Lesson Plan •What’s A Bond? •Types of Bonds •Bond Valuation Techniques •The Bangladeshi Bond Market •Problem Set •A bond is a long-term debt instrument issued by a corporation or a government. It is a fixed-income security. •A bond is a formal contract to repay borrowed money with interest at fixed intervals. •A bond provides the borrower with external funds to: – finance long term investments (for corporations) What’s a bond?
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Lesson Plan•What’s A Bond?•Types of Bonds•Bond Valuation Techniques•The Bangladeshi Bond Market•Problem Set
•A bond is a long-term debt instrument issued by a corporation or a government. It is a fixed-income security. •A bond is a formal contract to repay borrowed money with interest at fixed intervals. •A bond provides the borrower with external funds to:
– finance long term investments (for corporations)– finance current expenditures (for municipal, state or national governments).
What’s a bond?
Difference between stocks and bonds
Shares of stock BondEquity stake in the firmCreditor stake in the firm[i.e. owners] [.i.e. lenders]
Undefined term Defined term (maturity)(outstanding indefinitely)Types of bonds
• A non-zero coupon-paying bond is a coupon-paying bond with a finite life. •A zero-coupon bond is a bond that pays no interest but sells at a deep discount from face value. • A perpetual bond is a bond that never matures. It has an infinite life.
Types of bonds• A fixed rate bond is a bond whose coupon rate remains constant throughout the life of the bond. •A floating rate bond is a bond with a variable coupon that is linked to a reference rate of interest, such as the LIBOR. [LIBOR + 20 b.p.]• An inflation-linked bond is a bond whose coupon payments and principal are indexed to inflation.
– Gilts in the UK– TIPS in the US
• A Municipal bond (or muni) is a bond issued by a municipality, city, state or their agencies and is usually tax exempt. •A lottery bond is a bond with coupon payments like fixed-rate bonds, but the issuer will redeem randomly selected individual bonds for a higher value than the bond’s face value. • An asset-backed security (e.g. CDOs, CMOs, MBSs) is a bond whose interest and principal payments are backed by underlying cash flows from other assets.
Coupon rate =Annual coupon payments (CP)
Maturity value (MV)
For example:Annual coupon payments = $80Face value = $1,000Coupon rate =
$80/$1,000 = 0.08 = 8%
The maturity value•The maturity value (MV) [or face value] of a bond is the stated value.
– In the case of a U.S. bond, the MV is usually $1,000. – In the case of a Bangladeshi prize bond, the MV is usually 100 Taka. Coupon rate
•The coupon rate [or coupon yield] of a bond is the stated rate of interest.
Sample problem #1
•If the annual coupon payments are $70 and the face value of a bond is $1,000, what is its coupon rate?
The discount rate•The discount rate [or capitalization rate] of a bond is dependent on the risk of the bond.
•The discount rate (kd) is composed of the risk-free
rate plus a premium for risk. Bond valuation•Bond value = PV of coupons + PV of MV•Bond value = PV annuity + PV of lump sum
Remember: as interest rates increase, the PVs decrease.So, as interest rates increase, bond prices decrease.
V = CP (PVIFA kd, nn) + MV (PVIF kd, nn)
A bond has a $1,000 face value and provides an 8% annual coupon for 3030 years. The appropriate discount rate is 10%. What is the value of the bond?
Bond valuationA bond has a $ 1,000 face value and provides an 8% annual coupon for 3030 years. The appropriate discount rate is 10%. What is the value of the bond?VV = CP (PVIFA 10%, 3030) +
Sample problem #1A bond has a $ 1,000 face value and provides a 6% annual coupon for 2020 years. The appropriate discount rate is 6%. What is the value of the bond?VV = CP (PVIFA 6%, 2020) +
A bond has a $ 1,000 face value and provides a 6% annual coupon for 1010 years. The appropriate discount rate is 10%. What is the value of the bond?VV = CP (PVIFA 10%, 1010) + MV (PVIF 10%, 1010)
A bond has a $ 1,000 face value and provides an 8% semi-annual coupon for 1515 years. The appropriate discount rate is 10% (annual rate). What is the value of the coupon bond?VV = CP/2 (PVIFA 10%/2,
value and provides a 6% semi-annual coupon for 1515 years. The appropriate discount rate is 6% (annual rate). What is the value of the coupon bond?VV = CP/2 (PVIFA 6%/2,
Zero-coupon bond valuation•A zero-coupon bond is a bond that pays no interest but sells at a deep discount from its face value.
V = MV (PVIF kd, nn)
Zero-coupon bond example
A bond has a $1,000 face value and a 3030-year life. The appropriate discount rate is 10%. What is the value of the zero-coupon bond? VV = MV (PVIF 10%,
3030) = $1,000
(0.057)= $57.00$57.00
A bond has a $1,000 face value and a 3030-year life. The appropriate discount rate is 6%. What is the value of the zero-coupon bond?
Zero-coupon bond example #3A bond has a $1,000 face value and a 1010-year life. The appropriate discount rate is 6%. What is the value of the zero-coupon bond? VV = MV (PVIF 6%, 1010)
= $1,000 (0.5584)= $558.40$558.40Perpetual
bond valuation
•A perpetual bond is a bond that never matures. It has an infinite life.
V = CP / kd
Perpetual bond example
A bond has a $1,000 face value and provides an 8% coupon. The appropriate discount rate is 10%. What is the value of the perpetual bond?CP = $1,000 * (8%) = $80kd = 10% = 0.10VV = CP / kd
= $80 / 0.10 = $800$800
Perpetual bond example #2
A bond has a $1,000 face value and provides a 6% coupon. The appropriate discount rate is 20%. What is the value of the perpetual bond?