BOND VALUATION

Bond
Bond is a long term contract under which a borrower agrees to make payments of
interest and principal, on specific dates, to the holders of the bond
Key characteristics:
VB = value of a bond/bond price
M = par or maturity value of the bond; it is the stated face value of the bond and
this is amount that must be paid off at maturity and it is often equal to $ 1.000
INT = coupon payment or dollars of interest paid each year; (Coupon rate x Par
value)
rk = coupon interest rate; (coupon payment / par value)
rd = the bond's required rate of the return; that is the market rate of interest for that
type of bond; it is also called the yield
N = number of years before the bond matures; maturity date is a date on which the
par value must be repaid
m = number of discounting periods per year
The value of any financial asset - a stock, a bond, a lease, or even a
physical asset such as an apartment building is simply the present value
of the cash flows the asset is expected to produce.

Bond Valuation
The cash flows from a specific bond depend on the contractual features meaning
the type of the bond.
The following general equation, written in several forms, can be used to find the
value of any bond, VB.

(1+r d )

(1+ r d )2

M
N
( 1+r d )

++

+
(1+r d )1
V B =

(1+r d )

M
= PVIFA Nr + M PVIFrN
N
( 1+r d )
d

t =1

1
1
M

+
r d r d (1+r d ) N ( 1+ r d ) N

So, the cash flows consist of an annuity of N years plus a lump sum payment at the
end of Year N.
1. Standard coupon-bearing bond
Standard coupon-bearing bond =the cash flows consist of interest payment during
the life of the bond, plus the amount borrowed when the bond matures
Types:
Bond with a fixed coupon rate
= coupon payments are constant. It can be:
Floating-rate bond.
= if a bond's coupon payment vary over time, meaning that the coupon
rate is set for, say, the
initial six month period, after which it is adjusted
every six months based on some market rate.
1.1. Bond with a fixed coupon rate
Bond with a fixed coupon rate = coupon payments are constant. It can be:
a) the bond is selling at a price equal to its par value; required rate of return
(rd)=coupon rate (rk)
b) the bond is selling at a price below its par value; required rate of return (rd)
coupon rate (rk); it is called a discount bond
c) the bond is selling at a price above its par value; required rate of return (rd)
coupon rate (rk); it is called a premium bond.
Valuation of bonds on the date of their issue
=valuation of bonds at the beginning of an interest payment dates
Bonds with annual coupons
Example: (Tool Kit 4 Chapter)
A bond has a 15-year maturity, a 10% annual coupon and a $ 1,000 par value. The
required rate of return or the yield to maturity on the bond is 10%, given its risk,
maturity, liquidity and other rates in the economy. What is a fair value for the bond
i.e. its market price?
M (or FV)=$ 1,000
rk=10%
rd=10%
INT= $ 100
N=15
VB=?

15

15

V B =100 PVIFA 10 +1,000 PVIF 10 =100 7.606+1,000 0.239=1,000

or

V B =100

1
1
1,000

+
=1,000
15
0.10 0.10 (1+0.10)
( 1+ 0.10 )15

The bond is selling at a price equal to its par value.

Example: (Tool Kit 4.3.)
A bond matures in 6 years has a par value of $ 1.000, an annual coupon payment of
$ 80 and a market interest rate of 9%. What is its price?
M (or FV)=$ 1,000
rd=9%
INT= $ 80 rk=8%
N=6
VB=?
6

V B =80 PVIFA 9 +1,000 PVIF 9=80 4.48592+1,000 0.59627=955.14

The bond is selling at a price below its par value, meaning that the required rate of
return (rd) coupon rate (rk).It is called a discount bond.
Example: (Tool Kit 4.3.)
A bond matures in 18 years has a par value of $ 1,000, an annual coupon of 10%
and a market interest rate of 7%. What is its price?
M (or FV)=$ 1,000
rd=7%
rk=10%

INT= $ 100

N=18
VB=?
18
V B =100 PVIFA 18
7 +1,000 PVIF 7 =100 10.05909+1,000 0.29586=1,3011.77

The bond is selling at a price above its par value, meaning that the required rate of
return (rd) coupon rate (rk). It is called a premium bond.
Exercise: 1
Jackson Corporation's bonds have 12 years remaining to maturity. Interest is paid
annually, the bonds have a $1.000 par value, and the coupon interest rate is 8%.
The bonds have a YTM of 9%. What is the current market price of these bonds?

(1+r d )

M
= PVIFA Nr + M PVIFrN
N
( 1+r d )
d

t =1

1
1
M

+
r d r d (1+r d ) N ( 1+ r d ) N

M (or FV)=$1,000
rk=8%
rd=9%
INT=$80
N=12
VB=?

