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Unformatted text preview: 7 Interest Rates and Bond Valuation 72 How big? Over $27T How big? Over $27T 73 Government Bonds Government Bonds Treasury Securities Federal government debtno default risk Tbills (<2 years); Tnotes (210 years); T bonds (>10 years) Federal Agency Securities GNMA, FNMA, SLMA, others; very low risk Municipal Securities Debt of state and local governments; varying risk Interest received is taxexempt at the federal level, some also exempt at state, local level 74 Municipal bond example Municipal bond example A taxable bond has a yield of 8% and a municipal bond has a yield of 6% If you are in a 40% tax bracket, which bond do you prefer? 8%(1  .4) = 4.8% The aftertax return on the corporate bond is 4.8%, compared to a 6% return on the municipal At what tax rate would you be indifferent between the two bonds? 8%(1 T) = 6% T = 25% 75 Other Bond Types Other Bond Types Corporate bonds Risk determined by strength of company; judged by rating agencies Mortgage bonds (includes CMOs, Fan/Fred bonds, etc.) Passthrough securities. Mortgage payment becomes bond interest or principal. Risk of prepayment. Risk of collateral, as seen in subprime crisis. Assetbacked bonds (includes CDO, ABCP, etc.) Similar in structure to mortgage bonds, but with different cash flows (credit cards, e.g.). MBS, ABS examples of structured finance. Money market Shortterm corporate bonds, commercial paper 76 The BondPricing Equation The BondPricing Equation t t r) (1 F r r) (1 1 1 C Value Bond + + + = Where C is the coupon, F is the face value, r is the YTM and t is the number of periods. Face value of most bonds is $1000. 77 Example Example 7year bond with coupon rate of 14% and YTM of 16%. Coupons paid semi annually How many coupon payments are there? What is the semiannual coupon payment? What is the semiannual yield? B = 70{[1 1/(1.08) 14 ] / .08} + 1000 / (1.08) 14 = 917.56 Or PMT = 70; N = 14; I/Y = 8; FV = 1000; CPT PV = 917.56 78 Present Value of Cash Flows as Rates Present Value of Cash Flows as Rates Change Change Bond Value = PV of coupons + PV of par Bond Value = PV annuity + PV of lump sum Remember, as interest rates increase present values decrease So, as interest rates increase, bond prices decrease and vice versa 79 Valuing a Discount Bond with Annual Valuing a Discount Bond with Annual Coupons Coupons Consider a bond with a coupon rate of 10% and annual coupons. The par value is $1000 and the bond has 5 years to maturity. The yield to maturity is 11%. What is the value of the bond?...
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This note was uploaded on 02/20/2009 for the course H ADM 225 taught by Professor Jwellman during the Fall '07 term at Cornell University (Engineering School).
 Fall '07
 JWELLMAN

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