Dr.

Ridha ESGHAIER
Principles of Finance Dr. Ridha ESGHAIER

Chapter Plan
CHAPTER 4 1. Key features of bonds
2. Bond Pricing and listings
Bonds: Features and Valuation 3. Measuring yield
4. Current Yield, Capital Gains Yield and Total Return
Spring 5. Semiannual Bonds
6. Bond Pricing between two coupon payment dates
2021 7. Zero-coupon Bonds
8. Callable Bonds

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Dr. Ridha ESGHAIER Dr. Ridha ESGHAIER

LEARNING OUTCOMES
Introduction
The student should be able to:
a. describe basic features of a fixed- income security;
b. describe how cash flows of fixed- income securities are structured; Companies need money to finance their
c. calculate a bond’s price given a market discount rate; assets. They raise capital in two main forms:
b. Calculate and interpret the bond’s yield-to-maturity; debt and equity.
e. define spot rates and calculate the price of a bond using spot
rates; Debts are especially composed by bank loans
f. Calculate the Current Yield, Capital Gains Yield and Total Return of a and Bonds
bond We explained equity (stock) issuance and
g. describe and calculate the flat price, accrued interest, and the full
price of a bond; valuation in the previous chapter. The
h. Calculate and interpret the bond’s yield-to-call purpose of this chapter is to understand
bond issuance and valuation.
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 Dr. Ridha ESGHAIER Dr. Ridha ESGHAIER

What is a bond?
• A long-term debt instrument issued with the purpose • So it’s like a bank loan, but here, the lenders aren’t
of raising capital by borrowing, to finance a variety of necessarily banks: any investor can be a lender
projects and activities. (bondholder)
• It’s a form of interest-bearing notes payable issued to
obtain large amounts of long-term capital • To obtain the needed money, the company (the
(Generally issued when the amount of capital borrower) can issue (sell) bonds in the bond market
(it sells bonds in exchange for cash) with the
needed is too large for one lender to supply). agreement to pay to the holders of the bond
• A bond is a fixed-income security that allow interest (or coupon) on specific dates for the use of
governments, companies, and other types of issuers money and to pay back the bond value (the
to borrow money from investors. principal) at the maturity date.
• The terms “fixed-income securities,” “debt securities,”
and “bonds” are often used interchangeably
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Dr. Ridha ESGHAIER Dr. Ridha ESGHAIER

1. Key Features of a Bond Basic Features of a BOND

Maturity
• The maturity date is the date when the issuer is obligated to
• Par value – face amount of the bond, which is paid at redeem the bond.
maturity (= Maturity Value) • The tenor, also known as term to maturity, is the time remaining
(Par Value or Maturity Value. Assume $1,000 or $100). until the bond’s maturity date.
• Coupon interest rate – stated interest rate or contractual • Money market securities are fixed-income securities with
maturity up to one year.
rate (generally fixed) paid by the issuer. Multiply by par
• Capital market securities are fixed-income securities with
value to get dollar payment of interest (coupon payment) maturity longer than one year.
• Maturity – years until the par value of the bond must be
repaid. Par value (principal) of a bond
• Issue date – when the bond was issued.
• The par value of a bond is the amount the issuer agrees to repay
• Yield to maturity - rate of return earned on a bond held the bondholders on the maturity date. for illustrative purposes, we
until maturity. (will be developed later). generally assume a par value of $1,000. In practice, some bonds
have par values that are multiples of $1,000 (for example, $5,000)
and some have par values of less than $1,000 (for example, $100)
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 Dr. Ridha ESGHAIER Dr. Ridha ESGHAIER

Basic Features of a BOND Bond Basics Issuer of

Bonds
Coupon rate and frequency

• The coupon or nominal rate (yield) of a bond is the interest rate

that the issuer agrees to pay each year until the maturity date. 2013
Maturity
• The coupon is the annual amount of interest payments and is Date
determined by multiplying the coupon rate by the par value of the
bond. DUE 2013 DUE 2013

• Plain vanilla bonds pay a fixed rate of interest.

• Floating-rate notes (FRNs) or floaters pay a floating rate: a Contractual
reference rate plus a spread. Interest
• Bonds that do not pay interest are called “zero-coupon bonds.” Rate

Face or
9 Par Value 10

Dr. Ridha ESGHAIER Dr. Ridha ESGHAIER

Answer :
We know that:
Question: NPV = − I 0 +
CF1
+
CF2
+ ... +
CFn
(1 + r ) (1 + r )
1 2
(1 + r )n

he investor will accept to finance the project only if the NPV is at

• Consider an investor who demands 10% as a ►T

minimum equal to zero. The NPV is equal to zero when I0 is

return rate for a project. The future cash- flows to equal to the sum of the future cash flows discounted at the required
rate of return r.
be generated by this project are : CF1= $1000;
► The investor will accept to finance the project only when I is at
CF2= $1000; CF3= $1000; CF4= $2500. 0
maximum equal to the sum of the future cash flows discounted at
his required rate of return (r). The maximum investment amount
• What is the maximum investment amount I0 that the investor will accept to pay is :
that the investor will accept to pay today for I0 =
1,000
+
1,000
+
1,000
+
2,500
= $4,194.39
(1 + 10%)1 (1 + 10%) 2 (1 + 10%)3 (1 + 10%) 4
this project?
If the Investor knows the future cash flows of the project and the
rate of return he wants to earn, he can calculate the maximum
investment amount that he will accept to pay.
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 Dr. Ridha ESGHAIER
Dr. Ridha ESGHAIER

Price to pay to buy a bond 2. The Bond Princing

0 1 2 Maturity (N)
rd %
...
Since the purchase of a bond is an investment
project, to decide the amount of the investment (the PVB? INT INT INT
price to pay to buy a bond), an investor should: + Par Value
Bond pricing is an application of discounted cash flow analysis.
- Determine the future cash flows that the detention Assuming that the required rate of return on the bond is rd, the present
of the bond will allow him to earn from the value of the bond (its fundamental value or «correct» value) should be
purchasing date until the maturity date equal to the present value of the future revenues to be generated by this
bond (interest and par value) (discounted at its required rate of return rd)
(future interest + Maturity value) The Present Value of the Bond can be found by solving:
- Set the required rate of return (rd) INT INT INT Par Value
PVB = + + ... + +
(1 + rd )1 (1 + rd ) 2 (1 + rd ) N (1 + rd ) N
Equation.1
 1 - (1 + rd )- N  Par Value
PVB = INT   + (1 + r ) N
13  rd  d 14

