7-0 Interest Rates and Bond Valuation Chapter 7 Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Chapter Outline Bond Definitions Bond Valuation Interest Rate Risk Bond Features Types of Bonds Bond Markets & Reporting in the Press Interest Rates & Inflation Term Structure of Interest Rates 1

Bond Definitions Bond (=IOU) Par value (face value) Coupon rate Coupon payment Maturity Yield to maturity Bond Price Current Yield 2

Bond Valuation Bond Price = PV of coupons + PV of face Bond Price = PV annuity + PV of simple CF On the financial calculator use TVM keys: face value (F) = FV coupon payment (C) = PMT, time to maturity (t) = N, yield to maturity (r) = I/Y price = PV (the PV has the opposite sign of FV & PMT) 3

Bond Valuation Example 1 A bond has a $1,000 face value and makes annual coupon payments. If the coupon rate is 10% per year, the time to maturity is 5 years and the yield to maturity is 11% (EAR), what is the price of the bond? 4

Bond Valuation Example 2 A bond has a $1,000 face value and makes semi-annual coupon payments. The coupon rate is 8% per year (APR), the time to maturity is 10 years and the annual yield to maturity is 10%, compounded semi-annually. Calculate the price of the bond. 5

Bond Valuation Example 3 Assume a bond makes annual payments and has as a $1,000 face value. The coupon rate is 8% per year, the time to maturity is 10 years, and the bond sells currently for $945. What is the implied yield to maturity? 6

Bond Valuation Example 4 What is the price of a 10-year, zero coupon bond that pays $1,000 at maturity if the YTM is 9% (assume annual compounding). 7

Interest Rate Risk Definition: Change in price due to changes in interest rates. -As interest rates increase, bond prices, and vice versa. -Premium Bond: -Discount Bond: -Time to maturity is related to interest rate risk. -The coupon rate is related to interest rate risk.

Bond Features 3 Main differences between debt and equity: Indenture: Contract between the company and the bondholders –basic terms of the bonds –amount issued –collateral –seniority –repayment provisions –call provisions –protective covenants

Types of Bonds Government Bonds Zero Coupon Bonds Floating Rate Bonds Income Bonds Convertible Bonds Put Bonds TIPS (Treasury Inflation Protected Securities) 10

Bond Markets & Reporting in the Press Primarily OTC Large, non-transparent market Bond quotes are available online ( Corporate Bond Quote example (as of 3/2006): Current EST Name Coupon Maturity Price Yield YTM Spread UST Vol. AT&T (T) 6.25 Mar 15, ,936 Treasury Bond Quote example (5/2006): Coupon Maturity Bid Asked Change Asked Yield 8.00 Nov :07 128:

Interest Rates & Inflation The Fisher Effect defines the relationship between real rates, nominal rates and inflation (1 + R) = (1 + r)(1 + h), where R = nominal rate r = real rate h = expected inflation rate Approximation R ≈ r + h 12

Interest Rates & Inflation: Example Investors require a real return of 15%. Assume an inflation rate of 4%. What is the nominal rate? 13

Term Structure of Interest Rates Term structure is the relationship between time to maturity and yields, all else equal Yield curve – graphical representation of the term structure 14

Upward-Sloping Yield Curve 15

5-16 Term Structure Source: WSJ, 2/14/2012