Chapter 7

Chapter 7 - Interest Rates and Bond Valuation Valuation...

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Interest Rates and Bond aluation Valuation -- Chapter 7 Yihui Wang Interest Rates and Bond Valuation
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Main Issues • Bond valuation • Yield to maturity (YTM) • Interest rate redit (default) risk • Credit (default) risk • Bond classification and bond market Interest Rates and Bond Valuation 2
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What Is a Bond? • A bond: Is evidence of debt issued by a corporation or a governmental body. epresents a loan made by investors to the issuer Represents a loan made by investors to the issuer. • The issuer promises to: Make regular coupon payments every period until the bond matures gp p y y p Pay the face/par/maturity value of the bond when it matures. • In return for his/her money, the investor receives a legal claim on future cash flows of the borrower. Interest Rates and Bond Valuation 3
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Differences Between Debt and Equity •D e b t •E quity Not an ownership interest Creditors do not have voting rights Ownership interest Common stockholders have voting rights Interest is considered a cost of doing business and is tax deductible Dividends are not considered a cost of doing business and are not tax deductible Creditors have legal recourse if interest or principal payments are missed xcess debt can lead to financial Dividends are not a liability of the firm and stockholders have no legal recourse if dividends are not id Excess debt can lead to financial distress and bankruptcy paid An all equity firm can not go bankrupt Interest Rates and Bond Valuation 4
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Cash Flow Features of Bond • Par value (face value): F • Coupon payment • Coupon rate •M a t u r i t y F C C C C … … … C C 0 1 2 3 4 … … … T-1 T t Interest Rates and Bond Valuation 5
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Bond Valuation • Bond Value: P = PV of coupons + PV of par = PV annuity + PV of lump sum t F r) (1 1 - 1 C P : Value Bond + + = = Yi ld t M t it (YTM) t r) (1 r + r = Yield to Maturity (YTM) = Market interest rate for bonds with similar features Interest Rates and Bond Valuation 6
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Bond Valuation – Discount Bond • Consider a bond with a coupon rate of 10% and annual coupons. The par value is $1000 and the bond has 5 years maturity The yield to maturity is 11% What is the to maturity. The yield to maturity is 11%. What is the value of the bond? Interest Rates and Bond Valuation 7
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Bond Valuation – Premium Bond • Suppose you are looking at a bond that has a 10% annual coupon and a face value of $1000. There are i d h i ld i i 8% 20 years to maturity and the yield to maturity is 8%. What is the price of this bond? Interest Rates and Bond Valuation 8
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Relation of YTM and Coupon • If YTM = coupon rate, then par value = bond price • If YTM > coupon rate, then par value > bond price Why?
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Chapter 7 - Interest Rates and Bond Valuation Valuation...

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