UB MGF 401 - chap005 (25 pages)

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5 1 Chapter 5 Topics Covered Bond Characteristics reading the financial pages Interest Rates and Bond Prices Current Yield and Yield to Maturity Bond Rates and Returns Corporate Bonds and the Risk of Default The Yield Curve McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 5 2 Bonds Terminology Bond Legal Agreement that obligates the issuer to make specified payments to the bondholder Coupon The interest payments made to the bondholder usually due every six months Face Value Par Value or Principal Value Payment at the maturity of the bond usually 1 000 Coupon Rate Annual interest payment as a percentage of face value McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 5 3 Bonds WARNING The coupon rate IS NOT the discount rate used in the Present Value calculations The coupon rate merely tells us what cash flow the bond will produce Since the coupon rate is listed as a this misconception is quite common McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 5 4 Bond Pricing The price of a bond is the Present Value of all cash flows generated by the bond i e coupons and face value discounted at the required rate of return cpn cpn cpn par PV 1 2 t 1 r 1 r 1 r McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 5 5 Bond Pricing Example What is the price of a 5 5 annual coupon bond with a 1 000 face value which matures in 3 years Assume a required return of 3 5 55 55 1 055 PV 1 2 1 035 1 035 1 035 3 PV 1 056 03 McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 5 6 Bond Cash Flows McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 5 7 Bond Pricing Example continued What is the price of the bond if the required rate of return is 5 5 55 55 1 055 PV 1 2 3 1 055 1 055 1 055 PV 1 000 McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 5 8 Bond Pricing Example continued What is the price of the bond if