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Valuing bond

Valuing bond. Fundamentals of corporate finance, BMM Chapter 6 Valuing bond Finansiell ekonomi höst 2012. Topics Covered. Using The Present Value Formula to Value Bonds How Bond Prices Vary With Interest Rates The Term Structure of Interest Rates Real and Nominal Rates of Interest

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Valuing bond

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  1. Valuing bond Fundamentals of corporate finance, BMM Chapter 6 Valuing bond Finansiellekonomihöst 2012

  2. Topics Covered • Using The Present Value Formula to Value Bonds • How Bond Prices Vary With Interest Rates • The Term Structure of Interest Rates • Real and Nominal Rates of Interest • Corporate Bonds and the Risk of Default

  3. The Structure of Corporate Governance Entities with capital at risk in the corporation, but can also reap gains or returns from activities with the corporation Equity Markets Analysts and other market agents evaluate the performance of the firm on a daily basis Debt Markets Ratings agencies and other analysts review the ability of the firm to service debt The Corporation (internal) Board of Directors Chairman of the Board and members are accountable for the organization Regulators SEC, the OMX, or other regulatory bodies by country The Marketplace (external) Management Chief Executive Officer (CEO) and his team run the company Auditors External opinion as to the fairness of presentation and conformity to stds of financial statements Legal Counsel Provides legal opinions and recommendations on legality of corporate activities Entities whose services are purchased by the corporation

  4. Why companies issue bonds? • To finance their investment project. • Issuing bond does not have the loss of ownership as issuing stocks do, since bond is a debt certificate. • Bondholders have a role in monitoring the firm´s activities due to the periodic payment feature of the bond. • Bonds provide a fixed rate of return for investors! • The required rate of return on bond is lower than the stocks. Since stocks are inherently riskier.

  5. Definitions • Abond is a debt security. It is a formal contract promising to repay borrowed money with interest at fixed intervals. (Obligation) • Maturity date — the date on which the issuer has to repay the nominal amount. (löptid) • Yield to maturity is internal rate of return (IRR, overall interest rate) earned by an investor who buys the bond today at the market price.

  6. ZeroCoupon Bond (nollkupongare) • A zero coupon bond pay no regular interest. It is issued at a substantial discount to par value (face value). Sensitive to interest rate changes. t.ex. SSVX Statsskuldsväxlarärnollkupongare. • Current yield: annual coupon payments divided by bond price.

  7. Kopioravaktiebrevoch obligation frånBofors-GullspångAktiebolag

  8. Premium bond issued by British National savings association

  9. Government bond issued by the State of South Carolina 2011

  10. (SOX) Obligationer Sverige

  11. Exempel: statsobligation

  12. Räkna ut ränta (Yieldtomaturity) • RGKB 1047, säljränta 128,48%, kupong 5kr, slutvärde 100, löptid 8 år + 96/360=8,267 år. • Yielden blir 1,338 %.

  13. Exempel (yieldtomaturity) • RGKB 1046, löptid 44 dagar/360 år. • Kupong 5,5 säljränta 100,486, slutvärde 100, • Yielden blir 1,49%. • Du märkte att yielden är lite högre än 8 års yield.

  14. The pricing of bonds • Any bond can be valued as an annuity plus a single payment. • It is the present value of the interest payments and the principal payment (face value) discounted at the yield to maturity of the bond. • Bond dealers earn a spread by selling higher than its bid price. Bid price –ask price= spread

  15. Zero coupon bond (discount bond) • Consider a 30-year zero-coupon bond with a face value of $100. If the bond is priced at an annual YTM of 10%, what is the price of the bond today? Price = PV (cash flow)=100/(1,1)30 = 5,73 $ the discount amount is your interest payment. 5,73 $ is the price you pay for the bond. At the maturity date, you will be paid 100 $ face value, the effective annualized return or Yield to Maturity is 10%.

  16. Valuing a Coupon Bond

  17. Valuing a Bond Example • If today is October 1, 2010, what is the value of the following bond? An IBM Bond pays $115 every September 30 for 5 years. In September 2015 it pays an additional $1000 and retires the bond. The bond is rated AAA (WSJ AAA YTM is 7.5%) Cash Flows Sept 11 12 13 14 15 115 115 115 115 1115

  18. Valuing a Bond Example continued • If today is October 1, 2010, what is the value of the following bond? An IBM Bond pays $115 every September 30 for 5 years. In September 2015 it pays an additional $1000 and retires the bond. The bond is rated AAA (WSJ AAA YTM is 7.5%)

  19. Valuing a Bond Example - France • In December 2008 you purchase 100 Euros of bonds in France which pay a 8.5% coupon every year. If the bond matures in 2012 and the YTM is 3.0%, what is the value of the bond?