Dr. Ridha ESGHAIER

What is the discount rate (rd)? Example 1: Dr. Ridha ESGHAIER

Q1. What is the current value of a 10-year bond with an annual

coupon i=10%, if the required return on that type of bond
- The discount rate (rd ) is the Bond’s required rate of return,
which is the market rate of interest for that type of bond rd=10% and the par Value =$1000?
(according to its maturity, liquidity, default risk, the risk-free
rate and the expected inflation*). 0 1 2 10
- (rd ) is the rate of return investors (lenders) are currently
rd=10%
...
demanding for bonds of a given maturity and rating (given
the risk of the investment in the bond) PVB = ? 100 100 100 + 1,000
- It can also be viewed as the opportunity cost of the bond, i.e
the rate that could be earned on alternative investments of This bond has an annual coupon payment of 10% x $1000 = $100
equal risk, also called “the required Yield to Maturity” or The price of the bond can be found by solving for the PV of these cash flows
“the required Yield” $100 $100 $100 $1,000
- The market discount rate is used in the time-value-of- PVB = + + ... + + = $1,000
(1.10)1 (1.10)2 (1.10)10 (1.10)10
money calculation to obtain the present value.  1 - (1 + 10%) -10  $1,000
or PVB = $100   + (1 + 10%)10 = $1,000
 10% 
rd is not the coupon interest rate (i)
In this case the bond sells at par (PVB= par value) because the
* Will be developed more in the next chapter (The determinants of the bond’s yield to maturity) 15 coupon rate (i=10%) equals the market rate of interest (rd=10%). 16
 Dr. Ridha ESGHAIER
Example 2: The same company also has 10-year bonds
Q2. What would be the value of the bond one year from now if outstanding with the same required rate of return (rd=10%), the
the coupon rate (i) and the market interest rate (required return same par value, but a 12% annual coupon rate.
on the bond rd) remain unchanged? Q1. What is the current value of this bond?
• This bond has an annual coupon payment of 12% x $1000 = $120.
0 1 2 9
• Since the risk is the same the bond has the same required return as the
rd=10%
... previous bond (rd=10%).

PVB = ? 100 100 100 + 1,000

$120 $120 $120 $1,000
After one year, the number of years before Maturity will be: 10 – 1 = 9 years PV B = 1
+ 2
+ ... + 10
+ = $1,122.89
The price of the bond can be found by solving: (1.10) (1.10) (1.10) (1.10) 10
 1 - (1 + 10%) - 10  $1,000
$100 $100 $100 $1,000 or PV B = 1,000 × 12%   + = $1,122.89
 (1 + 10%)
10
PVB = + + ... + + = $1,000  10%
(1.10)1 (1.10)2 (1.10)9 (1.10)9
 1 - (1 + 10%)-9  $1,000
or PVB = $100   + (1 + 10%)9 = $1,000
 10% 
In this case the bond sells at a premium (PVB> par
In this case the value of this par bond remains constant at $1,000 as long value) because the coupon rate (i=12%) exceeds the
as the coupon rate (i=10%) and the required return (rd=10%) remain required return on the bond (rd=10%).
constant. 17
Dr. Ridha ESGHAIER
18

Dr. Ridha ESGHAIER Example 3: The same company also has 10-year bonds
Q2. What would be the value of the bond one year from now if outstanding with the same required yield, the same par value,
the coupon rate (i) and (rd) remain unchanged? but an 8% annual coupon rate
Q1. What is the current value of this bond?
This bond has an annual coupon payment of 8% x $1000 = $80.
0 1 2 9 Since the risk is the same the bond has the same yield to maturity as
rd=10%
... the previous bond (rd= 10%).

PVB = ? 120 120 120 + 1,000

$80 $80 $80 $1,000
PV B = 1
+ 2
+ ... + 10
+ = $877.11
After one year, the number of years before Maturity will be: 10 – 1 = 9 years (1.10) (1.10) (1.10) (1.10) 10
The price of the bond can be found by solving:
 1 - (1 + 10%) - 10
 $1,000
$120 $120 $120 $1,000 or PV B = 1,000 × 8%   + (1 + 10%) 10
= $877.11
PVB = + + ... + + = $1,115.17  10% 
(1.10)1 (1.10)2 (1.10)9 (1.10)9
 1 - (1 + 10%)-9  $1,000
or PVB = $120   + (1 + 10%)9 = $1,115.17 < $1,122.89
 10% 
In this case the bond sells at a discount (PVB< par
In this case the value of this premium bond decreases over time as long value) because the coupon rate (i=8%) is less than the
as the coupon rate (i=12%) and the required return (rd=10%) remain required return (rd=10%).
constant. 19 20
Dr. Ridha ESGHAIER
 Dr. Ridha ESGHAIER
Dr. Ridha ESGHAIER
• The coupon rate indicates the amount the issuer promises to pay the
Q2. What would be the value of the bond one year from now if bondholders each year in interest.
the coupon rate (i) and (rd) remain unchanged? • The market discount rate reflects the amount investors need to receive
in interest each year in order to pay full par value for the bond.
Therefore, assuming that these three bonds (from example 1 , 2 and 3)
0 1 2 9 have the same risk, which is consistent with them having the same market
rd=10%
... discount rate of 10%, the 8% bond offers a “deficient” coupon rate. The
amount of the discount below par value is the present value of the
PVB = ? 80 80 80 + 1,000 deficiency, which is 2% of par value each year. The present value of the
deficiency, discounted using the market discount rate, is –122.89.
After one year, the number of years before Maturity will be: 10 – 1 = 9 years
- $20 - $20 - $20
The price of the bond can be found by solving: Deficiency = + ... + +
(1.10)1 (1.10)9 (1.10)10
$80 $80 $1,000  1 - (1 + 10%) -10 
PVB = + ... + + = $884.82
(1.10)1 (1.10)9 (1.10)9 or Deficiency = - $20   = - $122.89
 10% 
 1 - (1 + 10%) -9  $1,000
or PVB = $80   + (1 + 10%)9 = $884.82 > $877.11 The price of the 8% coupon bond is $877.11 (= 1,000 – 122.89). In the
 10% 
same manner, the 12% bond offers an “excessive” coupon rate given the
In this case the value of this discount bond increases over time as long risk because investors require only 10%. The amount of the premium is
as the coupon rate (i=8%) and the required return (rd=10%) remain constant. the present value of the excess cash flows, which is +122.89. The price of
21 the 12% bond is $1,122.89 (= 1,000 + 122.89). 22

Dr. Ridha ESGHAIER

These examples demonstrate that the price of a fixed- rate bond,
relative to par value, depends on the relationship of the coupon rate Bond values over time
to the market discount rate. Here is a summary:

If the bond price is At maturity, the value of any bond must equal its
higher than par value, • This happens when the coupon rate is par value.
the bond is said to be greater than the market discount rate.
traded at a premium. If the required return on the bond (market interest
rate for that type of bond) remains constant:
If the bond price is
equal to par value, the • This happens when the coupon rate is
– The value of a premium bond would decrease over
bond is said to be equal to the market discount rate. time, until it reached $1,000.
traded at par. – A value of a par bond stays at $1,000.
If the bond price is – The value of a discount bond would increase over
lower than par value, • This happens when the coupon rate is time, until it reached $1,000.
the bond is said to be less than the market discount rate.
traded at a discount.
Dr. Ridha ESGHAIER 23 24
 Changes in Bond Value over Time Issue at Par, Discount, or Premium?
 1 - (1 + rd )-N  Dr. Ridha ESGHAIER
we knowthat 1 - (1 + rd )-N =   rd
What would happen to the value of these three bonds  rd 
if its required rate of return rd remained at 10%?  1 - (1 + rd )-N 
 rd = (1 + rd )
-N
1- 
 rd 
PVB  1 - (1 + rd ) -N  Par Value
since PV B = i × Par Value   + (1 + r ) N
 rd  d

