Chapter_7_FI311_FA2011_SS (1)

Chapter_7_FI311_FA20 - Click to edit Master title style 1 Chapter 7 Interest Rates and Bond Valuation Click to edit Master title style 2 Key

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Unformatted text preview: Click to edit Master title style 10/25/11 1 10/25/11 Chapter 7 Interest Rates and Bond Valuation Click to edit Master title style 10/25/11 2 10/25/11 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 Click to edit Master title style 10/25/11 3 10/25/11 Bond Definitions • Bond = debt security. Usually an interest-only loan • Face value (par value) = typically $1,000 • Coupon rate = stated in the indenture (contract) • Coupon payment (Pmt) = calculated based on the coupon rate (Coupon Rate)*(Face Value)/(#of payments per year) • Maturity = number of periods before a bond is paid • Yield or Yield to maturity (YTM) = bond’s market rate (required return). The rate which discounts the bond’s cash flows to its current market price. Click to edit Master title style 10/25/11 4 10/25/11 Premium and Discount Bonds • If a bond sells for MORE than its face value, it is called PREMIUM BOND . Its yield to maturity is LOWER than the coupon rate. • If a bond sells for LESS than its face value, it is called DISCOUNT BOND . Its yield to maturity is HIGHER than the coupon rate. • A bond can be a premium bond at a certain time and become a discount bond at a later time (or vice versa). Click to edit Master title style 10/25/11 5 10/25/11 Bond Values and Yields • The market price of a bond is calculated by discounting the interest payments (coupons) and face value at the current market rate . • The Yield to Maturity (YTM) of a bond is the current market rate of return on a bond. It is the rate that makes the PV of future cash flows equal to current price. • If a bond sells at face value, its YTM is equal to its coupon rate . Click to edit Master title style 10/25/11 6 10/25/11 Present Value of Cash Flows as Rates Change • Bond Value = PV of coupons + PV of face amount • Bond Value = PV of annuity + PV of lump sum • Bond prices and interest rates always move in opposite directions. Inverse relationship – As interest rates increase, bond prices decrease = as interest rates increase, present values decrease – As interest rates decrease, bond prices increase = as interest rates decrease, present values increase Click to edit Master title style 10/25/11 7 10/25/11 Basic Bond Valuation Model • PV of an annuity, where PMT=coupon payment ( 29 ( 29 + + +- = n n i Par i i PMT P 1 1 1 1 1 • PV of a future cash flow. The bond issuer repays the par value at maturity i = discount rate Click to edit Master title style 10/25/11 8 10/25/11 Present Value of a Bond Company Alpha issues a 20 year bond with annual payments. The face value of the bond is $1,000 and the coupon rate is 5%. If the current market rate of the coupon rate is 5%....
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This note was uploaded on 10/25/2011 for the course FI 311 taught by Professor Booth during the Fall '06 term at Michigan State University.

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Chapter_7_FI311_FA20 - Click to edit Master title style 1 Chapter 7 Interest Rates and Bond Valuation Click to edit Master title style 2 Key

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