Valuing bonds Cheat Sheet

by Natalie Moore (NatalieMoore) via cheatography.com/19119/cs/8225/

Formula key Asset valuation basics (cont) Bond features (cont)

Po = Asset's price today (at time 0) Therefore pricing an asset requires knowledge Makes borrowers future cash

CFn = Cash flow expected at time t of obliga​tions unpred​ictable

- its future benefits Risk is transf​erred from buyer to

t = time
- the approp​riate discount rate to convert issuer
r = required return. Discount rate that
future benefits into a present value London The interest rate that banks in
reflects the asset's risk.
Interbank London charge each other for
Cert​ainty
n = Assets life / period it distri​butes cash
Offered overnight loans. Widely used as a
flows If an assets future benefits are uncertain then
Rate benchmark interest rate for short-
$C = Coupon payment amount investors will apply a larger rate when
(LIBOR) term fl oatingrate debt.
discou​nting those benefits to present value
$M = par value maturity amount Cash Rate Aus banks charge each other
An inverse relati​onship exists between risk and rate for overnight loans
value
Required rate of return Spread The difference between the rate
Investors will pay a higher price for investment that a lender charges for a loan
The rate of return that investors expect or
with more credible promise. and the underlying benchmark
require an investment to earn given its risk.
Riskier invest​ments must offer higher returns interest rate
Riskier = higher the return required by investors
Marginal benefit of owning an asset = right Also called the credit spread
in the market​place
to receive cash flows it pays to the benchmark interest rate,
Purchase of investment means investor loses
Marginal cost = opport​unity cost of committing according to the risk of the
the opport​unity to invest their money in another
asset. Opport​unity cost. funds to this asset rather than to an equally borrower
risky altern​ative Lenders charge higher spreads for
Po = CF1/(1 + r)1 + CF2/(1 + r)2 + ... + CFn/(1
less credit​worthy borrowers
+ r) n
Bond features
Capital Issued by Aus govt, face value

Floati​ Bonds that make coupon payments indexed changes each year with inflation
Asset valuation basics
ng- that vary through time. The coupon bonds /
In a market economy, ownership of an asset rate payments are usually tied to a inflation
confers rights to stream of benefits generated bonds benchmark market interest rate linked
by asset. bonds
also called variab​le-rate bonds
Benefits may be tangible, such as interest
provide some protection against
payments on bonds, or intang​ible, e.g. viewing
interest rate risk
a beautiful ring
If market interest rates increase, then
Asset value = present value of all its future
eventu​ally, so do the bond’s coupon
benefits
payments
Finance theory focuses on tangible benefits,
usually cash flows an asset pays over time

e.g. landlord. Incoming = Rental payments from

tenants. Outgoing = Liabil​ities for mainta​ining
premises, paying taxes, etc.

When selling an asset the market price should

equal present value of all future net cash flows

Step Estimate $$ an investment distri​butes

1: over time

Step Discount expected cash payments using

2: time value of money maths

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 Valuing bonds Cheat Sheet
by Natalie Moore (NatalieMoore) via cheatography.com/19119/cs/8225/

Bond features (cont) Bond features (cont) Bond Vocabulary

Unsecured Debt instru​ments issued by an Exchan​ge Bonds issued by corpor​ations Fundam​ent​ally, a bond is just a loan
debt entity backed only by faith and able which may be converted into Bonds make intere​st-only payments until they
credit score of borrowing bonds shares of a company other than
mature
company the company that issued the
Principal The amount of money on which
bonds.
Subord​inate Debt instru​ments issued by an
interest is paid
d entity which is backed only by Callable Bonds that the issuer can
Maturity The date when a bond’s life ends
unsecured the credit of the borrowing entity repurchase from investors at a
date and the borrower must make the fi
debt which is paid only after senior predet​ermined price known as the
nal interest payment and repay the
debt is paid call price
principal.
Collateral The specifi c assets pledged to Call price The price at which a bond issuer
Par value The face value of a bond, which
secure a loan. may call or repurchase an
(bonds) the borrower repays at maturity
Mortgage A bond secured by real estate or outsta​nding bond from investors
Typically $1,000 for corporate
bonds buildings Putable Bonds that investors can sell back
bonds
Collateral A bond secured by financial bonds to the issuer at a predet​ermined
price under certain conditions Coupon A fixed amount of interest that a
trust bonds assets held by a trustee
bond promises to pay investors
Sinking A provision in a bond indenture
Debentures Usually backed by property
fund that requires the borrower to make Usually semian​nually
Equipment A bond often secured by various
regular payments to a third-​party Indenture A legal document stating the
trust types of transp​ort​ation equipment
trustee for use in repurc​hasing conditions under which a bond has
certif​icates
outsta​nding bonds, gradually over been issued
Pure Bonds that pay no interest and time
Specifies dollar amount of coupon
discount sell below par value. Also called
Protective Specify requir​ements that the
bonds zero-c​oupon bonds. Specifies when the borrower must
covenants borrower must meet as long as
make coupon payments
Conver​tible A bond that gives investors the bonds remain outsta​nding
bond option to convert their bonds into Coupon The rate derived by dividing the
the issuer’s common stock. rate bond’s annual coupon payment by
its par value.