1,122 12% coupon rate (premium)  1 - (1 + rd ) - N  −N

or PV B = i × Par Value   + Par Value (1 + rd )
 rd 
10% coupon rate (at par)  1 - (1 + rd ) - N    1 - (1 + rd ) - N  
1,000 PV B = i × Par Value   + Par Value  1 -   rd 
 rd    rd  
  1 - (1 + rd ) - N 
PV B = Par Value  1 + (i - rd )   
877 8% coupon rate (discount)   rd 
 1 - (1 + rd )-N 
since   is always positif :
 rd 
Years
0 1 2 3 ……… 9 10 - If i = rd then, PVB = Par Value ► Par bond
Maturity - If i > rd then, PVB > Par Value ► Premium bond
Dr. Ridha ESGHAIER 25 - If i < rd then, PVB < Par Value ► Discount bond 26

Dr. Ridha ESGHAIER Dr. Ridha ESGHAIER

Bond Price Listings 3. The Yield to Maturity

• When bond prices are listed, the convention is to list them as a percentage of
(expected return on the bond)
par value, regardless of what the face value of the bond is, with 100 being • The Yield to maturity (YTM) of a bond (sometimes called the redemption
equal to par value. Thus, a bond with a face value of $1,000 which is selling
yield, yield-to-redemption or promised yield) can be viewed as the bond’s
for par, sells for $1,000, and a bond with a face value of $5,000 that is also
promised rate of return. It is the internal rate of return (IRR) earned by
selling for par will both have their price listed as 100, which means their
prices are equal to 100% of par value, or $100 for each $100 of face value. an investor who buys the bond today at its market price, assuming that
• This pricing convention allows different bonds with different face values to be the bond will be held until maturity, and that all coupon and principal
compared directly. For instance, if a $1,000 corporate bond was listed as 90 payments will be made on schedule.
and a $5,000 municipal bond was listed as 95, then it can be easily seen that • If the market price of a bond is known, Equation.1 can be used to
the $1,000 bond is selling at a bigger discount, and, therefore, has a higher
calculate its yield-to-maturity
yield. To find the actual price of the bond, the listed price must be multiplied
as a percentage by the face value of the bond, so the price for the $1,000 • YTM is simply the discount rate at which the sum of all future cash
bond is 90% × $1,000 = 0.9 × $1,000 = $900, and the price for the $5,000 flows from the bond (coupons and principal) is equal to the price of
bond is 95% × $5,000 = .95 × $5,000 = $4,750. the bond.
• A point is equal to 1% of the bond's face value. Thus, a point's actual value
The Yield to Maturity on a particular bond is usually the same
depends on the face value of the bond. Thus, 1 point = $10 for a $1,000
as the market rate of interest for that type of bond (the
bond, but $50 for a $5,000 bond. So a $1,000 bond that is selling for 97 is
required return rd) when the market price of the bond is equal
selling at a 3 point discount, or $30 below par value, which equals $970.
27 to its fundamental value. 28
 Dr. Ridha ESGHAIER
Dr. Ridha ESGHAIER
Example 4 : What is the YTM on a 10-year, 9%
annual coupon, $1,000 par value bond, selling for
The YTM calculation $887?

Maturity
Must find the discount rate (YTM)that solves this model.
YTM Calculation
0 YTM? 1 2 … N Market Price(MP) Bond =
INT
+ ... +
INT
+
Par Value
(1 + YTM )1 (1 + YTM ) N (1 + YTM ) N
Market PriceBond INT INT … INT
+ Par Value 1 - (1 + YTM ) - N  Par Value
Market Price(MP) Bond = INT   +
INT/(1+YTM)1  YTM  (1 + YTM ) N

ΣPV of futur CFs INT/(1+YTM)2 1 - (1 + YTM ) -10  1,000

$887 = 9% ×1,000  +
 (1 + YTM )
10
of the bond  YTM

…
= PVBond
(INT+MV)/(1+YTM)N Since Market Price Bond (887) lower than its par value (1,000) : Discount Bond the
discount rate must be higher than the coupon rate i (9%)
Must find the discount rate YTM that solves this model - When we use 10% as a discount rate, we calculate the PVB to be $938.514
PVB = 90 x 6.1446 + 1,000 /2,8392 = 938.514
INT INT INT Par Value
Market Price Bond = + + ... + + - When we use 11% as a discount rate, we calculate the PVB to be $882.228
(1 + YTM ) 1 (1 + YTM ) 2 (1 + YTM ) N (1 + YTM ) N
PVB = 90 x 5.8892 + 1,000 /2,8393 = 882.228
 1 - (1 + YTM ) -N
 Par Value
Market Price Bond = INT   + (1 + YTM ) N
→ So, our YTM is between these numbers (10% and 11%) . (YTM) will give us a present
 YTM  29 value (PVB) exactly equal to the current Market price of $887 30

Dr. Ridha ESGHAIER Dr. Ridha ESGHAIER

Example 5: What is the YTM on a 10-year, 9% annual

Linear interpolation system coupon, $1,000 par value bond, selling for $1,134.2?
 1 - (1 + YTM )-10  1,000
Using the linear interpolation system: $1,134 .2 = 9% × 1,000   +
 (1 + YTM )
10
 YTM
• 10% PVB = $938.514
• YTM? PVB = Market PriceBond $887 • Since the bond sells at a premium (market PriceBond higher
then its par value), the discount rate must be lower than
• 11% PVB = $882.228
the coupon rate (9%)
YTM - 10% 887 - 938.514 Using the linear interpolation system:
= = 0.92 • 8% PVB = 90x6.7101 +1000/2,1589 = $1,067.109
11% - 10% 882.228 - 938.514
• YTM? PVB = Market Price $1,134.2
YTM = 10 % + (1 % × 0 .92 ) = 10 .92 % • 7% PVB = 90x7.0236 + 1000/1,9673 = $1,140.424

YTM - 7% 1,134.2 - 1,140.424

annual YTM = 10.92% =
8% - 7% 1,067.109 - 1,140.424
YTM = 7% + 0.08% = 7.08%
31 32
 Dr. Ridha ESGHAIER Dr. Ridha ESGHAIER

Yield to Maturity & Pricing Bonds with Spot Rates

bond’s price When a fixed- rate bond is priced using the market discount rate,
the same discount rate is used for each cash flow. A more
fundamental approach to calculate the price of a bond is to use a
sequence of market discount rates that correspond to the cash
flow dates. These market discount rates are called spot rates.

General formula for calculating a bond price given the

sequence of spot rates:
+
= + + ⋯+ Equation.2
( + ) ( + ) ( + )
where Z1, Z2, and ZN are spot rates for period 1, 2, and N, respectively.

