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Unformatted text preview: minal rate of interest – quoted rate of Nominal interest, change in purchasing power, and inflation inflation The ex ante nominal rate of interest includes The our desired real rate of return plus an adjustment for expected inflation adjustment 36 The Fisher Effect The Fisher Effect defines the relationship The between real rates, nominal rates, and inflation between (1 + R) = (1 + r)(1 + h), where R = nominal rate r = real rate h = expected inflation rate Approximation R=r+h 37 Example 7.5 If we require a 10% real return and we expect If inflation to be 8%, what is the nominal rate? inflation R = (1.1)(1.08) – 1 = .188 = 18.8% Approximation: R = 10% + 8% = 18% Because the real return and expected inflation Because are relatively high, there is significant difference between the actual Fisher Effect and the approximation. the 38 Term Structure of Interest Rates Term structure is the relationship between time to Term maturity and yields, all else equal maturity It is important to recognize that we pull out the effect of It default risk, different coupons, etc. default Yield curve – graphical representation of the term Yield structure structure Normal – upward-sloping, long-term yields are higher than shortterm yields Inverted – downward-sloping, long-term yields are lower than Inverted short-term yields short-term 39 Figure 7.6 – Upward-Sloping Figure Yield Curve Yield 40 Figure 7.6 – Downward-Sloping Figure Yield Curve Yield 41 Figure 7.7 42 Factors Affecting Bond Yields Default risk premium – remember bond ratings Taxability premium – remember municipal Taxability versus taxable versus Liquidity premium – bonds that have more Liquidity frequent trading will generally have lower required returns required Anything else that affects the risk of the cash Anything flows to the bondholders will affect the required returns returns 43 Quick Quiz How do you find the value of a bond and why do bond How prices change? prices What is a bond indenture and what are some of the What important features? important What are bond ratings and why are they important? How does inflation affect interest rates? What is the term structure of interest rates? What factors determine the required return on bonds? What 44 7 End of Chapter 45 45 Comprehensive Problem What is the price of a $1,000 par value bond with What a 6% coupon rate paid semiannually, if the bond is priced to yield 5% YTM, and it has 9 years to maturity? maturity? What would be the price of the bond if the yield What rose to 7%. rose What is the current yield on the bond if the YTM What is 7%? is 46...
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This document was uploaded on 10/01/2013.

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