Chapter 6Learning Objectives6.1 Application of the Time Value of Money Tool: Bond PricingTable 6.1 Bond Information August 1, 20086.1 (A) Key Components of a Bond6.1 (A) Key Components of a Bond6.1 (B) Pricing a Bond in Steps6.1 (B) Pricing a Bond in Steps (continued)Slide 9Slide 106.2 Semiannual Bonds and Zero-Coupon Bonds (continued)6.2 Semiannual Bonds and Zero- Coupon Bonds (continued)Slide 14Slide 156.2 (A) Pricing Bonds after Original Issue6.2 (A) Pricing Bonds after Original Issue (continued)6.2 (A) Pricing Bonds after Original Issue (continued)Slide 196.2 (B) Zero-Coupon BondsTable 6.2 Amortized interest on a Zero-Coupon Bond6.2 (C) Amortization of a Zero-Coupon Bond6.2 (C) Amortization of a Zero-Coupon Bond (continued)Slide 24Slide 25Slide 266.3 Yields and Coupon Rates6.3 (A) The First Interest Rate: Yield to Maturity6.3 (B) The “Other” Interest Rate: Coupon Rate6.3 (C) Relationship of Yield to Maturity and Coupon RateTable 6.3 Premium Bonds, Discount Bonds, and Par Value BondsFigure 6.8 Bond prices and interest rates move in opposite directions6.3 (C) Relationship of Yield to Maturity and Coupon Rate (continued)6.3 (C) Relationship of Yield to Maturity and Coupon Rate (continued)Slide 356.4 Bond Ratings6.4 Bond Ratings (continued)6.5 Some Bond History and More Bond Features6.5 Some Bond History and More Bond Features (continued)Slide 40Slide 416.6 U.S. Government BondsTable 6.6 Government Notes and Bonds (Prices as of April 8, 2008)6.6 (A) Pricing a U.S. Government Note or Bond6.6 (B) Pricing a Treasury bill6.6 (B) Pricing a Treasury bill (continued)Table 6.7 Selected Historical Treasury Bill Bank Discount RatesADDITIONAL PROBLEMS WITH ANSWERS Problem 1ADDITIONAL PROBLEMS WITH ANSWERS Problem 1 (ANSWER)ADDITIONAL PROBLEMS WITH ANSWERS Problem 2ADDITIONAL PROBLEMS WITH ANSWERS Problem 2 (ANSWER)ADDITIONAL PROBLEMS WITH ANSWERS Problem 3ADDITIONAL PROBLEMS WITH ANSWERS Problem 3 (ANSWER)ADDITIONAL PROBLEMS WITH ANSWERS Problem 4ADDITIONAL PROBLEMS WITH ANSWERS Problem 4 (ANSWER)ADDITIONAL PROBLEMS WITH ANSWERS Problem 4 (ANSWER continued)ADDITIONAL PROBLEMS WITH ANSWERS Problem 5ADDITIONAL PROBLEMS WITH ANSWERS Problem 5 (ANSWER)Figure 6.3 Future Cash Flow of a Merrill Lynch BondFigure 6.7 Goodyear Semiannual Corporate BondTable 6.5 Annual Interest Rates on Corporate Bonds Rated Aaa to Baa, 1980 to 2006Figure 6.9 Pacific Bell Semiannual Callable Corporate BondFigure 6.10 Pacific Bell Callable Bond Cash FlowsCopyright © 2010 Pearson Prentice Hall. All rights reserved.Chapter 6Bonds and Bond ValuationCopyright © 2010 Pearson Prentice Hall. All rights reserved.6-2Learning Objectives1. Understand basic bond terminology and apply the time value of money equation in pricing bonds. 2. Understand the difference between annual and semiannual bonds and note the key features of zero-coupon bonds.3. Explain the relationship between the coupon rate and the yield to maturity. 