Module 2: Bond Valuation
Arthur Taburet
Duke Fuqua
2025
Arthur Taburet Module 2: Bond Valuation 1
Outline
Topics
1. Overview of bond markets
2. Valuation of bonds
Zero-coupon bonds
Coupon bonds
Arbitrage
3. Finding discount rates
4. The term structure
5. Bond risk
Readings
Berk and DeMarzo: section 5.3; sections 6.1-6.4
Practice Problems
Problem set #1
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Overview of the bond market
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What is a bond?
A bond is a contract in which:
Issuer (borrower) promises to repay the investor (lender)
The issuer repays the owner of the bond some amount over some specified period of time
Bonds are also called fixed income securities
Because the cash flows are specified in the contract
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Type of bonds
Bonds differ in several respects:
Issuer
When and period over which the payments are made
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Example of a bond: coupon bonds
A coupon bond promises:
a periodic interest payment (e.g., every 6 months or year) called coupons
The repayment of the face value (F ) of the bond at the maturity date (T )
Here is the timeline for the payments made by a bond with an annual coupon C and a
face value of F :
maturity
date
0 1 2 3 ··· T −1 T
C C C ··· C C +F
coupon face
value
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Why is it called coupon?
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Coupon bond: Additional terminology
The coupon bond contract often reports the debt face value and the coupon rate instead of the
coupon
Coupon rate: The annual percentage rate that the issuer agrees to pay on the face value
There is a link between the coupon rate and the coupon:
For a bond that makes m payments a year, the coupon is given by:
F × Coupon Rate
C=
m
For example, a $1, 000 bond with a 6% coupon rate and semiannual coupons pays:
$1, 000 × 6%
= $30 every 6 months.
2
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Types of bonds by repayment
$1,000
Example:
0 6m 1yr
1. Pure Discount or Zero-Coupon Bonds
Pay no coupons prior to maturity
Pay the bond’s face value at maturity
2. Coupon Bonds
C + $1,000
Pay a stated coupon at periodic intervals prior to C C C
Example:
maturity 0 6m 1yr 18m 2yrs
Pay the bond’s face value at maturity
3. Floating-Rate Bonds
Pay a variable coupon, reset periodically to a
reference rate (e.g., 13-week Treasury bill) C2yr + $1,000
C6m C1yr C18m
Pay the bond’s face value at maturity Example:
0 6m 1yr 18m 2yr
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Types of bonds by repayment
C C C ···
Example:
4. Perpetual Bonds (Consols) 0 6m 1yr 18m ··· ∞
No maturity date
Pay a stated coupon at periodic intervals
5. Annuity or Self-Amortizing Bonds
Pay a regular fixed amount each payment period C C C C
Example:
Principal repaid over time rather than at maturity 0 6m 1yr 18m 2yr
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Types of bonds by issuer: U.S. government bonds
1. Treasury bills
No coupons (zero coupon security)
Face value paid at maturity
Maturities up to one year
2. Treasury notes
Coupons paid semiannually
Face value paid at maturity
Maturities from 2-10 years
3. Treasury bonds
Coupons paid semiannually
Face value paid at maturity
Maturities over 10 years
The 30-year bond is called the long bond
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Types of bonds by issuer: Corporate bonds
Corporate bonds
Bonds issued by corporations
Bond indentures
Includes bond payment terms, redemption, and covenants
Seniority: Secured bonds; Debentures
Coupon: Fixed-rate versus floating-rate bonds
Investment-grade vs. below investment-grade bonds
Additional features:
Call provisions
Convertible bonds
Puttable bonds
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Debt of Nonfinancial Sectors, 1952 - 2024
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Bond Valuation
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Zero-coupon bonds
Notation
P is the market price of the bond
F is the face value
R is the Annual Percentage Rate (APR), which is the discount rate when payments are made annually
T is the maturity (in years)
Two cash flows to the purchaser of the bond:
Pay the price P at time 0 and receive the face F at time T
F
What is the price of a bond? Use the present value formula: P = (1+R)T
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F
Why should we have P = (1+R)T?
Consider you can get a return of (1 + R)T − 1 on any dollar you invest for T years
The return y from investing in a zero-coupon bond with maturity T and face value F is y := PF − 1
Consider two cases:
if P > (1+FR)T : The return on the bond y is lower than (1 + R)T
=⇒ nobody would want to buy it =⇒ demand goes down =⇒ P goes down
if P < (1+FR)T : The return on the bond y is higher than (1 + R)T
=⇒ everyone would want to buy it =⇒ demands goes up =⇒ P goes up
The present value of a bond should be equal to its price
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Example: Valuing zero coupon bonds
What is the current market price of a U.S. Treasury strip that matures in exactly 5 years and has a
face value of $1, 000. The APR is 4% with annual compounding?
