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Bonds

Lecture No. 12
Chapter 4
Contemporary Engineering Economics
Third Canadian Edition
Copyright 2012

2012 Pearson Canada Inc., Toronto, Ontario 12-1


Lecture 12 Objectives
What are some basics of investing in bonds?

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Bonds

Bonds are a specialized form of a loan in which the


creditor - usually a business or the federal, provincial, or
local government - promises to pay a stated amount of
interest at specified intervals for a defined period and
then to repay the principal at a specific date, known as
the maturity date of the bond.

The concept of economic equivalence can be important


in determining the worth of bonds

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Bond Terminology

Par value: the stated face value on the individual bond


Maturity date: a specified date on which the par value is
to be repaid.
Bonds can be classified into the following categories: short-term
bonds (maturing within three years), medium-term bonds
(maturing from three to 10 years), and long-term bonds (maturing
in more than 10 years).
Coupon rate: the interest rate on the par value of a bond
Discount or premium bond: A bond that sells below its
par value is called a discount bond. When a bond sells
above its par value, it is called a premium bond.

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Bond Valuation

Bond prices change over time because of the risk of


nonpayment of interest or par value, supply and
demand, and the economic outlook. These factors
affect the yield to maturity (or return on investment) of
the bond
Yield to Maturity: the interest rate that establishes the
equivalence between all future interest and face-
value receipts and the market price of the bond
Current Yield: the annual interest earned as a
percentage of the current market price

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Example 4.17: Yield to Maturity and
Current Yield
Consider buying a $1,000 corporate bond at the market
price of $996.25. The interest will be paid semiannually,
the interest rate per payment period will be simply
4.8125%, and 20 interest payments over 10 years are
required. The resulting cash flow to the investor is shown
in the figure below. Find (a) the yield to maturity and (b)
the current yield.

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Example 4.17: Solution
Given: Initial purchase price = $996.25, coupon rate =
9.625% per year paid semiannually, and 10-year
maturity with a par value of $1000

a) Yield to maturity
=
$996.25 $48.13(P / A, i ,20) + $1,000(P / F , i ,20)
i = 4.84% per semiannual period
i a = (1 + 0.0484)2 1 = 9.91%

b) Current yield
$48.13
= 4.83% per semiannual period
$996.25

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Finding the Yield to Maturity with Excel

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Example 4.18: Bond Value Over Time

Consider again the bond investment introduced in


Example 4.17. If the yield to maturity remains constant at
9.68%,
a) what will be the value of the bond one year after it was
purchased?
b) If the market interest rate drops to 9% a year later, what
would be the market price of the bond?

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Example 4.18: Solution
Given: Initial purchase price = $996.25, coupon rate =
9.625% per year paid semiannually, and 10-year
maturity with a par value of $1000
a) The value of the bond one year later (if YTM is constant)

$48.13(P / A,4.84%,18) + $1,000(P / F ,4.84%,18) =


$996.80

b) Market price of the bond if the market interest rate drops


to 9% a year

$48.13(P / A,4.5%,18) + $1,000(P / F ,4.5%,18) =


$1038.06

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Summary

The yield to maturity on a bond is the interest rate that


establishes the equivalence between all future interest
and face-value receipts and the market price of the
bond.

2012 Pearson Canada Inc., Toronto, Ontario 12-11

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