# 4 - Chapter 7 Interest Rates and Bond Valuation FINA1003...

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FINA1003 Corporate Finance Faculty of Business and Economics University of Hong Kong Dr. Tao Lin Chapter 7: Interest Rates and Bond Valuation

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Chapter Outline Bond basics and valuation Interest Rate Risk Current yield, YTM and HPR Bond indenture Bond types and bond markets Interest rate determinants
Bond Basics Terminology Bond - Security that obligates the issuer to make specified payments to the bondholder. Coupon -The interest payments made to the bondholder. Face Value (Par Value or Maturity Value) - Payment at the maturity of the bond. Coupon Rate - Annual interest payment, as a percentage of face value.

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Bonds WARNING The coupon rate IS NOT the discount rate used in the Present Value calculations.
Bonds WARNING The coupon rate IS NOT the discount rate used in the Present Value calculations. The coupon rate merely tells us what cash flow the bond will produce. Since the coupon rate is listed as a %, this misconception is quite common.

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Bond Pricing The price of a bond is the Present Value of all cash flows generated by the bond (i.e. coupons and face value) discounted at the required rate of return. t r par cpn r r PV ) 1 ( ) ( .... ) 1 ( ) 1 ( 2 1
Present Value & Interest Rates Bond Value = PV of coupons + PV of par Bond Value = PV annuity + PV of lump sum Remember, as interest rates increase the PV’s decrease So, as interest rates increase, bond prices decrease and vice versa

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Bond Pricing: Premium Bond Example What is the price of a 6.5 % annual coupon bond, with a \$1,000 face value, which matures in 3 years? Assume a required return of 3.9%. 29 . 072 , 1 \$ ) 039 . 1 ( 000 , 1 039 . 1 1 1 039 . 0 65 3 3 PV
Bond Pricing: at par value Example (continued) What is the price of the bond if the required rate of return is 6.5 %? 000 , 1 \$ ) 065 . 1 ( 000 , 1 065 . 1 1 1 065 . 0 65 3 3 PV

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Bond Pricing: Discount Bond Example (continued) What is the price of the bond if the required rate of return is 15 %? 93 . 805 \$ ) 15 . 1 ( 000 , 1 15 . 1 1 1 15 . 0 65 3 3 PV PV
Bond Pricing Example (continued) What is the price of the bond if the required rate of return is 3.9% AND the coupons are paid semi- annually? 94 . 072 , 1 \$ ) 0195 . 1 ( 50 . 032 , 1 ) 0195 . 1 ( 50 . 32 ... ) 0195 . 1 ( 50 . 32 ) 0195 . 1 ( 50 . 32 6 5 2 1 PV PV

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Bond Pricing Example (continued) Q: What happened when the required return is less than the coupon rate?
Bond Pricing Example (continued) Q: What happened when the required return is greater than the coupon rate?

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Bond Pricing Example (continued) Q: How did the calculation change, given semi-annual coupons versus annual coupon payments?
Bond Pricing Example (continued)

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## This note was uploaded on 05/11/2011 for the course BUSI 1003 taught by Professor Cyc during the Spring '11 term at HKU.

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4 - Chapter 7 Interest Rates and Bond Valuation FINA1003...

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