A B C D E F G H

1 Tool Kit Chapter 5 5/6/2013

2
3 Bonds, Bond Valuation, and Interest Rates
4
5 The value of any financial asset is the present value of the asset's expected future cash flows.
6 The key inputs are (1) the expected cash flows and (2) the appropriate discount rate, given the
bond's risk, maturity, and other characteristics. The model developed here analyzes bonds in
7 various ways.
8
9 5-3 Bond Valuation
10
11 A bond has a 15-year maturity, a 9% annual coupon, and a $1,000 par value. The required rate
12 of return (or the yield to maturity) on the bond is 10%, given its risk, maturity, liquidity, and
13 other rates in the economy. What is a fair value for the bond, i.e., its market price?
14
15 We list the key features of the bond in the INPUT section of Table 5-1.
16
17 Figure 5-1
18 Finding the Value of MicroDrive Inc.'s Bond (V B)
19 INPUTS:
20 Years to maturity = N = 15
21 Coupon payment = INT = $90
22 Par value = M = $1,000
23 Required return = rd = 9%
24
25 1. Step-by-Step: Divide each cash flow by (1 + r d)t
PV of
26 Coupon Coupon PV of
Year (t) Payment Payment Par Value Par Value
27 1 $90 $82.57
28 2 $90 $75.75
29 3 $90 $69.50
30 4 $90 $63.76
31 5 $90 $58.49
32 6 $90 $53.66
33 7 $90 $49.23
34 8 $90 $45.17
35 9 $90 $41.44
36 10 $90 $38.02
37 11 $90 $34.88
38 12 $90 $32.00
39 13 $90 $29.36
40 14 $90 $26.93
41 15 $90 $24.71 $1,000 $274.54
42 Total = $725.46
43
44 VB = PV of all coupon payments + PV of par value = $1,000.00
45
46 Inputs: 15 0 90 1,000
47 2. Financial Calculator: N I/YR PV PMT FV
48 Output: −$1,000.00
49
 A B C D E F G H
50 3. Excel: PV function: PVN = =PV(9%,15,90,1000)
51 Fixed inputs: PVN = =PV(9%,15,90,1000) = −$1,000.00
52 Cell references: PVN = =PV(C23,C20,C21,C22) = −$1,000.00
53
54
55
 A B C D E F G H
56 Bond Prices on Actual Dates
57
58
59
Thus far we have evaluated bonds assuming that we are at the beginning of an interest payment
60 period. This is correct for new issues, but it is generally not correct for outstanding bonds.
However, Excel has several date and time functions, and a bond valuation function that uses the
61 calendar, so we can get exact valuations on any given date.
62
63 Here is the data for MicroDrive's bond as of the day it was issued.
64
65 Settlement date (day on which you find bond price) = 1/5/2013
66 Maturity date = 1/5/2028
67 Coupon rate = 9.00%
68 Required return, rd = 9.00%

69 Redemption (100 means the bond pays

100% of its face value at maturity) = 100
70 Frequency (# payments per year) = 1
71 Basis (1 is for actual number of days in month and year 1
72
73 Click on fx on the formula bar (or click Insert and then Function). This gives you the "Insert
74 Function" dialog box. To find a bond's price, use the PRICE function (found in the "Financial"
category of the "Insert Function dialog box). The PRICE function returns the price per $100
75 dollars of face value.
76
77 Using PRICE function with inputs that are cell references:
78 Value of bond based on $100 face value = $100.00
79 Value of bond in dollars based on $1,000 face value = $1,000.00
80
81 Using the PRICE function with inputs that are not cell references:
82 Value of bond based on $100 face value = =PRICE(DATE(2013,1,5),DATE(2028,1,5),9%,9%,100,1,1)
83 Value of bond based on $100 face value = 100.000
84 Value of bond in dollars based on $1,000 face value = $1,000.00
85
86
87 Interest Rate Changes and Bond Prices
88
89 Suppose the going interest rate changed from 10%, falling to 5% or rising to 15%. How would
90 those changes affect the value of the bond?
