Chapter 7

Interest Rates and Bond Valuation

Bond Features

Bond - evidence of debt issued by a corporation or a governmental body. A bond represents a loan made by investors to the issuer. In return for his/her money, the investor receives a legaI claim on future cash flows of the borrower. The issuer promises to:

Make regular coupon payments every period until the bond matures, and

Pay the face/par/maturity value of the bond when it matures.

Default - since the above mentioned promises are contractual obligations, an issuer who fails to keep them is subject to legal action on behalf of the lenders (bondholders).

Bond Value = Present Value of the Coupons

+ Present Value of the Face Value

Bond Value = INT [1 – (1/(1 + rd)N)]/rd + M * 1/(1 + rd)N

where: INT = the promised coupon payment

M = the promised face value

N = number of periods until the bond matures

rd = the market’s required return, YTM

If a bond has five years to maturity, an $80 annual coupon, and a $1000 face value, its cash flows would look like this:

Time 0 1 2 3 4 5

Coupons $80 $80 $80 $80 $80

Face Value $ 1000

Market Price $____

How much is this bond worth? It depends on the level of current market interest rates. If the going rate on bonds like this one is 10%, then this bond is worth $924.18.

5 N 10 I/Y 80 PMT 1000 FV CPT PV (-924.18)

Suppose a bond currently sells for $932.90. It pays an annual coupon of $70, and it matures in 10 years. It has a face value of $1000. What are its coupon rate, current yield, and yield to maturity (YTM)?

A.. The coupon rate (or just “coupon”) is the annual dollar coupon as