Valuing Bonds Flashcards
Bonds as financial assets
Owner of a bond is entitled to a fixed set of cash payments in the future,
- interest (coupons) paid annually or semi-annually during the life of the bond.
- principal is repaid on the redemption/ maturity
Present Value of the bond
(interest paid * AF) + (principal repaid * DF)
AF= Annuity factor
DF= Discount factor
Relationship 1
The market price is the PV of future cashflow discounted at market interest.
If the market discount rate is lower (higher) than the coupon, bond trades above (below) nominal value.
Relationship 2
- The market price of a bond is inversely related to changes in the investor’s present required rate of return (yield to maturity).
- As market interest rates increase, the bond holder’s required return increases, but the coupon is fixed.
- So the market price of the bond decreases, as FV is now discounted with a higher rate.
Relationship 3
Changes in interest rate will cause a:
- Small change in the PV of a short term FV cash flows
- Larger impact on the PV of longer term cash flows
Hence the price of long term bonds is affected more by changes in the interest rate than the price of short term bonds.
The term structure of interest rates
- The relationship between short and long term interest rate.
- Short and long term rates do not always move in parallel
- Yield curve is a graphical representation of this.
Normal is upward sloping:
- long term rates are higher than short term rates
- related to higher interest rate risk
Yield to Maturity
YTM refers to the rate of return the investor will earn if the bond is held to maturity. Also known as bond holder’s expected rate of return.
YTM= discount rate that equates the present value of the future cash flows with the current market price of the bond.
Current Yield
It is the ratio of the coupon payment to the bond’s current market price.
CY= annual interest payment/current market price of bond
