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Bond Valuation Econ 181 Corporate Finance: Wadia Haddaji Department of Economics Duke University RK-CH
Bond Valuation Econ 181 Corporate Finance: Wadia Haddaji Department of Economics Duke University RK-CH
Bond Valuation Econ 181 Corporate Finance: Wadia Haddaji Department of Economics Duke University RK-CH
Econ 181
Corporate Finance
Wadia Haddaji
Department of Economics
Duke University
RK-CH
Bond Valuation An Overview
Coupon bonds
» Valuation
» Interest rate sensitivity
Bonds Issuer
Government Bonds US Treasury, Government
Agencies
Mortgage-Backed Securities Government agencies (GNMA etc)
Municipal Bonds State and local government
Corporate Bonds Corporations
Asset-Back Securities Corporations
U.S. Government Bonds
Treasury Bills
» No coupons (zero coupon security)
» Face value paid at maturity
» Maturities up to one year
Treasury Notes
» Coupons paid semiannually
» Face value paid at maturity
» Maturities from 2-10 years
U.S. Government Bonds (Cont.)
Treasury Bonds
» Coupons paid semiannually
» Face value paid at maturity
» Maturities over 10 years
» The 30-year bond is called the long bond.
Treasury Strips
» Zero-coupon bond
» Created by “stripping” the coupons and principal from Treasury
bonds and notes.
No default risk. Considered to be risk free.
Exempt from state and local taxes.
Sold regularly through a network of primary dealers.
Traded regularly in the over-the-counter market.
Agency and Municipal Bonds
Debentures
» Same priority as general creditors.
» Have priority over stockholders, but subordinate to secured debt.
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Bond Ratings
Moody’s S&P Quality of Issue
Aaa AAA Highest quality. Very small risk of default.
D - In default.
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The US Bond Market
Mortgages 12757.7
Value a 5 year, U.S. Treasury strip with face value of $1,000. The APR is
R=7.5% with annual compounding? What about quarterly compounding?
What is the APR on a U.S. Treasury strip that pays $1,000 in exactly 7 years
and is currently selling for $591.11 under annual compounding? Semi-annual
compounding?
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Interest Rate Sensitivity:
Zero Coupon Bonds
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Measuring Interest Rate Sensitivity
Zero Coupon Bonds
Method 3:
B $1,000 1
0.0001 T 0.0001 T * $0.10 *
R 1.10T 1 1.10T 1
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DV01: A Graphical Approach
10-Year
$1,200.00
$1,000.00
$800.00
$600.00
$400.00
$200.00
$0.00
Interest Rate
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Valuing Coupon Bonds
Example 1: Amortization Bonds
0 1 2 3 4
Buy Coupon Bond -$3,545.95 $1,000.00 $1,000.00 $1,000.00 $1,000.00
Buy 6-Month Zero -$952.38
Buy 1-Year Zero -$907.03
Buy 1.5-Year Zero -$863.84
Buy 2-Year Zero -$822.70
Portfolio -$3,545.95
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A First Look at Arbitrage
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A First Look at Arbitrage
What is the market price of a U.S. Treasury bond that has a coupon
rate of 9%, a face value of $1,000 and matures exactly 10 years from
today if the interest rate is 10% compounded semiannually?
45 45 45 45 1045
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Valuing Coupon Bonds
The General Formula
What is the market price of a bond that has an annual coupon C, face
value F and matures exactly T years from today if the required rate of
return is R, with m-periodic compounding?
» Coupon payment is: c = C/m
» Effective periodic interest rate is: i = R/m
» number of periods N = Tm
0 1 2 3 4 ... … N
c c c c… … c+F
B Annuity Zero
c 1 F
1 N
i 1 i N 1 i
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The Concept of a “Yield to Maturity”
So far we have valued bonds by using a given interest rate,
then discounted all payments to the bond.
Prices are usually given from trade prices
» need to infer interest rate that has been used
Definition: The yield to maturity is that interest rate that
equates the present discounted value of all future payments
to bondholders to the market price:
Algebraic:
c 1 F
B 1
yield / m 1 yield / m N 1 yield / m N
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Yield to Maturity
A Graphical Interpretation
$2,500.00
$2,000.00
$1,500.00
$1,000.00
$500.00
$0.00
0%
2%
4%
10%
12%
14%
16%
18%
20%
22%
24%
6%
8%
Consider a U.S. Treasury bond that has a coupon rate of 10%, a face value of
$1,000 and matures exactly 10 years from now.
» Market price of $1,500, implies a yield of 3.91% (semi-annual
compounding); for B=$1,000 we obviously find R=10%.
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Interest Rate Sensitivity:
Coupon Bonds
c if the1 APR
What is the price of Bthe bond is8%Fcompounded
1 N
semiannually? i 1 i 1 i N
Similarly:
If R=12%: B=$ 827.95
If R= 9%: B=$1,000.00
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Relationship Between Coupon Bond
Prices and Interest Rates
Bond prices are inversely related to interest rates (or yields).
A bond sells at par only if its interest rate equals the coupon
rate
Does the sensitivity of a coupon bond always increase with the term to
maturity?
3
Bond Prices and Interest Rates
$2,500.00
5-Year Bond
$2,000.00
10-Year Bond
$1,500.00
Price (P)
$1,000.00
$500.00
$0.00
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
24%
20%
22%
Interest Rate (R)
Why do we get different answers for two bonds with the same yield
and same maturity?
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Maturity and Price Risk
The duration of a bond is less than its time to maturity (except for
zero coupon bonds).
The duration of the bond decreases the greater the coupon rate.
This is because more weight (present value weight) is being given
to the coupon payments.
As market interest rate increases, the duration of the bond
decreases. This is a direct result of discounting. Discounting at a
higher rate means lower weight on payments in the far future.
Hence, the weighting of the cash flows will be more heavily
placed on the early cash flows -- decreasing the duration.
Modified Duration = Duration / (1+yield)
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A Few Bond Markets Statistics
U.S. Treasuries, May 20th 2007.
Bills
MATURITY DISCOUNT/YIELD DISCOUNT/YIELD TIME
DATE CHANGE
3-Month 08/16/2007 4.72 / 4.84 0.01 / .010 13:41
6-Month 11/15/2007 4.78 / 4.98 0.01 / .015 13:41
Notes/Bonds
COUPON MATURITY CURRENT PRICE/YIELD TIME
DATE PRICE/YIELD CHANGE
2-Year 4.500 04/30/2009 99-121⁄4 / 4.84 -0-02 / .035 14:08
3-Year 4.500 05/15/2010 99-081⁄2 / 4.77 -0-031⁄2 / .040 14:06
5-Year 4.500 04/30/2012 98-281⁄2 / 4.75 -0-06 / .043 14:07
10-Year 4.500 05/15/2017 97-15 / 4.82 -0-091⁄2 / .038 14:07
30-Year 4.750 02/15/2037 96-17+ / 4.97 -0-17 / .035 14:07
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Spot Rates
3
The Term Structure of Interest Rates
An Example
Yield
6.00
5.75
5.00
1 2 3 Maturity
3
Term Structure, July 1st 2005.
4
Term Structure, September 12th, 2006
4
Term Structure, May 20th, 2007
4
Term Structure of Interest Rates
4
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Summary
Bonds can be valued by discounting their future cash
flows
Bond prices change inversely with yield
Price response of bond to interest rates depends on term
to maturity.
» Works well for zero-coupon bond, but not for coupon bonds
Measure interest rate sensitivity using ‘DV01’ and
duration.
The term structure implies terms for future borrowing:
» Forward rates
» Compare with expected future spot rates
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