12
V B =80 PVIFA 12
9 +1.000 PVIF 9 =80 7.16073+1.000 0.35553=928.39

V B =80

1
1
1000

+
=928.39
12
0.09 0.09 (1+0.09)
( 1+ 0.09 )12

Bonds with semiannual coupons

PVIFA 2 N + M PVIF 2 N
2

2 N

V B =
t=1

rd
2

rd
2

2
t

(1+r d /2)

M
=
2 N
( 1+r d /2 )

Example: (Tool Kit 4.6.)

A bond has a 25-year maturity, an 8% annual coupon paid semiannually, and a face
value of $1,000. The going nominal annual interest rate is 6%. What is the bond's
price?
M (or FV)=$ 1,000
rd=6%
rk=8%

INT= $ 80

N=25
m=2
VB=?

V B=

80
50
PVIFA 50
3 +1,000 PVIF 3 =40 25.72976+1,000 0.22811=1,257.30
2

Exercise:
Rentro Rentals has issued bonds that have a 10% coupon rate, payable
semiannually. The bonds mature is 8 years, have a face value of $1,000 and a YTM
of 8.5%. What is the price of the bonds?

M (or FV)=$1,000
rd=8.5%
rk=10%

INT= $ 100

N=8
m=2
VB=?

r
r
( d / 2)(1+ r d /2)2 N
1
( d / 2 )
1
M
+ ( 1+r ) 2 N
d/2

m
V B=
5

V B=

100
1
1
1000

+
=1,085.80
2 (0.085/2) (0.085/2)(1+0.085 /2)16 ( 1+0.085 /2 )16

Exercise:
Suppose HM sold an issue of bonds with a 10-year maturity, a $1,000 par value, a
10% coupon rate, and semiannual interest payments.
a) two years after the bonds were issued, the going rate of interest on bonds such
as these fell to 6%; at what price would the bonds sell?
b) suppose that 2 years after the initial offering, the going interest rate had risen to
12%; at what price would the bonds sell?
c) suppose that the conditions in part a existed-2 years after the issue date, interest
rates fell to 6%. Suppose further that the interest rate remained at 6% for the next
8 years. What would happen to the price of bonds over time?
a)
M (or FV)=$1,000
rk=10%
m=2
INT=$100
N=10
rd fall to 6%
VB=?

V 1=

100
1
1
1,000

+
=1,251.22
16
2 (0.06 /2) (0.06 /2)(1+ 0.06/ 2)
( 1+ 0.06/ 2 )16

b)

V 1=

100
1
1
1,000

+
=898.94
16
2 (0.12/ 2) (0.12/ 2) (1+0.12/2)
( 1+ 0.12/ 2 )16
6

c) The price of the bond will decline toward $1,000, hitting $1,000 (plus accrued
interest) at the maturity date 8 years (16 six-month periods) hence.
2. Zero-coupon bond
Zero-coupon bond = bonds that pay no interest but are offered at a substantial
discount below their par values and hence provide capital appreciation rather than
interest income. These securities are called zero coupon bonds (zeros), or original
issue discount bonds (OIDs).
N

V B =M PVIF r

Bond yields
Unlike the coupon interest rate, which is fixed, the bond's yields vary from day to
day depending on current market conditions. The yield can be calculated in three
different ways, and three "answers" can be obtained.
These different yields are described in the following sections.
1. Yield to Maturity (YTM)
The YTM is defined as the rate of return that will be earned if a bond makes all
scheduled payments and is held to maturity. It can be viewed as the bond's
promised rate of return which is the return that investors will receive if all the
promised payments are made.
YTM equals to expected rate of return only if the probability of default is zero and
the bond cannot be called. If there is some default risk, or if the bond may be called,
then there is some probability that the promised payments to maturity will not be
received, in which case the calculated YTM will differ from expected return,
meaning that the expected rate of return will be less than the promised YTM.
The YTM for a bond that sells at pas consists entirely of an interest yield, but if the
bond sells at a price other than its par value, the YTM will consist of the interest
yield plus a positive or negative capital gains yield.
It cannot be solved for directly. It generally must be determined using trial and error
or an iterative technique.
Steps:
1. Given that it is difficult to guess the YTM of the first attempt, we are assuming at
least two rates: one that gives a lower price than current market price and the other
which results in a higher price of current market price
2. When we have those two prices we are approaching to the procedure for linear
interpolation:
7

YTM =rd1 +(rd2rd1)

(P1P)
(P1P2)

An Approximation: If you are not inclined to follow the trial-and-error approach, you
can employ the following formula to find the approximate YTM on a bond:

+M V B
YTM =

N
0.4 M +0,6 V B

This formula was suggested by Gabriel A. Hawawini and Ashok Vora, in the article
published in the Journal for Finance March 1982 issue.

