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,