturity calculation for a
bond that pays interest semiannually
results in the calculation of a semiannual
interest rate
The resulting yield to maturity is said to
be calculated on a bond-equivalent or
coupon-equivalent yield basis
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Price of an Option-Free
Bond (continued)
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Price of an Option-Free
Bond (continued)
The yield to maturity computed using this
conventiondoubling the semiannual
yieldis called the bond equivalent
yield
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Reinvestment of Cash
Flow and Yield
An investor will only realize the yield to
maturity that is calculated at the time of
purchase if
all the coupon payments can be reinvested
at the promised yield to maturity
the bond is held to maturity
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Convexity
Duration is in fact a first approximation for a
small change in yield. The approximation
can be improved by using a second
approximation. This approximation is the
bonds convexity. The convexity measure of
a security is the approximate change in the
price that is not explained by the duration
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Summary
The cash flow from a bond consists of
periodic coupon payments (semiannual
payments in the United States) and the
repayment of the principal
A bonds price changes over time for
several reasons
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Summary
(continued)
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Summary
(continued)
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