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Canada (161,660)
Economics (818)
ECON 2560 (71)
Chapter 6

Chapter 6 ECON 2560

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ECON 2560
Tahsin Mehdi

Chapter 6 ECON 2560 Valuing Bonds BONDS & THE BOND MARKET  Governments & corporations borrow money by selling bonds to investors  Bond market is hug  They money governments or companies collect when bonds are issued is the amount of the debt  As borrowers, they promise to make interest payments & then repay debt at the maturity date Coupon: The interest payment paid to the bondholder Face Value: Payment at the maturity of the bond also called maturity value/par value Bond Market Data Coupon Rate: Annual interest payment as a percentage of face value  Prices for some government and corporate bonds are reported on the web sites of major newspapers, such as National post & Globe & Mail, and are typically for the previous day’s trading activity  Price info for all bonds traded in Canada are available via subscription to financial data services such as GlobeInvestor Gold or through a bond dealer such as TD Waterhouse  Bonds are traded by a network of bond dealers who quote bid and ask prices at which they are prepared to buy & sell  In the past, bonds were traded in an over-the-counter market, in which securities aren’t traded in one central place but over the telephone  Development of electronic markets for bond trading such as CBID & CanDeal are changing the operation of the Canadian bond market  Both these allow institutional investors, such as pensions fund, who trade larger dollar values of bonds, to see bond quotes from multiple bond dealers at same time rather than having to call each dealer for a quote  Can execute a buy or sell order at the best price: increases competition & reduces the spread between bid & ask prices  If you a retail investor, wanted to buy a bond you would have to contact a bond dealer b/c they hold inventories of bonds and are usually part of financial institutions such as banks or brokerage houses  When you buy a bond you’ll pay more than the ask price if you do not happen to buy the bond on a coupon payment date  The buyer has to compensate seller for the coupon interest earned from the last coupon payment to the settlement date (date when buyer must pay the money for bond)  Settlement date is usually 3 days after the bond deal is executed  Extra payment is called accrued interest Accrued interest = coupon payment x (# of days from last coupon to settlement date/ # of days in coupon period) Accrued interest: Coupon interest earned from the last coupon payment to the purchase date of the bond Clean Bond Price: Bond price excluding accrued interest Dirty Bond Price: Bond price including accrued interest INTEREST RATES & BOND PRICES  The value of the bond is the value of the bond’s cash flows so to find the value you need to identify the bonds cash flows then calculate the PV of the cash flows using a discount rate that captures the bond’s opportunity cost of capital Example *3 year bond interest of $35 per year *Opportunity cost = 2.15% bonds Therefore PV = [$35/(1.0215)] + [$35/(1.0215) ] + [$1035/(1.0215) ] = $1038.82 PV (Bond) = PV (Coupons) + PV (Face value) = (coupon x annuity factor) + (face value x discount factor) = $35 x [(1/.0215) – (1/.0215(1.0215) )] + 1,000 x [1/(1.0215) ] = $1038.82 How Bond Prices Vary W/ Interest Rates  As interest rates change so do bond prices  When discount rate is the same as the coupon rate, the bond sells for its face value  When cash flows are discounted at a rate higher than the bond’s coupon rate, the bond is worth less than its face value and vice-versa CURRENT YIELD & YIELD TO MATURITY Current Yield: Annual coupon payment divided by current bond price Premium Bond: A bond that sells for more than its face value Discount Bond: A bond that sells for less than its face value Yield to maturity: Interest rate for which the PV of the bond’s payments equals the price  A measure of the bond’s total return including both coupon income and capital gain  If investor buys bond today and holds it till maturity, his return will be the yield to maturity  Can calculate this by trail & error Bond rates of Return Rate of return: Total income per period per dollar invested  The yield to maturity is defined as the discount rate that equates the bond’s current price to the PVB of all its promised future cash flows  Measures the rate of return that you will earn if you buy bond today and hold it till maturity  BUT interest rates fluctuate and the return you earn in the interim may be way different from the yield to maturity Rate of Return = (coupon income + price change) / investment Taxes & Rates of Return  Taxes reduce the rate of return on an investment Tax on coupon = personal tax rate x coupon income After-tax coupon income = coupon income = tax on coupon Tax on capital gain = personal tax rate x .5 x capital gain After-tax capital gain = capital gain – tax on capital gain After-tax rate of return = (after-tax coupon income + after-tax capital gain) / investment Multi-period rates of return How to calculate the rate of return if investment lasts longer than 1 year… Rate of Return = (coupon income + price change) / investment  The effective annual equivalent is (rate of retu-1 = annual rate of return (if this is a 2 year rate of return) THE YIELD CURVE  The longer the maturity of bonds, the slightly higher the yield  Usually the case but SOMETIMES long-term bonds offer lower yields Yield Curve/Term Structure of interest rates: Graph of the relationsh
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