CHAPTER 3

DEBT SECURITIES -

BOND VALUATION
Financial Theory 1
Bonds are issued by borrowers/
institutions having a need for money
(Companies or government)
Examples:
Debt securities issued by Government
- Treasury bill
- Treasury note
- Treasury bond
Financial Theory 2
Debt securities issued by Companies
(Corporate bonds)
- Secured bonds
- Debentures
- Subordinated bonds
- Convertible bonds
- Zero-coupon bonds

Financial Theory 3
Bonds are bought by investors/ parties
who possess money
Examples
Institutional investors
- Banks
- Insurance companies
- Pension funds

Individual investors
Need fixed cash flows at regular intervals
Financial Theory 4
Coupon payment = coupon rate *
nominal value
E.g. coupon rate = 5%; nominal
value = Rs1000
Coupon = 5%*1000 = Rs50

Financial Theory 5
Fixed coupon bond
50 50 50 50 50

1000
Variable coupon bond
40 60 80 70 50

Financial Theory
1000 6
 Intrinsic value > Market price
Underpriced/ Buys

 Intrinsic value < Market price

Overpriced/ Does not buy

 Bond value = Market price

Fairly priced/ Normally buys

Financial Theory 7
Example
The market price of a zero coupon bond is
equal to Rs857.34; it has a maturity of 2
years and pays a nominal of Rs1000.
Determine the annual interest rate on the
bond.
Assume annual interest rate = r
857.34 (1 + r) 2 = 1000
r = (1000/ 857.34) ½ – 1 = 7.99… = 8%

Financial Theory 8
 Example
50 50 50

Market price 1000

= 986.51
Assume annual interest rate/ discount rate = k
Market price= 986.51
= 50/ (1 + k) + 50/ (1 + k) 2
+ 1050/ (1 + k) 3

k = 5.5% Financial Theory 9

(equation solved through linear interpolation)

Example
Choose a bond:
- Company Bond selling at Rs900; offers a
coupon rate of 10%, a nominal of Rs1000
and has maturity of 5 years
- Government Bond selling at Rs900; offers
a coupon rate of 10%, a nominal of
Rs1000 and has maturity of 5 years

Financial Theory 10
Intrinsic value of bond (estimated
by investors/financial analysts) =

C/ (1 + k) + C/ (1 + k) 2 +
C/(1 + k) 3+ … + C/ (1 + k) T

+ N/ (1 + k) T

C = coupon payment; N = nominal

value; k = required rate of return;
T = maturity date
Financial Theory 11
 Example:

Bond has fixed coupon rate of

5%, nominal value of Rs1000
and maturity of 5 years.
Required rate of return (k) = 6%

Calculate the value of the bond.

Financial Theory 12
Future cash flows associated with
bond:
Coupon = (5%*Rs1000) = Rs50

YEAR Rs
1 50
2 50
3 50
4 50
5 50 + 1000

Financial Theory 13
Bond Value = 50/ 1.06 + 50/

1.06 2 + 50/ 1.06 3 + 50/ 1.06

4 + 1050/ 1.06 5 = Rs957.88

Financial Theory 14
 Example:

t=0 t=1 t=2

Rs1018.8609 Rs50 Rs1000

Rs50
Verify
1018.8609 (1.04) 2 = 50 (1.04) + 1050
1102 = 1102 (two equivalent ways of
looking at the return on the investment)

Financial Theory 15
France Telecom 6,625% 10/11/10
Market Interest
Date Price/ € rate/ %
26/11/2004 115.10 3.743
03/12/2004 115.31 3.699
10/12/2004 115.74 3.616
21/12/2004 115.90 3.577
23/12/2004 115.91 3.571
Financial Theory 16
Yield to maturity > required rate
of return
Buys

Yield to maturity < required rate

of return
Does not buy

Yield to maturity = required rate

of return
Normally Buys
Financial Theory 17
Current market price of bond
(available from bond market)
= C/ (1 + YTM) + C/ (1 +

YTM) 2 + C/ (1 + YTM) 3 + … +

C/ (1 + YTM) T + N/ (1 + YTM) T

YTM : Yield to maturity

Financial Theory 18
 Example:
A bond has the following
characteristics:
Coupon rate 5%, nominal value
Rs1000 and maturity 2 years.

If the market price of the bond is

equal to Rs960, calculate the
yield to maturity of the bond.

Financial Theory 19
960 = 50/ (1 + YTM) + 50/ (1 +

YTM) 2 + 1000/ (1 + YTM) 2

Multiply both sides by (1 + YTM) 2

and simplify:

960 (1 + YTM) 2 - 50 (1 + YTM)

– 1050 = 0
Financial Theory 20
Assume (1 + YTM) = A

960 A 2 – 50 A – 1050 = 0

Use quadratic equation formula to

solve

YTM = 7.2191%
Financial Theory 21
 Maturity:
01/05/11

Purchase
date
01/09/08
Last Next
coupon coupon
01/05/08 01/05/09

Financial Theory 22
Assume fixed coupon payments = C
Nominal value = N

Bond price at purchase date = PV of

future cash flows (discounted at
YTM)

Financial Theory 23
Fractional period =
Number of (days/months)
between purchase date and next
coupon payment date divided by
total number of (days/ months)
over coupon period

E.g. 01/ 09/ 08 to 01/ 05/ 09 = 8

months
Fractional period = 8/ 12
Financial Theory 24
 Fractional
period
= 8/ 12

Purchas
e date
E.g. 01/
Last Next
09/ 08
coupon coupon
E.g. E.g.
01/05/08 01/05/09

Financial Theory 25
PV coupon at 01/ 05/ 09 = C/ (1
+ YTM) 8/12

PV coupon at 01/ 05/ 10 = C/ (1

+ YTM) 1 + 8/12

PV coupon and nominal at 01/05/11

= [C + N]/ (1 + YTM) 2 + 8/12

Financial Theory 26
Bond Price (Dirty Price)=
C/ (1 + YTM) 8/12 + C/ (1

+ YTM) 1 + 8/12 + [C + N]/ (1 +

YTM) 2 + 8/12

Dirty price: price at which buyer

purchases bond.
Financial Theory 27
 Interest Interest
earned earned
by Seller by Buyer

Purchase
date
E.g. 01/
Last coupon 09/ 08 Next coupon
E.g. E.g.
01/05/08 01/05/09

Financial Theory 28
Interest earned by seller = accrued
interest

Accrued interest = Coupon paid

from 01/ 05/ 08 to 01/ 09/ 08
= 4/ 12*C

Financial Theory 29
Dirty Price = Clean Price +
Accrued Interest

Clean price = Dirty price – Accrued

interest

Clean price: price at which bond is

selling in bond market at purchase
date (01/ 09/ 08)
Financial Theory 30