we're talking about bomb theory in this
video bomb theory unfortunately that
does not revolve around the discussion
of James Bond movies like Casino Royale
in Skyfall though I'd love to talk about
those movies for 30 minutes at a time
will actually be discussing fixed
instruments otherwise known as bonds and
more specifically discounts premiums and
par bonds so in this example I'm going
to say that we are McDonald's and we're
going to issue some bonds to open up a
new greasy location where we can sell
some really cheap burgers and let's say
that we need $100,000 so we're going to
issue a bond for $100,000 and the stated
rate will be 10% and the term will be
for five years so the timeline for this
bond will look something like this we're
going to have five tick marks one two
three four five and the interest each
year will be 10% of $100,000 or $10,000
of interest a year for five years now
let's say one year from today we decide
to issue another $100,000 bond but
interest rates have changed due to
market supply and demand therefore this
second bond the green bond that I have
in the bottom right corner which I'm
moving at the moment is going to be
issued at 12% so the face value is going
to be the same it's going to be $100,000
let's the stator rate is going to be 12%
and in this example I want you to
consider this 12% as the stated rate or
the coupon rate but also the market rate
so the 12% represents both of those and
so the duration is the same five years
so the time line is going to actually
look very similar to the first one we're
going to have five tick marks one two
three four five and the interest is
going to be 12% of $100,000 or $12,000 a
year
now the question is who's going to want
to purchase this bonds the $10,000 a
year interest bond surely james bond is
going to want to purchase that he's
going to want to purchase the latter
bond which gives you twelve thousand
dollars of interest a year this bond is
no longer attractive to investors
because they're receiving less of a
return than the 12% market rate that
you're getting from the second bond
therefore there has to be an incentive
to purchase this first bond because they
need to sell it and what does a retail
store like Walmart do if products are
not selling they do to discount it so
we're going to take this $100,000 price
cross it out and it's going to be now
less than $100,000 we're going to issue
this at a discount because when things
aren't selling we got to put them on
sale so we're going to discount it and
it'll cost less than a hundred thousand
dollars and that way it'll be
competitive so this bond is now
discounted and you'll notice that when
the stated rate of a bond is less than
the market rate it's going to be issued
at a discount so there's going to be a
discount on that bond so you can see
here that the the stated rate is ten
percent of this bond well the market
rate is 12% therefore there's going to
be a discount on this bond to make it as
attractive now let's look at a different
scenario I'm just going to erase this
what do I need to erase I probably need
to erase this as well and this time line
okay so now let's say that the face
value is going to be for a hundred
thousand dollars again
but the the market rates and the stated
rate is going to be each percent so I'm
going to cross it this twelve percent
it's now eight percent and the five-year
duration will be the same so on the
timeline we're going to be receiving one
two three four five and we're going to
be receiving payments of eight thousand
dollars a year or eight percent times
one hundred thousand dollars for the
next five years now this bond is not as
attractive people are going to want to
purchase the first bond so the first
bond is actually going to have to trade
upwards of one hundred thousand dollars
so it's going to be trading at 101 102
103 thousand in order for this bond to
be equally as attractive so my second
point is that this bond will be trading
at a premium so when the stated rate
which you can see here is ten percent is
greater than the market rate which it is
because the market rate is 8 percent on
similar instruments then it's going to
be trading at a premium because more
people want this 10 percent bond
therefore they need to raise the price
to cover the demand for it so that's how
discounts and premiums work and if the
stated rate is equal to the market rate
then they'll be trained at par which
just means that the amount that you
invest one hundred thousand dollars will
be the same as the face value or the
amount that they'll pay you back at the
end which is also one hundred thousand
dollars and one point I wanted to make
is that discounts in premiums do not
represent which bond is better or worse
to buy all it represents is that the
stated rate is less than the market rate
or that the state irate is greater than
the market rates so don't think that
just because
has a bond is selling at a discount that
it's a better bond or that if it's
selling at a premium that it's a worse
bond that would be incorrect so I'm
going to leave it at that and in the
next tutorial we'll be discussing
long-term bonds I and I'm trying to
think of what else will be covering I
guess I'll think of it when it comes to
me in the next tutorial so I'll see you
guys then