Of course when the required return equals the coupon

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Unformatted text preview: ntil maturity, the value of the bond will approach its par value as the passage of time moves the bond’s value closer to maturity. (Of course, when the required return equals the coupon interest rate, the bond’s value will remain at par until it matures.) EXAMPLE interest rate risk The chance that interest rates will change and thereby change the required return and bond value. Rising rates, which result in decreasing bond values, are of greatest concern. Figure 6.6 depicts the behavior of the bond values calculated earlier and presented in Table 6.6 for Mills Company’s 10% coupon interest rate bond paying annual interest and having 10 years to maturity. Each of the three required returns—12%, 10%, and 8%—is assumed to remain constant over the 10 years to the bond’s maturity. The bond’s value at both 12% and 8% approaches and ultimately equals the bond’s $1,000 par value at its maturity, as the discount (at 12%) or premium (at 8%) declines with the passage of time. Changing Required Returns The chance that interest rates will change and thereby change the required return and bond value is called interest rate risk. (This was described as a shareholder-specific risk in Chapter 5, Table 5.1.) Bondholders are typically more concerned with rising interest rates because a rise in interest rates, and therefore in the required return, causes a decrease in bond value. The shorter the amount of time until a bond’s maturity, the less responsive Time to Maturity and Bond Values Relationship among time to maturity, required returns, and bond values (Mills Company’s 10% coupon interest rate, 10-year maturity, $1,000 par, January 1, 2004, issue paying annual interest) Market Value of Bond, B0 ($) FIGURE 6.6 Premium Bond, Required Return, kd = 8% 1,200 1,134 1,115 1,100 1,052 1,000 Par-Value Bond, Required Return, kd = 10% M 952 901 887 Discount Bond, Required Return, kd = 12% 800 10 9 8 7 6 5 4 3 2 Time to Maturity (years) 1 0 CHAPTER 6 FOCUS ON PRACTICE Interest Rates and Bond Valuation In Practice The Value of a Zero Many investors buy bonds to...
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