91
92
We could simply go to the input data section shown above, change the value for r from 10% to
93 5% and then 15%, and observe the changed values. An alternative is to set up a data table to
94 show the bond's value at a range of rates, i.e., to show the bond's sensitivity to changes in
95 interest rates. This is done below, and the values at 5% and 15% are boldfaced.
96 Bond Value
97 Going rate, r: $1,000 To make the data table, first type the headings, then
98 0% type the rates in the cells with the red font, and then
99 4% put the formula =-G52 in cell B97, then select the
rangeof yellow cells. Then click Data, What-IF-
100 9% Analysis, and then Table to get the menu. The input
101 14% data are in a column, so put the cursor on column and
102 20% enter C23 the place where the going rate is inputted.
Click OK to complete the operation and get the table.
103 30%
 To make the data table, first type the headings, then
type the rates in the cells with the red font, and then
put the formula =-G52 in cell B97, then select the
rangeof yellow cells. Then click Data, What-IF-
Analysis, and then Table to get the menu. The input
data are in a column, so put the cursor on column and
enter C23 the place where the going rate is inputted.
A B C Click D
OK to completeE the operationFand get the table.
G H
104
105 We can use the data table to construct a graph that
106 shows the bond's sensitivity to changing rates.
107
108
109
110 Interest Rate Sensitivity
111
112
113
114
$12
115
116 $10
117
118 $8
119
120 $6
121
122 $4
123
$2
124
125 $0
126 -5% 0% 5% 10% 15% 20% 25% 30%
127
128
129
130
131
132
133 5-4 Changes in Bond Values over Time
134
135
136 What happens to a bond price over time? To set up this problem, we will enter the different
interest rates, and use the array of cash flows above. The following example operates under the
137 precept that the bond is issued at par ($1,000) in year 0. From this point, the example sets three
138 conditions for interest rates to follow: interest rates stay constant at 10%, interest rates fall to
5%, or interest rates rise to 15%. Then the price of the bond over the fifteen years of its life is
139 determined for each of the scenarios.
140
141 Suppose interest rates rose to 15% or fell to 5% immediately after the bond was issued, and
they remained at the new level for the next 15 years. What would happen to the price of the
142 bond over time?
143
144
145 We could set up data tables to get the data for this problem, but instead we simply inserted the
PV formula into the following matrix to calculate the value of the bond over time. Note that the
146 formula takes the interest rate from the column heads, and the value of N from the left column.
147 Note that the N = 0 values for the 5% and 15% rates are consistent with the results in the data
148 table above. We can also plot the data, as shown in the graph below.
149
 A B C D E F G H
150 Value of Bond in Given Year:
151 N 4% 9% 14%
152 15 $1,555.92 $1,000.00 $692.89
153 14 $1,528.16 $1,000.00 $699.90
154 13 $1,499.28 $1,000.00 $707.88
155 12 $1,469.25 $1,000.00 $716.99
156 11 $1,438.02 $1,000.00 $727.36
157 10 $1,405.54 $1,000.00 $739.19
158 9 $1,371.77 $1,000.00 $752.68
159 8 $1,336.64 $1,000.00 $768.06
160 7 $1,300.10 $1,000.00 $785.58
161 6 $1,262.11 $1,000.00 $805.57
162 5 $1,222.59 $1,000.00 $828.35
163 4 $1,181.49 $1,000.00 $854.31
164 3 $1,138.75 $1,000.00 $883.92
165 2 $1,094.30 $1,000.00 $917.67
166 1 $1,048.08 $1,000.00 $956.14
167 0 $1,000.00 $1,000.00 $1,000.00
168
169
170 Figure 5-2
171 Time Path of the Value of a 9% Coupon, $1,000 Par Value Bond When Interest Rates Are 4%, 9%, and 14%
172
173 Bond Value Price of Bond Over Time
174 ($)
175 1,600
176 rd Falls and Stays at 4% (Premium Bond)
177 1,400
178
179
180 1,200
181 rd = Coupon Rate = 9% (Par Bond)
182 1,000
183
184
185 800
186
187 600 rd Rises and Stays at 14% (Discount Bond)
188
189
190 400
191
192 200
193
194
0
195
196 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0
197 Years Remaining Until Maturity
198
199
200
201
If rates fall, the bond goes to a premium, but it moves toward par as maturity approaches. The
202 reverse hold if rates rise and the bond sells at a discount. If the going rate remains equal to the
coupon rate, the bond will continue to sell at par. Note that the above graph assumes that
interest rates stay constant after the initial change. That is most unlikely--interest rates
fluctuate, and so do the prices of outstanding bonds.
