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Chapter 03  Interest Rates and Security Valuation
31
Chapter Three
Interest Rates and Security Valuation
I. Chapter Outline
1.
Interest Rates as a Determinant of Financial Security Values: Chapter Overview
2.
Various Interest Rate Measures
a.
Coupon Rate
b.
Required Rate of Return
c.
Expected Rate of Return
d.
Required Versus Expected Rates of Return: The Role of Efficient Markets
e.
Realized Rate of Return
3.
Bond Valuation
a.
Formula Used to Calculate Fair Present Values
b.
Formula Used to Calculate Yield to Maturity
c.
Equity Valuation Models
4.
Impact of Interest Rate Changes on Security Values
5.
Impact of Maturity on Security Values
a.
Maturity and Security Prices
b.
Maturity and Security Price Sensitivity to Changes in Interest Rates
6.
Impact of Coupon Rates on Security Values
a.
Coupon Rate and Security Price
b.
Coupon Rate and Security Price Sensitivity to Changes in Interest Rates
7.
Duration
a.
A Simple Illustration for Duration
b.
A General Formula for Duration
c.
Features of Duration
d.
Economic Meaning of Duration
e.
Large Interest Rate Changes and Duration
Appendix 3A: Duration and Immunization
Appendix 3B: More on Convexity
(Appendices are available only at
www.mhhe.com/sc4e
)
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View Full DocumentChapter 03  Interest Rates and Security Valuation
32
II. Chapter in Perspective
This is the second chapter that is designed to familiarize the students with the
determinants of fixed income valuation. This chapter has seven closely related sections
which focus primarily on bond pricing and the bond price formula.
From the first three
sections of the chapter readers should learn how to calculate a bond‟s price, the
difference between the required rate of return, the expected rate of return and the realized
return and how to calculate each.
Efficient markets are briefly introduced by relating the
expected and required rates of return and by comparing market prices to calculated fair
present values.
Section 4 introduces bond price volatility and illustrates how changing
interest rates can affect FIs.
Sections 5 and 6 discuss the effects of maturity and coupon
on bond price volatility.
Section 7 introduces the concept of duration and illustrates how
to calculate Macauley duration.
Appendix 3A provides an example of immunization
using duration and Appendix 3B explains more about the concept of convexity and
demonstrates the effect of convexity on bond price predictions.
III. Key Concepts and Definitions to Communicate to Students
Required rate of return
Price sensitivity
Expected rate of return
Maturity and price sensitivity
Realized rate of return
Coupon and price sensitivity
Coupon rate
Duration
Market efficiency
Elasticity
Zero coupon bonds
Modified duration
Par, premium and discount bonds
Convexity
Yield to maturity
Fair present value
IV. Teaching Notes
1.
Interest Rates as a Determinant of Financial Security Values: Chapter Overview
This chapter applies the time value of money concepts developed in Chapter 2 to explain
bond pricing and rates.
The determinants of bond price volatility, duration and convexity
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 Fall '10
 Chaddegy
 Financial Markets, Interest, Interest Rate, Valuation

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