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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
1,000 Par-Value Bond, Required Return, kd = 10% M 952
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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