Chapter 6

Valuing Bonds
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 Topics Covered

6.1 Bonds
6.2 Interest Rates and Bond Prices
6.3 Yield to Maturity

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 Bonds
▪ Bond
– tradable financial asset (loan) that requires the
borrower to make specified payments regularly
(interest) and payback the principal at maturity
▪ Face Value (Par Value or Principal Value)
– Payment at the maturity of the bond
▪ Coupon
– the interest payments made to the bondholder
▪ Coupon Rate (interest rate)
– the interest payment, as a percentage of
principal

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Coupon Bond (2 of 6)

A coupon bond is
identified by four pieces
of information:
1. Face value
2. Agencies that issue
this bond
3. Maturity date
4. The coupon rate

Source:
https://en.wikipedia.org/wiki/United_States_Treasury_security

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Interest Rates and Bond Prices (1 of 17)

WARNING
The coupon rate (is an interest rate but) IS NOT the
discount rate used in the Present Value calculations
– The coupon rate merely tells us what cash flow the
bond will produce
– Since the coupon rate is listed as a %, this confusion in
normal among students

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Interest Rates and Bond Prices (2 of 17)

▪ The price of a bond is the present value of all cash

flows generated by the bond (i.e. coupons and
face value) discounted at the required rate of
return

cpn is commonly used as an abbreviation for coupon

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Interest Rates and Bond Prices (4 of 17)

Example
What is the value (or price) of a 2.25 % annual
coupon bond, with a $1,000 face value, which
matures in 3 years? Assume a required return of
2.391%.

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Interest Rates and Bond Prices (3 of 17)
Cash flows to an investor in the 2.25% coupon bond maturing in
2021

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Interest Rates and Bond Prices (5 of 17)

Example (continued)
What is the price of a 2.25 % annual coupon
bond, with a $1,000 face value, which matures in
3 years? Assume a required return of 2.391 %.

Bond prices are quoted as a percentage of par

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Interest Rates and Bond Prices (13 of 17)

Example (continued)
What is the price of a 2.25 % annual coupon
bond, with a $1,000 face value, which matures in
3 years? What is the price of the bond if the
required rate of return is 2.25%?

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Interest Rates and Bond Prices (13 of 17)

Example (continued)
What is the price of a 2.25 % annual coupon
bond, with a $1,000 face value, which matures in
3 years?What is the price of the bond if the
required rate of return is 2.25%?

Price % = 100%
6-
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Interest Rates and Bond Prices (14 of 17)

Example (continued)
What is the price of a 2.25 % annual coupon
bond, with a $1,000 face value, which matures in
3 years? What is the price of the bond if the
required rate of return is 10%?

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Interest Rates and Bond Prices (14 of 17)

Example (continued)
What is the price of the bond if the required rate
of return is 10%?

Price % = 80.727%

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 8-6

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 8-7

Bond Example
□ Consider a U.S. government bond with as 6.375% annual
coupon rate that expires in December 2013.
■ The Par Value of the bond is $1,000.
■ Coupon payments are made semiannually (June 30 and
December 31 for this particular bond).
■ Since the coupon rate is 6.375%, the payment is $31.875.
■ On January 1, 2009 the size and timing of cash flows are:
$31.875 $31.875 $31.875 $1,031.875

1/1/ 09 6 / 30 / 09 12 / 31/ 09 6 / 30 /13 12 / 31/13

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 8-8

Bond Example
□ On January 1, 2009, the required yield is 5%.
□ The current value is:

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 8-1
6

Zero Coupon Bonds

□ Make no periodic interest payments (coupon rate
= 0%)
□ The entire yield to maturity comes from the
difference between the purchase price and the par
value
□ Cannot sell for more than par value
□ Sometimes called zeroes, deep discount bonds,
or original issue discount bonds (OIDs)
□ Treasury Bills and principal-only Treasury strips are
good examples of zeroes
 Bond Yields (1 of 6)
Bond Yields
▪ Current Yield
– annual coupon payments divided by
current bond price
▪ Yield To Maturity
– the annual rate of return until maturity

Coupon rate: Interest payment, as a

percentage of principal OR (C/P)*100

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 Bond Yields (2 of 6)

▪ Calculating Yield to Maturity (YTM = r)

– If you are given the price of a bond (PV) and
the coupon rate, the yield to maturity can be
found by solving for r

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 YtM Approximation

YTM = (C + (F - P) / t) / ((F + P) / 2)

Where...

YTM = Yield to Maturity

C = Coupon or Interest Payment
F = Face Value
P = Price
t = Years to Maturity

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Consider a bond with a 7% annual coupon and a face value of
$1,000. Complete the following table: What relationship do you
observe between yield to maturity and the current bond price
(present value)?

Period YTM Current Price

3 ? $1,054.46
3 ? $1,000.00
6 ? $1,000.00
9 ? $1,000.00
9 ? $880.10

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Consider a bond with a 7% annual coupon and a face value of
$1,000. Complete the following table: What relationship do you
observe between yield to maturity and the current bond price
(present value)?

Period YTM Current Price

3 5 $1,054.46
3 7 $1,000.00
6 7 $1,000.00
9 7 $1,000.00
9 9 $880.10

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