Lecture10

# Lecture10 - Lecture 10 Interest Rate and Bond Valuation...

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Lecture 10 Interest Rate and Bond Valuation Chapter 7 (omit 7.7) 1 Eco 365.02 Prof. Zhylenko

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Know the important bond features and bond types Understand bond values and why they fluctuate Understand bond ratings and what they mean Understand the impact of inflation on interest rates Learning Objectives 2 Eco 365.02 Prof. Zhylenko
Bond Par value (face value) Coupon payment Coupon rate Maturity date Yield or Yield to maturity Definitions 3 Eco 365.02 Prof. Zhylenko

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Bond Value = PV of coupons + PV of par Bond Value = PV of annuity + PV of lump sum As interest rates increase, present values decrease So, as interest rates increase, bond prices decrease and vice versa Present Value of Cash Flows as Rates Change 4 Eco 365.02 Prof. Zhylenko
Suppose the Xanth Co. were to issue a bond with 10 years to maturity. The Xanth bond has an annual coupon of \$80. Similar bonds have a yield to maturity of 8%. The Xanth bond will pay \$80 per year for the next 10 years in coupon interest. In 10 years, Xanth will pay \$1,000 to the owner of the bond. What would this bond sell for? Suppose a year has gone by. The Xanth bond now has nine years to maturity. If the interest rate in the market has risen to 10 percent, what will the bond be worth? What would the Xanth bond sell for if interest rates had dropped by 2 percent instead of rising by 2 percent? Valuing a Bond with Annual Coupons 5 Eco 365.02 Prof. Zhylenko

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Valuing a Premium Bond with Annual Coupons Suppose you are reviewing a bond that has a 10% annual coupon and a face value of \$1000. There are 20 years to maturity, and the yield to maturity is 8%. What is the price of this bond? 6 Eco 365.02 Prof. Zhylenko Using the formula: B = PV of annuity + PV of lump sum B = 100[1 – 1/(1.08) 20 ] / .08 + 1000 / (1.08) 20 B = 981.81 + 214.55 = 1196.36 Using the calculator: N = 20; I/Y = 8; PMT = 100; FV = 1000 CPT PV = -1,196.36
Graphical Relationship Between Price and Yield-to-maturity (YTM) 600 700 800 900 1000 1100 1200 1300 1400 1500 0% 2% 4% 6% 8% 10% 12% 14% 7 Eco 365.02 Prof. Zhylenko

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If YTM = coupon rate, then par value = bond price If YTM > coupon rate, then par value > bond price Why? The discount provides yield above coupon rate Price below par value, called a discount bond If YTM < coupon rate, then par value < bond price Why? Higher coupon rate causes value above par Price above par value, called a premium bond Bond Prices: Relationship Between Coupon and Yield 8 Eco 365.02 Prof. Zhylenko
The Bond Pricing Equation t t r) (1 FV r r) (1 1 - 1 C Value Bond + + + = 9 Eco 365.02 Prof. Zhylenko

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If an ordinary bond has a coupon rate of 14 percent, then the owner will get a total of \$140 per year, but this \$140 will come in two payments of \$70 each. The yield to maturity is quoted at 16%. The bond matures in 7 years. Find present values based on the payment period
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Lecture10 - Lecture 10 Interest Rate and Bond Valuation...

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