Professional Documents
Culture Documents
Future Value
When interest is paid more than one time per
year, both the interest rate and the number of
periods used to compute the future value must be
adjusted as follows:
r = annual interest rate number of times
interest paid per year
n = number of times interest paid per year times
number of years
The higher future value when interest is paid
semiannually, as opposed to annually, reflects the
greater opportunity for reinvesting the interest
paid.
Review of Time Value (continued)
1 r
n
1
Pn A r
1 0.08
15
1
Pn $2, 000, 000 0.08
Present Value
The present value is the future value process in reverse.
We have:
1
Pn
1 r
n
n
11 / 1 r
PV A
r
n
11 / 1 r
PV A
r
PV $100
11
/ 1 0.09 8
0.09
PV $100 5.534811
$553.48
PV and Fixed-Rate Mortgage
Suppose a 30-year $100,000 mortgage loan is financed at a fixed interest rate
(APR) of 8%. What is the monthly payment?
=($100,0000.08/12)/(11/(1+0.08/12)^360)=$733.76
Notice that you overall pay 733.763012=$264,154 for this loan, the majority
of which -- $164,154 -- constitutes interest payments.
What is the interest and principal payments in the first month and last month?
M
$1, 000
$117.46
1 r 1 0.055
n 40
1 r n
M t $ 1, 0 0 0
P $252.12
1 r n
1 0 . 0 4 7 3 0
Pricing a Bond (continued)
Price-Yield Relationship
A fundamental property of a bond is that its price
changes in the opposite direction from the change
in the required yield. (See Overhead 2-21).
The reason is that the price of the bond is the
present value of the cash flows.
If we graph the price-yield relationship for any
option-free bond, we will find that it has the
bowed shape shown in Exhibit 2-2 (See
Overhead 2-22).
Exhibit 2-1
Price-Yield Relationship for a
20-Year 10% Coupon Bond
Maximum
Price
Price
Yield
Pricing a Bond (continued)
When a bond sells below its par value, it is said to be selling at a discount.
A bond whose price is above its par value is said to be selling at a premium.
Pricing a Bond (continued)
Annualizing Yields
To obtain an effective annual yield associated with a
periodic interest rate, the following formula is used:
effective annual yield = (1 + periodic interest
rate)m 1
where m is the frequency of payments per year.
To illustrate, if interest is paid quarterly and the
periodic interest rate is 0.08 / 4 = 0.02, then we have:
effective annual yield = (1.02)4 1 = 1.0824 1 = .0824
or 8.24%
Computing the Yield or Internal Rate of Return
on any Investment (continued)
Annualizing Yields
We can also determine the periodic interest rate that will
produce a given annual interest rate by solving the
effective annual yield equation for the periodic interest
rate .
Solving, we find that
periodic interest rate = (1 + effective annual yield )1/m 1
To illustrate, if the periodic quarterly interest rate that
would produce an effective annual yield of 12%, then we
have:
periodic interest rate = (1.12)1/4 1 = 1.0287 1 =
0.0287 or 2.87%
Exercise in class
1. A coupon bond which pays interest semi-annually, has a par value of $1,000, matures in 5 years,
and has a yield to maturity of 8%. If the coupon rate is 10%, the intrinsic value of the bond today
will be __________.
A) $855.55
B) $1,000
C) $1,081
D) $1,100
2. A coupon bond which pays interest of $40 annually, has a par value of $1,000, matures in 5 years,
and is selling today at a $159.71 discount from par value. The actual yield to maturity on this bond
is __________.
A) 5%
B) 6%
C) 7%
D) 8%
Conventional Yield
Measures (continued)
3) Yield To Call
The call price is the price at which the bond may be called .
There is a call schedule that specifies a call price for each call
date.
The yield to call assumes that the issuer will call the bond at
some assumed call date and the call price is specified in the
call schedule.
C C C ... C M*
P The
= computation for the yield to call begins with this
1 y
expression:
1
1 y 2
1 y 3
1 y n*
1 y n*
Reference Cash
Period Rate Flowa 80 84 88 96 100
1 10% 5.4 5.1233 5.1224 5.1214 5.1195 5.1185
2 10 5.4 4.8609 4.8590 4.8572 4.8535 4.8516
3 10 5.4 4.6118 4.6092 4.6066 4.6013 4.5987
4 10 5.4 4.3755 4.3722 4.3689 4.3623 4.3590
5 10 5.4 4.1514 4.1474 4.1435 4.1356 4.1317
6 10 5.4 3.9387 3.9342 3.9297 3.9208 3.9163
7 10 5.4 3.7369 3.7319 3.7270 3.7171 3.7122
8 10 5.4 3.5454 3.5401 3.5347 3.5240 3.5186
9 10 5.4 3.3638 3.3580 3.3523 3.3409 3.3352
10 10 5.4 3.1914 3.1854 3.1794 3.1673 3.1613
11 10 5.4 3.0279 3.0216 3.0153 3.0028 2.9965
12 10 105.4 56.0729 55.9454 55.8182 55.5647 55.4385
Present Value = 100.0000 99.8269 99.6541 99.3098 99.1381
a
For periods 111: cash flow = 100 (reference rate + assumed margin)(0.5); for period
12: cash flow = 100 (reference rate + assumed margin)(0.5) + 100.
Potential Sources of a
Bonds
Dollar Return
An investor who purchases a bond can expect to receive
a dollar return from one or more of these sources:
i. the periodic coupon interest payments made by
the issuer
ii. any capital gain (or capital loss negative dollar
return) when the bond matures, is called, or is sold
iii. interest income generated from reinvestment of
the periodic cash flows
. The current yield considers only the coupon interest
payments.
. The yield to maturity, yield to call, and cash flow yield
all take into account the three components.
Potential Sources of a
Bonds Dollar Return
(continued)
Determining the Interest-On-Interest
Dollar Return
The interest-on-interest component can represent a
substantial portion of a bonds potential return. The
coupon interest plus interest on interest 1 can n
1
r be
couponinterest
found by using interestoninterest C
the following equation:
r
where
C is the coupon interest
r is the semiannual reinvestment rate
n is the number of periods
Potential Sources of a Bonds
Dollar Return (continued)
Determining the Interest-On-Interest
Dollar Return
The total dollar amount of coupon interest is found by
multiplying the semiannual coupon interest by the
number of periods:
total coupon interest = nC
where C is the coupon interest, r is the semiannual
reinvestment rate, and n is the number of periods.
The interest-on-interest component is then the difference
between the coupon interest plus interest on interest
1 r n as
and the total dollar coupon interest, 1 expressed by the
interestoninterest C
formula nC
r
Potential Sources of a Bonds
Dollar Return (continued)
59
Calculating Yield
Changes
The absolute yield change (or absolute rate
change) is measured in basis points and is the
absolute value of the difference between the two
yields as given by
absolute yield change = initial yield new yield 100.
The percentage change is computed as the natural
logarithm of the ratio of the change in yield as shown
by
percentage change yield = 100 ln (new yield / initial
yield)
where ln in the natural logarithm.
Consider the following bond: coupon rate =11%, maturity = 18 years, par
value = $1,000, first par call in 13 years, and only put date in five years
and putable at par value. Suppose that the market price for this bond
$1,169.
(a)Show that the yield to maturity for this bond is 9.077%.
(d) Suppose that the call schedule for this bond is as follows:
Can be called in eight years at $1,055
Can be called in 13 years at $1,000
And suppose this bond can only be put in five years. What is the yield to
worst for this bond?