 If rates fall, the bond goes to a premium, but it moves toward par as maturity approaches. The
reverseAhold if rates B C sells at aD
rise and the bond E going rate remains
discount. If the F equal G
to the H
203 coupon rate, the bond will continue to sell at par. Note that the above graph assumes that
interest rates stay constant after the initial change. That is most unlikely--interest rates
204 fluctuate, and so do the prices of outstanding bonds.
205
206 Market rate = 4%
Fall in
Price
207 Remaining Return Due Return Due from
Years Until Years After to Coupon to Price Previous
Maturity Issue Bond Price Payment Change Total Return Year
208 15 0 $1,555.92
209 14 1 $1,528.16 5.78% -1.78% 4.00%
210 13 2 $1,499.28 5.89% -1.89% 4.00% $28.88
211 12 3 $1,469.25 6.00% -2.00% 4.00% $30.03
212 11 4 $1,438.02 6.13% -2.13% 4.00% $31.23
213 10 5 $1,405.54 6.26% -2.26% 4.00% $32.48
214 9 6 $1,371.77 6.40% -2.40% 4.00% $33.77
215 8 7 $1,336.64 6.56% -2.56% 4.00% $35.13
216 7 8 $1,300.10 6.73% -2.73% 4.00% $36.54
217 6 9 $1,262.11 6.92% -2.92% 4.00% $37.99
218 5 10 $1,222.59 7.13% -3.13% 4.00% $39.52
219 4 11 $1,181.49 7.36% -3.36% 4.00% $41.10
220 3 12 $1,138.75 7.62% -3.62% 4.00% $42.74
221 2 13 $1,094.30 7.90% -3.90% 4.00% $44.45
222 1 14 $1,048.08 8.22% -4.22% 4.00% $46.22
223 0 15 $1,000.00 8.59% -4.59% 4.00% $48.08
224
225 Market rate = 9%

Fall in
Price
226 Remaining Return Due Return Due from
Years Until to Coupon to Price Previous
Maturity N Bond Price Payment Change Total Return Year
227 15 0 $1,000.00
228 14 1 $1,000.00 9.00% 0.00% 9.00%
229 13 2 $1,000.00 9.00% 0.00% 9.00% $0.00
230 12 3 $1,000.00 9.00% 0.00% 9.00% $0.00
231 11 4 $1,000.00 9.00% 0.00% 9.00% $0.00
232 10 5 $1,000.00 9.00% 0.00% 9.00% $0.00
233 9 6 $1,000.00 9.00% 0.00% 9.00% $0.00
234 8 7 $1,000.00 9.00% 0.00% 9.00% $0.00
235 7 8 $1,000.00 9.00% 0.00% 9.00% $0.00
236 6 9 $1,000.00 9.00% 0.00% 9.00% $0.00
237 5 10 $1,000.00 9.00% 0.00% 9.00% $0.00
238 4 11 $1,000.00 9.00% 0.00% 9.00% $0.00
239 3 12 $1,000.00 9.00% 0.00% 9.00% $0.00
240 2 13 $1,000.00 9.00% 0.00% 9.00% $0.00
241 1 14 $1,000.00 9.00% 0.00% 9.00% $0.00
242 0 15 $1,000.00 9.00% 0.00% 9.00% $0.00
243
244
245 Market rate = 14%
 A B C D E F G H
Increase
in Price
246 Remaining Return Due Return Due from
Years Until to Coupon to Price Previous
Maturity N Bond Price Payment Change Total Return Year
247 15 0 $692.89
248 14 1 $699.90 12.99% 1.01% 14.00%
249 13 2 $707.88 12.86% 1.14% 14.00% $7.99
250 12 3 $716.99 12.71% 1.29% 14.00% $9.10
251 11 4 $727.36 12.55% 1.45% 14.00% $10.38
252 10 5 $739.19 12.37% 1.63% 14.00% $11.83
253 9 6 $752.68 12.18% 1.82% 14.00% $13.49
254 8 7 $768.06 11.96% 2.04% 14.00% $15.38
255 7 8 $785.58 11.72% 2.28% 14.00% $17.53
256 6 9 $805.57 11.46% 2.54% 14.00% $19.98
257 5 10 $828.35 11.17% 2.83% 14.00% $22.78
258 4 11 $854.31 10.87% 3.13% 14.00% $25.97
259 3 12 $883.92 10.53% 3.47% 14.00% $29.60
260 2 13 $917.67 10.18% 3.82% 14.00% $33.75
261 1 14 $956.14 9.81% 4.19% 14.00% $38.47
262 0 15 $1,000.00 9.41% 4.59% 14.00% $43.86
263
264
265 5-5 Bonds with Semiannual Coupons
266
267 Since most bonds pay interest semiannually, we now look at the valuation of semiannual bonds.
268 We must make three modifications to our original valuation model: (1) divide the coupon
