Chapter #2

Pricing of Bond

Pricing a bond
Coupon payments are made every
six month.
Next coupon payment for bond is
received exactly six month from
now.
Coupon interest is fixed for term of
bond.

The Fundamentals of Bond

Valuation
If yield < coupon rate, bond will be priced
at a premium to its par value
If yield > coupon rate, bond will be priced
at a discount to its par value
Price-yield relationship is convex (not a
straight line)

Nominal Yield
Measures the coupon rate that a bond
investor receives as a percent of the bonds
par value

Time Value of Money

Future value
Future value of an ordinary annuity
Present value
Present value of an ordinary
annuity

FUTURE VALUE
FV=PV(1+r)

Future value of an ordinary annuity

(1 i)n 1
A
i

Present value
Present value
PV=FV/(1+i)n
Present value of an ordinary
annuity

Pricing zero coupon bonds

The investor realizes interest as
the difference between the
maturity value and the purchase
price.

Price yield relationship

The reason is that the price of the
bond is the present value of cash
flows.
as the require yield increase the
present value of the cash flow
decrease.

Relationship between coupon

rate, required yield and price
At par
At discount
At premium

Reason for change in price

of bond
There is a change in the required yield
owing to change to changes in the
credit quality of the issuer.
There is a change in the price of the
bond selling at a premium or a discount
Change in the required yield owing to a
change in the yield on comparable
bonds.

Floating Rate Bonds

The coupon for a floater is determined by the
following general formula:

Floater coupon = floating reference rate + fixed margin

(in bps)

Examples:

Floater coupon = 1-month LIBOR rate + 150bps

Floater coupon = 3-month T-bill rate + 80bps