Example: (Tool Kit 4 Chapter)

Suppose that you are offered a 14-year, 10% annual coupon, $1,000 par value bond
at a price of $1,494.93. What is the YTM of the bond?
M (or FV) =$ 1,000
rk=10%

INT= $ 100

N=14
VB=$ 1,494.93
rd/YTM=?
VB M YTM rk
So, YTM has to be less than a coupon rate, meaning less than 10%.
rd1=8%
P1=

100 PVIFA (8 ,14) +1,000 PVIF(8 ,14) =100 7.53608+1,000 0.39711=1,150.72

1,150.72 1,494. 93 P1 P 8% is too high rate

rd 2=5%
P2=

100 PVIFA (5 ,14) +1,000 PVIF (5 ,14) =100 9.89864+ 1,000 0.50507=1,494.934

1,494.93=1,494.93 P2=P 5% is YTM

Exercise: 4-2
Wilson Wonders' bonds have 12 years remaining to maturity. Interest is paid
annually, the bonds have a $1.000 par value, and the coupon interest rate is 10%.
The bonds sell at price of $850. What is their yield to maturity?
M (or FV)=$1,000
8

rk=10%
INT=$100
N=12
VB=$850
YTM=?
VB M YTM rk
So, YTM has to be higher than a coupon rate, meaning more than 10%
I way:
rd1=12%
P1=

100 PVIFA (12 , 12)+ 1.000 PVIF (12 ,12)=100 6.19437+1000 0.25668=876.117

876.117 850.00 P1 P 12% is too low rate

rd2=13%
P2=

100 PVIFA (13 ,12) +1.000 PVIF(13 ,12)=100 5.91765+1000 0.23071=822.475

822.475 850 P2 P 13% is too high rate

YTM=12%+x

P P
x
= 1
k 2k 1 P1P2
x
876.117850.00
=
0,130,12 876.117822.475
x
26.117
=
0.01 53.642
x=0,01 0.486=0.00486 0.486
YTM=12%+0.486%=12.486%
II way:

YTM =k 1 +( k 2k 1)

( P1P)
( P1 P 2)

YTM =0.12+ ( 0.130.12 )

(25.117 )
=0.12486 12.486
( 53.642 )

III way: Approximation

1,000850
12
YTM =
=0.1236 12.36
0.60 850+0.40 1,000
100+

Exercise: 4-10
The BC's bonds have 5 years remaining to maturity and interest is paid annually,
the bonds have a $1,000 par value, and the coupon rate is 9%.
a) what is the YTM at a current market price of $829
b) would you pay $829 for one of these bonds if you thought the appropriate rate of
interest was 12%
a) YR = 13.98%.
b) Yes. At a price of $829, the yield to maturity, 13.98 percent, is greater than your
required rate of return of 12 percent. If your required rate of return were 12
percent, you should be willing to buy the bond at any price below $891.86.

2.Yield to Call (YTC)

If you purchased a bond that was callable and the company called it, you would not
have the option of holding the bond until it matured. Therefore, the YTM would not
be earned.

(1+r d )

Call price
N
(1+r d )
N

Price of callable bond (if called at N )=

t =1

N = the number of years until the company can call the bond
Call price = the price the company must pay in order to call the bond (it is often set
equal to the par value plus 1 year's interest
rd = YTC
The YTC is the rate of return investors will receive if their bonds are called. If the
issuer has the right to call the bonds and if interest rate fall, then it would be logical
for the issuer to call the bonds and replace them with new bonds that carry a lower
coupon.

10

The YTC is find similarly to the YTM. The same formula is used, but years to maturity
are replaced with years to call, and the maturity value is replaced with the call
price.
Example: (Tool Kit 4 Chapter)
Suppose you purchase a 15-year, 10% annual coupon, $ 1.000 par value bond with
a call provision after 10 years at a call price of $ 1.100. One year later, interest
rates have fallen from 10% to 5% causing the value of the bond to rise to $
1.494,93. What is the bond's YTC?
Call price =$ 1,100
rk=10%

INT= $ 100

N=10-1=9 (years to call)

VB=$ 1,494.93
rd/YTC=?
VB Call price YTC rk
So, YTC has to be less than a coupon rate, meaning less than 10%.
rd 1=5%
P1=

100 PVIFA (5 ,9) +1,100 PVIF (5 ,9 )=100 7,10782+1,100 0,64461=1,419.853

1.419,853 1,494.93 P1 P 5% is too high rate

rd 2=4%
P2=

100 PVIFA (4 , 9) +1,100 PVIF (4 ,9) =100 7,4352+1,100 0,70259=1.516,369

1.516,369 1.494,93 P2 P 4% is too low rate

YTM=4%+x

P P
x
= 1
r d 2r d 1 P1 P 2
x
1,516.3691,494.93
=
0.050.04 1,516.3691,419.853
x
21.439
=
0.01 96.516
x=0.01 0.222=0.00222 0.222
YTM=4%+0.222%=4.22%
11

