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Unformatted text preview: Fundamentals of Corporate Finance, 2/e ROBERT PARRINO, PH.D. DAVID S. KIDWELL, PH.D. THOMAS W. BATES, PH.D. 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 BONDS 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. Corporate Bonds o MARKET FOR CORPORATE BONDS Life insurance companies and pension funds buy most corporate bonds Transactions tend to be in very large dollar amounts. Less than 1% of all corporate bonds are traded on organized exchanges Most transactions take place through dealers in the over-the-counter (OTC) market. Corporate Bonds o MARKET FOR CORPORATE BONDS Only a small fraction of the bonds outstanding are traded each day. The market is thin compared to markets for money- market securities and stocks. Corporate bonds are less marketable than securities with large daily trading volumes. Prices in the market tend to be more volatile than those of securities with greater trading volumes. Corporate Bonds o BOND PRICE INFORMATION Corporate bond pricing is not considered transparent. It is difficult for investors to obtain important information on prices and volume. Many transactions are negotiated directly between buyer and seller with little centralized reporting of transaction details. Corporate Bonds o FEATURES OF CORPORATE BONDS long-term claims against company assets face (par) value is $1,000 coupon rate is the annual coupon payment (C) divided by a bonds face value (F) fixed amounts paid to lenders for the life of the contract Vanilla Bonds o TYPES OF CORPORATE BONDS Vanilla bond coupon payments fixed for the life of the bond repay principal and retire the bonds at maturity contracts have the features and provisions found in most bond covenants. annual or semiannual coupon payments Zero Coupon Bonds o TYPES OF CORPORATE BONDS Zero coupon bond no coupon payments pays face value at maturity. sell at deep discount Convertible Bonds o TYPES OF CORPORATE BONDS Convertible bonds may be exchanged for shares of the firms stock sells for a higher price than a comparable non- convertible bond bondholders benefit if the market value of the companys stock gets high enough Bond Valuation o BOND PRICE In an efficient market, the price of an asset equals the present value of its future cash flows....
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