Chap005(WW-FIN357)NT

# Chap005(WW-FIN357)NT - Chapter5 ChapterOutline 5.1 5.2 5.3...

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Chapter 5 Interest Rates and Bond Valuation

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5-2 Chapter Outline 5.1 Bonds and Bond Valuation 5.2 Bond Features 5.3 Bond Ratings 5.4 Different Types of Bonds 5.5 Bond Markets 5.6 Inflation and Interest Rates 5.7 Determinants of Bond Yields
5-3 Key Concepts and Skills Know important bond features and types Understand bond values and fluctuations Understand what bond ratings mean Understand the effect of inflation on market interest rates Understand the term structure of interest rates and the determinants of bond yields

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5-4 5.1 Bonds and Bond Valuation A bond is a legally binding contract between a borrower and a lender that specifies : Par (face) value ( principal amount of loan ) Coupon rate Coupon payment Maturity Date
5-5 Bond Valuation  Primary Financial Principle: Value of financial securities = PV of expected future cash flows Bond value is determined by the PV of coupon payments and par value. Current bond values are inversely related to interest rates

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5-6 The Bond-Pricing Equation T T r) (1 F r r) (1 1 - 1 C Value Bond + + + =
5-7 Bond Example A U.S. government bond with a 6 3/8% coupon that expires in December 2009. The Par Value of the bond is \$1,000. Coupon payments are made semi-annually (June 30 and December 31). coupon rate is 6 3/8%, the payment is \$31.875. 05 / 1 / 1 875 . 31 \$ 05 / 30 / 6 875 . 31 \$ 05 / 31 / 12 875 . 31 \$ 09 / 30 / 6 875 . 031 , 1 \$ 09 / 31 / 12

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5-8 Bond Example On January 1, 2005, the required yield is 5%. The size and timing of the cash flows are: 05 / 1 / 1 875 . 31 \$ 05 / 30 / 6 875 . 31 \$ 05 / 31 / 12 875 . 31 \$ 09 / 30 / 6 875 . 031 , 1 \$ 09 / 31 / 12 17 . 060 , 1 \$ ) 025 . 1 ( 000 , 1 \$ ) 025 . 1 ( 1 1 2 05 . 875 . 31 \$ 10 10 = + - = PV
5-9 Bond Example: Calculator PMT I/Y FV PV N 31.875 = 2.5 1,000 – 1,060.17 10 1,000×0.06375 2 Find the present value (January 1, 2005) of a 6 3/8% coupon bond with semi-annual payments and a maturity date of December 31, 2009, if the YTM is 5%.

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5-10 Bond Example Now assume that the required yield is 11%. How does this change the bond’s price? 05 / 1 / 1 875 . 31 \$ 05 / 30 / 6 875 . 31 \$ 05 / 31 / 12 875 . 31 \$ 09 / 30 / 6 875 . 031 , 1 \$ 09 / 31 / 12 69 . 825 \$ ) 055 . 1 ( 000 , 1 \$ ) 055 . 1 ( 1 1 2 11 . 875 . 31 \$ 10 10 = + - = PV
5-11 YTM and Bond Value 800 1000 1100 1200 1300 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 Discount Rate Bond Value 6 3/8 When the YTM < coupon, the bond trades at a premium. When the YTM = coupon, the bond trades at par. When the YTM > coupon, the bond trades at a discount.

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5-12 Bond Concepts Bond prices and market interest rates move in opposite directions. When coupon rate = YTM, price = par When coupon rate > YTM, price > par value (premium bond) When coupon rate < YTM, price < par value (discount bond)
5-13 Interest Rate Risk Price Risk Change in price due to changes in interest rates Long-term bonds have more price risk than short-term bonds Low coupon rate bonds have more price risk than high coupon rate bonds.

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5-14 Interest Rate Risk Reinvestment Rate Risk Uncertainty concerning rates at which cash flows can be reinvested Short-term bonds have more reinvestment rate risk than long-term bonds.
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