33 34

Dr. Ridha ESGHAIER

4. Current Yield, Capital Gains Yield
Example 6: Suppose that the one-year spot rate is 2%, the two-year spot Dr. Ridha ESGHAIER
rate is 3%, and the three-year spot rate is 4%. and Total Return
Q1. Calculate the value of a three-year 5% annual coupon paying bond with The Current Yield provides information regarding the amount of
$100 par value. cash income that a bond will generate in a given year. It is the yield
Q2. Calculate the bond’s Yield to Maturity provided from the interest paid by the bond. The CY is the annual
interest payment divided by the bond’s current price. Unlike the yield to
Q1. + + = . + . + . = . maturity, the current yield does not represent the total rate of return
( . ) ( . ) ( . )
The bond price is $102.960 that investors should expect on the bond.
Q2. This three-year bond is priced at a premium above par value, so its yield- Annual coupon payment
to-maturity must be less than 5%. Using Equation.1 and the price calculated in - Current yield (CY) =
Q1, the yield-to-maturity is 3.935%. Current price
5 5 105
102.96 = + + so, YTM = 3.935% The Capital Gains Yield is used to calculate the return on a bond
(1 + YTM ) 1 (1 + YTM ) 2 (1 + YTM ) 3
based solely on the appreciation or depreciation of the bond (the relative
• When the coupon and principal cash flows are discounted using the yield- change in price)
to-maturity, the same price is obtained.
end price - beginning price
( . )
+
( . )
+
( . )
= . + . + . = . - Capital Gains Yield (CGY) =
beginning price
The present values of the individual cash flows discounted using spot rates
differ from those using yield-to-maturity, but the sum of the present values is
the same. Thus, the same price is obtained using either approach. Total Return (YTM) = Current Yield + Capital Gains Yield
35 36
 Dr. Ridha ESGHAIER Dr. Ridha ESGHAIER

Current Yield, Capital Gains Yield Example 7: Find the current yield, the capital gains yield and
the Total Return (YTM) for a 10-year, 9% annual coupon bond that
and Total Return sells for $887, and has a face value of $1,000.

Annual coupon payment

- The YTM for a bond that sells at par consists entirely of an
1. Current yield (CY) =
Current price
interest yield (Current Yield), [no CGY since PVB is constant over time]
Annual coupon = 9% x $1,000 = $90
- If the bond sells at a price other than its par value then the
YTM will consist of the interest yield (Current Yield) : Current yield = $90 / $887 = 10.15%
plus a positive capital Gains Yield, for Discount bonds [since 2. Total Return (YTM) is the discount rate solving:
PVB increases over time]
plus negative capital gains yield, for premium bonds [since  1 - (1 + YTM ) -10  1,000
PVB decreases over time] ) $ 887 = 90   +
 (1 + YTM )
10
 YTM

According to Example 4, YTM = 10.92%

Total Return (YTM) = Current Yield + Capital Gains Yield
37 38

3. Calculating capital gains yield Dr. Ridha ESGHAIER

5. Semiannual bonds Dr. Ridha ESGHAIER

Although some bonds pay interest annually, the vast majority actually make
YTM = Current yield + Capital gains yield payments semiannually which means they pay two coupon payments (interest)
each year. To evaluate semiannual bonds, we must modify the valuation model as
Capital Gains Yield (CGY) = YTM – Current Yield follows:
= 10.92% - 10.15% 1. Divide the annual coupon interest payment by 2 to determine the dollars of
= 0.77% interest paid each six months. Semiannual coupon intrest = INT/2
2. Multiply the years to maturity, N, by 2 to determine the number of semi-annual
Could also find the expected price one year from now assuming that periods. number of periods = 2N
the bond’s required return (rd) is equal to its expected return (YTM) 3. Divide the required rate of return on the bond, rd, by 2 to determine the periodic
and that this later remains unchanged, then divide the change in price (semiannual) rate = rd/2.
by the beginning price, which gives the same answer.
0 1 2 2N
90 90 1000 rd /2
PVB (1 year from now) =
(1 + rd )1
+ ... + +
(1 + rd )9 (1 + rd )9
...
 1 - (1 + 10 .92 % ) -9  1,000 PVB? INT/2 INT/2 INT/2 + par Value
PV Bond (1year from now) = 90   + = $ 893 .87
 (1 + 10 .92 %)
9
 10 .92 %
INT/2 INT/2 INT/2 Par Value
PV B = + + ... + +
CGY = Change in Price / Current Price = (893.87 - 887) / 887 = 0.77% (1 + rd /2) 1 (1 + rd /2) 2 (1 + rd /2) 2N (1 + rd /2) 2N

It’s a discount bond so YTM = Current Yield plus a positive Capital INT  1 - (1 + rd /2) -2N  Par Value
PV B =  + (1 + r /2) 2N
Gains Yield 39
2  rd /2  d
40
 Dr. Ridha ESGHAIER

Example 8: What is the value of a 9-year, 8% Example 9: Would you prefer to buy a 10-year, 12% annual coupon
bond or a 10-year, 12% semiannual coupon bond, all else equal?
semiannual coupon bond, if the required return
rd=10%? Par value $1,000. 0 1 2 … 10
Annual Coupon Bond
PVBond INT INT … INT
1. Divide annual coupon by 2 : INT/2 = 8%x1,000 /2 = 80/2 = 40 + Par Value

Semi-annual Coupon Bond

0 1 2 … 20
2. Multiply years by 2 : 2N = 2 x9 = 18.
M PVBond INT/2 INT/2 … INT/2
3. Divide required return by 2 : rd/2 = 10%/2 = 5%.  I  + Par Value
EAR% =  1 + NOM  − 1
 M 
- The semiannual bond’s effective rate is:
INT 1 - (1 + rd 2) -2N  Par Value
PVB = + EAR% = (1 + i % / 2 ) − 1 = (1 + 12% / 2 ) − 1 = (1 + 6% ) − 1 = 12.36%
2 2 2

 (1 + rd 2)
2N
2  rd 2
- The annual bond’s effective rate is EAR%= (1+12%/1)1 -1 = 12%
 1 - (1 + 5%) -18  $1,000 12.36% > 12%, so you would prefer the semiannual bond.
PV B = $40   + (1 + 5%) 18
 5%  Payment frequency mainly affects interest compounding. The more frequent a
= $ 883 .12 bond pays its coupon payments, the higher the effective yield of the bond under
the same annual coupon rate. If a bond pays coupon interest semiannually instead
of annually, it will compound interest twice rather than once, increasing total bond
41 returns at the end of a year. 42
Dr. Ridha ESGHAIER

Dr. Ridha ESGHAIER

Dr. Ridha ESGHAIER
Example 10: A Corporation is selling a new issue of bonds to raise b. Yield-to-maturity is YTM solving:
money. The bonds will pay a coupon rate of 10% and will mature in 6
years. The face value of the bonds is $1,000; interest is paid semi-annually.  1 - (1 + YTM 2 )-12  1,000
$1,100 = 50 ×   +
 (1 + YTM 2 )
12
The market rate of interest is currently 8% for similar bonds.  YTM 2

• For YTMd/2 = 4% PVB = 1,093.85

a. What is the fair price for an investor to pay for one of these bonds?
b. If you pay the current price of $1,100 for a bond, what will be your • YTM/2 ? PVB = Market price: 1,100
annual yield-to-maturity? • For YTMd/2 = 3% PVB = 50x 9.9540 + 1,000/1.4257= 1,199.08