Answer: R = 4%, m = 1, F = 1000, T = 5
1, 000
P= = $821.9
1.045
What is the APR on a U.S. Treasury strip that pays $1,000 in exactly 2 years and is currently selling
for $942.59 with annual compounding?
Answer:
r
1, 000 1, 000
P = 942.59 = ⇒R= − 1 = 3%
(1 + R)2 942.59
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Example: Valuing an amortization bond
Consider the following amortization bond:
Maturity T = 2 years
Pay coupon every 6 months m = 2
The periodic payments are C = $1,000
The APR is R = 10% ⇒ the discount rate is r = R/m = 10%/2 = 5%
How can we value this security?
Brute force discounting
Replication (i.e., use the price of other securities, more on next slides)
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Brute force discounting
The cash flow associated with the bond is:
$1,000 $1,000 $1,000 $1,000
0 6 months 12 months 18 months
24
Using the constant annuity formula, we get:
1, 000 1
PV = [1 − ] = $3, 545.95
5% (1 + 5%)4
The price of the bond should be $3, 545.95
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Replication
Coupon bond: $1,000 $1,000 $1,000 $1,000
0 24
Zero 1: $1,000
|
|
0 6
Zero 2: | $1,000
|
|
0 12
Zero 3: | | $1,000
|
|
0 18
Zero 4: $1,000
|
| | | |
0 6 12 18 24
Compare with a portfolio of zero-coupon bonds:
Coupon Bond Zero 1 Zero 2 Zero 3 Zero 4
Period/Price
3,545.95 952.38 907.03 863.84 822.70
1 1,000 1,000 0 0 0
2 1,000 0 1,000 0 0
3 1,000 0 0 1,000 0
4 1,000 0 0 0 1,000
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A first look at arbitrage
Reconsider the amortization bond. Suppose it trades at $3, 500
Can make riskless profit
Buy low: buy amortization bond
Sell high: Sell the portfolio of zero-coupon bonds
Coupon Bond Zero 1 Zero 2 Zero 3 Zero 4 Total
Period/Price
(3,500) 952.38 907.03 863.84 822.70 45.95
1 1,000 (1,000) 0 0 0 0
2 1,000 0 (1,000) 0 0 0
3 1,000 0 0 (1,000) 0 0
4 1,000 0 0 0 (1,000) 0
Risk-free profit of $45.95
No risk-free profit if the price is correct
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Arbitrage
The price of two assets (A and B) that deliver the same stream of cash flow should be the same
We can use this proposition to price assets or to find arbitrage strategies:
Pricing: If we know the price of A, we can infer the price of B
Arbitrage: If the two prices are not the same, we can make risk-free profits
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Valuing coupon bonds. The general formula
What is the market price of a U.S. Treasury bond that has an annual coupon C, face value F and
matures exactly T years from today if the required rate of return is R, with m-periodic
compounding?
Semiannual coupon is: c = C/m
Effective periodic interest rate is: r = R/m
number of periods N = mT
c c c c c +F
0 1 2 3 4 N
c 1 F
P = Annuity + Zero = · 1− +
r (1 + r)N (1 + r)N
Note: This formula is true when the yield curve is flat, we will see in the term structure subsection that it
is not necessarily the case
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Valuation of coupon bonds. Example 2: Standard coupon
bonds
What is the market price of a U.S. Treasury bond that has a coupon rate of 9%, a face value of $1,000
and matures exactly 10 years from today if the interest rate is 10% compounded semiannually?
$45 $45 $45 $45 $1, 045
0 6 12 18 24 120months
45 1 1, 000
B= · 1− + = $937.69
0.05 1.0520 1.0520
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How to find discount rates (APR)?
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Discount rates
Discount rate= Time value of money + Risk
Typically:
Data on government bonds (i.e., risk-free) is used to find the time value of money
A model (called CAPM), together with data on financial assets, are used to recover the
risk component (Module 5)
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How to find discount rates (APR)?
So far, we have valued bonds by using a given APR, then discounted all payments to the present.
How to find the APR in practice?
Find data on government bond prices
Infer the APR using:
Observable Depends on cash flow and the APR
z }| { z }| {
Market price of the Bond = Present Value
The above equation can be solved to find the APR.
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Example
A zero-coupon bond with maturity one year and a face value of $1,100 trades at $1,000.
What is the APR?