Exercise: 4-8
Thatcher Corporation's bonds will mature in 10 years. The bonds have a face value
of $1,000 and an 8% coupon rate, paid semiannually. The price of the bond is
$1,100. The bonds are callable in 5 years at a price of $1,050.
What is their YTM?
What is their yield to call?
M (or FV)=$1,000
rk=8%
m=2
INT=$80
N=10
VB=$1,100
Callable price in 5 years=$1,050
YTM=?
VB M YTM rk
So, YTM has to be lower than a coupon rate, meaning less than 8%
I way:
rd1=7% m=2

P1=

80
1
1
1000

+
=1,071.062
2 (0.07 / 2) (0.07 / 2)(1+0.07/ 2)20 ( 1+0.07/ 2 )20

1,071.062 1,100.00 P1 P 7% is too high rate

rd 2=6% m=2

P 2=

80
1
1
1000

+
=1,148.775
20
2 (0.06 / 2) (0.06 / 2)(1+0.06/ 2)
( 1+ 0.06 )20

1,148.775 1,100 P2 P 6% is too low rate

P P
x
= 1
k 2k 1 P1P2

YTM=6%+x

x
1,148.7751,100
=
0.070.06 1,148.7751,071.062
x
48.775
=
0.01 77.713
12

x=0.01 0.06276=0.006276 0.6276

YTM=6%+0.62%=6.62%
YTC=?

(1+r d )

Call price
N
(1+r d )
N

Price of callable bond (if called at N )=

t =1

N=5
Callable price=1,050

YTC=?
VB Callable price YTC rk

So, YTC has to be lower than a coupon rate, meaning less than 8%

I way:
rd1=7% m=2

P 1=

80
1
1
1,050

+
=1,077.029
10
2 (0.07 / 2) (0.07 / 2)(1+0.07/ 2)
( 1+0.07/ 2 )10

1,077.029 1,100.00 P1 P 7% is too high rate

rd 2=6% m=2

P 2=

80
1
1
1,050

+
=1,122.507
2 (0.06 / 2) (0.06 / 2)(1+0.06/ 2)10 ( 1+ 0.06 )10

1,122.507 1,100 P2P 6% is too low rate

YTM=6%+x

P P
x
= 1
k 2k 1 P1P2

13

x
1,122.5071,100
=
0.070.06 1,122.5071,077.029

x
22.507
=
0.01 45.478
x=0.01 0.4948=0.00494 0.494
YTM=6%+0.49%=6.49%
Exercise: 4-22
AI' bonds have a current market price of $1.200. The bonds have an 11% annual
coupon payment, a $1,000 face value, and 10 years left until maturity. The bond may
be called in 5 years at 109% of face value (call price=$1,090).
a)what is the YTM?
b)what is the YTC if they are called in 5 years?
c) which yield might investors expects to earn on these bonds and why?
d) the bond's indenture indicates that the call provision gives the firm the right to call
them at the end of each year beginning in Year 5. In Year 5 they must be called at
109% of face value, but in each of the next 4 years the cal percentage will decline by 1
percentage point. Thus, in Year 6 they may be called at 108% of face value, in Year 7
they may be called at 107% of face value and so on. If the yield curve is horizontal and
interest rate remains at their current level, when is the latest that investors might
expect the firm to call the bonds?
a) M (or FV)=$1,000
rk=11%
INT=$110
N=10
VB=$1,200
Callable price in 5 years=$1,090
YTM=?
VB M YTM rk
So, YTM has to be lower than a coupon rate, meaning less than 11%.
I way:
rd1=10%

P1=110

1
1
1,000

+
=1,061.446
10
(0.10) (0.10)(1+ 0.10)
( 1+ 0.10 )10

1,061.446 1,200 P1 P 10% is too high rate

14

rd 2=8%

P2=110

1
1
1,000

+
=
10
1,201.302
(0.08) (0.08)(1+ 0.08)
( 1+ 0.08 )10

1,201.302 1,200 P2 P 8% is too low rate

YTM=8%+x

P P
x
= 1
k 2k 1 P1P2
x
1,201.3021,200
=
0.100.08 1,201.3021,061.446
x
1.302
=
0.02 139.856
x=0.02 0.0093095=0.000186 0.02

YTM=8%+0.02%=8.02%
b) YTC=?
VB Callable price YTC rk
So, YTC has to be lower than a coupon rate, meaning lower than 11%
I/YR = YTC = 7.59%
rd1=10%

