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Ch. 6: Interest Rates and Bond Valuation

Ch. 6: Interest Rates and Bond Valuation. Bond Features and Prices More Features and Types Bond Quotations & Yield Calculations Inflation and Interest Rates Term Structure and Yield Curve Determinants of Bond Yields. Bond Features & Prices. Par Value Coupon Interest Rate Maturity Date

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Ch. 6: Interest Rates and Bond Valuation

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  1. Ch. 6: Interest Rates and Bond Valuation • Bond Features and Prices • More Features and Types • Bond Quotations & Yield Calculations • Inflation and Interest Rates • Term Structure and Yield Curve • Determinants of Bond Yields

  2. Bond Features & Prices Par Value Coupon Interest Rate Maturity Date Issue Date Price and Yield to Maturity

  3. Present Value of a Bond Find PV :10-year, 10% annual coupon bond if r= 10% 0 1 2 10 . . . 100 100 100 + 1000 PV = $90.91 + . . . + $38.55 + $385.54 = $1,000

  4. The bond consists of a 10-yr, 10% annuity of $100/yr plus a $1,000 lump sum at t = 10: PV of annuity PV of lump sum PV of bond = $614.46 = 385.54 = $1000.00 Solution on HP-10B: INPUTS 10 10 100 1,000 N I/YR PV PMT FV -1,000 OUTPUT

  5. What would happen to the PV of this bond if the market interest rate rose to 13%? INPUTS 10 13 100 1000 N I/YR PV PMT FV ? OUTPUT When r rises above the coupon rate, the bond’s value falls below par, so it sells at a discount.

  6. What would happen if the market interest rate declined to 7%? 10 7 100 1,000 N I/YR PV PMT FV ? INPUTS OUTPUT Price rises above par, and the bond sells at a premium, if coupon rate > r.

  7. Interest Rate Risk The risk that arises for bond owners from fluctuating interest rates. How sensitive the bond’s price is to interest rate changes.Other things equal, interest rate risk is greater the longer the time to maturity the lower the coupon rate

  8. Debt versus Equity • Debt • Not an ownership interest • Creditors do not have voting rights • Interest is considered a cost of doing business and is tax deductible • Creditors have legal recourse if interest or principal payments are missed • Excess debt can lead to financial distress and bankruptcy • Equity • Ownership interest • Common stockholders vote for the board of directors and other issues • Dividends are not considered a cost of doing business and are not tax deductible • Dividends are not a liability of the firm and stockholders have no legal recourse if dividends are not paid • An all equity firm cannot go bankrupt

  9. The Bond Indenture TermsSecuritySeniorityRepayment, Sinking FundCall ProvisionsProtective Covenants

  10. Some Bond Types TreasuryMunicipalZero CouponConvertibleFloating RateOther

  11. Bond Quotations Corporate Bonds ATT 71/206 7.4 45 101 +1/4 Treasury Bonds 9 Nov18 129:23 129:29 +40 6.26

  12. Reading Bond Quotations, Understanding Bond Talk Friday, October 4, 1996 Maturity Ask Rate Mo/Yr Bid Asked Chg. Yld. 6 3/4 Aug 26 100:05 100:07 +43 6.73 “A surprisingly weak employment report Friday morning doused inflation fears, ignited a bond market rally ... the price of the Treasury’s benchmark 30-year bonds leaped more than a point ...” (WSJ 10/7/96)

  13. Yield to Call Example A 10-year, 10% semiannual coupon, $1,000 par value bond is selling for $1,135.90 with an 8% yield to maturity. It can be called after 5 years at $1,050. What’s the bond’s nominal yield to call (YTC)? INPUTS 10 -1,135.9 50 1,050 N I/YR PV PMT FV ? OUTPUT

  14. Inflation and Interest Rates Real rates: rates that have been adjusted for inflation Nominal rate: rates that have not been adjusted for inflation. Fisher Effect: lenders require a real return (r) and compensation for expected inflation (h) 1 + R = (1 + r) * (1 + h)

  15. The Term Structure of Interest Rates Nominal interest rates on default-free, zero-coupon bonds of all maturitiesTreasuries Yield CurveThree components: real interest rate inflation premium interest rate risk premium

  16. Bond Yields Components in the spread from a same-maturity Treasury: Default Risk Premium bond ratings Taxability Adjustment Liquidity Premium Other

  17. Recommended Practice • Self-Test Problems 6.1 - 6.2, pp. 176-7 • Questions 1-3, 5, 8, 12, 14 pp. 177-8 • Problems on pp. 178-81: 3, 5, 7, 9, 11, 19, 25, 27, 29 (most answers are on p. 548)

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