Sessions 678: Bonds and Stocks

MIM
Financial Management and Corporate
Finance
Fall 2022

Merih Sevilir

0
Class Roadmap
 Topics
− Interest rate risk
− Bond pricing
− Yield to maturity
− Spot rates

 Assignments after today

− Review practice question 2
− Review class notes
− Prepare practice question 3 by next class
− Team assignment due tomorrow, Nov 22, 2022

1
Interest rates and bond prices

C 1  F
Bond Value  1 - T

r  (1  r)  (1  r)T

If r increases, bond prices will decrease.

This is called the interest rate risk.

2
Example

Consider a U.S. government bond, issued on Jan 1, 2014, with a 6.375% coupon that expires in
December 2018.

− The Face Value of the bond is $1,000.

− Coupon payments are made semi-annually (June 30 and December 31 for this particular
bond).

− Since the coupon rate is 6.375%, the semi-annual coupon payment is $31.875 (=
1000×6.375% /2).

3
Example cont’d

− On January 1, 2014 the size and timing of cash flows are:

$31.875 $31.875 $31.875 $1,031.875

 12 / 31 / 18
1 / 1 / 14 6 / 30 / 14 12 / 31 / 14 6 / 30 / 18

4
Example cont’d
 Assume similar bonds generate interest rate r of 375% per year, compounded
semiannually.
 The price of the bond

$31.875  1  $1,000
PV  1 10 
 10
 $1000
0.031875  (1.031875)  (1.031875)

5
Example cont’d

 Now assume that the interest rate rises to 11% per year, compounded
semiannually
 What happens to the price of the bond?

$31.875  1  $1,000
PV  1  10 
 10
 $825.69
.11 2  (1.055)  (1.055)

6
Example cont’d

 Now suppose that the interest rate declines to 5% per year, compounded
semiannually.
 What happens to the price of the bond?

$31.875  1  $1,000
PV  1 10 
 10
 $1,060.17
.05 2  (1.025)  (1.025)

7
Sensitivity of bond prices to interest rate changes

 Sensitivity of bond prices to changes in interest rates (measured by bond’s

duration) depends on

− Time to maturity: The longer the time to maturity, the greater the interest rate
risk.

− Coupon rate: The lower the coupon rate, the greater the interest rate risk.

8
Intuition

 Long term bonds receive most of their cash flows farther into the future, and
because of the time value of money, these cash flows are heavily discounted.

9
 Intuition

 Bonds with lower coupon rates receive most of their cash flows farther into the
future. The farther into the future the cash flows are to be received, the larger the
impact of a change in the discount rate on their present value.

10
Applications

 If you are the treasurer of a firm and are investing excess cash temporarily, would
you prefer a long-term zero coupon bond or a short-term bond with a high
coupon rate?

 If you are an investor, and you expect interest rates to decline, would you prefer a
long-term zero coupon bond or a short-term bond with a high coupon rate?

11
Example

 Consider a 30-year bond with a 10% coupon rate (annual coupon payments) and a
$1000 face value. What is the initial price of this bond if it has a 5% yield-to-
maturity?

12
Solution

100 1 1000
P (1  30
) 30
 $1768.62
0.05 1.05 1.05

13
Example, cont’d
 If the yield-to-maturity is unchanged, what will the price be immediately before
and after the first coupon is paid?

14
Solution, cont’d

Immediately before the first coupon is paid:

100 1 1000
P(just before first coupon)  100  (1  29
)  29
 $1857.05
0.05 1.05 1.05

15
Solution, cont’d

Immediately after the first coupon is paid:

100 1 1000
P(just after first coupon)  (1  29
)  29
 $1757.05
0.05 1.05 1.05

16
Calculating Yield-to-Maturity

 Recall that YTM is the single discount rate that sets the discounted value of the
cash flows equal to the price of the bond.

 Yield to maturity is the rate implied by the current bond price.

17
YTM with Annual Coupons

 Consider a bond with a 10% annual coupon rate, 15 years to maturity, and a face
value of $1,000. The current price is $928.09.
− What is the YTM?

18
Solution

0 1 2 T = 15

-928.09 100 100 100 + 1000

100 1 1000
928.09 = 1− +
𝑌𝑇𝑀 (1+𝑌𝑇𝑀)15 (1+𝑌𝑇𝑀)15

= RATE(15, 100, -928.09, 1000) = 11%

19
YTM with Semiannual Coupons
 Suppose a bond with a 10% coupon rate and semiannual coupons has a face
value of $1,000, 20 years to maturity, and is selling for $1,197.93.
− What is the YTM?

20
Solution

0 1 2 T = 40

-1197.93 50 50 50 + 1000

50 1
1197.93 = 1− +
𝑌𝑇𝑀6−𝑚𝑜𝑛𝑡ℎ (1+𝑌𝑇𝑀6−𝑚𝑜𝑛𝑡ℎ )40
1000
(1+𝑌𝑇𝑀6−𝑚𝑜𝑛𝑡ℎ )40

=RATE(40, 50, -1197.93, 1000) = 4%: YTM per 6-month

Yield to maturity, per year = 2×4% = 8%

21
Example
 Consider a 30-year bond with a 10% coupon rate (annual coupon payments) and a $1000 face
value.
 What is the initial price of this bond if it has a 5% yield-to-maturity.

