Chapter #2 Pricing of Bond

Pricing a bondCoupon payments are made every six month.Next coupon payment for bond is received exactly six month from now.Coupon interest is fixed for term of bond.

The Fundamentals of Bond ValuationIf yield < coupon rate, bond will be priced at a premium to its par valueIf yield > coupon rate, bond will be priced at a discount to its par valuePrice-yield relationship is convex (not a straight line)

Nominal YieldMeasures the coupon rate that a bond investor receives as a percent of the bonds par value

Time Value of MoneyFuture valueFuture value of an ordinary annuityPresent valuePresent value of an ordinary annuity

FUTURE VALUEFV=PV(1+r)N

Future value of an ordinary annuity

Present valuePresent valuePV=FV/(1+i)n

Present value of an ordinary annuity

Pricing zero coupon bondsThe investor realizes interest as the difference between the maturity value and the purchase price.

Price yield relationshipThe reason is that the price of the bond is the present value of cash flows. as the require yield increase the present value of the cash flow decrease.

Relationship between coupon rate, required yield and priceAt parAt discountAt premium

Reason for change in price of bondThere is a change in the required yield owing to change to changes in the credit quality of the issuer.There is a change in the price of the bond selling at a premium or a discountChange in the required yield owing to a change in the yield on comparable bonds.

Floating Rate BondsThe coupon for a floater is determined by the following general formula:Floater coupon = floating reference rate + fixed margin (in bps)Examples:Floater coupon = 1-month LIBOR rate + 150bpsFloater coupon = 3-month T-bill rate + 80bps

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