F F 1, 100
P= ⇐⇒ 1 + R = = = 1.1
1+R P 1, 000
This process can be done for bonds of any maturity
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The term structure of interest rates
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The term structure of interest rates
So far, we have assumed that the APR is the same for all maturities
In practice, the interest rate at which you can borrow/invest for, say, 1 year is often different from
the rate at which you can borrow/invest for, say, 5 years
The relationship among interest rates for different maturities is known as the term structure of
interest rates or yield curve
When interest rates are the same for all maturities we say the term structure is flat
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The term structure of interest rates
The term structure of U.S. interest rates in November 2006, 2007, and 2008 was:
6%
Term Date
(years) Nov-06 Nov-07 Nov-08 November 2006
0.5 5.23% 3.32% 0.47% 5%
1 4.99% 3.16% 0.91%
2 4.80% 3.16% 0.98% 4%
Interest Rate (EAR)
3 4.72% 3.12% 1.26% November 2007
4 4.63% 3.34% 1.69%
3%
5 4.64% 3.48% 2.01%
6 4.65% 3.63% 2.49% November 2008
7 4.66% 3.79% 2.90% 2%
8 4.69% 3.96% 3.21%
9 4.70% 4.00% 3.38% 1%
10 4.73% 4.18% 3.41%
15 4.89% 4.44% 3.86% 0%
20 4.87% 4.45% 3.87% 0 2 4 6 8 10 12 14 16 18 20
Term (Years)
The term structure was,
close to flat at 5% in Nov 2006
upward-sloping from 0.5% (short-term) to about 4% (long-term) in November 2008
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Implication for asset pricing
When the term structure is not flat, the APR is different for each maturity
The cash flow at time: 1 2 3 ···
should be discounted at: r1 r2 r3 ···
and we refer to r1 , r2 , r3 , . . . as the spot rates
We therefore need to compute the present value of the bond’s cash flows as follows:
C C C +F
P0 = + +···+
(1 + r1 ) (1 + r2 ) 2 (1 + rT )T
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The term structure of interest rates: An example
In November 2006, you hold a risk-free bond that will pay you the following cash flows:
Nov 2007 Nov 2008 Nov 2009 Nov 2010
Cash Flows 50 50 50 1,050
Use the data from the previous slide to answer the following questions:
1. What is the present value of the bond’s cash flows in Nov 2006?
Answer:
50 50 50 1,050
P2006 = + + + = 1,012.81
1.0499 (1.0480)2 (1.0472)3 (1.0463)4
2. It is now November 2008. You have received the first two cash flows, and the bond will pay the last two
cash flows in 1 and 2 years, respectively. What is the present value of these cash flows at that point?
Answer:
50 1,050
P2008 = + = 1,079.27
1.0091 (1.0098)2
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Example
Bond A: zero-coupon bond with maturity one year, face value of $100, trades at $95
Bond B: zero-coupon bond with maturity of two years, face value of $110, trades at $90
What is the APR for one year and for two years?
What is the fair price of a two-year coupon bond with face value 100 and a coupon rate of 10%
paid yearly?
Suppose that the two-year coupon bond trades at $100. How can you make money?
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Solution
The APR for one and two years are respectively:
F F1 100
P1 = ⇐⇒ R1 = − 1 = ≈ 0.05
1+R P 95
r
F2 F2
P2 = ⇐⇒ R2 = − 1 ≈ 0.11
(1 + R)2 P2
The fair price of a bond is equal to its present value:
c c +F
0 1yr 2yr
c c +F 10 10 + 100
PV = + ≈ + ≈ 99.5
1 + R1 (1 + R2 )2 1.05 1.22
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Solution
The PV of the bond is lower than its market price =⇒ the bond is overvalued
Trading strategy:
Sell the overvalued bond (e.g., 100 bonds)
Replicate its payoff using the zero-coupon bonds (buy 10 bond A and buy 100 bond B)
Coupon Bond Zero 1 Zero 2 Total
Period/Price
(100) 9.5 90 0.5
1 10 (10) 0 0
2 100 0 (100) 0
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The shape of the term structure
As the following figure shows, the term structure usually slopes up: long-term rates (e.g., 10-year)
are above short-term rates (e.g., 3-month)
This is not always the case: the term structure tends to invert before recessions
Source: Federal Reserve Bank of St. Louis, [Link]
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Term structure as a leading indicator
The slope of the treasury yield curve, (r10 − r0.25 ), is a predictor of future real economic activity
A high slope means good times ahead
A low (negative) slope forecasts a recession
Why does a downward sloping yield curve predict recessions?
It means that the market expects the spot rate in one year to be low (Why? see next slide)
=⇒ Market expects weaker demand for investment in the future (because of an economic
slowdown)
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Example: Term structure as a leading indicator
Suppose the spot rates are:
r1 = 0.5% indicating that the current rate for a one-year loan
r2 = 1% indicating that the current rate for a two-year loan
Let r11 denote the expected one-year rate in one year from now
What does the market expect the future one-year spot rate to be in one year?
