You then want to include some examples of how bonds are valued, including: a. Ho

Question

You then want to include some examples of how bonds are valued, including:

   a. How the value of any asset whose value is based on expected future cash flows is determined. The value of an asset is merely the present value of its expected future cash flows. If the cash flows have widely varying risk or if the yield curve is not horizontal, which signifies that interest rates are expected to change over the life of the cash flows, it would be logical for each period’s cash flow to have a different discount rate. However, it is very difficult to make such adjustments; hence it is a common practice to use single discount rates for all cash flows. The discount rate is the opportunity cost of capital that is, the rate of return that could be obtained on alternative investments of similar risk.

   b. An example of the valuation of a 10-year, $1000 par value bond with a 6% annual coupon if the required return rate is 6%.

   c. An example of what happens to the bond value above if the required return increases to 10% or decreases to 4%, particularly as it approaches maturity. Why might this be important to the client?

   d. An example of yield to maturity, using a 10-year, 5%, annual coupon, $1000 par value bond that currently sells for $887 and the same bond selling for $1134.20. Why is the fact that a bond is a discount or premium bond matter to the client?

   e. An example of how call provisions might impact the investment, considering a 10- year, 10%, semi-annual coupon bond with a par value of $1000, currently selling for $1135.90, producing a nominal yield to maturity of 8%. However, the bond can be called    after four years for a price of $1050. You want to demonstrate the bond’s nominal yield to call and explain the likelihood of actually receiving either the YTM or YTC.

Explanation / Answer

A. The value of a bond whose ytm or price will change significantly in each period will be determined assuming a single discount rate at a specified date because it is not possible to incorporate all the risk in the model, that is why we calculate standard deviation.

A bond whose ytm today is 5 and coupon is 6, but after 4 years the ytm will fall to 4 due to credit upgradation.

The discount rate will be taken as 5 assumed so the value of the bond will be 1000$ per bond as the coupon rate= ytm.

2. Par value = 1000$

Life 10 years

Coupon and ytm = 6

Price of bond= 60/(1.06)^1+....N+1000/(1.06)^6= 1000$

C. If the ytm increases to 10 then the value decreases

Price= 60/(1.10)+...N +1000/(1.1)^4= 873.20$

If the ytm decreases to 4 the value increases= 1072.59$

D. The par value of bond is 1000$ selling for less than 1000 is at discount having greater ytm as the investor think it as risky bond.

The bond selling at above par value is selling at premium, ytm is lower for that bond as it is thought to be less risky.

E. Call provisions would increase the ytm and decrease the value of bond.

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