P1=110

1
1
1,090

+
=1,093.791
(0.10) (0.10)(1+ 0.10)5 ( 1+ 0.10 )5

1,093.791 1,200 P1 P 10% is too high rate

rd1=7%

P2=110

1
1
1,090

+
=1,228.177
5
(0.07) (0.07)(1+0.07) ( 1+0.07 )5

1,228.177 1,200 P2 P 7% is too low rate

15

YTM=7%+x

P P
x
= 1
k 2k 1 P1P2
x
1,228.1771,200.00
=
0.100.07 1,228.1771,093.791
x
28.177
=
0.03 134.386
x=0.03 0.2096=0.006290 0.62
YTM=7%+0.62%=7.62%
c) The bonds are selling at a premium which indicates that interest rates have fallen
since the bonds were originally issued. Assuming that interest rates do not change
from the present level, investors would expect to earn the yield to call. (Note that the
YTC is less than the YTM).
d) Similarly from above, YTC can be found, if called in each subsequent year.
If called in Year 6:
YTC = 7.80%.
If called in Year 7:
YTC = 7.95%.
If called in Year 8:
YTC = 8.07%.
If called in Year 9:
YTC = 8.17%.
According to these calculations, the latest investors might expect a call of the bonds is
in Year 7. This is the last year that the expected YTC will be less than the expected
YTM. At this time, the firm still finds an advantage to calling the bonds, rather than
seeing them to maturity.

3. Current Yield
The current yield provides information regarding the amount of cash income that a
bond will generate in a given year, but since it does not take account of capital
gains or losses that will be realized if the bond is held until maturity or call, it does
not provide an accurate measure of the bond's total expected return.
16

Current yield=

Annual interest payment

Bonds current price

Example: (Tool Kit 4.4.)

A bond currently sells for $850. It has an 8-year maturity, an annual coupon of $80
and a par value of $1,000. What is its YTM? What is its current yield?
A bond currently sells for $1,250. It pays a $110 annual coupon and has a 20-year
maturity, but it can be called in 5 years at $ 1,100. What is its YTM and its YTC?
M (or FV) =$ 1,000
rk=8%

INT= $ 80

N=8
VB=$ 850
rd/YTM=?

Current yield=

Annual interest payment 80

=
=0.0941 9.41
Bonds current price
850

M (or FV) =$ 1,000

rk=11%

INT= $ 110

N=20
VB=$ 1,250
rd/YTM=?
VB M YTM rk
So, YTM has to be less than a coupon rate, meaning less than 11%.
rd1=9%
P1=

110 PVIFA (9 , 20)+ 1,000 PVIF(9 , 20)=110 9.12855+1,000 0.17843=1,182.57

1,182.57 1,250.00 P1 P 9% is too high rate

rd 2=8%
P2=

110 PVIFA (9 , 20)+ 1,000 PVIF(9 , 20)=110 9.81815+1,000 0.21455=1,294.5465

1,294.54651,250.00 P2P 8% is too low rate

YTM=8%+x

P P
x
= 1
rd 2rd 1 P1P2
17

x
1,294.54651,250.00
=
0.090.08 1,294.54651,182.57
x
44.5465
=
0.01 111,9765
x=0.01 0.39782=0.0039782 0.39782
YTM=8%+0.39782%=8.39%
Call price =$ 1,100
rk=10%

INT= $ 100

N=5 (years to call)

VB=$ 1,250.00
rd/YTC=?
VB Call price YTC rk
So, YTC has to be less than a coupon rate, meaning less than 11%.
rd 1=8%
P1=

110 PVIFA (8 , 5) +1,100 PVIF (8 , 5)=110 3.99271+1,100 0.68058=

1,187.84

1,187.84 1,250.00 P1 P 8% is too high rate

rd 2=6%
P2=

110 PVIFA (6 , 5) +1,100 PVIF (6 , 5)=110 4.21236+ 1,100 0.74726=1,285.35

1,285.35 1,250.00 P2 P 6% is too low rate

YTM=6%+x

P P
x
= 1
rd 2rd 1 P1P2
x
1,285.351,250.00
=
0.080.06 1,285.351,187.84
x
35.35
=
0.02 97.51

18

x=0.02 0.3625=0.007251 0.725

YTM=6%+0.725%=6.725%
Exercise: 4-3
Heath Foods's bonds have 7 years remaining to maturity. The bonds have face value
of $1.000 and a yield to maturity of 8%. They pay interest annually and have a 9%
coupon rate. What is the current yield?

Current yiel d=

Annual interest payment

Bonds current price

M (or FV)=$1,000
rk=9 %
YTM=8%
INT=$90
N=7
Current yield =?
1. have to find the current value of the bonds and then calculate their current yield:

V B =90

1
1
1,000

+
=1,052.06
7
0.09 0.09 (1+0.09) ( 1+0.09 )7

2.

