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ch08 - 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. Describe the market for corporate bonds and three types of corporate bonds. 2. Explain how to calculate the value of a bond and why bond prices vary negatively with interest rate movements. 3. Distinguish between a bond’s coupon rate, yield to maturity, and effective annual yield. 4. Explain why investors in bonds are subject to interest rate risk and why it is important to understand the bond theorems. 5. Discuss the concept of default risk and know how to compute a default risk premium. 6. Describe the factors that determine the level and shape of the yield curve. I. Chapter Outline 8.1 Corporate Bonds A. Market for Corporate Bonds At the end of 2006, for example, the amount of corporate and foreign bonds outstanding was $11.4 trillion. The next largest market is the market for corporate stock with a value of $18.6 trillion, followed by the state and local government bond market valued at $2.3 trillion. 1
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The largest investors in corporate bonds are life insurance companies and pension funds, with trades in this market tending to be in very large blocks of securities. Less than 1 percent of all corporate bonds are traded on exchanges. Most secondary market transactions for corporate bonds take place through dealers in the over-the-counter (OTC) market. Only a small number of the total bonds that exist actually trade on a single day. As a result, the market for corporate bonds is thin compared to the market for money market securities or corporate stocks. Corporate bonds are less marketable than the securities that have higher daily trading volumes. Prices in the corporate bond market also tend to be more volatile than securities sold in markets with greater trading volumes. The market for corporate bonds is not as efficient as that for stocks sold on the major stock exchanges or highly marketable money market instruments such as U.S. Treasury securities. B. Bond Price Information The corporate bond market is not considered to be very transparent because it trades predominantly over the counter and investors do not find it easy to view prices and trading volume. In addition, many corporate bond transactions are negotiated between the buyer and the seller, and there is little centralized reporting of these deals. 2
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C. Types of Corporate Bonds Corporate bonds are long-term IOUs that represent claims against a firm’s assets. Debt instruments, where the interest income paid to investors is fixed for the life of the contract, are called fixed-income securities . There are three types of corporate bonds: vanilla bonds, zero coupon bonds, and convertible bonds. 1. Vanilla Bonds These bonds have coupon payments that are fixed for the life of the bond, and at maturity, the principal is paid and the bonds are retired.
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