 What is the price of the bond six months from its issuance?

22
Solution

½ 1 2 T = 30

100 100 100 + 1000

100 1
100 (1 − ) 1000
0.05 1.05 29
𝑃= 1
+ 1
+
(1 + 5%)29.5
(1 + 5%)2 (1 + 5%)2

P = 1812.296

23
Risk-free government bonds and yield curve

 Lat class, we said understanding bonds is important because the prices of risk-
free government bonds can be used to determine the risk-free interest rates
(hence, the yield curve).
− Yield curve gives important information for valuing risk-free cash flows and
evaluating expectations of economic growth.

− How do we obtain risk-free interest rates?

24
Yield to Maturity and Spot Rates

Once again, recall that YTM is the single discount rate that sets the discounted
value of the cash flows equal to the price of the bond.

25
Yield to Maturity and Spot Rates

Consider a default-free zero coupon bond that matures at time t=1.

F
Bond Value 
(1  YTM 1 )
F
Bond Value 
(1  r1 )
where
YTM1 : yield - to - maturity of the one year zero coupon bond
r1 : one - year (risk - free) spot rate.

r1  YTM 1.

26
Yield to Maturity and Spot Rates

In general, consider a default-free zero coupon bond that matures at time t.

F
Bond Value 
(1  YTM t ) t
F
Bond Value 
(1  rt ) t
where YTM t : yield - to - maturity of the t - year zero coupon bond
rt : t  year (risk - free) spot rate.
rt  YTM t .

27
Term Structure of Risk-Free U.S. Interest Rates

Nov-08
Yield-to-maturity of a four-year zero coupon bond =YTM4 = 1.69%.
4-year spot rate = r4 = 1.69%
Source: Corporate Finance, Berk and De Marzo, third Editionfg
fg 28
Example

Suppose the following zero-coupon bonds are trading at the prices given below
per $1000 face value. Calculate the corresponding spot interest rates.

Maturity 1 year 2 years 3 years 4 years

Price $966.2 $924.5 $876.3 $830.6

29
Solution
1000 1000
966.2 = ;1 + 𝑟1 = = 1.0349; 𝑟1 = 3.5%;
1+𝑟1 966.2

1000 1000
924.5 = 2
; (1 + 𝑟2 )2 = = 1.081;
(1 + 𝑟2 ) 924.5
1
1 + 𝑟2 =1.0812 ;
𝑟2 = 4%

30
Solution, cont’d

1000 3
1000
876.3 = 3
; (1 + 𝑟3 ) = = 1.14;
(1 + 𝑟3 ) 876.3
1
1 + 𝑟3 = 1.143 ;
𝑟3 = 4.5%

1000 4
1000
830.6 = 4
; (1 + 𝑟4 ) = = 1.2039;
(1 + 𝑟4 ) 830.6
1
1 + 𝑟4 = 1.20394 ;
𝑟4 = 4.75%

31
Example

 Bond A has 5% coupon, annual coupon payments, $1000 face value and two years
to maturity.
 Bond B has 10% coupon, annual coupon payments, $1000 face value and two
years to maturity.

32
Example cont’d

 One-period spot rate (discount rate for year 1 cash flow) is 6%

 Two-period spot rate (discount rate for year 2 cash flow) is 8%.

33
Example cont’d

 Calculate the market prices of these two bonds.

50 1050
𝑃𝐴 = + = 947.38
1.06 1.082
100 1100
𝑃𝐵 = + = 1037.41
1.06 1.082
 Calculate the yields to maturity of these two bonds.

50 1050
947.38 = +
1+𝑌𝑇𝑀 (1+𝑌𝑇𝑀)2
=RATE (2, 50, -947.38, 1000) = 7.95%

100 1100
1037.41 = +
1+𝑌𝑇𝑀 (1+𝑌𝑇𝑀)2
=RATE (2, 100, -1037.41, 1000) = 7.90%
34
Next Class: Stocks

Stocks versus Bonds

 Bondholders receive returns in two ways: coupon payments and face value.

 The market price of a bond is always the present value of the future coupon
and face value payments (calculated using the current market interest rate
on a bond of similar risk)

 Bond holders do not have to hold bonds until maturity – they can always
sell a bond in the market to ‘capture’ the discounted value of the future
payments.

35
Stocks are similar to bonds

 Stockholders are in the same position as bondholders, except that there is no

‘face value’ payment.

 Stockholders receive dividends and (ultimately) liquidation value (when the firm is
liquidated).

 They don’t have to wait until liquidation!

− The market price of a share is the present value of all future cash flows.
− Stockholders can always sell their shares and ‘capture’ the discounted value of
future dividends and liquidation value.

36
 Practice question 3

Suppose you purchase a 10-year bond with 6% annual coupons and $1000 face value.
You hold the bond for four years, and sell it immediately after receiving the fourth
coupon. If the bond’s yield to maturity was 5% when you purchased and sold the bond.
a. What cash flows will you pay and receive from your investment in the bond?

b. What is the internal rate of return from your investment?

37