Current yield=

Annual interest payment

90
=
=0.0855 8.55
Bonds current price
1,052.06

Exercise: 4-14
A bond that matures in 7 years sells for $1,020. The bond has a face value of
$1,000 and a YTM of 10.5883%. The bonds pay coupons semiannually. What is the
bond's current yield?
M (or FV)=$1,000
N=7
VB=$1,020
YTM=10.5883%
Current yield=?

19

1
1
1,000

+
14
(0.105883/ 2) (0.105883/2) (1+0.105883/2)
( 1+0.105883/2 )14
1,020=

110
In order to solve for the current yield we need to find INT.
Current yield = Annual interest/Current Price = $110/$1,020 = 10.78%.
Exercise: 4-12
A 10 year, 12% semiannually coupon bond with a par value of $1,000 may be called
in 4 years at a call price of $1,060. The bond sells for $ 1,100. Assume that the
bond has just been issued.
a) what is the bond's yield to maturity?
b) what is the bond's current yield?
c) what is the bond's capital gain or loss yield
d) what is the bonds' yield to call?
a)
M (or FV)=$1,000
rk=12%
m=2
INT=$120
N=4
VB=$1,100
Callable price in 4 years=$1,000
YTM=?
VB M YTM rk
So, YTM has to be lower than a coupon rate, meaning less than 12%
I way:
rd1=10% m=2

P 1=

120
1
1
1,000

+
=1,124.62
20
2 (0.10/ 2) (0.10/2)(1+0.10 /2)
( 1+0.10 /2 )20

1,124.62 1,1000 P1 P 10% is too low rate

rd =11% m=2

P 2=

120
1
1
1,000

+
=1,059.75
20
2
2 (0.10/ 2) (0.10/2)(1+0.10 /2)
( 1+0.10 /2 )20
20

1,069.75 1,100

P2

P 11% is too high rate

YTM=10%+x

P P
x
= 1
k 2k 1 P1P2
x
1,124.621,100
=
0.110.10 1,124.621,059.75
x
24.62
=
0.01 64.87

x=0.01 0.37=0.0037 0.37

YTM=10%+0.37%=10.37%

b)

Current yield=

Annual interest payment 120

=
=0.109110.91
Bonds current price
1,100

c)

YTM =Current Yield +Capital Gains ( Loss ) Yield

10.37% = 10.91% + Capital Loss Yield
-0.54% = Capital Loss Yield

d) YTC
N = 8, PV = -1,100, PMT = 60, FV = 1,060, and solve for I/YR = 5.0748%.

M (or FV)=$1.000
rk=12%
m=2
INT=$120
N=10
VB=$1,100
21

Callable price in 4 years=$1,000

However, this is a periodic rate.

10.1495% 10.15%.

The nominal annual rate = 5.0748%(2) =

YTC=?
VB Callable price YTC rk
So, YTC has to be lower than a coupon rate, meaning lower than 12%
I way:
rd1=10%

P 1=

m=2

120
1
1
1,000

+
=1,064.632
8
2 (0.10/ 2) (0.10/ 2)(1+0.10 /2)
(1+0.10 /2 )8

1,064.632 1,100.00 P1 P 10% is too high rate

rd2=11%

P 2=

m=2

120
1
1
1,000

+
=1,059.75
20
2
2 (0.10/ 2) (0.10/ 2)(1+0.10 /2)
( 1+0.10 /2 )20

1,069.75 1,100 P2

P 11% is too high rate

YTM=10%+x

P P
x
= 1
k 2k 1 P1P2
x
1,124.621,100
=
0.110.10 1,124.621,059.75
x
24.62
=
0.01 64.87
x=0.01 0.37=0.0037 0.37
YTM=10%+0.37%=10.37%
Exercise: 4-12

22

A 10 year, 12% semiannually coupon bond with a par value of $1,000 may be called
in 4 years at a call price of $1,060. The bond sells for $ 1,100. Assume that the
bond has just been issued.
a) what is the bond's yield to maturity?
b) what is the bond's current yield?
c) what is the bond's capital gain or loss yield
d) what is the bonds' yield to call?
a)
M (or FV)=$1,000
rk=12%
m=2
INT=$120
N=4
VB=$1,100
Callable price in 4 years=$1,000
YTM=?
VB M YTM rk
So, YTM has to be lower than a coupon rate, meaning less than 12%
I way:
rd1=10% m=2

P 1=

120
1
1
1,000

+
=1,124.62
20
2 (0.10/ 2) (0.10/ 2)(1+0.10 /2)
( 1+0.10 /2 )20

1,124.62 1,1000 P1 P 10% is too low rate

rd =11% m=2

P 2=

120
1
1
1,000

+
=1,059.75
20
2
2 (0.10/ 2) (0.10/ 2)(1+0.10 /2)
( 1+0.10 /2 )20

1,069.75 1,100

P2

P 11% is too high rate

P P
x
= 1
k 2k 1 P1P2

YTM=10%+x

x
1,124.621,100
=
0.110.10 1,124.621,059.75

23

x
24.62
=
0.01 64.87
x=0.01 0.37=0.0037 0.37
YTM=10%+0.37%=10.37%
b)

