Financial Markets

Melziel Andag Emba

 Bonds and Their Valuation
• Bonds
• A bonds is a long-term contract which a
borrower agrees to make payments of interest
and principal, on specific dates, to the holders
of the bond.
• A bond is essentially a long-term loan from the
investor to the issuing corporation.
• Example: On January 3, 2019, Allied Foods
Products borrowed $50 million by issuing $50
million of bonds. In any event, Allied received
the $50 million, and in exchange it promised
to make annual interest payments and to
repay $50 million on a specific date.
Bonds are classified into four (4) main types:

• Treasury bonds – bonds issued by the

government, sometimes referred to as
government bonds.
• Corporate bonds – bonds issued by corporations.
• Municipal bonds – bonds issued by local
government.
• Foreign bonds – bonds issued by either foreign
government or foreign corporation.
 Key Characteristics of Bonds
• An indenture is the contract governing a bond.
The indenture describes the features of a bond.
• Par value is the stated face value of the bond.
The par value generally represents the amount of
money the firm borrows and promise to repay on
the maturity date.
• Coupon interest rate the stated annual interest
rate on a bond. (coupon payment)
• Maturity date a specific date on which the par
value of a bond must be repaid.
 Key Characteristics of Bonds
• Call provision or Call option a provision in a bond
contract that gives the issuer the right to redeem
the bonds under specified terms prior to the
normal maturity date.
• Sinking fund a provision in a bond contract that
requires the issuer to retire a portion of the
bonds issue each year.
 Other features
• Convertible bond. A bond that is exchangeable, at
the option of the holder, for common stock of
issuing corporation.
• Warrant. A long-term option to buy a stated
number of shares of common stocks at a specified
price.
• Putable bond. A bond with provisions that allows
the bond’s investors to sell the bonds back to the
company prior to maturity at a prearranged price.
• A mortgage bond is backed by collateral.
• A debenture is not secured by collateral but is still
backed by the corporation’s cash flow.
 Bond Valuation
• The value of any financial assets – a stock, a
bond, lease, or even a physical asset is simply
the present value of the cash flows the assets
expected to produce.
 Bond Valuation
• Key point….
• Whenever the going rate of interest (Market
Interest Rate), is equal to the coupon rate, a fixed-
rate bond will sell at its par value.
• Interest rates do change over time, but coupon
rate remains fixed after the bond has been issued.
Whenever the going rate of interest rises above
the coupon rate; a fixed-rate bond’s price will fall
below its par value. Such a bond is called a
discount bond. (Discount bond a bond that sell
below its par value; occurs whenever the going
rate of interest is above the coupon rate)
 Bond Valuation
• Key point…
• Whenever the going rate of interest falls below
the coupon rate, a fixed-rate bond’s price will
rise above its par value. Such a bond called a
premium bond. (Premium bond a bond that sells
above its par value; occurs whenever the going
rate of interest is below the coupon rate)
• Thus, an increase in interest rates will cause the
price of outstanding bonds to fall, whereas a
decrease in rates will cause bond price to rise.
 Bond Valuation
• The value of a bond is simply the present value
of the cash flows an investor expects to receive.
The cash flows are:
• The coupon payment. (This is equal to the
coupon rate times the par value)
Coupon payment*PV of Ordinary Annuity of 1
• The par value at maturity.
Par Value*PV of 1
• Problem: (Bond Price #9)
• A corporation has promised to pay $10,000 20
years from today for each bond sold now. No
interest will be paid on the bonds during the
twenty years, and the bonds are said to offer a
9% interest rate. Approximately how much
should an investor pay for each bond?
• Suggested answer:
 • Problem: (Bond Price #9)
• A corporation has promised to pay $10,000 20
years from today for each bond sold now. No
interest will be paid on the bonds during the
twenty years, and the bonds are said to offer a
9% interest rate. Approximately how much
should an investor pay for each bond?
• Suggested answer:
Coupon Payment*PV of an Annuity of 1
Par Value*PV of 1
Value of the Bond
 • Problem: (Bond Price #9)
• A corporation has promised to pay $10,000 20
years from today for each bond sold now. No
interest will be paid on the bonds during the
twenty years, and the bonds are said to offer a
9% interest rate. Approximately how much
should an investor pay for each bond?
• Suggested answer:

Coupon Payment*PV of an Annuity of 1 $0

Par Value*PV of 1
Value of the Bond
 • Problem: (Bond Price #9)
• A corporation has promised to pay $10,000 20
years from today for each bond sold now. No
interest will be paid on the bonds during the
twenty years, and the bonds are said to offer a
9% interest rate. Approximately how much
should an investor pay for each bond?
• Suggested answer:

Coupon Payment*PV of an Annuity of 1 $0

Par Value*PV of 1 ($10,000*0.17843)
Value of the Bond
 • Problem: (Bond Price #9)
• A corporation has promised to pay $10,000 20
years from today for each bond sold now. No
interest will be paid on the bonds during the
twenty years, and the bonds are said to offer a
9% interest rate. Approximately how much
should an investor pay for each bond?
• Suggested answer:

Coupon Payment*PV of an Annuity of 1 $0

Par Value*PV of 1 ($10,000*0.17843 $1,784.3
Value of the Bond
 • Problem: (Bond Price #9)
• A corporation has promised to pay $10,000 20
years from today for each bond sold now. No
interest will be paid on the bonds during the
twenty years, and the bonds are said to offer a
9% interest rate. Approximately how much
should an investor pay for each bond?
• Suggested answer:

Coupon Payment*PV of an Annuity of 1 $0

Par Value*PV of 1 ($10,000*0.17843 $1,784.3
Value of the Bond $1,784.3
• Problem: (Bond Price #10)
• A 3-year bond with 10% compound rate and
$1,000 face value yields 8% APR. Assuming
annual compounding payment, calculate the
price of the bond.
• Suggested Answer:
 • Problem: (Bond Price #10)
• A 3-year bond with 10% compound rate and
$1,000 face value yields 8% APR. Assuming
annual compounding payment, calculate the
price of the bond.
• Suggested Answer:
Coupon Payment*PV of an Annuity of 1
Par Value*PV of 1
Value of the Bond
 • Problem: (Bond Price #10)
• A 3-year bond with 10% compound rate and
$1,000 face value yields 8% APR. Assuming
annual compounding payment, calculate the
price of the bond.
• Suggested Answer:
Coupon Payment*PV of an Annuity of 1 ($100*2.577) $257.7
Par Value*PV of 1
Value of the Bond
 • Problem: (Bond Price #10)
• A 3-year bond with 10% compound rate and
$1,000 face value yields 8% APR. Assuming
annual compounding payment, calculate the
price of the bond.
• Suggested Answer:
Coupon Payment*PV of an Annuity of 1 ($100*2.577) $257.7
Par Value*PV of 1 ($1,000*.794) $794.0
Value of the Bond
 • Problem: (Bond Price #10)
• A 3-year bond with 10% compound rate and
$1,000 face value yields 8% APR. Assuming
annual compounding payment, calculate the
price of the bond.
• Suggested Answer:
Coupon Payment*PV of an Annuity of 1 ($100*2.577) $257.7
Par Value*PV of 1 ($1,000*.794) $794.0
Value of the Bond $1,051.7
• Problem: (Bond Price #10 modified)
• A 3-year bond with 8% compound rate and
$1,000 face value yields 10% APR. Assuming
annual compounding payment, calculate the
price of the bond.
• Suggested Answer:
 • Problem: (Bond Price #10 modified)
• A 3-year bond with 8% compound rate and
$1,000 face value yields 10% APR. Assuming
annual compounding payment, calculate the
price of the bond.
• Suggested Answer:
Coupon Payment*PV of an Annuity of 1
Par Value*PV of 1
Value of the Bond
 • Problem: (Bond Price #10 modified)
• A 3-year bond with 8% compound rate and
$1,000 face value yields 10% APR. Assuming
annual compounding payment, calculate the
price of the bond.
• Suggested Answer:
Coupon Payment*PV of an Annuity of 1 ($80*2.487)
Par Value*PV of 1
Value of the Bond
 • Problem: (Bond Price #10 modified)
• A 3-year bond with 8% compound rate and
$1,000 face value yields 10% APR. Assuming
annual compounding payment, calculate the
price of the bond.
• Suggested Answer:
Coupon Payment*PV of an Annuity of 1 ($80*2.487) $198.96
Par Value*PV of 1
Value of the Bond
 • Problem: (Bond Price #10 modified)
• A 3-year bond with 8% compound rate and
$1,000 face value yields 10% APR. Assuming
annual compounding payment, calculate the
price of the bond.
• Suggested Answer:
Coupon Payment*PV of an Annuity of 1 ($80*2.487) $198.96
Par Value*PV of 1 ($1,000*.751)
Value of the Bond
 • Problem: (Bond Price #10 modified)
• A 3-year bond with 8% compound rate and
$1,000 face value yields 10% APR. Assuming
annual compounding payment, calculate the
price of the bond.
• Suggested Answer:
Coupon Payment*PV of an Annuity of 1 ($80*2.487) $198.96
Par Value*PV of 1 ($1,000*.751) $751.0
Value of the Bond
 • Problem: (Bond Price #10 modified)
• A 3-year bond with 8% compound rate and
$1,000 face value yields 10% APR. Assuming
annual compounding payment, calculate the
price of the bond.
• Suggested Answer:
Coupon Payment*PV of an Annuity of 1 ($80*2.487) $198.96
