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Bond Valuation

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Rhea Mathew
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4 views

Bond Valuation

Uploaded by

Rhea Mathew
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Bond Valuation

What is a Bond
 Bond is a financial instrument through
which a firm/Government/person raises
funds and promised to pay a rate of
interest and is having a promised date of
repayment.
Bond Features
 Coupon rate and its schedule of
payment
◼ ZERO-COUPON BOND

 Face value;
 Maturity period
◼ Perpetual bonds
Bond Pricing
 The price of a bond is nothing but
equal to the present value of the
expected cash flows.
 The interest rate or discount rate
used to compute the present value is
a function of yield on comparable
instruments available in the market
elsewhere.
Bond Pricing – Fixed Rate
Bonds
 Bond Price: It is the sum of
◼ Present value of the coupon payments
◼ present value of par value at maturity
n
Ct M
P= +
t =1 (1 + i )t
(1 + i )n

◼ P = price of the bond


◼ C = periodic coupons
◼ i = yield to maturity (YTM)
◼ M = Maturity value
Coupon Rate and Bond Value
 For a given maturity period and given
YTM

◼ As coupon increases, the price of


bond increases

◼ The relationship is linear


YTM and Bond Prices

For a given maturity period


◼ Higher the YTM, lower the bond value
and

◼ The relation is inverse and convex


RELATION BETWEEN BOND VALUATION AND BOND YIELD
700

600

GAINS BECOME
500 GREATER!!
PRICE (Rs.)

400

300 CONVEX SHAPE


OF THE CURVE

200

LOSSES BECOME
LOSSES
SMALLER!!
BECOME
100
SMALLER!!

0
1% 7% 13% 20% 30% 50%
YIELD
YTM and Bond Prices
 For a given maturity period,
◼ If YTM is greater than coupon rate, then
the bond is sold at a discount.

◼ If YTM is less than coupon rate, then the


bond is sold at a premium.

◼ If YTM is equal to coupon rate, then the


bond is sold at par.
Time to Maturity and Bond Prices
 As a bond approaches to its maturity, its price
approaches to its face value
◼ When the required rate of return is greater than
the coupon rate, the discount on the bond
declines as maturity approaches.
◼ When the required rate of return is less than the
coupon rate, the premium on the bond declines
as maturity approaches
YTM, Time to Maturity and Bond
Value
 Value of Long-term bonds is more
sensitive to any change in YTM
◼ If YTM declines, long term bonds will
appreciate more that the short-term
bonds
◼ If YTM increases, long-term bonds will
fall more that the short term bonds
Valuation of Floating Rate Bond
 Valuation of Floating Rate Bond is done on the
assumption that on the next coupon date, the
bond will trade par
◼ As the coupon rate will be the same as the market
rate
 Fair Value of a floating rate bond therefore =
Present Value of the coupon payment and Par
Value on the next coupon date
Ct + FaceValue
P=
(1 + i) t

 Where t = time for the next coupon payment


Yield
 Various measures
◼ Current Yield
◼ Yield to Maturity
Current Yield
 Bonds annual coupon divided by the
current market price
◼ Not a good measure as it does not
account for the difference between the
bond’s purchase price and redemption at
par value
Yield to Maturity
 Yield to Maturity (YTM)
◼ Yield to Maturity (YTM) is that interest rate
which makes the present value of the cash flows
equal to the price of the bond. Thus
n
Ct M
P= +
t =1 (1 + i )t (1 + i )n
◼ P = Current Price
◼ Ct = Coupon in amount
◼ M = Maturity Value
◼ i = YTM
◼ n=number of period to maturity
Yield to Maturity
 Suppose an 8% coupon (Semiannual), 30 year
bond is selling at 1276.76. What is the YTM of the
bond? (Note: Par value of the bond is 1000)

60
40 1000
1276.76 =  +
t =1 (1 + i ) 60
(1 + i ) 60

 Solving this we find i = 0.03 or 3%. This is


considered the bond’s semi-annual YTM.
◼ The effective annual YTM will be (1+1.03)2 -1 =
6.09%
Yield to Maturity
 Yield to Maturity
◼ YTM is the rate of return on the bond realized by the
investor if,
 bond is held till maturity, and
 coupon payments can be reinvested at the rate of
YTM.
 Yield to Maturity: It considers the followings
◼ Coupon income
◼ Timing of the cash flows
◼ Interest on interest

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