Introduction to Bond Valuation

(Text reference: Chapter 5 (Sections 5.1-5.3, Appendix))

Topics
types of bonds
valuation of bonds
yield to maturity
term structure of interest rates
more about forward rates

AFM 271 - Introduction to Bond Valuation Slide 1

Types of Bonds

a bond is a form of debt (i.e. a contractual liability; basically just

a certificate showing that a borrower promises to repay interest
and principal on specified dates
issued by both governments and corporations
example: the Goverment of Canada issued a bond with a face
value of $1,000 in June 2002 which matures in June 2022. The
stated annual interest rate is 8%:
the face value is $1,000 (a.k.a. the principal or par value)
the annual coupon is $80
the coupon rate is 8%
the time to maturity is 20 years
the maturity date is June 1, 2022
AFM 271 - Introduction to Bond Valuation Slide 2
 Cont’d
there are many varieties of bonds:
a pure discount bond (a.k.a. zero coupon bond) pays the
bond’s face value at maturity (and nothing else)
a consol pays a stated coupon at periodic intervals and has
no maturity date
a level coupon bond pays the bond’s face value at maturity
and a stated coupon at periodic intervals prior to maturity
a callable bond gives the issuer the right to buy the bond
back before maturity for specified price(s) on specified
date(s)
a convertible bond allows the owner to exchange it for a
specified number of shares of stock

AFM 271 - Introduction to Bond Valuation Slide 3

Valuation of Bonds
at the time of issue a level coupon bond is usually sold for a
price which is close to its par value
after issue a bond is traded on the market at a price which
reflects the current level of interest rates and the degree of risk
associated with the bond
typically we are interested in calculating either the market price
that a bond should sell for, given that the investor wants to
obtain a particular market yield; or the effective yield (a.k.a. the
yield to maturity), given the price at which the bond is trading
the value of a financial security is the PV of expected future
cash flows ⇒ to value bonds we need to estimate future cash
flows (size and timing) and discount at an appropriate rate

AFM 271 - Introduction to Bond Valuation Slide 4

 Cont’d
notation: coupon payment C face value F
discount rate r time to maturity T
value of a consol:
C
PV of consol =
r
value of a pure discount bond:
F
PV of pure discount bond =
(1 + r)T

value of a level coupon bond:

1 − (1 + r)−T
 
F
PV of level coupon bond = C × +
r (1 + r)T
F
= C × ATr +
(1 + r)T
AFM 271 - Introduction to Bond Valuation Slide 5

Cont’d

example: consider a $1,000 par value bond with 17

years remaining until maturity and a coupon rate of 6%
what is the price of this bond if market interest rates
are 8%?

suppose an investor buys this bond at this price and

holds it for one year. If interest rates remain at 8%,
what rate of return has the investor earned?

AFM 271 - Introduction to Bond Valuation Slide 6

 Cont’d
suppose instead interest rates fall to 6%:

suppose instead interest rates rise to 10%:

AFM 271 - Introduction to Bond Valuation Slide 7

Cont’d
when interest rates rise, market prices of bonds fall (and vice
versa) (the longer the time until maturity, the more sensitive the
bond price is to changes in interest rates)
if price < par value, a bond is said to sell at a discount
if price > par value, a bond is said to sell at a premium
if price = par value, a bond is said to sell at par
in practice most bonds pay interest semi-annually, so we have
to find the appropriate semi-annual rate and adjust coupon
payments. For example, consider the bond above (top of
slide 6) but with semi-annual payments, and assuming that the
8% annual rate is a stated rate (not the effective annual rate):

AFM 271 - Introduction to Bond Valuation Slide 8

 Yield to Maturity

the yield to maturity of a bond is the discount rate which

equates the price of a bond with the PV of its expected
future cash flows
example: what is the yield to maturity of a 5% coupon 9
year $1,000 par value bond if the price is $813 (annual
coupons)? We need to solve the following equation for
r:
9
50 1000
813 = ∑ +
t=1 (1 + r)
t (1 + r)9

AFM 271 - Introduction to Bond Valuation Slide 9

Cont’d
suppose instead coupons are semi-annual:
18
25 1000
813 = ∑ (1 + r)t + (1 + r)18
t=1

AFM 271 - Introduction to Bond Valuation Slide 10

 Term Structure of Interest Rates
what determines interest rates?
investor preferences (e.g. willingness to save affects the
supply of capital)
productive opportunities (e.g. firms’ desire to invest affects
the demand for capital)
inflation (let i denote the expected rate of inflation)
inflation erodes the purchasing power of money ⇒ distinguish
between nominal and real interest rates:

1 + rnominal = (1 + rreal ) × (1 + i)
⇒ rnominal = rreal + i + i × rreal ≈ rreal + i

nominal rates will change whenever expected inflation does

AFM 271 - Introduction to Bond Valuation Slide 11

Cont’d
until now we have assumed that nominal interest rates as of
today are the same for all future periods; this allowed us to use
the general PV formula:
T
Ct
PV = ∑ t
t=1 (1 + r)

but on May 11, 2005 we saw the following rates in the market:
1-mo. 3-mo. 6-mo. 1-yr. 2-yr. 5-yr. 7-yr. 10-yr. 30-yr.
2.41 2.46 2.58 2.82 3.06 3.50 3.93 4.09 4.52

