All Rights Reserved Dr David P Echevarria 1 CHAPTER 8 BOND VALUATION AND RISK

All Rights Reserved 2Dr David P Echevarria BOND VALUATION The value of any debt claim is equal to the sum of the discounted future cash flows. The discount [interest] for future cash flows is a function of the level of riskiness for a particular bond and is termed the Yield to Maturity (YTM). Bond valuation model; 1.V b = Coupon * PVIFA + Face Value * PVIF

All Rights Reserved 3Dr David P Echevarria BOND VALUATION A.Valuation of Bonds with Annual, Semi-annual, or quarterly Payments 1.Two cash streams are expect for each bond a.Coupons b.Face or maturity value 2.Coupons valued like an annuity 3.Face Value a single discounted future cash flow B.Methods for computing Bond Market Values 1.Bond Tables 2.Financial Calculators (preferred)

USING FINANCIAL CALCULATORS TO COMPUTE BOND VALUES A bond pays a coupon of $120 per year, paid semi-annually. The bond matures in 20 years and has a face value of $1,000. If the current YTM rates are 9 percent, how much should this bond sell for? 1.ENTER 20 [2nd] [N], [N]: Display: N = ENTER 9 [I/Y]: Display: I/Y = ENTER 60 [PMT]: Display: PMT = ENTER 1000 [FV]: Display: FV = 1, PRESS [CPT] [PV]: Display: PV = -1,276.02

USING FINANCIAL CALCULATORS TO COMPUTE BOND VALUES A.What If Examples 1.Suppose the YTM is 11 percent; "I/Y" = 11. Enter 11, press [I/Y], then [CPT], then [PV]; - 1, If the YTM is 12%; enter 12, press [I/Y], then [CPT], [PV]; PV = 1, or $1, If the YTM is 15%, the price [PV] is $ Note as YTM increases, V B decreases Note as YTM increases, V B decreases

Yield to First Call A.Callable Bonds Pay Premiums 1.The premium results in a Yield-to-First-Call different from the Coupon Rate. 2.Calling a 30-year bond 5% coupon bond four years after N = 4 4.PV = PMT = 50 6.FV = CPT I/Y = 6.70% Dr. David P. Echevarria All Rights ReservedSlide 6

All Rights Reserved 7Dr David P Echevarria BOND VALUATION C.Impact of Interest Rate Movements on Bond Prices 1.Bond Prices move in the Opposite Direction to Interest Rates. 2.Bonds will sell at discounts or premiums or equal to Face values 3.Interest Rates move in the Same Direction as Inflationary Expectations 4.Interest Rates move in the Same Direction as Perceived Riskiness

All Rights Reserved 8Dr David P Echevarria BOND VALUATION D. Factors Affecting Bond Price Interest Rate Sensitivity 1.The time remaining to maturity; direct relationship 2.The size of the coupon payments 3.The frequency of coupon payments; i.e., annual, Semi-, quarterly, monthly

All Rights Reserved 9Dr David P Echevarria BOND VALUATION F.Determination of Bond Yields 1.Yield to Maturity (YTM) 2.Current Yield 3. Tax treatment of gains and loses a.Premiums b.Discounts G.Using Expectations to Manage Total Returns on Bond Portfolios 1.If you know were interest rates are going you know where bond prices are going 2.Riding the yield curve or betting on the movement of interest rates

Duration A. Measuring Sensitivity to Interest Rate Movements: Duration 1.As duration increases, the greater the sensitivity to interest rate fluctuations 2.Sensitivity is also a function of coupon rates a.The larger the coupon rate, the shorter the duration b.Zero coupon bonds: duration = maturity 3.Importance of determining the investment horizon 4.Key strategy for immunizing the yield on a bond portfolio All Rights Reserved 10Dr David P Echevarria

All Rights Reserved 11Dr David P Echevarria BOND PORTFOLIO MANAGEMENT B. Use of Duration as an Immunization Strategy "A portfolio of bonds is immunized from interest rate risk if the duration of the portfolio equals the desired investment horizon" Fisher and Weil 1.Requires a known investment horizon; when do you need the cash? 2.Involves periodic adjustment in portfolio composition; see #3 below 3.Increase in YTM after the position is set results in a decrease in duration and vice-versa (Reinvestment of cash flows at higher rates than original YTM) 4.Duration affected by calls, serial redemptions, and sinking fund provisions

All Rights Reserved 12Dr David P Echevarria Managing Bond Risk: Duration

Duration for a Zero Coupon Bond All Rights Reserved 13Dr David P Echevarria Effects of Coupon Rates on Duration: As coupon rates increase, duration decreases and vice- versa. As YTM decrease, duration increases and vice versa. The duration for a zero- coupon bond is equal to its maturity.

All Rights Reserved 14Dr David P Echevarria BOND PORTFOLIO MANAGEMENT B.Use of Derivative Securities as Hedges 1.Interest rate futures, as well as options on futures 2.May also involve currency hedges 3.SWAP agreements may also be used

Interest Rates, Economic Activity and Long Term Cycles All Rights Reserved 15Dr David P Echevarria

The Kondratieff Cycle Where is the US (and Everyone one else) Headed? All Rights Reserved 16Dr David P Echevarria

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CHAPEL HILL, N.C. (MarketWatch) — There are eerie parallels between the stock market’s recent behavior and how it behaved right before the 1929 crash. All Rights Reserved 18Dr David P Echevarria

All Rights Reserved 19Dr David P Echevarria HOMEWORK QUESTIONS A.What 2 cash flows are associated with bond investments? B.What effects do interest rate increases (decreases) have on; 1.Market values of bonds? 2.Current yields? 3.Yields to maturity? C.What does it mean when a bond sells at par, at a discount, at a premium? D.What information is necessary in order to make good bond investments?