FINANCIAL MANAGEMENT

Bonds
Debt Securities

• Debt securities are issued when an organisation wishes to borrow

money from the public on a long-term basis.
• Bonds are issued by the government.
• Debentures are secured and issued by a corporation.
• Notes are unsecured debt securities issued by a corporation.
• More recently, these are all known as bonds.
Definitions

• Coupon: The stated interest payment made on bond

• Face Value: The stated principal value that is repaid at the end of the
term at the maturity of the bond
• Also called par value
• Usually in denominations of $1,000
• Maturity: The specified date on which the principal amount of the
bond is paid
Bond Yields
• Yield to maturity is the market interest rate that equates a bond’s
present value of interest payments and principal repayment with its
price.
• There is an inverse relationship between market interest rates and
bond price.
Bond Value

V  PV of coupon payments  PV of face value

1  1/ 1  r t 
C   
F
r 1  r t
Example 1—Bond Value

• A bond with a face value of $1000 and a coupon rate of 6 per cent has 10
years to maturity. What is the market price of this bond if the market
interest rate is 10 per cent?

V  $60 

1  1/ 1.10 10

 $1000
0.10 1.10 10
 $60  6.1446  
$1000
2.5937
 $771.10
BOND-par, premium and discount

• Par Value Bond: A bond that sells for exactly the face value after
being discounted at YTM
• Condition: Coupon Rate= YTM
• Premium Value Bond: A bond that sells for higher than the par value
• Condition: Coupon Rate > YTM
• Discount Value Bond: A bond that sells for lower than the par value
• Condition: Coupon Rate < YTM
 Interest Rate Risk

• Interest rate risk: is the risk that arises for bond holders from changes in
interest rates.

• All other things being equal, the longer the time to maturity, the greater
the interest rate risk.
• Why? Because a large part of the bond’s PV is derived from its Face
Value
• Longer the compounding periods, greater the effect on the PV of the
face value
Interest Rate Risk

• All other things being equal (bond maturity time etc), the lower the
coupon rate, the greater the interest rate risk
• Why?
• Because the bond with the smaller coupon amounts means that its
value is derived mostly from the Face Value which is susceptible to
interest rate fluctuations
FISHER EFFECT

• Real Rates of Interest:

Interest rate that has been adjusted for inflation

• Nominal Rates of Interest:

Interest rate that has not been adjusted for inflation

• Fisher effect: Shows the relationship between inflation, nominal rate

and real rate of returns
FISHER EFFECT

Fisher Effect:

1+R= (1+r)(1+h)

R: Nominal Rate h: Inflation

r: Real Rate
Fisher Effect

• Nominal Rate: 15.50%

• Inflation: 5%
• Real Rate=?

Stated Simply,

R ~ r+h