6-1 July 20 Outline TVM Lab, Interest Rates and Bond Valuation.

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Presentation transcript:

6-1 July 20 Outline TVM Lab, Interest Rates and Bond Valuation

TVM Lab 2 Download and complete the spreadsheet template located at: 5/07/Class-Spreadsheet-and-Calculator- Exercise-20-July-1cyg68n.xlsx

3 5 years = N 14% = Discount rate (YTM) $60 = Payment (PMT) $1,000 = FV PV = ? st 2nd TI BA II Plus

4 Bond Valuation

5 Download and complete the spreadsheet template located at: 5/07/Interest_Rate_Sensitivity- 1q0zohb.xlsx

Nominal vs Real Interest Rates: The Fisher Effect 6 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

Fisher Effect Example 7 If we require a 10% real return and we expect inflation to be 8%, what is the nominal rate? R = (1.1)(1.08) – 1 =.188 = 18.8% An Approximation: R = 10% + 8% = 18% Because the real return and expected inflation in this example are relatively high, there is significant difference between the actual Fisher Effect and the approximation.

Term Structure of Interest Rates 8 The term structure is the relationship between time to maturity and yields, all else equal; AKA the “yield” curve.

Term Structure of Interest Rates 9 “Normal” yield curve – upward-sloping; long- term yields are higher than short-term yields “Inverted” yield curve – downward-sloping; long-term yields are lower than short-term yields

Upward-Sloping Yield Curve 10

Downward-Sloping Yield Curve 11

12 See rates/Pages/Historic-Yield-Data-Visualization.aspx for the current US Treasury Yield Curve. rates/Pages/Historic-Yield-Data-Visualization.aspx See for inflation data.

Bond Ratings – Investment Quality 13 High Grade – Moody’s Aaa and S&P AAA – capacity to pay is extremely strong – Moody’s Aa and S&P AA – capacity to pay is very strong Medium Grade – Moody’s A and S&P A – capacity to pay is strong, but more susceptible to changes in circumstances – Moody’s Baa and S&P BBB – capacity to pay is adequate, adverse conditions will have more impact on the firm’s ability to pay

Bond Ratings – Speculative (Junk) 14 Low Grade – Moody’s Ba and B – S&P BB and B – Considered possible that the capacity to pay will degenerate. Very Low Grade – Moody’s C (and below) and S&P C (and below) income bonds with no interest being paid, or in default with principal and interest in arrears