(Source: National Post)

the rates above are zero coupon rates, or spot rates

the term structure of interest rates or yield curve is the
relationship between spot rates of different maturities
AFM 271 - Introduction to Bond Valuation Slide 12
 Cont’d
denote the t-period spot rate by rt . Then our general PV
formula becomes:
T
Ct
PV = ∑ t
t=1 (1 + rt )

our earlier formula is a special case of this with a “flat

term structure” (i.e. r1 = r2 = r3 = · · · = r)
rather than discounting each period’s cash flow at a
different rate, we could find a single rate which gives the
same PV. This is just the yield to maturity from above
(more generally, it is known as internal rate of return
(IRR))

AFM 271 - Introduction to Bond Valuation Slide 13

Cont’d
some problems with yield to maturity:
1. The same rate is used to discount all payments, but what if
r1 6= r2 6= r3 . . .? For example:
Bond A: 3 years, annual coupon of 5%
Bond B: 3 years, annual coupon of 15%
Spot rates: r1 = .04, r2 = .048, r3 = .054
Calculate the yield to maturity and PV for each bond:

AFM 271 - Introduction to Bond Valuation Slide 14

 Cont’d
2. Yields to maturity do not add up—even if you know
the yield to maturity for A and the yield to maturity for
B, you do not know the yield to maturity for A plus B

3. Yield to maturity can give a misleading impression of

return since it implicitly assumes that all
intermediate payments are reinvested and earn the
same rate of return

AFM 271 - Introduction to Bond Valuation Slide 15

Cont’d

how can we measure the term structure?

1. Calculate yields to maturity on zero coupon bonds.
2. Calculate spot rates from coupon bonds with the
same maturity and different coupon rates. Consider
our earlier example (slide 14) with Bonds A and B:

AFM 271 - Introduction to Bond Valuation Slide 16

 Cont’d
explaining the term structure: Assume r1 = 5%, r2 = 4%.
Suppose I want to invest $100 for two years. I can:
(a) buy a two year bond:

$100 × 1.042 = $108.16

or $100 × 1.05 × (1 + f 2 ) = $108.16 ⇒ f 2 = .0301

where f 2 is the forward rate implied by the two year spot

rate
(b) buy a series of one year bonds:

$100 × 1.05 × (1 + r1,2 )

where r1,2 is the one year spot rate next year

AFM 271 - Introduction to Bond Valuation Slide 17

Cont’d
(a) provides a certain payoff of $108.16, whereas (b) provides
an expected payoff of $100 × 1.05 × [1 + E(r1,2 )]
suppose instead that I want to invest $100 for one year. I can:
(c) buy a one year bond: $100 × 1.05 = $105
(d) buy a two year bond and sell it after one year—what is the
price of a one year bond a year from now?
100(1 + r2 )2 100(1 + r1 )(1 + f2 )
PV = =
1 + r1,2 1 + r1,2

(c) provides a certain payoff of $105, while (d) provides an

expected payoff of
100(1 + r1 )(1 + f2 )
PV =
1 + E(r1,2 )

AFM 271 - Introduction to Bond Valuation Slide 18

 Cont’d
if all investors try to maximize expected return, then

f2 = E(r1,2 )

Why?

this is called the expectations hypothesis: forward rates are

equal to expected future spot rates. The term structure slopes
up if expected future spot rates are higher than current spot
rates, and vice versa.
AFM 271 - Introduction to Bond Valuation Slide 19

Cont’d
note that the expectations hypothesis ignores risk. One
alternative is the liquidity preference hypothesis: the shape of
the term structure depends on the investment horizons of
investors.
suppose investors have a short term horizon, e.g. one year.
This implies that short term bonds are less risky than long
term bonds (compare (c) and (d) above) ⇒ to induce
investors to hold long term bonds, they must receive a risk
premium.
suppose instead investors have a long term horizon. In this
case, long term bonds are less risky than short term bonds
(compare (a) and (b) above) ⇒ to induce investors to hold
short term bonds, they must receive a risk premium.
AFM 271 - Introduction to Bond Valuation Slide 20
 More About Forward Rates
start with a foreign currency example. On May 11, 2005, the
National Post reported that the spot exchange rate between
$CAD and $US was 1.2518, and the one year forward
exchange rate was 1.2429.
to determine the forward rate, we also need one year T-bill
rates in each country; the National Post reported the Cdn rate
was 2.82%; the U.S. rate was not given, but assume 3.56%
a Canadian investor with $100 to invest for one year can make
a risk free investment in Canada:
alternatively:

AFM 271 - Introduction to Bond Valuation Slide 21

Cont’d

equilibrium requires that these two risk free strategies

offer the same rates of return:
1
1 + rC = × (1 + rF ) × F1
E0
where rC is the one year Cdn T-bill rate, E0 is the spot
exchange rate, rF is the one year US T-bill rate, and F1
is the one year forward rate
the equation above is called spot-forward parity
given any three of the four variables (rC , rF , E0 , F1 ), we
can always find the fourth using spot-forward parity

AFM 271 - Introduction to Bond Valuation Slide 22

 Cont’d

now consider forward interest rates: these aren’t quoted

in the financial press, but they are established in
financial markets from prices of zero coupon bonds (i.e.
the term structure)
a simple example: suppose a one year zero coupon
bond ($1,000 par value) is selling for $952.38 and a two
year zero coupon bond is selling for $902.73
consider the cash flows from buying a one year zero
coupon bond today and simultaneously selling
952.38/902.73 = 1.055 two year zero coupon bonds:

AFM 271 - Introduction to Bond Valuation Slide 23

Cont’d

we can see from this example that there is no cash flow

today, but the investor has effectively locked in a rate to
borrow money after one year for repayment after two
years
recall from earlier that (1 + r2 )2 = (1 + r1 )(1 + f2 ),
implying f2 = (1 + r2 )2 /(1 + r1 )
in this case:

AFM 271 - Introduction to Bond Valuation Slide 24