It should be the same to invest in one dollar in r2 or in r1 then in r11 , thus:
(1 + r2 )2
(1 + r2 )2 = (1 + r1 ) · (1 + r11 ) ⇐⇒ 1 + r11 =
1 + r1
So when r1 high (downward slopping yield curve), we should have r11 low
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Bond risk
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Bond Prices
Consider the following zero-coupon bonds (bonds 1 and 2), issued by the US government with
a one-year maturity:
Bond Price Face Value
Bond 1 $950 $1,045
Bond 2 $800 $880
Because the face value is different, it is hard to compare them
Also, investors care, ultimately, about returns rather than prices
=⇒ Practitioners often report the bond’s "Yield to Maturity"
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The concept of a “Yield to Maturity”
In practice, practitioners report yield to maturity rather than bond price
Definition: The yield to maturity is the interest rate that equates the present discounted value of
all future payments to bondholders to the market price
Here is the algebraic expression:
T
Ct
P= ∑ (1 + y)t
t=0
The yield on a bond is the return that an investor will earn if she buys the bond today and
holds it until maturity
In general, solving for a bond’s yield requires a numerical search
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Previous example
Going back to our previous example
Bond Price Face Value Yield to Maturity
Bond 1 $950 $1,045 10%
Bond 2 $800 $880 10%
The two bonds have the same yield to maturity ( 1,045
1.10 = 950,
880
1.10 = 800 )
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Yield to maturity and discount rates
The yield to maturity is different from the discount rate (APR)
Yields and discount rates are only equal for zero-coupon bonds
Example: Consider a two-year coupon bond with face value F and a coupon of c = 10 paid
yearly and a price P = 100, its yield (y) solves:
10 10 + 100
P = 100 = +
1 + y (1 + y)2
The price of P = 100 must be consistent with discount rates (r1 , r2 ) that compose the yield curve:
10 10 + 110
P= +
1 + r1 (1 + r2 )2
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The concept of a “Yield to Maturity”
Example:
A coupon bond has a face value of $1,000, pays annual coupons of $50, and matures exactly 10 years
from now. The bond’s market price is $926.08
What is the bond’s yield to maturity?
50 1 1,000
926.08 = · 1− +
yield (1 + yield)10 (1 + yield)10
⇒ The implied yield is 6%
Note that for B = $1,000 we find that the yield = 10%
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Credit risk
Consider a risk-free zero-coupon bond:
1 year maturity, face value of 110 and price of 100
110
The bond yield to maturity is: y = 100 − 1 = 10%
Now consider another zero-coupon bond with the same maturity and face value, but:
The face value will only be paid fully with probability 0.5 because the issuer may go
bankrupt
The cash flow is: 110 with probability 0.5 and 100 with probability 0.5
110
Suppose the bond’s price is also 100, the bond yield to maturity is: y = 100 − 1 = 10%
110
However, the expected return of investing in that bond is: 0.5 · ( 100 − 1) + 0.5 · ( 110
100 − 1) = 5%
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Credit risk
When investing in fixed-income securities, the cash flows are specified in the contract
However, issuers may be unable to repay
=⇒ Investors should thus assess the issuer’s ability to repay
Credit agencies provide a score for the issuer quality to help investors
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Bond Ratings
Three rating agencies: Moody’s, Standard & Poor’s, Fitch
Moody’s:
Bonds rated above Ba considered Investment Grade. Below Ba considered speculative, also known as Junk or High-Yield
bonds
Source: Moody’s investors services ([Link]
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Bond Ratings
The ’BBB’ category is the largest by dollar amount, with 40.1% of the total, followed by the ’A’ category with 27.3%
In terms of issuers, the ’B’ category stands out as it accounts for the largest share of U.S. issuers (with close to a one-third), yet only 12.5% of rated debt. Speculative grade rated
issuers tend to have smaller amounts of debt outstanding
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Interest rate risk
Imagine you hold a portfolio of bonds and plan to sell it before maturity
The price at which you can sell depends on the APR
How does the price of bonds vary with the discount rate?
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Interest rate sensitivity of zero-coupon bonds
Consider the following 1, 2 and 10-year zero-coupon bonds, all with face value of F = 1, 000. The
APR, R, is 10%, compounded annually
We obtain the following table for increases and decreases of the interest rate by 1%:
Bond 1 Bond 2 Bond 3
Interest Rate (R)
1-Year 2-Year 10-Year
9% 917.43 841.68 422.41
10% 909.09 826.45 385.54
11% 900.90 811.62 352.18
Bond prices move up if interest rates drop, decrease if interest rates rise
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Bond prices are inversely related to interest rates
Longer term bonds are more sensitive to interest rate changes than short term bonds
The lower the interest rate, the more sensitive the price
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Conclusion
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Summary
Bonds can be valued by discounting their future cash flows
Discount rates for safe investments can be found using government bonds data
The term structure of interest rates
Potential information about expected future spot rates
Bond prices change inversely with the discount rate
Price response of bond to interest rates depends on term to maturity
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