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fin. ch3 - Lecture 3 Interest Rates and Bond Valuation 3-1...

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Lecture 3 Interest Rates and Bond Valuation
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3-2 Key Concepts and Skills Know the important bond features and bond types Understand bond values and why they fluctuate Understand the term structure of interest rates
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3-3 Lecture outline Key Features Of Bonds Bond Valuation Bond Risk Measures Bond Return Measures Term Structure of Interest Rates Yield Curve Pure Expectation Hypothesis
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3-4 What Is a Bond? A long-term debt instrument in which a bond issuer promises to pay the bond holders periodic interest payments and a face/par value when it matures. Issuer of Bonds Treasury Corporate Municipal Foreign              Int.      Int.      Int.           Int.+Principal      0        1         2        3    ………          N
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3-5 Key Features of a Bond Par value: face amount of the bond, which is paid at maturity (normally $1,000). Coupon interest rate : the stated interest rate (generally fixed) paid that times the par value to get the periodic interest payments. Maturity date : when the bond will be repaid. Time to maturity is the time period between now to the maturity date. Yield to maturity : annualized rate of return earned on a bond held until maturity.
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3-6 Other Features Callable bond: allows issuer to buyback the bond before maturity. Most bonds have a deferred call and a declining call premium. Issuers will likely to refund the bond issue if rates decline (helps the issuer, but hurts the investor). Convertible bond: bond holders can exchange the bond for common stock of the firm. Holders will likely to convert the bond if the stock price goes up.
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3-7 The Value of Financial Assets n ) (1 n CF ... 2 r) (1 2 CF 1 r) (1 1 CF Value r + + + + + + = 0 1 2 n r CF 1 CF n CF 2 Value ... Definition:  The value of a financial asset is equal to the  present value of the future cash flows generated from  the asset.
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3-8 Bond Value: Using the Formula $1,000 $385.54 $38.55 ... $90.91 B V 10 (1.10) $1,000 10 (1.10) $100 ... 1 (1.10) $100 B V = + + + = + + + = 0 1 2 n r 100 100 + 1,000 100 V B = ? ... Bond Value: Defined as the PV of a bond     interest payments and par value. Example: A 10-year, 10% coupon bond with  r d  =  10%
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3-9 Bond Value: Use Financial Calculator This bond has two types of cash flows: Periodic interest payments (an annuity): $100 a year over the next 10 years in this case A single par value at maturity: $1,000 in year 10 Compute the PV to get the bond value INPUTS OUTPUT N I/YR PMT PV FV 10 10 100 1000 -1000
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3-10 Discount Bond -- Example Consider a bond with a coupon rate of 10% and coupons paid annually. The par
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