1. Introduction
Welcome to this course in bond valuation and analysis using R!
2. About me
I am Vice President at Compass Lexecon, an economic consulting firm. I advise clients on a variety of financial issues, such as valuation and corporate finance.
I am also the author of Analyzing Financial Data and Implementing Financial Models Using R. My book serves as a reference and I encourage everyone to check it out for additional material.
3. Bonds
In this course we focus on the simplest but most common of the group of fixed income instruments - a bond.
A bond is a debt instrument that requires the issuer to repay the lender the amount he or she borrows plus interest over a specified period of time. Using bonds allow us to learn the fundamental concepts of bond valuation and analysis without the unnecessary complications that arise when using more complex fixed income securities.
4. Characteristics of a bond
Each bond has some basic characteristics that define it. We now describe some of these main characteristics.
Each bond has an issuer. This is the entity that borrows the money. Some examples are corporations, governments, or municipalities.
The amount borrowed is called the principal. The principal is also called the par value or face value of the bond.
The amount of interest paid is denoted by the coupon rate. Coupon rates can be paid out at different frequencies, such as annually, semi-annually, or quarterly. Coupons can be fixed for the life of the bond or they can be floating, meaning they change at each payment period.
5. Characteristics of a bond
Most bonds have a maturity date. This is when the bond ceases to become outstanding and the principal is paid back. However, some bonds don't mature. An example are consol bonds issued by the British Government.
Finally, some bonds also have embedded options.
These are features that change the cash flow profile of a bond, such as cutting short the maturity of the bond. An example of this is a callable bond, where the issuer can buyback the bond from the investor earlier than the original maturity date. Bonds with embedded options generally require more complex analyses and are beyond the scope of this course.
6. Bonds in this course
To focus on the fundamental concepts of bond valuation and analysis, we will conduct analysis on a simple, yet realistic bond for the duration of this course.
We will use bonds that pay fixed, annual coupons. Our bond will also have a fixed maturity date with no embedded options.
7. Price vs. value
In this course, we will use the terms "bond price" and "bond value" interchangeably. However, you should be aware that there is a difference between these two terms. The price of a bond is the amount you pay to buy the bond. The value of a bond is how much you think the bond is worth.
Why is this important? Suppose a buyer believes a bond is worth $105, while a seller believes that same bond is worth $95. The two may trade when the price of the bond is $100. This is because the buyer will pay $100 for something he thinks is worth $105 and the seller will accept the $100 because she thinks the bond is only worth $95.
As this example shows, the value of a bond is different for different sellers and buyers. But, if the bond trades frequently, the price of the bond could be considered an average price that eliminates buyer- and seller-specific valuation differences.
So for actively traded bonds, price may be considered the best estimate of the bond's value. However, because many bonds are infrequently traded, the odds are against you in finding such bonds.
8. Let's practice!
Ok that was a lot of material! Now, let's practice!