INT 1 - (1 + rd 2) -2N  Par Value Using the linear interpolation system

a. Fair Price of the Bond: PVB =  +
 (1 + rd 2)
2N
2  rd 2 YTM/2 - 3% 1,100 - 1,199.08
= = 0.94
2N = 2x 6=12; INT/2= 10% /2 x1,000 = $50 ; Par Value= 1,000; rd/2 = 8%/2 = 4% 4% - 3% 1,093.85 - 1,199.08
YTM / 2 = 3% + 1% × 0.94 = 3.94%
 1 - (1 + 4%) -12  $1,000
PV B = $50   + = $1093.85 YTMd/2 = the semi-annual yield-to-maturity = 3.94%
 (1 + 4%)
12
 4%
→ Annual YTM = 2x 3,94% = 7.88%

Fair Value = $1,093.85

43 44
 Example 11: Dr. Ridha ESGHAIER INT  1 - (1 + rd 2 )-2N  Par Value
(1) Issue Price : PVB =  +
 (1 + rd 2 )
2N
On January 1st, 2010, Mr A purchased a $1,000 (face value) 2  rd 2
five-year, 10% bond issued by a Corporation. Assume that 2N = 2x 5=10; INT/2 = 10% /2 x1,000 = $50 ; rd/2 = 12%/2 = 6%
interest is payable semiannually on January 1st and July 1st, and  1 - (1 + 6 %) -10  $1,000
that the market interest rate (rd) is 12%. PV B = $50   + (1 + 6%) 10 = $926.39
 6% 
(1) What should be the issue price of the bond. Issue Price = $926,39
(2) Compute the discount amount
(2) Discount = face value – issue price = $1,000 - $926.39 = $73.61
(3) January 1st, 2012, after receiving the coupon: Mr A sold this
bond to Mr B. rd at this date is 9%. Compute the bond price at (3) From January 1, 2012 to January 1, 2015 : 3 years so 2N = 6 semesters
which Mr B purchased the bond. rd/2 = 9%/2 = 4,5%
(4) July 1st, 2013, after receiving the coupon : Mr B sold the bond  1 - (1 + 4.5%) -6  $1,000
PV B = $50  + = $1025.78
to Mr C. rd at this date is 10%. Compute the bond price at which  4.5%  (1 + 4.5%) 6
Mr C purchased the bond. (4) From July 1, 2013 to January 1, 2015 : 1,5 years so 2N = 3 semesters
(5) February 7, 2014: Mr C sold the bond to Mr D. The market rd/2 = 10%/2 = 5%
interest rate rd at this date is 11%. Compute the bond price (Full  1 - (1 + 5%) -3  $1,000
Price) at which Mr D purchased the bond. What is the Clean PV B = $50   + = $1,000
 (1 + 5%)
3
 5%
Price?
45 46
Dr. Ridha ESGHAIER

Example 11 : Graph Dr. Ridha ESGHAIER

rd=12% rd=9% rd=10% rd=11%

6. Bond pricing between
1/1/10 1/1/11 1/1/12 1/1/13 1/1/14 1/1/15
two coupon dates
july1 july1 july1 july1 Feb 7 july1

Up to this point we have assumed that we are purchasing

50 50 50 50 50 50 50 50 50 50+1000 bonds whose next coupon payment occurs one payment
PriceA = 926.39 period away, according to the regular payment-frequency
PriceB = 1025.78
pattern. So far, if we were to price a bond that pays semi-
PriceC = 1000 37
annual coupons and we purchased the bond today, our
180 calculations would assume that we would receive the next
coupon payment in exactly six months. Of course, because
P1/1/14 = 990.76 Full2/7/14 = 1001.73
you won't always be buying a bond on its coupon payment
– Accrued interest2/7/14 = 10.27 date, it's important you know how to calculate price if, say, a
Clean2/7/14 = 991.46 semi-annual bond is paying its next coupon in three
Full 2/7/2014 = 990.77 (1.055) 37/180 = $1001.73 months, one month, or 21 days.
Accrued interest = $50 x (37/180) =$10.27
Clean2/7/14 = 1001.73 – 10.27 = $ 991.46 47 48
Dr. Ridha ESGHAIER
 Primary vs Secondary bond market Dr. Ridha ESGHAIER

• Generally, the issuer sets the price and the yield of the bond so that it will Primary and secondary bond markets
sell enough bonds to supply the amount that it desires. Dr. Ridha ESGHAIER

• When a bond is first issued in the primary bond market (where the buyer
buys the bond from the issuer), it is generally sold at par (by setting a Secondary
Primary
coupon rate i equal to the required return by the investors rd), which is the bond
bond
face value of the bond. Most corporate bonds, for instance, have a face and Issuers first sell markets Existing bonds
markets
par value of $1,000. The par value is the principal, which is received at the bonds to are subsequently
end of the bond's term, i.e., at maturity. Sometimes when the demand is investors to raise traded among
higher or lower than an issuer expected, the bonds might sell higher or capital. investors.
lower than par.
• after issuance in the primary market, bonds are traded between investors in
the secondary market. In the secondary market bond prices are almost
A bond issue in primary markets
always different from par, because interest rates change continuously.
can be sold via
When a bond trades for more than par, then it is selling at a premium,
which will pay a lower yield than its stated coupon rate, and when it is
selling for less, it is selling at a discount, paying a higher yield than its a public offering (or public offer), in a private placement, in which only
coupon rate. When interest rates rise, bond prices decline, and vice versa. which any member of the public OR
a selected group of investors may
• Bond prices will also include accrued interest, which is the interest earned may buy the bonds, buy the bonds.
between coupon payment dates but not paid. Clean bond prices are prices49 50
without accrued interest; Full bond prices include accrued interest.

Dr. Ridha ESGHAIER Dr. Ridha ESGHAIER

Clean price, Full price and conventions for quotes and

Accrued interest calculations
Bond price consists of
• Listed bond prices are clean prices (or flat two components
prices), which do not include accrued interest.
accrued interest is the interest earned between
coupon payment dates but not paid. Flat (clean) price (Pclean) Accrued interest (AI)

• Most bonds pay interest semi-annually. For The sum of flat price and accrued interest is the full (dirty) price
settlement dates when interest is paid, the bond (Pfull).
price is equal to the clean (or flat) price. Between
!! = "!#$% + AI
payment dates, accrued interest must be added
to the Clean price (or flat price), which is often Bond dealers Buyers pay the full
usually quote
called the Full price (or dirty price): the flat price.
price for the bond on
the settlement date.
Full price = Clean price + accrued interest
51 52
 Dr. Ridha ESGHAIER
Dr. Ridha ESGHAIER
• When you actually buy a bond on the secondary market, you would have to
pay the former owner of the bond the accrued interest to compensate him Bond pricing between two coupon dates
for the days during which he held the bond from the last coupon payment
date to the date on which you bought the bond from him. If this were not so,
you could make a fortune buying bonds right before they paid interest then Full Price Calculation
selling them afterward.
• Because the interest accrues every day, the bond price increases To compute the Full Price of a bond, follow the subsequent
accordingly until the interest payment date, when it drops to its flat (or
clean) price, then starts accruing interest again. three steps:
• Below is a graph of the purchase price of a bond over 2 years, which is
equal to the flat (or clean) price + accrued interest. (It is assumed that the 1st step: Compute the bond price just after the payment of the
flat (or clean) price remains constant over the 2 years, but would actually
fluctuate with market interest rates, and because of other factors). The flat previous coupon (on the most recent coupon payment date)
(or clean) price is what is listed in bond tables for prices. Note that the bond
price steadily increases each day until reaching a peak the day before an
interest payment, then drops back to the flat (or clean) price on the day of 2nd step: Determine the Number of Days between the desired
the payment. date (or transaction date) and last coupon payment date.

