Bond Valuation

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# Bond Valuation - PowerPoint PPT Presentation

Bond Valuation. Economics 71a: Spring 2007 Mayo Chapter 13 Lecture notes 4.4. Goals. Easy valuation Present values Yield Yield to maturity Difficult issues Interest rates Defaults Call options. Present Values and Bonds. Bond example: Par = 1000 Coupon = 5% = \$50 (per year)

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### Bond Valuation

Economics 71a: Spring 2007

Mayo Chapter 13

Lecture notes 4.4

Goals
• Easy valuation
• Present values
• Yield
• Yield to maturity
• Difficult issues
• Interest rates
• Defaults
• Call options
Present Values and Bonds
• Bond example:
• Par = 1000
• Coupon = 5% = \$50 (per year)
• Required return, k = 7%
• Maturity = 3 years
Bond Pricing
• Bonds trade at a given price
• May be above or below your valuation
• Strategy
• Buy if price < present value
• Sell if price > present value
Yield
• Interest/Price
• Example
• Par = 1000
• Coupon = 5%
• Current price = 900
• Yield = 50/900 = 5.56%
Yield to Maturity
• Similar to internal rate of return
• Requires computer
Semiannual InterestPays every 6 months
• Par = 1000
• Coupon = 5%, pays (1/2)50 = 25 every 6 months
• Maturity = 3 years
• k = 8% (k per 6 months = 4%)
Goals
• Easy valuation
• Present values
• Yield
• Yield to maturity
• Difficult issues
• Interest rates
• Defaults
• Call
Interest Rates
• k = RF + RP
• RF = risk free rate
• RF rises
• Bond price falls
• RF falls
• Bond price rises
• Sensitivity to interest changes = “Duration”
Bond Prices and Duration
• Two bonds: 1 and 5 year zero coupon
• RP = 0 (government bond)
• Interest rate change 3% to 5%
• 1 year bond
• Price = 970.87 -> 952.38
• 5 year bond
• Price = 862.61 -> 783.53
• Longer maturity leads to more interest sensitivity
The Term Structure
• Different rates for different horizons
• 6 month
• 1 year
• 2 years
• 5 years
• 10 years
• 30 years
Yield Curve

Interest Rate

Annual %

5%

1 2 5 10 20

Years into future

Time of maturity

The Yield Curve
• The yield curve changes over time
• See “The living yield curve” website
• Inverted yield curves
• The yield curve and GDP
Defaults
• When bond defaults, investors get firm assets (likely zero)
• Probability related to bond rating
• Risk premium increases with probability of default
• k = RF + RP
• Higher default probability
• Higher RP
• Lower price
Call Option
• Definition
• Option that lets firm buy back bond
• Get paid par + some percentage
• Shuts down bond investment
• Similar to refinancing
• Depends on interest movements
• Impacts price, but difficult to value
Final Thoughts on Bonds
• Stable income streams
• Easier to evaluate than stocks
• More structure
• Fewer hunches
• Easier for sophisticated professionals to have an edge
• Stocks are more guesswork