payment by 2, (2) multiply the years to maturity by 2, and (3) divide the nominal interest rate
269 by 2.
270
271 Suppose MicroDrive's bond pays interest semiannually. What is its price if the the price if there
272 are still 15 years until maturity but r d has fallend to 4%?
273
274 Use the PV function with adjusted data to solve the problem.
275
276 Periods to maturity = 15*2 = 30
277 Semiannual pmt = $90/2 = $45.00
278 Current price: $1,000.00
279 Periodic rate = 4%/2 = 2.0%
280
281 PV = $1,559.91 if semiannual payments
282 PV = $1,555.92 if annual payments
283
Note that the bond is now more valuable with semiannual paymens because interest payments
284 come in slightly earlier.
285
286 5-6 Bond Yields
287
288 Yield to Maturity
289
290
291 The YTM is defined as the rate of return that will be earned if a bond makes all scheduled
payments and is held to maturity. The YTM is the same as the total rate of return discussed in
292 the chapter, and it can also be interpreted as the "promised rate of return," or the return to
investors if all promised payments are made. The YTM for a bond that sells at par consists
entirely of an interest yield. However, if the bond sells at any price other than its par value, the
YTM consists of the interest yield together with a positive or negative capital gains yield. The
YTM can be determined by solving the bond value formula for I. However, an easier method for
finding it is to use Excel's Rate function. Since the price of a bond is simply the sum of the
present values of its cash flows, so we can use the time value of money techniques to solve these
problems.
 The YTM is defined as the rate of return that will be earned if a bond makes all scheduled
payments and is held to maturity. The YTM is the same as the total rate of return discussed in
A
the chapter, B also be interpreted
and it can C D"promised rate
as the E of return," or
F the return to
G H
investors if all promised payments are made. The YTM for a bond that sells at par consists
293 entirely of an interest yield. However, if the bond sells at any price other than its par value, the
YTM consists of the interest yield together with a positive or negative capital gains yield. The
294 YTM can be determined by solving the bond value formula for I. However, an easier method for
295 finding it is to use Excel's Rate function. Since the price of a bond is simply the sum of the
present values of its cash flows, so we can use the time value of money techniques to solve these
296 problems.
297
298
299
300 Problem: Suppose that you are offered a 14-year, 9% annual coupon, $1,000 par value bond at
301 a price of $1,528.16.
302
303 Use the Rate function to solve the problem.
304
305 Years to Mat: 14
306 Coupon rate: 9%
307 Annual Pmt: $90.00
308 Current price: $1,528.16
309 Par value = FV: $1,000.00
310
311 Going rate, rd =YTM= 4.00%
312
313
314 The yield-to-maturity is the same as the expected rate of return only if (1) the probability of
315 default is zero, and (2) the bond can not be called. If there is any chance of default, then there is
a chance some payments may not be made. In this case, the expected rate of return will be less
316 than the promised yield-to-maturity.
