Shivam Gupta Financial Sector Research June 8, 2014
1 Introduction Corporations and municipal governments use bonds to borrow money from the public. In this research, we will define a bond, how to value a bond, and the effect of interest rates on bonds. Since this research is brief, we have not covered all possible material related to bonds; however, we have laid the foundation for future inquiries and subsequent research projects on the topic
2 Definition A bond is a debt security where an investor (public) will loan money to a borrower (corporation or government). Typically, a bond is an interest-only loan, meaning that the borrower will pay interest on the loan every period. If the bond is held until maturity (when the term for the loan expires), then the face value, which is the original investment for the bond, will be paid out to the investor. As we will see, if the bond
# is sold earlier then maturity, then the value of the bond fluctuates based on marketplace interest rates.
3 Valuation of a Bond When valuing a bond, we must take into consideration two distinct parts: the face value portion and the bonds coupons. Lets look at an example. Kabra Corporation issues a $5000 bond with 20 years to maturity and a coupon rate of 10%. Thus, the bond will pay an annual coupon of $500 and in 20 years, Kabra Corporation will pay the holder of the bond $5000. In order to value the bond, we must calculate the present value of the bond. PV= FV ! !!!!! !
= 5000 ! !!!!!! !"
= $743.22 The present value of $5000 paid after 20 years at a 10% interest rate is $743.22. Now, we must calculate the present value of the coupons. Annuity Present Value= C * ( !!!!!!! !! ! ) = 500 * ( !!!!!!!! !!! !! ) = $4256.78 Total Value of Bond= $4256.78 + $743.22 = $5000 If the interest rate matches the coupon rate (10%), then the value the bond sells for is equal to the face value the investor receives at the end of maturity. 4 Effects of Fluctuating Market Interest Rates Lets assume the scenario above, but pretend that after one year the interest rate rises to 15%. We now have 19 years until maturity and a higher interest rate. PV= FV ! !!!!! !
=5000 ! !!!!!"! !"
=$817.54
$ The present value of $5000 paid after 19 years at a 10% interest rate is $817.54. Now we look at the coupons. Annuity Present Value= C * ( !!!!!!! !! ! ) = 500 * ( !!!!!!!"! !!" !!" ) = $3099.12 Total Value of Bond= $3099.12 + $817.54 = $3916.66 When the interest rate rises above the coupon rate, Kabra bond sells for less than its face value. In this case, the bond sells for $3916.66. Investors are less willing to invest money in a security that returns 10% when they can get a return of 15% elsewhere. Thus, the discount bond makes up for this by offering a bond for a cheaper price and having a built-in profit ($5000-$3916.66=$1083.64). Subsequently, when interest rates go below coupon rates, premium bonds sell at an excess amount compared to face value because investors wish to take advantage of the favorable coupon rate.
5 Generalized Equation for Bond Value Bond Value= C * ( !!!!!!! !! ! ) + FV ! !!!!! !