Par Value*PV of 1 ($1,000*.751) $751.0
Value of the Bond $949.96
• Problem: (Bond Price #11)
• A three-year bond has 8.1% compound rate
and face value of $1000. If the yield to
maturity on the bond is 10%, calculate the
price of the bond assuming that the bond
makes semi-annual compound interest
payments.
• Suggested Answer:
• Problem: (Bond Price #11)
• A three-year bond has 8.1% compound rate
and face value of $1000. If the yield to maturity
on the bond is 10%, calculate the price of the
bond assuming that the bond makes semi-
annual compound interest payments.
• Suggested Answer:
• Divide the rate, multiply the period
• 8.1%/2 = 4.05%
• 3yr*2= 6 period
 • Problem: (Bond Price #11)
• A three-year bond has 8.1% compound rate
and face value of $1000. If the yield to
maturity on the bond is 10%, calculate the
price of the bond assuming that the bond
makes semi-annual compound interest
payments.
• Suggested Answer:
Coupon Payment*PV of an Annuity of 1
Par Value*PV of 1
Value of the Bond
 • Problem: (Bond Price #11)
• A three-year bond has 8.1% compound rate
and face value of $1000. If the yield to
maturity on the bond is 10%, calculate the
price of the bond assuming that the bond
makes semi-annual compound interest
payments.
• Suggested Answer:
Coupon Payment*PV of an Annuity of 1 ($40.5*5.076
Par Value*PV of 1
Value of the Bond
 • Problem: (Bond Price #11)
• A three-year bond has 8.1% compound rate
and face value of $1000. If the yield to
maturity on the bond is 10%, calculate the
price of the bond assuming that the bond
makes semi-annual compound interest
payments.
• Suggested Answer:
Coupon Payment*PV of an Annuity of 1 ($40.5*5.076 $205.578
Par Value*PV of 1
Value of the Bond
 • Problem: (Bond Price #11)
• A three-year bond has 8.1% compound rate
and face value of $1000. If the yield to
maturity on the bond is 10%, calculate the
price of the bond assuming that the bond
makes semi-annual compound interest
payments.
• Suggested Answer:
Coupon Payment*PV of an Annuity of 1 ($40.5*5.076 $205.578
Par Value*PV of 1 ($1,000*.746)
Value of the Bond
 • Problem: (Bond Price #11)
• A three-year bond has 8.1% compound rate
and face value of $1000. If the yield to
maturity on the bond is 10%, calculate the
price of the bond assuming that the bond
makes semi-annual compound interest
payments.
• Suggested Answer:
Coupon Payment*PV of an Annuity of 1 ($40.5*5.076 $205.578
Par Value*PV of 1 ($1,000*.746) $746.0
Value of the Bond
 • Problem: (Bond Price #11)
• A three-year bond has 8.1% compound rate
and face value of $1000. If the yield to
maturity on the bond is 10%, calculate the
price of the bond assuming that the bond
makes semi-annual compound interest
payments.
• Suggested Answer:
Coupon Payment*PV of an Annuity of 1 ($40.5*5.076 $205.578
Par Value*PV of 1 ($1,000*.746) $746.0
Value of the Bond $951.578
 Yield to Maturity (YTM)
• The
  rate of return earned on a bond if it is
held to maturity. The yield to maturity is
generally the same as the market rate of
interest.
• Formula:
•  Illustration 1: Discount Bond
• Suppose you are offered a 10-year, 8
percent coupon, P1,000 par value bond at
a price of P877.60. What rate of return
could you earn if you bought the bond and
held it to maturity?

• YTM= 10%
•  Illustration 2: Premium Bond
• You were offered a 14-year, 10% annual
coupon, P1,000 par value bond at a price
of P1,494.93. What rate of interest would
you earn on your investment if you
bought the bond and held to maturity?

• YTM= 5%
 Yield to Call (YTC)
• The
  rate of return earned on a bond if it is
called before its maturity date.
• Formula:
• Illustration:
 
• Henderson Company bonds currently sell for
$1,275. These bonds can be called in five years
at a call price of $1,120 and pay annual
coupon of $120. What is their yield to call?

• YTC=7.4%
 Current Yield (CY)
• Provides
  information regarding the amount of
cash income that a bond will generate in a
given year. The computation is the annual
interest payment on a bond divided by the
bond’s current price.
• Formula:
• Illustration 3:
• Halley’s Enterprises’ bonds currently sell for
P975. The bonds have a seven-year maturity,
pay an annual coupon of $90, and have a par
value of $1,000. What is the Yield to Maturity?
and Current Yield?
• YTM = 9.48%
• CY = 9.23%