Chapter_07_Presentation - 7 Interest Rates and Bond...

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Unformatted text preview: 7 Interest Rates and Bond Valuation 7-2 How big? Over $27T How big? Over $27T 7-3 Government Bonds Government Bonds Treasury Securities Federal government debtno default risk T-bills (<2 years); T-notes (2-10 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 tax-exempt at the federal level, some also exempt at state, local level 7-4 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 after-tax 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% 7-5 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.) Pass-through securities. Mortgage payment becomes bond interest or principal. Risk of prepayment. Risk of collateral, as seen in sub-prime crisis. Asset-backed 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 Short-term corporate bonds, commercial paper 7-6 The Bond-Pricing Equation The Bond-Pricing 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. 7-7 Example Example 7-year 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 7-8 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 7-9 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).

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Chapter_07_Presentation - 7 Interest Rates and Bond...

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