Key conceptions about Bond ( Part 2 )
Key conceptions about Bond ( Part 2 ) FIN 323
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This 11 page Class Notes was uploaded by Winn on Wednesday February 24, 2016. The Class Notes belongs to FIN 323 at Marshall University taught by in Spring 2016. Since its upload, it has received 35 views. For similar materials see Principles of Finance in Business at Marshall University.
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Date Created: 02/24/16
Chapter 6 : Bond Concepts ( Part 2 ) Bond- Pricing Equation With the Texas Instruments BA-II plus , we have : n = number of periods to maturity I/Y = period interest rate = y P = PV = present value = bond value C = PMT = coupon payment FV = M = face value = par value = future value With the excel , we have : = FV ( Rate, Nper , Pmt , PV , 0/1 ) => calculate the face value = PV (Rate, Nper , Pmt, FV , 0/1 ) => calculate the bond value = RATE ( Nper , Pmt , PV, FV , 0/1) => calculate the period interest rate ( I/Y) = NPER ( Rate, Pmt, PV , FV , 0/1) => calculate the number of periods to maturity = PMT ( rate, nper, pv ,fv , 0/1 ) => calculate coupon payment With 0/1 : Ordinary annuity = 0 ( default ) Annuity Due = 1 Graphical Relationship between price and yield-to-maturity Valuing a Discount bond with Annual Coupons : Coupon rate = 12 % Annual coupons Par = $1000 Maturity = 6 years YTM = 15 % B = 886.47 which include the bond price annuity and the lump sum. When YTM > Coupon rate -> bond price < par value = “Discount Bond” Valuing a Premium Bond with Annual Coupons : Coupon rate = 11% Annual Coupons Part = $1000 Maturity = 7 years YTM = 10% B = 1048.68 When YTM < Coupon rate -> bond price > par value = “Premium Bond” The Bond – Pricing Equation Adjusted for Semi-annual Coupons C = Annual coupon payment => C/2 = semi-annual coupon. YTM = annual YTM ( as an APR ) => YTM/2 = semi-annual YTM t = years to maturity => 2t = Number of 6-month periods to maturity Interest rate risk : - Change in the bond price due to the changes in period interest rate. - Long-term bonds have more risk than short-term bonds. - Low coupon rate bonds have more price risk than high coupon rate bonds ? Explaining : if you have a bond that has a low coupon rate, there is a higher chance that the market yield will be higher than your coupon rate. so if that’s the case, then all of a sudden, your bond is trading at a discount. which in sense, means you just lost a boat load of money (assuming you started off at par) but on the bright side is, lower coupon means you have lower reinvestment risk because less of your cashflows are going to be reinvested at that prevailing market rate _ Reinvestment rate risk : Debt versus Equity : Bond Ratings: is like credit scores for people who show the overall credit worthiness of your institution. It represents to prospective investors the riskiness of loaning your college money through the sale of the bond. The greater the risk of not being paid on time, or at all, the lower the credit worthiness and the higher the interest rate the school will pay to borrow the funds. Explainning: In determining the rating for your institution’s bond, the rating agency will evaluate several factors affecting your credit worthiness and the riskiness of the debt. In general those factors are: The economy Your current debt structure (total obligation and the debt service) Financial conditions Demographic factors Management practices of the organization and its administration. ** Government bonds: a) Municipal Securities: A general term referring to a bond, note, warrant, certificate of participation or other obligation issued by a state or local government or their agencies or authorities (such as cities, towns, villages, counties or special districts or authorities. b) Treasury Securities = Federal government debt : _Treasury Bills ( T-bills ): a short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-bills are sold in denominations of $1,000 up to a maximum purchase of $5 million and commonly have maturities of one month (four weeks), three months (13 weeks) or six months (26 weeks) _ Treasury notes : a marketable U.S. government debt security with a fixed interest rate and a maturity between one and 10 years. Treasury notes can be bought either directly from the U.S. government or through a bank. _ Treasury bonds: a marketable, fixed-interest U.S. government debt security with a maturity of more than 10 years. Treasury bonds make interest payments semi-annually and the income that holders receive is only taxed at the federal level. - ** Zero Coupon Bonds: _Zero coupon bonds are sold at a substantial discount from the face amount. For example, a bond with a face amount of $20,000, maturing in 20 years with a 5.5% coupon, may be purchased for roughly $6,757. At the end of the 20 years, the investor will receive $20,000. The difference between $20,000 and $6,757 represents the interest that compounds automatically until the bond matures. ** Floating Rate Bonds : ** Factors affecting required return: _ Default risk premium: What is the chance that the borrower won't make payments on time, or will be unable to pay what is owed? This component will be high or low depending on the creditworthiness of the person or entity involved _ Taxability premium _ Liquidity premium : A premium that investors will demand when any given security can not be easily converted into cash, and converted at the fair market value. When the liquidity premium is high, then the asset is said to be illiquid, which will cause prices to fall, and interest rates to rise _ Maturity premium : All else being equal, a bond obligation will be more sensitive to interest rate fluctuations the longer to maturity it is _ Inflation : In general, when inflation is on the rise, bond prices fall. When inflation is decreasing, bond prices rise. That’s because rising inflation erodes the purchasing power of what you’ll earn on your investment. In other words, when your bond matures, the return you’ve earned on your investment will be worth less in today’s dollars ** The fisher effect : is an economic theory proposed by economist Irving Fisher that describes the relationship between inflation and both real and nominal interest rates. The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation.
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