L6 - Bonds

# L6 - Bonds - Financial Management Fall 2010 Lecture 6 Bond...

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Financial Management Fall 2010 Lecture 6: Bond valuation (II) Professor Erica Li Ross School of Business

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Last class ! Bond terminology ! Pricing a bond " Present value of coupons and face value ! Bond price changes as time approaches the maturity because " the number of coupons left decreases " coupons and face value are discounted less " the yield may change over time => interest rate risk
Roadmap of today ! Factors that determine the bond price ! Inflation and yield " Real vs. nominal return " Fisher effect ! Term structure and yield curve " Expectations hypothesis ! Credit risk ! Textbook reading: 7.6 and 7.7

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Example from last class ! You bought the 10% coupon bond issued by XYZ Co. with semiannual coupon payments and time to maturity of 2 years. The yield is 8% at t=0 and the bond price is P 0 = \$1036.29. t=0 1 2 3 4 Coupons \$50 \$50 \$50 \$50 Face value \$1,000
Return on the bond ! At t=1 (0.5 yr), after you get the coupon, you can sell the bond at P 1 =\$1027.75 if the yield is still 8%. Your return on the bond during the holding period (half a year) is ! If the yield increases to 10% at t=1, you can sell the bond at P 1 =1,000. Your return on the bond during the holding period is r = C + P 1 P 0 " 1 = 50 + 1027.75 1036.29 " 1 = 4% (the yield for six - month) r = C + P 1 P 0 " 1 = 50 + 1000 1036.29 " 1 = 1.32%

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Interest rate risk ! Assume that there is no default risk, i.e., you will get the promised coupon payments and face value with probability one ! Your payoffs from the bond are certain only if you hold the bond until maturity ! your payoffs on the bond are uncertain if you sell the bond before maturity, due to the time-varying interest rate on the bond (i.e., the yield) ! This uncertainty that bondholders face is called interest rate risk
The great American Bond Bubble If 10-year interest rates, which are now 2.8%, rise to 4% as they did last spring, bondholders will suffer a capital loss more than three times the current yield. ---Jeremy Siegel and Jeremy Schwarts August 18, 2010 ! Should you be worried? How big is the exposure of your bondholdings to the interest rate risk?

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Interest rate risk (I): bond price and maturity \$450.00 \$950.00 \$1,450.00 \$1,950.00 \$2,450.00 \$2,950.00 \$3,450.00 \$3,950.00 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00% 20.00% Bond Price Yield to Maturity FV = \$1,000 CR = 10% Annual Coupon T = 1 T = 30
Interest rate risk (I): bond price and maturity ! FV = \$1,000, CR (coupon rate) = 10%, annual coupon. When the yield changes from 10% to 13%:

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L6 - Bonds - Financial Management Fall 2010 Lecture 6 Bond...

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