1
Chapter 8
Bond Valuation and Risk
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
2
Chapter Outline

Bond valuation process

Relationships between coupon rate, required
return, and bond price

Explaining bond price movements

Sensitivity of bond prices to interest rate
movements

Bond investment strategies used by investors

Return and risk of international bonds
3
Bond Valuation Process

Bonds:

Are debt obligations with long-term maturities issued by
government or corporations to obtain long-term funds

Are commonly purchased by financial institutions that wish to

coupon rate of 5 percent. The prevailing
annualized yield on other bonds with similar
characteristics is 7 percent. What is the
appropriate market price of the bond?
84.963
07.1
050,1
07.1
50
)1(
Par
....
)1()1(
bond of
2
21
=
+=
+
+
+
+
+
+
=
n
k
C
k
C

bond using PVIFs?
80.963$
07.917$73.46$
)8734(.050,1$)9346(.50$
)(050,1$)(50$bond of
2%,71%,7
=
+=
+=
+=
==== nknk
PVIFPVIFPV
7
Bond Valuation Process (cont’d)

Impact of the timing of payments on bond valuation

Funds received sooner can be reinvested to earn additional
returns

A dollar to be received soon has a higher present value than
one to be received later

Valuation of bonds with semiannual payments

First, divide the annual coupon by two

Second, divide the annual discount rate by two

Third, double the number of years

prevailing annualized yield on other bonds with
similar characteristics is 7 percent. What is the
appropriate market price of the bond?
27.963
035.1
025,1
035.1
25
035.1
25
035.1
25
)2/1(
Par2/
....
)2/1(
2/
)2/1(
2/
bond of
4321
221
=
+++=
+
+
+
+
+
+

bond?
1,102.80$$75.40$1,027.40bond of
40.75$)0754(.000,1$
)(000,1$principal of
40.027,1$)274.10(100$
)(payments coupon of
30%,9
30%,9
=+=
==
=
==
=
==
==
PV
PVIFPV
PVIFACPV
nk
nk
11
Relationship between Coupon
Rate, Required Return, and Price

If the coupon rate of a bond is below the
investor’s required rate of return, the present
value of the bond should be below par value
(discount bond)

If the coupon rate equals the required rate of

14
Explaining Bond Price Movements

The price of a bond should reflect the present
value of future cash flows based on a
required rate of return:

An increase in either the risk-free rate or the
general level of the risk premium results in a
decrease in bond prices
- - -
),()( RPRfkfP
fb
∆∆=∆=∆
15
Explaining Bond Price Movements
(cont’d)

Factors that affect the risk-free rate

Inflationary expectations

Economic growth

Money supply

Budget deficit
+++
∆∆∆∆=∆
-