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InterestRatesAndBondValuation

# InterestRatesAndBondValuation - Interest Rates and Bond...

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Interest Rates and Bond Valuation BUAD 306 - Spring 2009 Jesus Sierra USC-FBE January 31, 2009 Jesus Sierra (USC-FBE) Interest Rates and Bond Valuation January 31, 2009 1 / 47

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Key concepts and skills Understand important bond features and types of bonds. How to calculate the market value of a bond. Bond values and why they fluctuate. The concept of yield to maturity ( ytm ). The impact of inflation on interest rates. Jesus Sierra (USC-FBE) Interest Rates and Bond Valuation January 31, 2009 2 / 47
Outline 1 Bond valuation. 2 Interest rate risk. 3 Yield to maturity. 4 Types of bonds. 5 Inflation and interest rates. Jesus Sierra (USC-FBE) Interest Rates and Bond Valuation January 31, 2009 3 / 47

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Bond Valuation In this lecture, we will apply the techniques we learned about DCF valuation to one of the most common of all financial assets: a bond. When a corporation (or government) wishes to borrow money from the public on a long term basis, it usually does so by issuing, or selling, debt securities. These securities are generically called “bonds”. Jesus Sierra (USC-FBE) Interest Rates and Bond Valuation January 31, 2009 4 / 47
Bond features and prices A bond is an interest-only loan; that is, the borrower will pay interest every period, but none of the principal will be repaid until the end of the loan. For example, suppose that Eastman Kodak wants to borrow \$1000 for 30 years and that the interest rate on similar debt is 12%. This means that: Kodak will pay \$1000 × 0 . 12 = \$120 in interest every year for 30 years. At the end of 30 years, Kodak will repay the \$1000 loan. Jesus Sierra (USC-FBE) Interest Rates and Bond Valuation January 31, 2009 5 / 47

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Bond terminology There is a special terminology when referring to the components of a bond contract. The \$120 regular interest payments that Kodak promises to make are called coupons . The amount that will be repaid at the end of the loan, \$1000, (what we called before the principal ) is called the face value or par value . The annual coupon divided by the face value is called the coupon rate . In the previous example, the coupon rate was \$120/\$1000 = 0 . 12, or 12 percent. The number of years until the face value is paid is called the bond’s time to maturity ( ttm ). In this example, ttm = 30. Jesus Sierra (USC-FBE) Interest Rates and Bond Valuation January 31, 2009 6 / 47
Bond Values and Yields Interest rates change in the marketplace every day. The cash flows of a bond, however, stay the same. As a result, the value of a bond will fluctuate. As with any PV problem, when interest rates go up, the value of a bond goes down. If interest rates fall, the bond is worth more. Jesus Sierra (USC-FBE) Interest Rates and Bond Valuation January 31, 2009 7 / 47

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Bond Values and Yields To determine the value of a bond, we need to know the number of periods until maturity, the face value, the coupon, and most importantly, the market interest rate for bonds with similar features.
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InterestRatesAndBondValuation - Interest Rates and Bond...

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