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PowerPoint Slides for:

Financial Markets and Institutions 6th Edition


By Jeff Madura

CHAPTER

Bond Valuation and Risk

Chapter Objectives
Demonstrate how bond market prices are established and influenced by interest rate movements Identify the factors that affect bond prices Explain how the sensitivity of bond prices to interest rates is dependent on particular bond characteristics Explain the benefits of diversifying the bond portfolio internationally

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Bond Valuation Process


Bonds are debt obligations with long-term maturities issued by governments or corporations to obtain long-term funds Commonly purchased by financial institutions that wish to invest funds for long-term periods Bond price (value) = present value of cash flows to be generated by the bond

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Bond Valuation Process

Impact of the Discount Rate on Bond Valuation


Discount rate = market-determined yield that could be earned on alternative investments of similar risk and maturity Bond prices vary inversely with changes in market interest rates

Cash

flows are contractual and remain the same each period Bond prices vary to provide the new owner the market rate of return
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Bond Risks and Prices


Higher risk Higher discount rates Lower bond prices

Lower risk Lower discount rates Higher bond prices

Note Inverse Relationship Between Risk, required returns and Bond Prices

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Bond Valuation Process

Bond Price = present value of cash flows discounted at the market required rate of return
C

= Coupon per period (PMT) Par = Face or maturity value (FV) i = Discount rate (i) n = Compounding periods to maturity

C + PV = (1+ i)1

C + Par C + (1+ i)2 (1+ i)n


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Bond Valuation Process

Consider a $1000, 10% coupon (paid annually) bond that has three years remaining to maturity. Assume the prevailing annualized yield on other bonds with similar risk is 12 percent. Calculate the bonds value.
The expected cash flows of a coupon bond includes periodic interest payments, and A final $1000 payoff at maturity Discounted at the market rate of return of 12%

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Bond Valuation Process


PV = $100/(1+.12)1 + $100/(1+.12)2 + $1100/(1+.12)3

= $951.97 N I PV
PMT

FV

12

100 1000

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Bond Valuation Process


PV = $100/(1+.12)1 + $100/(1+.12)2 + $1100/(1+.12)3

= $951.97 N I PV
PMT

FV

12

951.97 100 1000

Copyright 2002 Thomson Publishing. All rights reserved.

Bond Valuation Process

Valuation of Bonds with Semiannual Payments


Most bonds pay interest semiannually Double the number of compounding periods (N) and halve the annual coupon amount (PMT) and the discount rate (I)

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Re-work the above problem assuming semiannual compounding

N 6

I 6

PV ?

PMT

FV 1000

50

Copyright 2002 Thomson Publishing. All rights reserved.

Re-work the above problem assuming semiannual compounding

N 6

I 6

PV 950.82

PMT

FV 1000

50

Copyright 2002 Thomson Publishing. All rights reserved.

Relationships Between Coupon Rate, Required Return, and Bond Price


Zero-Coupon Bonds
No periodic coupon Pays face value at maturity Trade at discount from face value No reinvestment risk Considerable price risk

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Relationships Between Coupon Rate, Required Return, and Bond Price


Discount bonds are bonds priced below face value; premium bonds above face value Discounted bond

Coupon < Market rates Rates have increased since issuance Adverse risks factors that may have occurred

Price

riskdepends on maturity Default risk may have increased Fisher effect of higher expected inflation
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Relationships Between Coupon Rate, Required Return, and Bond Price

Premium bond
Coupon > Market Rates decreased since issuance Favorable risk experience

Price

riskdepends on maturity Default risk might have decreased as economic activity has increased Low inflation expectations

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Relationships Between Coupon Rate, Required Return, and Bond Price


Bond Maturity and Price Variability

Long-term bond prices are more sensitive to given changes in market rates than short-term bonds Changes in rates compounded many times for later coupon and maturity value, impacting price (PV) significantly Short-term securities have smaller price movements

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Exhibit 8.4
1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 0 5 8 10 12 15 20

5-Year Bond 10-Year Bond 20-Year Bond

Required Return (Percent)


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Relationships Between Coupon Rate, Required Return, and Bond Price


Coupon Rates and Price Variability

Low coupon bond prices more sensitive to change in interest rates PV of face value at maturity a major proportion of the price

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Explaining Bond Price Movements


The price of a bond should reflect the present value of future cash flows discounted at a required rate of return The required return on a bond is primarily determined by

Prevailing risk-free rate Risk premium

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Explaining Bond Price Movements

Factors that affect the risk-free rate

Changes in returns on real investment


Financial

investment an alternative to real investment Opportunity cost of financial investment is the returns available from real investment Federal Government deficits/surplus position

