The MBA Math Monday series returns after a break since mid-July for classroom teaching. The series helps prospective MBA students to self assess their proficiency with the quantitative building blocks of the MBA first-year curriculum.
As described in the first three MBA Math Monday finance exercises, quantitative finance builds incrementally. The first and second finance exercises deal with converting a single amount of money at one point in time into a different single amount at a different time. The third exercise, covering constant annuities, deals with converting multiple future cash flows into a single current cash flow.
Bonds, which we cover in this lesson, combine a steady stream of small, periodic coupon payments with a single large payment in the last period. The coupon payments, typically paid every six months, are a constant annuity and the single large payment is a future value.
Companies and governments (local, state, and national) raise money by issuing bonds, typically for long-term projects. The key to valuing bonds is determining the appropriate discount rate to reflect the chance that the borrower will default and fail to pay the borrowed money.
The bond market can turn quickly on companies or governments that appear vulnerable financially. President Bill Clinton’s advisor James Carville famously captured the immense power of the bond market when he quipped that if he could be reincarnated he wanted to come back as the bond market. Understanding bonds begins with the mechanics underlying this exercise.
What is the current value of a $1,000 bond with a 10% annual coupon rate (paid semi-annually) that matures in 5 years if the appropriate stated annual discount rate is 12%?
Solution (with audio commentary): click here