Chapter 6: Valuing Bonds Flashcards
The Law of One Price
- implies that the price of a security in a competitive market should be the present value of the cash flows an investor will receive from owning it
- directly relates to the return of a bond and its price
- guarantees that the risk-free interest rate equals the yield to maturity on such a bond
Bond
is a security sold by governments and corporations to raise money from investors today in exchange for the promised future payment
Face Value
- the notional amount of a bond used to compute its interest payments
- generally due at the bond’s maturity
- aka par value or principal amount
- default: $1000
Value of a Bond
- the PV of the bonds cash flow
- = coupons + face value
Coupons
the promised interest payments of a bond
Coupon Rate
- the percent of a bond’s face value paid out as coupons over a one-year period
- indicates the percentage of face value paid out as coupons each year
- expressed as an APR, is set by the issuer and stated on the bond certificate
- does not = discount rate
- does not change during life of the bond
Zero-coupon Bond
- a bond that makes only one payment at maturity
- always sells at a discount (a price lower than face value)
- no CPN/PMT
- aka pure discount bonds
- treasury bills
Treasury Bills
short-term (with a maturity of up to one year), zero-coupon debt, issued by the Government of Canada to provide financing for the government
Discount
- price lower than the face value
- the amount by which a cash flow exceeds its present value
- if a coupon bond trades at a discount, an investor will earn a return both from receiving the coupons and from receiving a face value that exceeds the price paid for the bond
Discount Rate
- used to discount all cash flows arising from the bond, interest (coupons payments), and the principal repayment
- both interest and discount rates determine its present value
Yield to Maturity
- the IRR of a bond is called its yield to maturity (or yield)
- the discount rate that sets the present value of the promised bond payments equal to the current market price of the bond
Par
- a bond is selling at par if the price is equal to the face value
- when a bond trades at a price equal to its face value, it is said to trade at par
Premium
- a bond is selling at a premium if the price is greater than the face value
- if a coupon bond trades at a premium it will earn a return from receiving the coupons but this return will be diminished by receiving a face value less than the price paid for the bond
When the bond price is greater than face value
- say its above par or at a premium
- coupon rate > yield to maturity
When the bond price is equal to face value
- say its at par
- coupon rate = yield to maturity
When the bond price is less than face value
- say its below par or at a discount
- coupon rate < yield to maturity
Rise in interest rates and bond yield
bond prices falls
Fall in interest rates and bond yield
bond prices rise
Bond’s Duration
- measures the sensitivity of a bond’s price to changes in interest rates
- the value-weighted average maturity of a bond’s cash flow
Bonds with high durations
highly sensitive to interest rate changes
Bonds with low durations
less sensitive to interest rate changes
