1 Chapter 8 Bond Valuation and Risk Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 2 Chapter Outline  Bond valuation process  Relationships between coupon rate, required return, and bond price  Explaining bond price movements  Sensitivity of bond prices to interest rate movements  Bond investment strategies used by investors  Return and risk of international bonds 3 Bond Valuation Process  Bonds:  Are debt obligations with long-term maturities issued by government or corporations to obtain long-term funds  Are commonly purchased by financial institutions that wish to invest for long-term periods  The appropriate bond price reflects the present value of the cash flows generated by the bond (i.e., interest payments and repayment of principal): n k C k C k C PV )1( Par )1()1( bond of 21 + + + + + + = 4 Computing the Current Price of A Bond A 2-year bond has a par value of $1,000 and a coupon rate of 5 percent. The prevailing annualized yield on other bonds with similar characteristics is 7 percent. What is the appropriate market price of the bond? 84.963 07.1 050,1 07.1 50 )1( Par )1()1( bond of 2 21 = += + + + + + + = n k C k C k C PV 5 Bond Valuation Process (cont’d)  Bond valuation with a present value table  Present value interest factors in Exhibit 8A.3 can be multiplied by coupon payments and the par value to determine the present value of the bond  Impact of the discount rate on bond valuation  The appropriate discount rate for valuing any asset is the yield that could be earned on alternative investments with similar risk and maturity  Investors use higher discount rates to discount the future cash flows of riskier securities  The value of a high-risk security will be lower than the value of a low-risk security 6 Computing the Current Price of A Bond Using PVIFs A 2-year bond has a par value of $1,000 and a coupon rate of 5 percent. The prevailing annualized yield on other bonds is 7 percent. What is the appropriate market price of the bond using PVIFs? 80.963$ 07.917$73.46$ )8734(.050,1$)9346(.50$ )(050,1$)(50$bond of 2%,71%,7 = += += += ==== nknk PVIFPVIFPV 7 Bond Valuation Process (cont’d)  Impact of the timing of payments on bond valuation  Funds received sooner can be reinvested to earn additional returns  A dollar to be received soon has a higher present value than one to be received later  Valuation of bonds with semiannual payments  First, divide the annual coupon by two  Second, divide the annual discount rate by two  Third, double the number of years n k C k C k C PV 221 )2/1( Par2/ )2/1( 2/ )2/1( 2/ bond of + + + + + + = 8 Computing the Current Price of A Bond With Semiannual Coupons A 2-year bond has a par value of $1,000 and a semiannual coupon rate of 5 percent. The prevailing annualized yield on other bonds with similar characteristics is 7 percent. What is the appropriate market price of the bond? 27.963 035.1 025,1 035.1 25 035.1 25 035.1 25 )2/1( Par2/ )2/1( 2/ )2/1( 2/ bond of 4321 221 = +++= + + + + + + = n k C k C k C PV 9 Bond Valuation Process (cont’d)  Use the annuity tables for valuation  A bond can be valued by separating its payments into two components: PV of bond = PV of coupon payments + PV of principal  The bond’s coupon payments represent an annuity (an even stream of payments over a given period of time)  The present value can be computed using PVIFAs 10 Computing the Current Price of A Bond Using PVIFs and PVIFAs A 30-year bond has a par value of $1,000 and an annual coupon rate of 10 percent. The prevailing annualized yield on other bonds with similar characteristics is 9 percent. What is the appropriate market price of the bond? 1,102.80$$75.40$1,027.40bond of 40.75$)0754(.000,1$ )(000,1$principal of 40.027,1$)274.10(100$ )(payments coupon of 30%,9 30%,9 =+= == = == = == == PV PVIFPV PVIFACPV nk nk [...]... coupon rate of 10 percent The current price of this bond is $1,273.24 If the yield to maturity increases to 9 percent, the new price of the bond is $1 ,080 .61 What is ?this bond’s bond price elasticity percent change in P p = percent change in k e $1 ,080 .61 − $1,273.24 $1,273.24 = 9% − 7 % 7% = −0.53 25 Sensitivity of Bond Prices to Interest Rate Movements (cont’d)  Duration  Duration measures the . 1 Chapter 8 Bond Valuation and Risk Financial Markets and Institutions, 7e, Jeff. ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 2 Chapter Outline  Bond valuation process  Relationships between coupon rate,