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Chapter_7_FI311_FA2011_SS - Click to edit Master title...

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Click to edit Master title style 12/29/11 1 Chapter 7 Interest Rates and Bond Valuation
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Click to edit Master title style 12/29/11 2 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
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Click to edit Master title style 12/29/11 3 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.
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Click to edit Master title style 12/29/11 4 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).
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Click to edit Master title style 12/29/11 5 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 .
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Click to edit Master title style 12/29/11 6 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
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Click to edit Master title style 12/29/11 7 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 0 PV of a future cash flow. The bond issuer repays the par value at maturity i = discount rate
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Click to edit Master title style 12/29/11 8 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 return is 8%, what is the price of the bond?
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