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 – upwardsloping, longterm yields are higher than shortterm yields
Inverted – downwardsloping, longterm yields are lower than
Inverted
shortterm yields
shortterm 39 Figure 7.6 – UpwardSloping
Figure
Yield Curve
Yield 40 Figure 7.6 – DownwardSloping
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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 Fall '09
 Inflation, Interest Rates, Interest, Interest Rate, Valuation, YTM, Bond Markets

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