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# Outline-8 - Ec 173A FINANCIAL MARKETS LECTURE OUTLINE...

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Ec 173A – FINANCIAL MARKETS LECTURE OUTLINE Foster, UCSD October 21, 2010 TOPIC 8 – BONDS & INTEREST RATES A. Bond Prices and Yields [BKM, Ch. 14] 1. Review: a) Fixed-income securities b) Basic bond value equation and definitions. 2. Yield to Maturity: 1 a) YTM -- pure discount bonds. b) YTM -- annual coupon interest. c) YTM -- semi-annual coupon interest. 3. Interpretation of YTM: a) r y = rate of return on bond if it is held to maturity . b) Zero-coupon bonds. c) Coupon bonds. 4. Bond Price Patterns over Time: a) Initial issue bond pricing. b) Premium, par, and discount bonds. c) Bond price convergence. 1 See the Appendix for E XCEL spreadsheet formulas to compute YTM, accrued interest, and bond duration. Bond Notation B 0 current price of bond (\$) M par or face value (usually \$1,000) T term to maturity (years) r c coupon interest rate (%/yr) I annual coupon interest (\$) r y yield to maturity (YTM, %/yr) Y r Begin Balanc e Table 1 End Balance Interest Deposi t 1 \$0 \$0 \$80 \$80 2 \$80 \$8 \$80 \$168 3 \$168 \$16.80 \$1,080 \$1,264.8 0 M r M r r rM r M PVA rM B T T T T r = + + + - = + + × = ) 1 ( ) 1 ( 1 1 1 ) 1 ( , 0 25 T 0 \$1117 \$1000 \$ 900 Fig. 1 r y 7% 8% 9% B t ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 ) ( ] 2 / 1 [ 2 / ] 2 / 1 [ 2 / 2 / 1 2 / 2 2 0 terest in semiannual r M I r I r I B T + + + + + + + = T y y y r M I r I r I B ) 1 ( ) 1 ( ) 1 ( 2 0 + + + + + + + = 3 2 0 0 B M T B M I r y + - +

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Ec 173A BONDS & INTEREST RATES p. 2 of 9 B. Bond Risk and Duration [BKM, Ch. 16] 1. Bond Risk: a) Default, liquidity, and maturity risk. b) Default risk. c) Liquidity risk (narrowly defined). d) Maturity or interest rate risk (liquidity risk broadly defined). 2. Interest Rate Risk and Term to Maturity: a) The setting. b) Years to maturity. c) The sensitivity works in both directions. d) The pattern of price sensitivity. [Fig. 2] 3. Measuring Interest Rate Risk with Bond Duration: a) Average maturity. b) Duration. 2 c) Duration, elasticity, and interest rate risk. d) Modified duration D*. e) Illustration. f) Final notes. 4. The Risk Structure of Interest Rates: [Fig. 3] 2 See the Appendix for the E XCEL spreadsheet formula for computing duration and modified duration. B 0 M Fig. 2 6 8 10 r y T=10 T=20 r y Fig. 3 Junk Bonds Investment Grade Treasuries T r f DP+LP ( 29 t y t t T T t t r CF B where T t D + = + + + + = = = 1 1 , 3 2 0 3 2 1 1 ϖ + + - + = + + = - y y y y y r r D B B r B r r B B D 1 ) 1 ( ) 1 ( % % 1 ) 1 ( 0 0 + = + = 2 1 * : 1 * : y y r D D Semiannual r D D Annual
Ec 173A BONDS & INTEREST RATES p. 3 of 9 C. Term Structure of Interest Rates [BKM, Ch. 15] 1. Yield Curves: a) Many interest rates. b) Term structure of interest rates.

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## Outline-8 - Ec 173A FINANCIAL MARKETS LECTURE OUTLINE...

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