Chapter 6: Valuing bonds
1. The bond market
B ONDS
= Debt instrument
= Financing by borrowing money
Bond
Security that obligates the issuer to make specified payments to the bondholder
Face value (par value or principal value)
Payment at the maturity of the bond
Coupon
The interest payments made to the bondholder
Coupon rate
Annual interest payment as a percentage of face value
BONDS AT INCEPTION /CREATION
5-year bond example
Coupon of 2% every year
At inception, most bonds typically sell for their face value, but this depends on the coupon and yield
the maturity (see further)
, 2. Interest rates and bond prices
WARNING
The coupon rate 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 misconception is quite common
The discount rate is the rate at which cash flows can be invested > Therefore in
the context of bonds, we use a required rate of return as discount rate
The theoretical 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
Bond prices are quoted as a percentage of par Par value x price % = $ Price
Cash flows to an investor in the 1.25%
coupon bond maturing in 2018
1. The bond market
B ONDS
= Debt instrument
= Financing by borrowing money
Bond
Security that obligates the issuer to make specified payments to the bondholder
Face value (par value or principal value)
Payment at the maturity of the bond
Coupon
The interest payments made to the bondholder
Coupon rate
Annual interest payment as a percentage of face value
BONDS AT INCEPTION /CREATION
5-year bond example
Coupon of 2% every year
At inception, most bonds typically sell for their face value, but this depends on the coupon and yield
the maturity (see further)
, 2. Interest rates and bond prices
WARNING
The coupon rate 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 misconception is quite common
The discount rate is the rate at which cash flows can be invested > Therefore in
the context of bonds, we use a required rate of return as discount rate
The theoretical 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
Bond prices are quoted as a percentage of par Par value x price % = $ Price
Cash flows to an investor in the 1.25%
coupon bond maturing in 2018
