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Unformatted text preview: 7. Interest rates and bond valuation This is a crash course overview of bonds. We could easily spend an entire semester on the subject. In fact, many people have devoted their entire careers to studying bonds. Fixed income is a broad asset class which includes bonds as well as various asset-backed securities (including the mortgage-backed securities appearing frequently in the news recently). Although fixed income may not seem as exciting as stocks, it is a huge and very active market (many times larger than stocks). Fixed income is not just for widows and orphans. Indeed, fixed income securuties are heavily traded by hedge funds. Bonds are not boring!! Bonds some terminology When a corporation or government wishes to borrow money from the public on a long-term basis, it usually does so by issuing (sell- ing) a security referred to generically as a bond . The repayment schedule for a bond typically involves a series of payments, called coupons and a final payment, referred to as the face value or par value of the bond. A bond in which the coupon payments are all of equal size is called a level coupon bond . The annual coupon payment divided by the face value is called the coupon rate . The time until the final payment is called the time to maturity of the bond. 2 Yields and prices Given the cash flow of a bond and its selling price, we can compute the equivalent interest rate. This is called the yield to maturity . The inverse problem is also possible: given the cash flow structure and yield to maturity, we can compute the bonds market price . The coupon divided by the market price of the bond is its current yield . A bond selling for more than its face value is called a premium bond . A bond selling for less than its face value is called a dis- count bond . 3 Example Bark Dog Biscuits Inc. is offering a bond with a face value of $1000, time to maturity of 7 years, and a $50 annual coupon. If the yield to maturity is 11%, what is the selling price? What is the coupon rate? What is the current yield? Note: We will assume throughout this chapter that the compounding period coincides with the coupon period. 4 Example Now consider the same set-up, but suppose the selling price is $800 and compute the yield to maturity. Also, what are the coupon rate, current yield, and yield to maturity? 5 Interest rate risk Notes: Price and yield move in opposite direction. Prices of bonds with longer maturity are more sensitive to swings in interest rate. (Interest rate risk). 6 Holding period returns The return to holding a bond can be decomposed into two parts: current income and capital gain. Example: Suppose you buy a bond with a face value of $1000, 10 years to maturity and an annual coupon of 7%. The bond is selling at par. At the end of one year, you collect the coupon and then sell the bond. The sales price corresponds to a yield to maturity of 6%. What is your overall rate of return?...
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slides07 - 7. Interest rates and bond valuation This is a...

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