FIN-2Lecture 9-The Term Structure of Interest Rates and Yield Derivation

FIN-2Lecture 9-The Term Structure of Interest Rates and Yield Derivation

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FIN-2 1st Year IBMS THE HAGUE UNIVERSITY // IBMS 5/3/13 1 Bond Risks, Ratings & The Term Structure of Interest Rates
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Lecture Timeline Topic Week 1 Introduction to Corporate Finance (Chapter 1) Week 2 Constructing a firm’s financial statements: The Cash Flow Statement Week 3 Analysing the performance of the firm using financial statements: Ratios. (Chapter 2) Week 4 Short term financial planning techniques: preparing a Cash Budget and projected statements. (Linked to IP-2). (Chapter 15) Week 5 Revenue forecasting and long-term financial planning techniques (Chapter 15) Week 6 Working capital management techniques: Current Assets & Current Liabilities management (Chapter 16-17) FIN 2.1 Exam 40% Week 7 How to Calculate Present Values: Time Value of Money (Chapter 3) Week 8 &9 Bond and Stock Valuation (Chapter 4 & 5) Week 11 Making Investment decisions & the NPV rule (Chapter 8) Week 12 Wrap-up and Exam Preparation FIN 2.2 Exam 40%
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Taking a Managerial Perspective Non-current Assets Non-current Liabilities Notes payable Finance/Capital Leases Straight Bonds Callable Bonds Convertible Bonds Puttable Bonds Owners’ Equity Common Shares Preferred Shares § Week 7: Time Value of Money: PV, FV, Annuities, etc.… (Chap 3) § Week 8: Bond issues & Valuation (Chap 4) § Week 9: The term Structure of Interest Rates (Chap 4) § Week 10: Stock issue & Valuation techniques (Chap 5) § Week 11 : Capital Budgeting & decision-making techniques (Chap 8) § Week 12 : Wrap-up & Exam Preparations
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Today’s Agenda § Investment, Risks & Required rates of Return § Derivation of Bond Yields § The Yield Curve § Term Structure Theories
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Yield-to-Maturity: Try & Error § Illustration: Suppose you decide to buy a 3-year bond with a 6% coupon rate and face Value of $1,000 for $960.99. We assume the bond pays coupons annually. What is the bond’s Yield-to-Maturity? + PV Coupon Payments PV Face Value 1000[(1+0.07)-3] PV = 60 [1-(1+0.07)- 3] 0.07 PV = 973.76 + PV Coupon Payments PV Face Value 1000[(1+0.077)-3] PV = 60 [1-(1+0.077)- 3] 0.077 PV = $955.95
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Yield-to-Maturity § Illustration: Suppose you decide to buy a 3-year bond with a 6% coupon rate and face Value of $1,000 for $960.99. We assume the bond pays coupons annually. What is the bond’s Yield-to-Maturity? PV 7% = 973.76 PV 7.7%= 955.95 [Pricelow y – Priceunknown y] Pricelow y – Pricehigh y Yunkno wn = Ylow + x (yhigh y – ylow y) [955.95 - 960.99] 955.95 - 973.76 Yunkno wn = 7% + x (7.7% - 7%) Yunkno wn = 7.5% Do not make this gap too wide!! N=3 PV= -960.99 PMT=60 FV=1,000; CPT I/Y
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Effective Annual Yield § Illustration: Suppose you decide to buy a 30-year bond with a 8% coupon rate and face Value of $1,000 for $800. We assume the bond pays coupons semi- annually . What is the bond’s Yield-to-Maturity? PV 10% = 810.71 PV 10.2%= 795.22 [Pricelow y – Priceunknown y] Pricelow y – Pricehigh y Yunkno wn = Ylow + x (yhigh y – ylow y) [810.71 - 800] 810.71 – 795.22 Yunkno wn = 5% + x (5.1% - 5%) + PV Coupon Payments PV Face Value 1000[(1+0.05)-60] PV = 40 [1-(1+0.05)-60] 0.05 Yunkno wn = 5.07% x 2 10.14% = N=60 PV= -800 PMT=40 FV=1,000; CPT I/Y Do not make this gap too wide!!
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Effective Annual Yield Illustration: Suppose you decide to buy a 30-year bond with a 8% coupon rate and face Value of $1,000 for $800.
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