Bond Valuation Lecture in 2 Easy Steps - Usual Confusion in Bond Value for Valuing Bonds
Okay.
Welcome back again to www.MBAbullshit.com.
The topic for this video is Bond Valuation for Coupon Bonds.
Before we go into actual bond valuation, we should first understand or look at the usual
confusion when it comes to computing bond values.
Remember, you can always go back to www.MBAbullshit.com for cool videos in these topics.
Now, before this video, you should already understand Future Value, Present Value, Net
Present Value and Internal Rate of Return.
If you do not understand this yet, you can watch my other free videos on these topics
first.
Let’s get down to it.
Let’s start with a story.
What if a company sells you a piece of paper for one thousand dollars and this piece of
paper promises to pay the buyer or you, five percent of that one thousand dollars which
is equal to fifty dollars every year for three years.
And it promises to pay-back the entire one thousand dollars at the end of three years,
in addition to the promised fifty dollars at the end of three years.
Remember, every year they are giving you fifty dollars including the third year.
So in the third year, you get the promised fifty dollars plus you get back the entire
one thousand dollars which you paid to the company in the beginning.
Now, this piece of paper is called a “Bond” and bond means promise.
As you know, you make a bond with a friend or you make a bond with a loved one or your
father.
You’re making a promise.
Or in this case, it’s a promise to pay you five percent of one thousand or fifty dollars
every year.
It’s a promise that they will pay you back the entire one thousand dollars that you paid
in the beginning, alright?
Now, in this case, it can be said that the “Face Value” of the bond is one thousand
dollars and the “Coupon Rate” is five percent which is equal to fifty dollars.
It’s so simple.
It’s not confusing at all.
Now, what if the company sells it to the original buyer for one thousand which is the face value
and then the original buyer or you or whoever, sells it to somebody else for another price
like maybe nine hundred thirteen dollars.
So you are not selling it at the face value of one thousand anymore.
You’re selling it at a different price of only nine hundred thirteen dollars.
So now, is the bond value one thousand dollars or is it nine hundred thirteen dollars?
It’s kind of confusing now, isn’t it?
Well, the answer is it’s both.
One thousand dollars is always called the “Face Value.”
The original value is one thousand dollars is called the “Face Value” and that never
changes.
Always is the same.
But after the value change or the price changed because the original buyer sold it to someone
else, this new value over here is called the “Market Value.”
Now you know that the face value is still one thousand dollars and it will always be
one thousand dollars.
But the market value is nine hundred thirteen dollars because that is the amount it was
resold in the real, everyday market.
This is the first usual confusion.
People calculating bond values or yields or whatever, they cannot properly calculate that
unless they know the difference between face value and market value.
Now another question, what if the new owner because you sold it now to another guy, right?
The original buyer sold it to somebody else.
So the new owner is still getting fifty dollars per year because that is five percent of the
face value.
Now the question is, “Is he still getting five percent?”
The answer is NO.
Of course, he is not getting five percent.
Why?
Because fifty dollars is five percent of one thousand dollars but it is not five percent
of nine hundred thirteen dollars.
So how much is the new owner getting in terms of percent?
In terms of dollars the new owner is still getting the same fifty dollars but how many
percent is that?
What is the new percentage?
Well, fifty dollars per year divided by nine hundred thirteen dollars is equal to zero
point zero five four eight or five point forty eight percent.
So this is now the new percentage, is it?
So question is the Coupon Rate still five percent or is it five point forty eight percent?
Confusion here again, right?
The answer is that the Coupon Rate is still five percent but the Current Yield is five
point forty eight percent.
So this five point forty eight percent is called the “Current Yield” but the Coupon
Rate is still five percent.
This is the second usual confusion.
The Coupon Rate never changes.
It is always five percent and it always depends on the Face Value.
The Face Value also never changes.
However, this new percentage you’re getting is now called the “Current Yield.”
Again, Coupon Rate is how much percent based on the Face Value.
The Current Yield is how much percent based on the Market Value.
The Market Value now, as we know, is nine hundred thirteen dollars.
You have to remember this difference.
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