Inflationary expectations
Consumer

price index Federal Reserve monetary policy position Oil prices and other commodity prices Exchange rate movements
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Explaining Bond Price Movements

Factors that affect the credit or default risk premium

Strong economic growth


High

level of cash flows Investors bid up bond prices; lower default premium

Weak economic growth


Lower

profits and cash flows Impact on specific industries varied Investors flee from risky bonds to Treasury bonds Bond prices fall; default premiums increase
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Exhibit 8.8
U.S. Fiscal Policy U.S. Monetary Policy U.S. Economic Conditions Issuers Industry Conditions Issuers Unique Conditions

Long-T erm Risk-Free Interest Rate (T reasury Bond Rate) Required Return on the Bond

Risk Premium of Issuer

Bond Price
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Sensitivity of Bond Prices to Interest Rate Movements


Bond Price Elasticity = Bond price sensitivity for any % change in market interest rates Bond Price Elasticity =

(% Change In Price)/(% Change In Interest Rates)

Increased elasticity means greater price risk

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Sensitivity of Bond Prices to Interest Rate Movements

Calculate the price sensitivity of a zerocoupon bond with 10 years until maturity if interest rates go from 10% to 8%.

First, calculate the price of the bond for both rates


When

k = 10%, PV = ? When k = 8%, PV = ? Hint: Remember zero-coupon or no PMT in this calculation The price of a zero-coupon bond is the present value of a single future value cash flow.
Copyright 2002 Thomson Publishing. All rights reserved.

Sensitivity of Bond Prices to Interest Rate Movements

Calculate the price sensitivity of a zerocoupon bond with 10 years until maturity if interest rates go from 10% to 8%.

First, calculate the price of the bond for both rates


When

k = 10%, PV = $386 When k = 8%, PV = $463

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Sensitivity of Bond Prices to Interest Rate Movements


Calculate the bond elasticity:
$463 $386 percentP $386 e P .997 8% 10% percentk 10%
Bond elasticity or price sensitivity to changes in interest rates approaches the limit at 1 for zero-coupon bonds. Price sensitivity is lower for coupon bonds. The inverse relationship between k and p causes the negative numbers
Copyright 2002 Thomson Publishing. All rights reserved.

Sensitivity of Bond Prices to Interest Rate Movements

Price-Sensitive Bonds
Longer maturitymore price variation for a change in interest rates Lower coupon rate bonds are more price sensitive (the PV is a greater % of current value) Zero-coupon bonds most sensitive, approaching 1 price elasticity Greater for declining rates than for increasing rates

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Sensitivity of Bond Prices to Interest Rate Movements


Duration
Measure of bond price sensitivity Measures the life of bond on a PV basis Duration = Sum of discounted, time-weighted cash flows divided by price

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Sensitivity of Bond Prices to Interest Rate Movements


Duration
The longer a bonds duration, the greater its sensitivity to interest rate changes The duration of a zero-coupon bond = bonds term to maturity The duration of any coupon bond is always less than the bonds term to maturity

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Sensitivity of Bond Prices to Interest Rate Movements

Modified duration is an easily calculated approximate of the duration measure

DUR DUR * (1 k )

DUR* is a linear approximation of DUR which measures the convex relationship between bond yields and prices

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Bond Investment Strategies Used by Investors


Matching Strategy
Create bond portfolio that will generate income that will match their expected periodic expenses Used to provide retirement income from savings accumulation Estimate cash flow needs then select bond portfolio that will generate needed income

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Bond Investment Strategies Used by Investors


Laddered Strategy
Funds are allocated evenly to bonds in several different maturity classes Example: funds invested in bonds with 5 years until maturity, in10-year bonds, in 15-year bonds, and in 20-year bonds Investor receives average return of yield curve over time as maturing bonds are reinvested

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Bond Investment Strategies Used by Investors


Barbell Strategy

Allocated funds to short-term bonds and long-term bonds Short-term bonds provide liquidity from maturity Long-term bonds provide higher yield (assuming up-sloping yield curve)

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Bond Investment Strategies Used by Investors


Interest Rate Strategy
Funds are allocated in a manner that capitalizes on interest rate forecasts Example: if rates are expected to decline, move into longer-term bonds Problems:

High

transaction costs because of higher trading Difficulty in forecasting interest rates


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Foreign Exchange Rates and Interest Rates


Country interest rate differences reflect expected future spot foreign exchange rates Expected future spot foreign exchange rates (forward forex rates) reflect expected inflation differences between countries Expected return on foreign bond portfolio related to return on bonds adjusted for expected changes in forex rates

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Diversifying Bonds Internationally

Investor may diversify by:


Credit risk Country risk Foreign exchange risk Interest rate risk

Seek lower total variability of returns per level of risk assumed

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