Bond Valuation and Bond Markets

Valuation Problem

Establishing the value today of future cashflows, central to finance.

Risk and Required Returns

Required return linked to uncertainty about future cash flows; higher uncertainty = higher required return.

Investor Required Return

The interest rate required by investors based on the risk of the investment.

Security Market Pricing

Investor's estimate future cashflows and discount them to establish market price of securities.

Bond Definition

A financial asset issued when a government or corporation borrows money, promising regular interest payments and face value at maturity.

Maturity Date

The contractual final redemption date of a bond.

Principal or Face Value

The amount that the issuer agrees to repay, generally calculated for interest.

Coupon Rate

The stated interest rate paid under the bond, usually fixed until maturity.

Callable Bonds

Bonds that grant the issuer the right to repurchase the bond before maturity.

Convertible Bonds

Bonds that give investors the option to exchange them for specified securities.

Zero-Coupon Bonds

Bonds that pay only the face value at maturity with no regular coupon payments.

Primary Market

The market where new bonds are sold through auctions and investment banks.

Secondary Markets

Markets for trading existing bonds, typically involving dealers and brokers.

Bond Valuation Process

1. Define cashflows. 2. Calculate aggregate present value of those cashflows.

Yield to Maturity (YTM)

The discount rate used to calculate the market price of the bond, estimating the expected return if held to maturity.

Price Relationship with Interest Rates

As interest rates increase, bond prices decrease and vice versa.

Interest Rate Risk

The risk of fluctuations in bond prices due to changes in interest rates.

Holding Period Return

The internal rate of return on a bond considering its cash flows over time.

Zero Coupon Bond Returns

Returns are based on the discounted price paid and the full par value received at maturity.

Corporate Bond Pricing

Corporate bonds must provide higher yields than Treasury bonds due to potential default risk.

Default Risk

The likelihood that a corporation will fail to make required bond payments.

Bond Rating Agencies

Agencies that assess the default risk of corporations; major ones include Moody's and Standard & Poor's.