3rd step: Capitalize the computed price (bond price just after
the payment of the previous coupon) until the the desired date
(or transaction date) using the market intrerest rate (rd)
53 54

Dr. Ridha ESGHAIER

Example 11 : (Cont.) Dr. Ridha ESGHAIER

Determining Day Count (5) February 7, 2014: Mr C sold the bond to Mr D. The market interest
To price a bond between payment periods, we must use the appropriate day-count rate (rd) at this date is 11%. Compute the bond price (Full Price) at
convention. Day count is a way of measuring the appropriate interest for a specific which Mr D purchased the bond. What is the bond Clean Price?
period of time. In this course we will use the day-count basis referred to
as actual/actual basis, because the actual number of days are used in the
Solution: Full Price Calculation
calculations. 1st step: the previous coupon payment date is January 1, 2014
The Actual/actual day Count convention : from January 1, 2014 to January 1, 2015: 1 year so 2N= 2
The actual/actual day count is used mainly for Treasury securities. This method counts the exact
number of days until the next payment. For example, if you sold a semi-annual Treasury bond on March INT/2=$50; rd/2 = 11%/2 = 5.5%
13, 2016, and its previous coupon payment was in January 1, 2016), the Number of Days between Bond price (January 1, 2014) :
transaction date and last coupon payment is 72 days:  1 - (1 + 5.5%)
-2
 $1,000
PV 1/1/2014 = $50   + (1 + 5.5%) 2
= $990.76
Time Period = Days Counted 2nd step:  5.5% 
January 1-31 = 31 days
February 1-29 = 29 days Nber of days between transaction date and last coupon payment:
March 1-13 = 13 - 1* days from January 1, 2014 to February 7,2014 (transaction date): (31+7) -1 = 37 days
= 72 days
* When figuring accrued interest using any day-count convention, the 1st day is counted, but not Total days in period (1st semester 2014) = (31+28+31+30+31+30) -1= 180 days
the last day. So in the previous example, January 1st is counted, but not March 13
3rd step:
To determine the day count, we must also know the number of days in the six-month period of the
regular payment cycle. In these six months there are exactly 181 days : (31+29+31+30+31+30) -1, so Bond price (February 7, 2014) = PV1/1/2014 (1+ 5.5%)37/180
the day count of the Treasury bond would be 72/181, which means that out of the 181 days, 72 days of
the payment period have already passed. If the bondholder sold the bond today (March 13, 2016), PVFeb 7,2014 = 990.77 (1.055) 37/180 = $1001.73
he or she must be compensated for the interest accrued on the bond over these 72 days.
55
this is called the bond full price, because it includes an accrued interest 56
(Note that if it is a leap year, the total number of days in a year is 366 rather than 365.)
 Dr. Ridha ESGHAIER
Dr. Ridha ESGHAIER
Clean Price Calculation
To compute the Clean Price of a bond, follow the subsequent Example 12 :
two steps:
Consider the following annual-pay bond:
i=6% (coupon rate)
1st step: Compute the Accrued interest rd = 7% (required yield to maturity)
Issue date : March 1st 2015
The Accrued interest is the interest that has been earned, but not paid.
The accrued interest is calculated by the following formula:
Maturity : after 5 years
Par value : $100
Number of days since Last Payment
Accrued Interest = Coupon Payment ×
Number of days between payments Instructions:
1. Is the bond issued at premium, at discount or at par? Explain!
Accrued interest = $50 x (37/180) =$10.27 2. Calulate the issue price of the bond
3. Calculate the bond price on March 1st 2016 after the payment of
2nd step: Compute the Clean price the coupon, assuming a yield to maturity of 7.5% on that date!
4. Calculate the bond price (full price) on June 5th 2017, assuming a
Clean price = Full price – accrued interest yield to maturity of 6.5% on that date. Determine the clean price!
Clean PriceFeb 7,2014 = 1001.73 – 10.27 = $ 991.46 57 58

Dr. Ridha ESGHAIER

Dr. Ridha ESGHAIER
1. it’s a discount bond since the coupon rate i (6%) is less than the required rate
of return rd (7%) Clean Price Calculation
 1 - (1 + 7%) -5  $100
2. PV March 1st 2015 = 6% × 100   + (1 + 7%) 5 = $95.90 1st step:
 7% 
3. On march 1st 2016 the number of coupon payments remaining until maturity is 4. Number of days since Last Payment
Accrued Interest = Coupon Payment ×
at this date rd is 7.5% Number of days between payments
 1 - (1 + 7.5%) 
-4
$100
PVMarch1st 2016 = 6% × 100   + (1 + 7.5%)4 = $94.98
 7.5%  Accrued interest = 6 x (96/365) =$ 1.58

4. Full price on june 5, 2017?

1st step: bond price just after the payment of the previous coupon payment 2nd step:
On March 1st 2017 the number of coupon payments remaining until maturity is 3.
at this date rd is 6.5% Clean price = full price – accrued interest
 1 - (1 + 6.5%)
-3
 $100
PV March 1st 2017 = 6% × 100   + (1 + 6.5%) = $98.68
 6.5% 
3 Clean Price June 5, 2017 = 100.32 – 1.58 = $ 98.74
2nd step: from March1, 2017 to June 5, 2017: 31+30+31+5 -1= 96 days
Total days in period (year 2017) = 365
3rd step: Bond price (June 5, 2017) = Bond price (March1, 2017) x (1.065)(96/365)
= $98.68 (1.065)(96/365) = $100.32
(this is called the bond full price, because it includes an accrued interest)
59 60
 Dr. Ridha ESGHAIER
Example 12 : Graph Full Price of a bond: the alternative
rd=7% rd=7.5% rd=6.5% formula
3/1/15 3/1/16 3/1/17 1/1/18 1/1/19 1/1/20
Another way to calculate the full price (PVFull) of the bond
June 5 including accrued interest is to compute the present
value of the coupon interest and principal payments, with
6 6 6 6 6+100 each cash flow discounted by the same market discount
Price3/1/15 = 95.9
rate, rd (YTM) by using the following formula:
INT INT INT Par Value
Price3/1/16 = 94.98 PV Full
= + + ... + +
96
(1 + rd ) 1- t/T
(1 + rd ) 2 - t/T
(1 + rd ) N - t/T
(1 + rd ) N - t/T
365 1 − (1 + rd )- N  Par Value
= INT × (1 + rd )t/T   + (1 + r ) N - t/T
 rd  d
Price3/1/17 = 98.68 Full6/5/17 = 100.32
– Accrued interest6/5/17 = 1.58
where INT is the coupon interest payment per period; t is the
number of days from the last coupon payment to the settlement
Clean6/5/17 = 98.74
date; T is the number of days in the coupon period; N is the
Full Price June 5, 201 = $98.68 (1.065)(96/365) = $100.32 number of coupon periods to maturity and t/T is the fraction of the
Accrued interest = 6 x (96/365) =$ 1.58 coupon period that has gone by since the last payment
Clean Price June 5, 2017 = 100.32 – 1.58 = $ 98.74 61 62
Dr. Ridha ESGHAIER

