19c: Bond Pricing A bond is characterized by three sets of cash flows: initial investment, periodic coupons, and final

redemption. Value of a bond is simply the present value of its cash flows. In general, there are three types of bonds: pure discount bond, level-coupon bond, and consol. Pure Discount Bond Pure discount bond is also nown as the zero-coupon bond. It promises a single fi!ed payment at a fi!ed future date. In another word, the holder of a pure discount bond receives no cash payments until maturity, as presented in "ig. # below.
"ig . # 3as h " lows f or a P ure %isco unt &o nd "

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$herefore, the value of a pure discount bond is the present value of its final redemption amount. $he formula to price of a pure discount bond is as follows: Value of a Pure %iscount &ond ' " ( )#*r+$ " ' the face value of the bond r ' the interest rate $ ' years to maturity Level-Coupon Bond ,nli e pure discount bond, level-coupon bond offer cash payments not -ust at maturity, but also at regular times in between, as shown in "ig. .. below. $hese regular payments are referred to as coupons of the bond. $ypical bonds issued by either ,./. governments or American corporations are level-coupon bonds. "ig. . 3ash "lows for a 4evel 3oupon &ond "*3 3 3 3

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3onse5uently, the value of a level-coupon bond is the present value of its stream of coupon payments plus the present value of its repayment of principal. $he formula to value a level-coupon bond is as follows: Value of a 4evel-3oupon &ond ' 63()#*r+7*63()#*r+.7*00*63()#*r+$7*6P()#*r+$7 3 ' 3oupon payments r ' interest rate P ' Principal or "ace Value $ ' 8umber of years to maturity Consol A consol is a type of bond that perpetuates forever because it never stops paying a coupon, has no final maturity date, and therefore never matures, as shown in "ig. 9 below. "ig. 9 3ash "lows for a 3onsol 3 3 3 3

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$his type of bond, a product of &an of :ngland, is still being offered in 4ondon today. $o value a consol, a perpetuity formula would need to be used: Value of a 3onsol ' 3(r 3 ' 3oupon payments r ' mar et interest rate Basic bond valuation equation: B0 = I/ 1!r" # ! I/ 1!r"#$ ! I!%#/ 1!r"#& &1 ' current mar et price of bond or debt security );+ < ' par )face, maturity+ value of security );+ $ ' term to maturity )years+ r ' coupon )interest+ rate )=+ I ' r< ' annual interest );+ ry ' yield to maturity )2$<, =+

$o truly understand bond pricing, we would need to e!amine some important bond concepts: #+ relationship between bond prices and interest rates and .+ yield to maturity. 'elations(ip bet)een bond prices and interest rates $here is an inverse relationship between bond prices and interest rates. As interest rates rise, bond prices fall, and vice versa. "or e!ample, let>s ta e a two-year level-coupon bond paying #1= coupon annually and assume that the current interest rate is #1=. $he bond is priced at its face value of ;#,111: Value of the level-coupon bond ' 6#11(#.#17 * 6)#,111*#11+()#.#1+.7 ' ;#,111 8ow, if the interest rate une!pectedly rises to #? percent, this bond that originally issued under the #1= interest rate environment would sell at Value of the bond ' 6#11(#.#?7 * 6)#,111*#11+()#.#?+.7 ' ;@#A.B# As it has indicated through the pricing, higher interest rates lead to lower bond prices. /ince the ;@#A.B# is below ;#,111, the bond is said to sell at a discount. Cowever, if a new bond is being issued with coupon rate of #?= in the #?= interest rate environment, the bond would be valued at ;#,111. $o see the opposite effect, if interest rates fall to ?=, the original bond that was issued under the #1= interest rate mar et would sell at Value of the bond ' 6#11(#.1?7 * 6)#,111*#11+()#.1?+.7 ' ;#,1@..@B Again, as interest rates fall, the value of the bond increases. /ince the ;#,1@..@B is above ;#,111, the bond is said to sell at a premium. *ield to %aturit" In reality, there are many incidences when a set of facts of a bond, including coupon rate, mar et value, years to maturity, face value, etc., are given e!cept for the interest rate. In this situation, the interest rate is referred to as yield to maturity or bond>s yield. $o determine the yield to maturity, one would go through a process of trial and error or typing into a fancy calculator. "or e!ample, a two-year level-coupon bond is currently selling at ;#,1@..@B with #1= coupon, the return that the bondholder will receive, y, is ;#,1@..@B ' 6#11()#*y+7 * 6)#,111*#11+()#*y+ .7 y ' ?=, as it has shown in previous e!ample. De interpret ry as the compound annual rate of return on the investment of ;&1 in the bond if it is held to maturity. #+ $his is easy to see with pure coupon bonds .+ It is a bit more complicated with coupon bonds because the interpretation holds e!actly only if the bondholder can reinvest each future coupon payment at today>s ry. 2$< E annual coupon interest: r" + ,I ! %-B0#/&- / , %!$B0#/.2$< E pure discount bonds: % = B0 1!r"#& / Ln 1!r"# = Ln %/B0#/& = 01 1!r" = e0

2a3ple 4uestions: #. .. 9. G. ?. H. B. A. Cow many different sets of cash flows is a bond characterized byF 8ame them. Cow many types of bonds are thereF 8ame them. Dhat is a pure discount bondF Dhat is its valueF Dhat is a level-coupon bondF Dhat is its valueF Dhat is a 3onsolF Cow is it valuedF Cow is annual interest calculatedF Dhat are some of the important bond conceptsF Dhat is the relationship between bond prices and interest ratesF

5ns)ers: #. .. 9. G. ?. H. B. A. A bond is characterized by three sets of cash flows: initial investment, periodic coupons, and final redemption. $here are three types of bonds: pure discount bond, level-coupon bond and consol. Pure discount bond is also nown as zero-coupon bond. It promises a single fi!ed payment at a fi!ed future date. $he value of a pure discount bond is the present value of its final redemption amount. 4evel-coupon bond offer cash payments not -ust a maturity, but also at regular times in between. It is the present value of its stream of coupon payments plus the present value of its repayment of principal. A consol is a type of bond that perpetuates forever because it never stops paying a couponI it has no final maturity date and will never mature. $o value a consol, a perpetuity formula would be needed. Annual interest )I+ ' rJ< )coupon interest rate times par value of security+ /ome important bond concepts are: #+ relationship between bond prices and interests and .+ yield to maturity. $here is an inverse relationship between bond prices and interest rates. As interest rate fall, the value of the bond increases and as the interest rate rises, the value of the bond decreases.