317
318 Finding the Yield to Maturity on Actual Dates
319
320 Thus far we have evaluated bonds assuming that we are at the beginning of an interest payment
321 period. This is correct for new issues, but it is generally not correct for outstanding bonds.
However, Excel has a function that uses the actual calendar when finding yields. Consider the
322 bond above, with 14 years until maturity. Suppose the actual current date is 1/5/2014, so the
bond matures on 1/5/2028.
323
324
325 Here is the data for the bond.
326
327 Settlement date (day on which you find bond price) = 01/05/14
328 Maturity date = 01/05/28
329 Coupon rate = 9.00%
330 Price = bond price per $100 par value = $152.82

331 Redemption (100 means the bond pays

100% of its face value at maturity) = 100
332 Frequency (# payments per year) = 1
333 Basis (1 is for actual number of days in month and year 1
334
335 Using the YIELD function with inputs that are cell references:
336 Yield to maturity = 4.0%
337
338
339 Yield to Call
340
The yield to call is the rate of return investors will receive if their bonds are called. If the issuer
has the right to call the bonds, and if interest rates fall, then it would be logical for the issuer to
call the bonds and replace them with new bonds that carry a lower coupon. The yield to call
(YTC) is found similarly to the YTM. The same formula is used, but years to maturity is replaced
with years to call, and the maturity value is replaced with the call price.
 A B C D E F G H
341 The yield to call is the rate of return investors will receive if their bonds are called. If the issuer
has the right to call the bonds, and if interest rates fall, then it would be logical for the issuer to
342 call the bonds and replace them with new bonds that carry a lower coupon. The yield to call
343 (YTC) is found similarly to the YTM. The same formula is used, but years to maturity is replaced
344 with years to call, and the maturity value is replaced with the call price.
345
346
Problem: Suppose you purchase a 15-year, 9% annual coupon, $1,000 par value bond with a
347 call provision after 10 years at a call price of $1,100. One year later, interest rates have fallen
from 9% to 4% causing the value of the bond to rise to $1,528.16. What is the bond's YTC? Note
348 that this is the same bond as in the previous question, but now we assume it can be called.
349
350
351 Use the Rate function to solve the problem.
352
353 Years to call: 9
354 Coupon rate: 9%
355 Annual Pmt: $90.00
356 Current price: $1,528.16
357 Call price = FV $1,100.00
358 Par value $1,000.00
359
360 Rate = I = YTC = 3.15%
361
362 This bond's YTM is 4%, but its YTC is only 3.15%. Which would an investor be more likely to actually earn?
363
364
This company could call the old bonds, which pay $90 per year, and replace them with bonds
365 that pay somewhere in the vicinity of $40 (or maybe even only $31.50) per year. It would want
366 to save that money, so it would in all likelihood call the bonds. In that case, investors would
367 earn the YTC, so the YTC is the expected return on the bonds.
368
369 Current Yield
370
The current yield is the annual interest payment divided by the bond's current price. The
371 current yield provides information regarding the amount of cash income that a bond will
372 generate in a given year. However, it does not account for any capital gains or losses that will be
373 realized fi the bond is held to maturity or call.
374
375 Problem: What is the current yield on a $1,000 par value, 9% annual coupon bond that is
376 currently selling for $985?
377
378 Simply divide the annual interest payment by the price of the bond. Even if the bond made
379 semiannual payments, we would still use the annual interest.
380
381 Par value $1,000.00
382 Coupon rate: 9%
383 Annual Pmt: $90.00
384 Current price: $985.00
385
386 Current Yield = 9.14%
387
388
The current yield provides information on a bond's cash return, but it gives no indication of the
389 bond's total return. To see this, consider a zero coupon bond. Since zeros pay no coupon, the
390 current yield is zero because there is no interest income. However, the zero appreciates
391 through time, and its total return clearly exceeds zero.