Current yield=

Annual interest payment 120

=
=0.109110.91
Bonds current price
1,100

c)

YTM =Current Yield +Capital Gains ( Loss ) Yield

10.37% = 10.91% + Capital Loss Yield
-0.54% = Capital Loss Yield

d) YTC
N = 8, PV = -1,100, PMT = 60, FV = 1,060, and solve for I/YR = 5.0748%.
M (or FV)=$1.000
rk=12%
m=2
INT=$120
N=10
VB=$1,100
Callable price in 4 years=$1,000
However, this is a periodic rate.
10.1495% 10.15%.

The nominal annual rate = 5.0748%(2) =

YTC=?
VB Callable price YTC rk
So, YTC has to be lower than a coupon rate, meaning lower than 12%
I way:
rd1=10%

P 1=

m=2

120
1
1
1,000

+
=1,064.632
2 (0.10/ 2) (0.10/ 2)(1+0.10 /2)8 (1+0.10 /2 )8

1,064.632 1,100.00 P1 P 10% is too high rate

24

rd2=11%

P 2=

m=2

120
1
1
1,000

+
=1,059.75
20
2
2 (0.10/ 2) (0.10/2)(1+0.10 /2)
( 1+0.10 /2 )20

1,069.75 1,100 P2

P 11% is too high rate

YTM=10%+x

P P
x
= 1
k 2k 1 P1P2
x
1,124.621,100
=
0.110.10 1,124.621,059.75
x
24.62
=
0.01 64.87
x=0.01 0.37=0.0037 0.37

YTM=10%+0.37%=10.37%
Exercise: 4-13
You just purchased a bond that matures in 5 years. The bond has a face value of
$1,000 and has an 8% annual coupon. The bond has a current yield of 8.21%. What
is the bond's YTM?
M (or FV)=$1,000
rk=8%
INT=$80
N=5
Current yield= 8.21%
YTM=?
However, you are also given that the current yield is equal to 8.21%. Given this
information, we can find PV.
Current yield
0.0821
PV

= Annual interest/Current price

= $80/PV
= $80/0.0821 = $974.42.
YTM = 8.65%.

The Determinants of Market Interest Rates (rd)

25

The quoted/nominal interest rate on a debt security, rd, is composed of a real riskfree rate of interest r*, plus several premiums that reflect inflation, the risk of the
security and the security's marketability or liquidity.
rd = r*+IP+DRP+LP+MRP = rRF + DRP + LP + MRP
rd = quoted or nominal rate of interest
r*= real risk-free rate of interest - the rate that would exist on a riskless
security if zero inflation were expected ; inflation-indexed Treasury bond (TIPS) is a
good estimate of the real interest rate
IP = inflation premium - it is equal to the average expected inflation rate over the
life of the security
In inflation rate built into a 1-year bond is expected inflation rate for the next year,
but the inflation rate built into a 3-year bond is average rate of inflation expected
over the next 30 years.
If It is the expected inflation during the year t, then the inflation premium for an Nyear bond's yield (IPN) can be approximated as:

IP N =

I 1+ I 2 ++ I N
N

DRP = default risk premium - this premium reflects the possibility that the issuer
will not pay interest or principal at the stated time and in the stated amount.
Bond's rating as an indicator of its default risk; the rating has a direct, measurable
influence on the bond's yield. A bond spread is the difference between a bond's
yield and the yield on some other security of the same maturity, mostly a similar
maturity T-bond.
LP = liquidity or marketability premium - a premium charged by lenders to
reflect the fact that some securities cannot be converted to cash on short notice at
a "reasonable" price
MRP = maturity risk premium - all bonds, even T-bonds, are exposed to two
additional sources of risk: interest rate risk and reinvestment risk; the net effect of
these two sources of risk upon a bond's yield is called the maturity risk premium
Example: (Tool Kit 4.13.)
Assume that the real risk-free rate is r* = 3% and the average expected inflation
rate is 2.5% for the foreseeable future. The DRP and LP for a bond are each 1%, and
the applicable MRP is 2%.What is the bond's yield?
rd = r*+IP+DRP+LP+MRP = 3+2.5+1+1+2=9.5%
Example:
In investors expect inflation to average 3% during Year 1 and 5% during Year 2.
Then the inflation premium built into a 2-year bond's yield can be approximated by:

