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**Unformatted text preview: **Chapter 7 Interest Rates and Bond Valuation 7-2 FIN 3716 Key Concepts and Skills Key Concepts and Skills 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 Understand the term structure of interest rates and the determinants of bond yields 7-3 FIN 3716 Chapter Outline Chapter Outline Bonds and Bond Valuation More on Bond Features Bond Ratings Some Different Types of Bonds Bond Markets Inflation and Interest Rates Determinants of Bond Yields 7-4 FIN 3716 Bond Definitions Bond Definitions Bond Par value (face value) Coupon rate Coupon payment Maturity date Yield or Yield to maturity 7-5 FIN 3716 Present Value of Cash Flows as Rates Present Value of Cash Flows as Rates Change Change Bond Value = PV of coupons + PV of par Bond Value = PV of annuity + PV of lump sum Remember, as interest rates increase present values decrease So, as interest rates increase, bond prices decrease and vice versa 7-6 FIN 3716 Valuing a Discount Bond with Annual Valuing a Discount Bond with Annual Coupons Coupons Consider a bond with a coupon rate of 10% and annual coupons. The par value is $1,000 and the bond has 5 years to maturity. The yield to maturity is 11%. What is the value of the bond? Using the formula: B = PV of annuity + PV of lump sum B = 100[1 – 1/(1.11) 5 ] / .11 + 1,000 / (1.11) 5 B = 369.59 + 593.45 = 963.04 Using the calculator: N = 5; I/Y = 11; PMT = 100; FV = 1,000 CPT PV = -963.04 7-7 FIN 3716 Valuing a Premium Bond with Annual Valuing a Premium Bond with Annual Coupons Coupons Suppose you are looking at 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? 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 7-8 FIN 3716 Graphical Relationship Between Price Graphical Relationship Between Price and Yield-to-maturity (YTM) and Yield-to-maturity (YTM) 600 700 800 900 1000 1100 1200 1300 1400 1500 0% 2% 4% 6% 8% 10% 12% 14% Bond Price Yield-to-maturity (YTM) 7-9 FIN 3716 Bond Prices: Relationship Between Bond Prices: Relationship Between Coupon and Yield Coupon and Yield 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 7-10 FIN 3716 The Bond Pricing Equation The Bond Pricing Equation t t r) (1 F r r) (1 1- 1 C Value Bond + + + = 7-11...

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