TAILIEUCHUNG - Fi8000 Valuation of Financial Assets

Trichet bonds will be long-duration (30-year) new bonds issued by countries in the EU featuring a 30-year zero-coupon bond issued by the ECB, to be held as collateral for the new sovereign bonds, to insure at least the full payment of principal at maturity. The new bonds are to be issued at market interest rates, but will be offered for old debt at market value (now about 65- 70% of face value). Present debt holders will face a significant haircut (of the order of 30-35% for Greece and Ireland) because new bonds will be sold/exchanged at present market prices. Because the bond exchange will occur at. | Fi8000 Valuation of Financial Assets Fall Semester 2009 Dr. Isabel Tkatch Assistant Professor of Finance Debt instruments Types of bonds Ratings of bonds default risk Spot and forward interest rate The yield curve Duration Bond Characteristics A bond is a security issued to the lender buyer by the borrower seller for some amount of cash. The bond obligates the issuer to make specified payments of interest and principal to the lender on specified dates. The typical coupon bond obligates the issuer to make coupon payments which are determined by the coupon rate as a percentage of the par value face value . When the bond matures the issuer repays the par value. Zero-coupon bonds are issued at discount sold for a price below par value make no coupon payments and pay the par value at the maturity date. Bond Pricing - Examples The par value of a risk-free zero coupon bond is 100. If the continuously compounded risk-free rate is 4 per annum and the bond matures in three months what is the price of the bond today A risky bond with par value of 1 000 has an annual coupon rate of 8 with semiannual installments. If the bond matures 10 year from now and the risk-adjusted cost of capital is 10 per annum compounded semiannually what is the price of the bond today Yield to Maturity - Examples What is the yield to maturity annual compounded semiannually of the risky couponbond if it is selling at 1 200 What is the expected yield to maturity of the risky coupon-bond if we are certain that the issuer is able to make all coupon payments but we are uncertain about his ability to pay the par value. We believe that he will pay it all with probability pay only 800 with probability and won t be able to pay at all with probability . Default Risk and Bond Rating Although bonds generally promise a fixed flow of income in most cases this cash-flow stream is uncertain since the issuer may default on his obligation. US government bonds are usually treated as free of default credit

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