Bond Valuation Essay example

3886 Words May 27th, 2013 16 Pages
BOND VALUATION
Bond
Bond is a long term contract under which a borrower agrees to make payments of interest and principal, on specific dates, to the holders of the bond Key characteristics: VB = value of a bond/bond price M = par or maturity value of the bond; it is the stated face value of the bond and this is amount that must be paid off at maturity and it is often equal to $ 1.000 INT = coupon payment or dollars of interest paid each year; (Coupon rate x Par value) rk = coupon interest rate; (coupon payment / par value) rd = the bond's required rate of the return; that is the market rate of interest for that type of bond; it is also called the yield N = number of years before the bond matures; maturity date is a date on which the par
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It can be: a) the bond is selling at a price equal to its par value; required rate of return (rd)=coupon rate (rk) b) the bond is selling at a price below its par value; required rate of return (rd) coupon rate (rk); it is called a discount bond c) the bond is selling at a price above its par value; required rate of return (rd) coupon rate (rk); it is called a premium bond. Valuation of bonds on the date of their issue =valuation of bonds at the beginning of an interest payment dates Bonds with annual coupons Example: (Tool Kit 4 Chapter) A bond has a 15-year maturity, a 10% annual coupon and a $ 1,000 par value. The required rate of return or the yield to maturity on the bond is 10%, given its risk, maturity, liquidity and other rates in the economy. What is a fair value for the bond i.e. its market price? M (or FV)=$ 1,000 rk=10% rd=10% INT= $ 100 N=15 VB=?

= 100 ∙

The bond is selling at a price equal to its par value.

= 100 ∙

1 1 − 0.10 0.10 ∙ (1 + 0.10)

+ 1,000 ∙

or

= 100 ∙ 7.606 + 1,000 ∙ 0.239 = 1,000 + 1,000 (1 + 0.10) = 1,000

Example: (Tool Kit 4.3.) A bond matures in 6 years has a par value of $ 1.000, an annual coupon payment of $ 80 and a market interest rate of 9%. What is its price? M (or FV)=$ 1,000 rd=9% INT= $ 80  rk=8% N=6 VB=? = 80 ∙

The bond is selling at a price below its par value, meaning that the required rate of return (rd) coupon rate (rk).It is called a discount bond. 2

+ 1,000…

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