PK08 - CHAPTER 8 Bond Valuation and the Structure of...

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CHAPTER 8 Bond Valuation and the Structure of Interest Rates Learning Objectives 1. Explain what an efficient capital market is and why “market efficiency” is important to financial managers. 2. Describe the market for corporate bonds and three types of corporate bonds. 3. Explain how to calculate the price of a bond and why bond prices vary negatively with interest rate movements. 4. Distinguish between a bond’s coupon rate, yield to maturity, and effective annual yield, and be able to calculate their values. 5. Explain why investors in bonds are subject to interest rate risk and why it is important to understand the bond theorems. 6. Discuss the concept of default risk and know how to compute a default risk premium. 7. Describe the factors that determine the level and shape of the yield curve. I. Chapter Outline 8.1 Capital Market Efficiency A. Overview The supply and demand for securities are better reflected in organized markets. 1
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Any price that balances the overall supply and demand for a security is a market equilibrium price. A security’s true value is the price that reflects investors’ estimates of the value of the cash flows they expect to receive in the future. In an efficient capital market, security prices fully reflect the knowledge and expectations of all investors at a particular point in time. If markets are efficient, investors and financial managers have no reason to believe the securities are not priced at or near their true value. The more efficient a security market, the more likely securities are to be priced at or near their true value. The overall efficiency of a capital market depends on its operational efficiency and its informational efficiency . Operational efficiency focuses on bringing buyers and sellers together at the lowest possible cost. Markets exhibit informational efficiency if market prices reflect all relevant information about securities at a particular point in time. In an informationally efficient market, market prices adjust quickly to new information about a security as it becomes available. Competition among investors is an important driver of informational efficiency. 2
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A. Efficient Market Hypotheses Prices of securities adjust as the buying and selling from investors lead to the price that truly reflects the market’s consensus. This reflects the market’s efficiency. Market efficiency can be explained at three levels—strong form, semistrong form, and weak form. Strong form market efficiency states that the price of a security in the market reflects all information—public as well as private or inside information. Strong form efficiency implies that it would not be possible to earn abnormally high returns (returns greater than those justified by the risks) by trading on private information. Semistrong
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This note was uploaded on 03/31/2012 for the course BUS 3140 taught by Professor Bens during the Spring '12 term at FIU.

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PK08 - CHAPTER 8 Bond Valuation and the Structure of...

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