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Chapter 6

# Chapter 6 - Chapter 6 Interest Rates and Bond Valuation In...

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Chapter 6 Interest Rates and Bond Valuation In this chapter, we apply the “time value of money” tools from the previous chapters to the topic of bond valuation. We will also discuss the forces behind interest rates (i.e., what makes them high or low), and how changes in interest rates affect bond values. What is a bond? As the name is commonly used, a “bond” is a long-term debt security. Corporations (and other entities, such as a partnerships and governments) raise money by issuing (i.e., selling) bonds to investors. The price of the bond (i.e., the amount raised when sold to investors) is its present value. There are different types of bonds, but the most common one makes interest only “coupon” payments until the maturity date. On the maturity date, the “face” (or “par”) amount is paid plus the final interest payment. (This is the “interest-only loan” from Chapter 5.) Example : Issue date = December 31, 2008 Maturity date = December 31, 2018 Coupon rate = 6% with semi-annual payments (June 30 and December 31) Face amount = \$1,000 per bond Time line 0 1 2 3 4 5 6 19 20

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Bond Valuation We calculate the market value of a bond by its present value. Example – What is the present value of the bond described on page 1 using an 8% discount rate? Note: since the bond makes semi-annual payments, we will use semi-annual compounding for the discount rate. (What is the EAR?) Formula Calculator : N I/Y PV PMT FV Example – Now assume the discount rate is 6%. What is the present value now? What is the relation between changes in discount rates and bond values? What are the relations between the discount rate, the bond’s present value, and its face amount? Terminology: par value, premium, and discount bonds 2
Interest Rate Risk As noted on the previous page, increases in discount rates decrease the market value of a bond. However, not all bonds are affected in the same way. Bond A (same as described above) Issue date = December 31, 2008 Maturity date = December 31, 2018 Coupon rate = 6% with semi-annual payments (June 30 and December 31) Face amount = \$1,000 per bond Bond B Issue date = December 31, 2008 Maturity date = December 31, 2038 Coupon rate = 6% with semi-annual payments (June 30 and December 31) Face amount = \$1,000 per bond Starting at the coupon rate of 6%, what is the affect of an increase and decrease in the discount rate of 1% on the two bonds? Bond 5% 6% 7% A \$1,000 B \$1,000 So, bonds with ______________________ have more interest rate risk. 3

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Interest Rate Risk - continued Differences in coupon rates Bond A (same as described above) Issue date = December 31, 2008 Maturity date = December 31, 2018 Coupon rate = 6% with semi-annual payments (June 30 and December 31) Face amount = \$1,000 per bond Bond B Issue date = December 31, 2008 Maturity date = December 31, 2018 Coupon rate = 8% with semi-annual payments (June 30 and December 31) Face amount = \$1,000 per bond Starting at the coupon rate, what is the affect of an increase and decrease in the discount rate of 1% on the two bonds?
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Chapter 6 - Chapter 6 Interest Rates and Bond Valuation In...

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