Example 13: A 5.8% semiannual payment corporate bond that matures Q2.
Dr. Ridha ESGHAIER

on 14 February 2027 is purchased for settlement on 11 April 2019. The

INT INT INT Par Value
coupon payments are $2.9 per 100 of par value, paid on 14 February and 14 PV Full
= + + ... + +
August of each year. The yield-to-maturity is 6%. (1 + rd ) 1 - t/T (1 + rd ) 2 - t/T (1 + rd ) N - t/T (1 + rd ) N - t/T
Q1. Calculate the full and the flat price of the bond 2.9 2.9 2.9 + 100
= + + ... + = $99.651
Q2. Find the full price using the alternative formula (1 + 3%) 1 - 56/181 (1 + 3%) 2 - 56/181 (1 + 3%) 16 - 56/181

Q1. There are 16 semiannual periods to maturity between the last coupon
payment date of 14 February 2019 and maturity on 14 February 2027.
The price of the bond at the date of the last coupon payment,14
February 2019, is 1 − (1 + rd ) -N  Par Value
 1 - (1 + 3%) -16 
PV Full
= INT × (1 + rd ) t/T   + (1 + r ) N - t/T
$100 rd
PV 14 Feb 2019 = $2.9   + (1 + 3%) 16 = $98.744   d
 3% 
 1 − (1 + 3% ) - 16  100
The full price of this bond comprises the flat price plus accrued interest. = 2.9 × (1 + 3%) 86/181   +
 (1 + 3% )
16 - 86/181
 3%
The accrued interest is calculated using the actual/actual day convention to
count days. This settlement date is 15+31+11 -1= 56 days into the = $99.651
15+31+30+31+30 +31+14 -1 =181-day semiannual period, so t/T = 56/181.
• Full price for the bond is 98.744x1.0356/181 = 99.651
• Accrued interest is 0.897 (= 2.9 x 56/181) per 100 of par value.
• Clean price = 99.651 – 0.897 = 98.754
Dr. Ridha ESGHAIER 63 64
 Dr. Ridha ESGHAIER

7. The pure discount The pure discount bond is perhaps the simplest kind of
bond. It promises a single payment at a fixed future
(or Zero Coupon) Bond date. If the payment is one year from now, it is called a
one-year discount bond; if it is two years from now, it is
• Some bonds pay no coupons at all but are offered at a called a two-year discount bond, and so on.
substantial discount below their par values and hence
provide capital appreciation rather than interest income. Par Value
These securities are called zero coupon bonds (“zeros”). Most PVB =
(1 + rd )N
zero coupon bonds are Treasury bonds, although a few
corporations, such as Coca-Cola, have zero coupon bonds N : maturity date of the bond.
outstanding. Par Value : par value to be reimbursed at the maturity
date (= Maturity value)
• Some bonds are issued with a coupon rate too low for the rd : required yield to maturity
bond to be issued at par, so the bond is issued at a price less
Pure discount bonds are often called zero-coupon bonds or
than its par value. In general, any bond originally offered at a
zeros to emphasize the fact that the holder receives no cash
price significantly below its par value is called an original
payments until maturity. We use the terms zero, bullet, and
issue discount (OID) bond.
discount interchangeably to refer to bonds that pay no coupons
65 66

Dr. Ridha ESGHAIER Dr. Ridha ESGHAIER

8. Callable (or Redeemable) Bonds

Example 14:
• Most corporate bonds contain a call provision, which gives the
issuing corporation the right to call the bonds for redemption
Consider a zero coupon bond with a face value of $1 prior to its date of maturity. The call provision generally states
million that matures in 20 years. Suppose that the that the company must pay the bondholders an amount greater
required Yield to Maturity rd is 10%. What should be the than the par value if they are called (but lower than the market
value of this discount bond today? price of the bond).
• The additional sum, which is termed a call premium, is often
N = 20 set equal to 1 year’s interest if the bonds are called during the
Par Value : $ 1million to be reimbursed at the maturity date first year, and the premium declines at a constant rate of INT/N
(also called the Maturity value) each year thereafter (where INT = annual interest and N =
rd : 10%
original maturity in years).
• For example, the call premium on a $1,000 par value, 10-year,
Par Value $1 million
PVB = = = $148,643.628 10% bond would generally be $100 if it were called during the
(1 + rd ) N
(1 + 10%)20 first year, $90 during the second year (calculated by reducing
the $100, or 10%, premium by one-tenth), and so on.
67 68
 Dr. Ridha ESGHAIER Dr. Ridha ESGHAIER

Callable Bonds principle Cause of calling a bond

• Bonds are often not callable until several years • The main cause of a call is a decline in market
(generally 5 to 10) after they are issued. This is known interest rates.
as a deferred call, and the bonds are said to have call
protection. • If market interest rates (rd) have declined since a
• Suppose a company sold bonds when interest rates
company first issued the bonds, it will likely want to
were relatively high. Provided the issue is callable, the refinance this debt at a lower rate of interest. In this
company could sell a new issue of low-yielding case, the company will call its current bonds and
securities if and when interest rates drop. It could reissue them at a lower rate of interest, and save
then use the proceeds of the new issue to retire the money.
high-rate issue and thus reduce its interest expense. This would be good for the company but not for
This process is called a refunding operation. the bondholders

69 70

Dr. Ridha ESGHAIER

Example 15: A Company decides to borrow $10 million in the bond market.
Dr. Ridha ESGHAIER
The Yield to Call (YTC)
The bond's coupon rate is 8%. Company’s management believe interest rates will
go down during the 7 year term of the bonds. To take advantage of lower rates in 0 1 2 Call date N
YTC?
the future, the company issues callable bonds. ...
Under the terms of the bonds, the company has the option to call the bonds any
time after year 3. However, if it decides to exercise its right to call, it needs to PVCallable Bond INT INT INT+ Call Price
pay bondholders a call price of $1,020 for every $1,000 of principal. • If you purchased a bond that was callable and the company called it, you
After year 4, interest rates fall to 6%. The company exercises its right to call the would not have the option of holding the bond until it matured. Therefore,
8% bonds. It issues new 6% coupon bonds and pays back the 8% bonds. the yield to maturity would not be earned.
Calculate the amount saved by the company if bonds are called. • If current interest rates are well below an outstanding bond’s coupon rate,
Solution : then a callable bond is likely to be called, and investors will estimate its
- Number of old 8% bonds issued = $10M / $1,000 = 10,000 bonds expected rate of return as the yield to call (YTC) rather than as the yield to
maturity (YTM).
- Amount to be borrowed via the issuance of new bonds to pay back the old bonds =
10,000 x $1,020 = $10.2M • To calculate the Yield to call, solve this equation for YTC:
- Number of new 6% bonds issued = $10,2M/ $1,000 = 10,200 new bonds INT INT Call Price
PV Callable = + ... + +
(1 + YTC) (1 + YTC) (1 + YTC) N
Bond 1 N
- Annual interest payment to new bondholders = 6%x $1,000x 10,200= $612,000
N
INT Call Price
- Annual interest payment to old bondholders = 8% x 1,000 x 10,000 = $800,000 PV Callable Bond = ∑
t=1 (1 + YTC) t
+
(1 + YTC) N
- interest saving = $800,000 - $612,000 = $188,000 each year for 3years
Total amount saved = 3 x $188,000 – ($10.2 – $10M) = $364,000 71 with N : number of years untill call date 72
 Dr. Ridha ESGHAIER