Coupon The amount obtained by dividing

yield the bond’s coupon by its current
market price (which does not
always equal its par value). Also
called current yield

Might have additional features:

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 Valuing bonds Cheat Sheet
by Natalie Moore (NatalieMoore) via cheatography.com/19119/cs/8225/

Bond Vocabulary (cont) Issuer types (cont) Semiannual Compou​nding

- Call feature allows the issuer to Corporate Issued by corpor​ations Most bonds make 2 payments a year
redeem the bond at a bonds
Po = (C / 2) / (1 + r)1 + (C / 2) / (1 + r)2 + ... +
predet​ermined price prior to - Finance new invest​ments (C / 2) / (1 + r)2n + M / (1 + r)2n
maturity
- Fulfil other needs
- Conv​ersion feature grants
- Range from 1 - 100 years Factors affecting bond prices
bondho​lders right to redeem bonds
for a predet​ermined number of - Under 10 years usually called a A bonds market price changes frequently as
shares of stock in borrowing firm note means the same time passes

Premium A bond that sells for more than its - Most corporate bonds have a Term to maturity
par value par value of $1,000 and pay
Whether a bond sells at a discount or a
interest semian​nually
Selling at a better than market premium, its price will converge to par value (+
return Australian Issued by Australian final interest payment) as maturity date draws
government government near.
As more investors buy the price
bonds
goes up Economic Forces

Yield to The discount rate that equates the Most important factor is prevailing market
Bond Markets
maturity present value of the bond’s cash interest rate
flows to its market price Larger than the stock market
Required return
Discount A bond sells at a discount when its Bond Price Quotations
When required return on a bond changes,
market price is less than its par bond prices are quoted as a percentage of par bonds price changes in opposite direction
value values
Higher bonds required return = lower its price,
Might be offset with a built-in gain Yield The diff erence in yield to maturity and vice versa
at maturity spread between two bonds or two classes of
General lessons
bonds with similar maturities
Changes in Issuer Risk Bond prices and interest rates move in opposite
Basis 1/100 of 1 percent; 100 basis points
directions
When macroe​conomic factors change point equal 1.000 percent
Prices of long-term bonds display greater
- Yields may change simult​ane​ously on a Bond Letter ratings assigned to bonds by
sensit​ivity to changes in interest rates than do
wide range of bonds ratings specia​lized agencies that evaluate the
prices of short-term bonds
capacity of bond issuers to repay their
- Return on a particular bond can also
debts. Lower ratings signify higher
change as market reassesses borrower's Interest Rate Risk
default risk.
default risk (risk issuer could default on
payments) Junk Bonds rated below investment grade. Risk that changes in market interest rates will
bonds Also known as high-yield bonds move bond price
- Changes may be positive or negative
Interest rates fluctuate widely, so investors
Basic bond valuing equation must be aware of interest rate risk
Issuer types
Bond makes a fixed coupon payment each Inherent in these instru​ments
Treasury Debt instru​ments issued by the
year Inflation is a main factor
bonds federal government with maturities
of up to 30 years Po = C / (1 + r)1 + C / (1 + r)2 + ... + C / (1 + r)n Impo​rtant because
+ M / (1 + r)n
- When investors buy financial assets, they
expect these invest​ments to provide a
return that exceeds inflation rate.

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 Valuing bonds Cheat Sheet
by Natalie Moore (NatalieMoore) via cheatography.com/19119/cs/8225/

Interest Rate Risk (cont)

- Investors want to achieve a better standard of living by saving and

investing their money

- If asset returns do not exceed inflation investors are not better off
for having invested

Real return

Bond yields must offer investors a positive real return

Approx​imately equals difference between stated or nominal return

and inflation rate

Bond Markets

Many types of bonds in modern financial markets

Many bonds provide a steady, predic​table stream of income

Others have exotic features that make returns volatile and

unpred​ictable

Bond trading occurs in either primary or secondary market

Primary market trading

Initial sale of bonds by firms or government entities

Might be through auction process

With help of investment bankers who assist bond issuers with design,
marketing, and distri​bution of new bond issues

Once issued in primary market, investors trade them with each other
in secondary market

Often purchased by instit​utional investors who hold bonds for a long

time

Seco​ndary market

Because instit​utions hold bond for a long time, trading in bonds can
be somewhat limited

But bond market is large which means investors have a wide range
of choices

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