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Unformatted text preview: ctures 1 and 12 Last week we discussed… Lectures 11 and 12 • Valuing assets based on time value of $$ – Coupon Bonds • Annuity with a final repayment of principle – Zero Coupon (i.e., pure discount) Bonds • Simple present value calculation • Determinants of bond prices/yields – Expected inflation eal rate of interest – Real rate of interest – Tax treatment – Liquidity – Default risk Remember , investors pay less for a security that is riskier or has less favorable characteristics! – Interest rate risk Interest rate risk: Q1 1. You have just purchased a zero ‐ coupon bond, with a face value of $1000 and yield to maturity of 6%. The bond matures in 5 years. What is your annualized rate of return (i.e., your annualized return on investment) if… a. You hold the bond to maturity? u sell the bond next year at which point the market’s required rate b. You sell the bond next year, at which point the market s required rate of return has increased to 8% (what if it had increased to only 7%?) Interest rate risk: Q2 2. You have just purchased a par value bond with a coupon rate of 8%. This bond has a face value of $1000, matures in 10 years, and makes annual coupon payments. What is your rate of return if you sell the bond next year (right after receiving the annual coupon payment), at which point the market’s required rate of return has decreased to 5%. a) What if the req. rate of return had increased to 9%? b) What if it remained at 8%? What affects how sensitive bond prices are to interest rates? All else equal… 1. The longer the time to maturity, the ___________ the interest rate risk 2. The lower the coupon rate, the ___________ the interest rate risk • Thus, financial managers like to look at a bond’s duration : F cash flows from bond at time 1 1 2 3 2 3 T t t T PV CF Duration t PV bond PV CF PV CF PV CF PV CF CF t = cash flows from bond at time t PV(bond) = price of bond (i.e., PV of all cash flows promised by the bond) uration ives us a measure of how exposed is the bond’s price to fluctuations in 1 2 3 ... T PV bond PV bond PV bond PV bond Duration gives us a measure of how exposed is the bond s price to fluctuations in interest rates (i.e., higher duration means price is more sensitive) Bond characteristics Indenture (describes details of the bond agreement) 1. Basic terms of the bond issue 2. Total amount of bonds issued escription of the security (if any) 3. Description of the security (if any) 4. Repayment arrangements 5. Call provisions 6 . Details of the protective covenants Keep in mind, investors “ price protect ” themselves....
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This note was uploaded on 02/27/2012 for the course MGMT 310 taught by Professor Matthewjamesbarcaskey during the Spring '08 term at Purdue.
 Spring '08
 MATTHEWJAMESBARCASKEY
 Management

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