Example 16: A 10-year, 10% annual coupon bond selling for Example 16: A 10-year, 10% annual coupon bond selling for
$1,134.20 can be called in 4 years for $1,050. Par value =$1000 $1,134.20 can be called in 4 years for $1,050. Par value =$1000
Q1- what is the bond’s yield to Maturity (YTM)? Q2- Compute the yield to call (YTC) of the bond

0 YTM? 1 2 10 0 YTC? 1 2 4
... ...
PVB= 1,134.20 100 100 100 + 1,000 PVB= 1,134.2 100 100 100 + 1,050
• YTM ?
• YTC ?
• int = 10%x1,000 =$100
• int = 10%x1,000 =100
• N = 10 ; PVB= 1,134.20 ; Par Value = 1,000 • N = 4 ; PVB= 1,134.20 ; Call price= 1,050
 1-( 1 + YTM) -10  1 ,000  1-( 1 + YTC ) -4  1,050
$1 ,134 .20 = 100   + $1,134 .20 = 100   +
 YTM  ( 1 + YTM) 10  YTC  (1 + YTC )
4

The bond’s annual YTM = 8%. Using the linear interpolation

The bond’s annual YTC = 7.154%.
Dr. Ridha ESGHAIER

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Dr. Ridha ESGHAIER Dr. Ridha ESGHAIER

Q3- If you bought these premium bonds, would you

be more likely to earn YTM or YTC? A call provision is valuable to the firm but potentially
detrimental to investors:
• If interest rates go up, the company will not call the bond,
and the investor will be stuck with the original coupon rate
• Coupon rate = 10% >> YTC = 7.154%. on the bond, even though interest rates in the economy
have risen sharply.
• The company could raise money by selling new • However, if interest rates fall, the company will call the
bonds which pay 7.154%. bond and pay off investors, who then must reinvest the
• It could thus replace bonds which pay 10% interest proceeds at the current market interest rate, which is
($100/year) with bonds that pay only 7.154% lower than the rate they were getting on the original bond.
interest ($71.54/year). In other words, the investor loses when interest rates go up
but doesn’t reap the gains when rates fall. To induce an
Investors should expect a call, hence YTC = investor to take this type of risk, a new issue of callable
7.154%, not YTM = 8%. bonds must provide a higher coupon rate than an otherwise
similar issue of noncallable bonds .

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 Dr. Ridha ESGHAIER
Dr. Ridha ESGHAIER
Example 17: MicroDrive issued a 15-year, 10% annual coupon,
$1,000 par value bond. 1 year after issuance the going interest rate (market
When is a call more likely to occur? rate) had declined from 10% to 5%, causing the price of the bonds to rise to
$1,494.93.
Q1. If you bought this bond one year after issuance at a price of $1,494.93,
what rate of interest would you earn on your investment if you hold it to
• In general, if a bond sells at a premium, maturity?

(coupon rate > market interest rate rd ), a Here is the time line and the setup for finding the bond’s YTM:
call is more likely to occcur. YTM=? 13 14

• So, investors expect to earn: 1,000

– YTC on premium bonds.  1-( 1 + YTM ) -14  1,000
$ 1, 494 . 93 = 100   +
 (1 + YTM )
14
 YTM
– YTM on par & discount bonds.
The YTM is 5%—this is the return you would earn if you bought the
bond at a price of $1,494.93 and you hold it to maturity (14 years from
today. (it’s a 15-year bond and 1 year has gone by after issuance, so
there are 14 years left until maturity date.)
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Dr. Ridha ESGHAIER

Dr. Ridha ESGHAIER
Example 17. cont: suppose MicroDrive’s 10% coupon bonds had a
provision that permitted the company, if it desired, to call the bonds 10 Q3. Do you think MicroDrive will call the bonds when they become
years after the issue date at a price of $1,100. Suppose further that 1 year callable?
after issuance the going interest rate (market rate) had declined from 10%
to 5%, causing the price of the bonds to rise to $1,494.93. MicroDrive’s actions depend on the going interest rate when the
Q2. Calculate the YTC bonds become callable. If the going rate remains at 5%, then
MicroDrive could save 10% - 5% = 5%, or $50 per bond per year, by
Here is the time line and the setup for finding the bond’s YTC: calling them and replacing the 10% bonds with a new 5% issue.

There would be costs to the company to refund the issue, but the
interest savings would probably be worth the cost, so MicroDrive
would probably refund the bonds. Therefore, you would probably
 1-( 1 + YTC ) -9  1,100 earn YTC = 4.21% rather than YTM = 5% if you bought the bonds
$ 1, 494 . 93 = 100   + (1 + YTC ) 9 under the indicated conditions.
 YTC 

The YTC is 4.21%—this is the return you would earn if you bought the
bond at a price of $1,494.93 and it was called 9 years from today. (The
bond could not be called until 10 years after issuance, and 1 year has
gone by, so there are 9 years left until the first call date.)
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Example 18: Call Price, semiannual payment Dr. Ridha ESGHAIER

A 15-year bond with a 10% semiannual coupon and a $1,000 face value
has a nominal yield to maturity of 7.5%. The bond, which may be called Other types (features) of bonds
after 5 years, has a nominal yield to call of 5.54%. What is the bond’s
call price?
• Convertible bond – may be exchanged for common stock
Solution: of the firm, at the holder’s option.
• YTM = 7.5% so YTM/2 = 3.75% ; 2N = 30; INT/2 = 10%/2 x100 = 50 • Warrant – long-term option to buy a stated number of
 1 - (1 + 3.75%) -30  $1,000 shares of common stock at a specified price.
current price = $50 ×   + • Putable bond – allows holder to sell the bond back to
 (1 + 3.75%)
30
 3.75%
the company prior to maturity.
Current price = $1,222.86
• Income bond – pays interest only when interest is
• YTC = 5.54% so YTC/2 = 2.77% ; 2N = 10; INT/2 = 10%/2 x100 = 50 earned by the firm.
 1 - (1 + 2.77%) -10  Call Price • Indexed bond – interest rate paid is based upon the rate
1,222.86 = $50 ×   + of inflation.
 (1 + 2.77%)
10
 2.77%

Call Price = $1,039.93

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Dr. Ridha ESGHAIER

Dr. Ridha ESGHAIER

Types of bonds
• Mortgage bonds: backed by fixed assets
– First mortgage bonds and second mortgage bonds
• Debentures: unsecured bonds
• Subordinated debentures: bonds having a claim on
assets only after the senior debt has been paid off
• Investment-grade bonds: bonds rated triple B or
higher
• Junk bonds: high-risk and high yield

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