  20. Kalkyler i excel Example - France • In December 2008 you purchase 100 Euros of bonds in France which pay a 8.5% coupon every year. If the bond matures in 2012 and the YTM is 3.0%, what is the value of the bond? (obs! Påengelska version använder vi NPV I stääletförNetnuvärde)

  21. Valuing a Bond Another Example - Japan • In July 2010 you purchase 200 Yen of bonds in Japan which pay a 8% coupon every year. If the bond matures in 2015 and the YTM is 4.5%, what is the value of the bond? Note the value is 230.73. corrected!

  22. Valuing a Bond Example - USA • In February 2009 you purchase a 3 year US Government bond. The bond has an annual coupon rate of 4.875%, paid semi-annually. If investors demand a 0.006003% semiannual return, what is the price of the bond? Present value of c/2 coupon payment over 2 t period. Apply Annuity formula. Halva kupongochdubbellöptid! Samt relevant yielden!

  23. Valuing a Bond Example continued - USA • Take the same 3 year US Government bond. If investors demand a 4.0% semiannual return, what is the new price of the bond?

  24. Interest Rate on 10yr Treasuries Yield , % Year

  25. Bond Prices and Yields (inverse relationship) Bond Price Interest Rates, %

  26. Time to Maturity and Prices: increase interest rate, the price of longer term bonds decrease more, all else konstant! 30 yr bond When the interest rate equals the 5% coupon, both bonds sell for face value Bond Price, ($) 3 yr bond Interest Rates, %

  27. Figure 1: Yield Curve January 2008: changing term structure

  28. The recent term structure of interest Rate: upward sloping

  29. UK gilt and US treasury yield vs. Time to maturity (2011 aug 22.)

  30. Interest Rates • Short- and long-term interest rates do not always move in parallel. Between September 1992 and April 2000 U.S. short-term rates rose sharply while long term rates declined. A indication of recession in 2000.

  31. Term Structure of Interest Rates YTM (r) The relationship between short term and long term interest rate is called the term structure of interest rate. Spot Rate - The actual interest rate today (t=0) Forward Rate - The interest rate, fixed today, on a loan made in the future at a fixed time. Future Rate - The spot rate that is expected in the future 1981 1987 & Normal 1976 Year 1 5 10 20 30

  32. U.S. Treasury Strip Spot Rates as of February 2009: the yield curve Spot rates (%) Maturity The yield curve depicts the term structure of interest rate.

  33. Yield to Maturity Example • A $1000 treasury bond expires in 5 years. It pays a coupon rate of 10.5%. If the market price of this bond is 1078.8, what is the YTM? C0 C1 C2 C3 C4 C5 -1078.80 105 105 105 105 1105 Calculate IRR = 8.5% Obs: användRänta= som argument I excel program svenska version.

  34. Inflation Rates Annual rates of inflation in the United States from 1900–2008. Annual Inflation (%)

  35. Global Inflation Rates Averages from 1900-2006

  36. Debt & Interest Rates Nominal r = Real r + expected inflation (approximation) Actual formula

  37. UK Bond Yields 10 year nominal interest rate Interest rate (%) 10 year real interest rate

  38. Govt. Bills vs. Inflation (’53-’08) United Kingdom Inflation % T-Bill Returns

  39. Govt. Bills vs. Inflation (’53-’08) United States Inflation % T-Bill Returns

  40. Govt. Bills vs. Inflation (’53-’08) Germany T-Bill Returns % Inflation

  41. Bond Ratings • Key to bond ratings. The highest-quality bonds are rated triple A. Bonds rated triple B or above are investment grade. Lower-rated bonds are called high-yield, or junk, bonds. Check the coursebook BMM for moredetails.

  42. Yield Spread: credit risk Yield spreads between corporate and 10-year Treasury bonds. Obs: the spread indicates the credit risk of Baa related corporate bond over riskfree treasury bond! Yield spread between corporate and government bonds, % Years

  43. Prices and Yields • Prices and yields of a sample of corporate bonds, December 2008. (jämför yield to maturity! Kapitalkostnadförföretag!) Source: Bond transactions reported on FINRA’s TRACE service: http://cxa.marketwatch.com/finra/BondCenter

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