f. What is the face value of the bond? g. What is the maturity date of the bond?
53 Solution a. On March 1, 2006, you buy the bond from Ford Motor Company for $1000. b. Interest is paid semi-annually, or every 6 months. Six months from the issue date of March 1 is August 31. Six months from August 31 is February 28. So interest is paid on August 31, 2006 and February 28, 2007. Interest is paid on those dates every year until the final payment is made on February 28, 2016. c. The amount of each interest payment is (1/2)X $80 = $40. d. There will be 10X2 =20 interest payments. e. The total interest paid over the life of the bond is $40 X 20 = $800. f. The face value of the bond is $1000. g. The maturity date of the bond is February 29, 2016.
54 Determinants of Bond Yields: Inflation and Interest Rates • Real rate of interest – rate reflecting the real increase in change in purchasing power of $ invested. • Nominal rate of interest – quoted rate of interest, reflects actual money increase versus money invested. • The nominal rate of interest includes our desired real rate of return plus an adjustment for expected inflation • Recall the relationship between real rates, nominal rates and inflation • (1 + r n ) = (1 + r r )(1 + i), where r n = nominal rate r r = real rate i = expected inflation rate • Also called the Fisher Effect • Approximation of the Fisher Effect: r n ≈ r r + i
55 Example: The Fisher Effect • If we require a 10% real return and we expect inflation to be 8%, what is the nominal rate? • Nominal r = (1.1)(1.08) – 1 = .188 = 18.8% • Approximation: r n = 10% + 8% = 18% • Because the real return and expected inflation are relatively high, there is significant difference between the actual Fisher Effect and the approximation.
56 Term Structure of Interest Rates • Term structure is the relationship between time to maturity and yields , for bonds of the same risk and holding all else equal. • “All else equal” means we remove the effect of default risk, different coupons, etc., and are able to focus on the relationship between maturity and yields. • Yield curve – graphical representation of the term structure Normal – upward-sloping, long-term yields are higher than short-term yields Inverted – downward-sloping, long-term yields are lower than short-term yields
57 The Term Structure of Interest Rates Discount rate or required rate of return
58 The Term Structure of Interest Rates
59 Example: Treasury Yield Curve
60 Summary of Factors That Affect Bond Yields 1. Real rate of interest 2. Expected future inflation 3. Interest rate risk 4. Default risk 5. Taxability 6. Lack of liquidity
Sample Bond Headlines: • $1B Temasek Bond Sale by Fiona Chan, 9 th February, 2010 : The state investment company said on Monday that its latest offering - the fifth in as many months - will have a coupon rate of 3.265 per cent and it will mature in 2020. Over $4B Raised Since Last October Through Bond Issues.
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- Spring '11