4. Delineate bond ratings and why ratings affect bond prices.5. Appreciate bond history and understand the rights and obligations of buyers and sellers of bonds.6. Price government bonds, notes, and bills.Copyright © 2010 Pearson Prentice Hall. All rights reserved.6-36.1 Application of the Time Value of Money Tool: Bond Pricing•Bonds – Long-term debt instruments •Provide periodic interest income – annuity series•Return of the principal amount at maturity – future lump sum•Prices can be calculated by using present value techniques, i.e., discounting of future cash flows•Combination of present value of an annuity and of a lump sumCopyright © 2010 Pearson Prentice Hall. All rights reserved.6-4Table 6.1 Bond Information August 1, 2008Copyright © 2010 Pearson Prentice Hall. All rights reserved.6-56.1 (A) Key Components of a Bond•Par value: Principal or face Par value: Principal or face value; tvalue; typically $1000•Coupon rate: Coupon rate: Annual rate of interest paid.•Coupon:Coupon: Regular interest payment received by holder per year.•Maturity date: Maturity date: Expiration date of bond when par value is paid back.•Yield to maturity: Yield to maturity: Expected rate of return, based on price of bond.FIGURE 6.1 Merrill Lynch corporate bond.Copyright © 2010 Pearson Prentice Hall. All rights reserved.6-66.1 (A) Key Components of a BondExample 1: Key Components of a Corporate BondLet’s say you see the following price quote for a corporate bond:Issue Price Coupon(%) Maturity YTM% Current Yld. RatingHertz Corp.Hertz Corp.91.5091.506.356.3515-Jun-201015-Jun-201015.43815.4386.946.94BBPrice = 91.5% of $1000$915$915; Annual coupon = 6.35% *1000  $63.50$63.50Maturity date = June 15, 2010June 15, 2010; If bought and held to maturityYield = 15.438%15.438%Current Yield = $ Coupon/Price = $63.5/$915  6.94%6.94%Copyright © 2010 Pearson Prentice Hall. All rights reserved.6-76.1 (B) Pricing a Bond in StepsSince a bond involves a combination of an annuity (coupons) and a lump sum (par value), its price is best calculated by using the following steps:FIGURE 6.2 How to price a bond.Copyright © 2010 Pearson Prentice Hall. All rights reserved.6-86.1 (B) Pricing a Bond in Steps (continued)Example 2: Calculating the Price of a Corporate BondCalculate the price of an AA-rated, 20-year, 8% coupon (paid annually) corporate bond (par value = $1,000), which is expected to earn a yield to maturity of 10%.Annual coupon = Coupon rate * Par value = .08 * $1,000 = $80 = PMTYTM = r = 10%Maturity = n = 20Price of bond = Present value of coupons + Present value of par valueYear 01$802$803$8020 $80$1,00018 19$80 $80…Copyright © 2010 Pearson Prentice Hall. All rights reserved.6-96.1 (B) Pricing a Bond in Steps (continued)Example 2: Calculating the price of a corporate bondIPresent value of coupons = = = $80 x 8.51359 = $681.09Present Value of par value = Present Value of par value = Present Value of par value = $1,000 x 0.14864 = $148.64Price of bond = $681.09 + $148.64 = $829.73 PMT ×1−11+r( )nr⎛⎝⎜⎜⎜⎜⎞⎠⎟⎟⎟⎟ $80 ×1−11+0.10( )200.10⎛⎝⎜⎜⎜⎜⎞⎠⎟⎟⎟⎟ FV ×11+r( )n $1,000 ×11+0.10( )20Copyright © 2010 Pearson Prentice Hall. All rights reserved.6-106.1 (B) Pricing a Bond in Steps (continued)Method 2. Using a financial calculatorIMode: P/Y=1; C/Y = 1IInput: N I/Y PV PMT FVKey: 20 10 ? 80 1000Output -829.73Copyright © 2010 Pearson Prentice Hall. All rights reserved.6-11•Most corporate and