26

IP2=

3 +5
=4
2

Example:
In March 2008 the yield on a 5-year non-indexed T-bond was 2.46% and the yield on
5-year TIPS was -0.05%.
IP5=2.46%-(-0.05%)=2.51%
This implies that investors expected inflation to average 2.51% over the next 5
years.
Example: (Tool Kit 4.9.)
The yield on 15-year TIPS is 3% and the yield on a 15-year Treasury bond is 5%.
What is the inflation premium for a 15-year security?
IP15=5%-2%=3%
rRF=r*+IP ( it is either quoted U.S. T-bill rate or the quoted T-bond rate)
Example: (Tool Kit 4.11.)
A 10-year T-bond has a yield of 6%. A corporate bond with a rating of AA has a yield
of 7.5%. If the corporate bond has excellent liquidity, what is an estimate of the
corporate bond's default risk premium?
Yield on T-Bond
- Yield on corporate bond
= Default risk premium

6.0%
7.5%
1.5%

Exercise: 4-5
A T-bond that matures in 10 years has a yield of 6%. A 10-year corporate bond has a
yield of 9%. Assume that the liquidity premium on the corporate bond is 0.5%. What
is the default risk premium on the corporate bond?
rT-10 = 6%;
rC-10 = 9%;
LP = 0.5%;
DRP = ?
r = r* + IP + DRP + LP + MRP
rT-10 = 6% = r* + IP + MRP; DRP = LP = 0
rC-10 = 8% = r* + IP + DRP + 0.5% + MRP

27

Because both bonds are 10-year bonds the inflation premium and maturity risk
premium on both bonds are equal. The only difference between them is the
liquidity and default risk premiums.
rC-10 = 9% = r* + IP + MRP + 0.5% + DRP
But we know from above that r* + IP + MRP = 6%; therefore,
rC-10 = 9% = 6% + 0.5% + DRP
2.5% = DRP
Exercise: 4-6
The real risk-free rate is 3% and inflation is expected to be 3% for the next 2 years.
A 2-year Treasury security yields 6.3%. What is the maturity risk premium for the 2year security?
r* = 3%;
IP = 3%;
rT-2 = 6.3%;
MRP2 = ?
rT-2 = r* + IP + MRP = 6.3%
rT-2 = 3% + 3% + MRP = 6.3%
MRP = 0.3%.
Exercise: 4-19
Assume that the real risk-free rate r* is 3% and that inflation is expected to be 8%
in Year 1, 5% in Year 2 and 4% thereafter. Assume also that all Treasury securities
are highly liquid and free of default risk. If 2-year and 5-year Treasury notes both
yield 10%, what is the difference in the maturity risk premiums (MRPs) on the two
notes, that is, what is MRP5 minus MRP2?
First, note that we will use the equation rt = 3% + IPt + MRPt
We have the data needed to find the IPs:

IP5 =

8% + 5% + 4% + 4% + 4%
5

25%
5

= 5%

28

IP2 =

8% + 5%
2

= 6.5%

Now we can substitute into the equation:

r2 = 3% + 6.5% + MRP2 = 10%
r5 = 3% + 5% + MRP5 = 10%
Now we can solve for the MRPs, and find the difference:
MRP5 = 10% - 8% = 2%
MRP2 = 10% - 9.5% = 0.5%
Difference = (2% - 0.5%) = 1.5%

Exercise: 4-4
The real risk-free rate of interest is 4%. Inflation is expected to be 2% this year and
4% during the next 2 years. Assume that he maturity risk premium is zero.
What is the yield on 2-year Treasury securities?
What is the yield on 3-year Treasury securities?
r* = 4%;
I1 = 2%;
I2 = 4%;
I3 = 4%;
MRP = 0;
rT-2 = ?;
rT-3 = ?
r = r* + IP + DRP + LP + MRP

IP N =

I 1+ I 2 ++ I N
N

29

 Since these are Treasury securities, DRP = LP = 0.

rT-2 = r* + IP2
IP2 = (2% + 4%)/2 = 3%
rT-2 = 4% + 3% = 7%

rT-3 = r* + IP3
IP3 = (2% + 4% + 4%)/3 = 3.33%
rT-3 = 4% + 3.33% = 7.33%
Exercise: 4-18
The real risk-free rate is 2%. Inflation is expected to be 3% this year, 4% next year
and then 3.5% thereafter. The maturity risk premium is estimated to be 0.0005 x (t1), where t = number of years to maturity. What is the nominal interest rate on a 7year Treasury security?
r = r* + IP + MRP + DRP + LP
r* = 0.02
IP = [0.03 + 0.04 + (5)(0.035)]/7 = 0.035
MRP = 0.0005(6) = 0.003
DRP = 0
LP = 0
r = 0.02 + 0.035 + 0.003 = 0.058 = 5.8%.

30