FIN335 CH06 Interest Rates & Bond Valuation

8/3/2019 FIN335 CH06 Interest Rates & Bond Valuation

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Interest Rates & Bond Valuation

Chapter 6

Bonds and Bond Valuation

Term Structure of Interest Rates


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CHARACTERISTICS OF ALL DEBTINSTRUMENTS

A. Pay Interest (coupons) and have a fixedmaturity value ($1000 for corporate bonds).

B. Indenture Agreement

1. Loan agreement between lender and borrower.2. Appoints the trustee; a fiduciaryresponsible for

guarding the lenders' interests.

3. Indenture agreement provides for legal remedies if

terms & conditions of indenture are not met.


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CHARACTERISTICS OF ALL DEBTINSTRUMENTS

C. Sources of risk1. Default; probability of not getting all of the promised

interest and principal.

2. Price; changes in prices as interest rates change overtime. The longer the time to maturity, the greaterthe sensitivity. (See Fig 7-3)

3. Purchasing power; effects on inflation on buying

power of coupon income.4. Liquidity: inability to buy or sell at intrinsic value dueto inactive market or small float.


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TYPES OF BONDS

A. Mortgage bonds: bonds secured by realproperty

B. Equipment trust certificates: bondssecured by equipment (rolling stock)

C. Debentures: unsecured bonds (nocollateral).

D. Revenue bonds: interest paid only if aspecified level of earnings is achieved


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TYPES OF BONDS

E. Convertible bonds: bonds that may beconverted into the firm's common stock

F. Variable interest rate bonds: coupons thatchange with changes in interest rates

G. Zero coupon bonds (also called purediscount bonds): dont pay coupons.

H. Callable Bonds: can be called prior tostated maturity (early redemption).


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BOND VALUES AND BOND YIELDS

A. Bond valuation model;1. VB = Coupon * PVIFA + Face Value * PVIF2. The valueof a bond (VB) is a combination of a present value of

an annuity (PV of coupons to be received) and PV of facevalue of the bond. VB is also the PV of all expected cash flows

N...,3,2,1,nfor)k(1

CFV

N

1nn

b

nB


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BOND VALUES AND BOND YIELDS

B. Current yield = coupon divided by the[current] price (PV)

C. Yield to maturity (YTM) = rate earned if

held to maturityD. Interest rates and bond values

1. YTM go up --- bond prices go down [and vice-

versa]2. If company gets riskier, then YTM goes upand prices down [and vice-versa].


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USING FINANCIAL CALCULATORSTO COMPUTE BOND VALUES

A bond pays a coupon of $120 per year, paid semi-annually. The bond matures in 20 years and has a facevalue of $1,000. If the current YTM rates are 9 percent,how much should this bond sell for?

1. ENTER 20 [2nd] [N], [N]: Display: N = 40.00

2. ENTER 9 [I/Y]: Display: I/Y = 9.00

3. ENTER 60 [PMT]: Display: PMT = 60.00

4. ENTER 1000 [FV]: Display: FV = 1,000.005. PRESS [CPT] [PV]: Display: PV = -1,276.02


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USING FINANCIAL CALCULATORSTO COMPUTE BOND VALUES

A. What If Examples1. Suppose the YTM is 11 percent; "I/Y" = 11.

Enter 11, press [I/Y], then [CPT] , then [PV];

-1,080.23.2. If the YTM is 12%; enter 12, press [I/Y], then

[CPT], [PV]; PV = 1,000.00 or $1,000.00.

3. If the YTM is 15%, the price [PV] is $811.08. Note as YTM increases, VB decreases


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TERM STRUCTURE OF INTEREST RATES

A. Factors Influencing Interest rates.1. Federal Reserve Monetary Policy.

2. Investor expectations about economy.

3. Inflation expectations.

4. Business Decisions.


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B. Composition ofNominalInterest Rates.1. Real rate of return.

2. Inflation premium.

3. Default premium.

4. Liquidity premium.

5. Maturity Risk premium


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C. r = r* + IP + DRP + LP + MRP r = required return on a debt security

r* = real risk-free rate of interest

IP = inflation premium

DRP = default risk premium

LP = liquidity premium

MRP = maturity risk premium


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Years to

Maturity

Realrisk-free rate

0

5

10

15

1 10 20

Interest

Rate (%)

Maturity risk premium

Inflation premium


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HOMEWORK ASSIGNMENT

A. Critical Thinking & Concepts: 6.1, 6.2,6.5, 6.9, 6.15 (part c)B. Questions and Problems: 3, 4, 5, 22, 23

(parts a, b)

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FIN335 CH06 Interest Rates & Bond Valuation