392
 A B C D E F G H
393 5-7 The Pre-Tax Cost of Debt: Determinants of Market Interest Rates
394
395 Quoted market interest rate = rd = r* + IP + DRP + LP + MRP
396
397 r* = Real risk-free rate of interest
398 IP = Inflation premium
399 DRP = Default risk premium
400 LP = Liquidity premium
401 MRP = Maturity risk premium
402
403
404 5-8 The Real Risk-Free Rate of Interest, r*
405
406 r* = Real risk-free rate of interest
407 r* = Yield on short-term (1-year) U.S. Treasury Inflation-Protected Security (TIPS)
408 r* = -2.00% March, 2012
409
410
411 5-9 The Inflation Premium (IP)
412 1 Maturity 1 1
413 1 1 Year 5 Years 20 Years
414 Non-indexed U.S. Treasury Bond 0.23% 1.21% 2.97%
415 TIPS -2.00% -1.05% 0.58%
416 Inflation premium 2.23% 2.26% 2.39% March, 2012
417
418
419 5-10 The Nominal, or Quoted, Risk-Free Rate of Interest, rRF
420
421 Nominal, or quoted, rate = rd = rRF + DRP + LP + MRP
422
423
424 5-11 The Default Risk Premium (DRP)
425
426 Table 5-1
427 Bond Ratings, Default Risk, and Yields

428 Percent upgraded or

Rating Agencya Percent defaulting within:b Median Ratiosc downgraded in 2011:b
Total
429 Return on debt/Total
S&P and Fitch Moody’s 1 year 5 years capital capital Down Up
430 (1) (2) (3) (4) (5) (6) (7) (8)
431 Investment grade bonds:
432 AAA Aaa 0.00 0.00 27.60 12.40 0.00 NA
433 AA Aa 0.03 0.12 27 28.3 29.24 0.00
434 A A 0.09 0.74 17.5 37.5 7.79 0.00
435 BBB Baa 0.23 2.54 13.4 42.5 3.29 2.95
436 Junk bonds:
437 BB Ba 1.17 6.91 11.3 53.7 4.82 8.13
438 B B 2.14 9.28 8.7 75.9 3.48 7.59
439 CCC Caa 24.5 35.23 3.2 113.5 16.67 20.00
440
441 Notes:
442
a
The ratings agencies also use “modifiers” for bonds rated below triple-A. S&P and Fitch use a plus and minus
system; thus, A+ designates the strongest A-rated bonds and A– the weakest. Moody’s uses a 1, 2, or 3 designation,
with 1 denoting the strongest and 3 the weakest; thus, within the double-A category, Aa1 is the best, Aa2 is average,
and Aa3 is the weakest.
 a
A B C D E F G H
The ratings agencies also use “modifiers” for bonds rated below triple-A. S&P and Fitch use a plus and minus
443 system; thus, A+ designates the strongest A-rated bonds and A– the weakest. Moody’s uses a 1, 2, or 3 designation,
with 1 denoting the strongest and 3 the weakest; thus, within the double-A category, Aa1 is the best, Aa2 is average,
444 and Aa3 is the weakest.
445
b
Default data are from Fitch Ratings Global Corporate Finance 2011 Transition and Default Study, March 16, 2012:
446 see www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=669829.
447 Median ratios are from Standard & Poor’s 2006 Corporate Ratings Criteria, April 23, 2007: see
c

448 http://www2.standardandpoors.com/spf/pdf/fixedincome/Corporate_Ratings_2006.pdf.
449
d
Composite yields for 10-year AAA, AA, A, and BBB bonds can be found at
450 www.bondsonline.com/Todays_Market/Composite_Bond_Yields_table.php. Representative yields for 10-year BB, B,
and CCC bonds can be found using the bond screener at
451 http://cxa.marketwatch.com/finra/bondcenter/AdvancedScreener.aspx.
452
453 Bond spreads are the difference between the yield on a bond and the yield on some other bond
of the same maturity. For a bond with good liquidity, its spread relative to a T-bond of similar
454 maturity is a good estmat of the default risk premium.
455
456 Figure 5-3
457 Bond Spreads
458
459
460 Spread Data for chart to rig
461 (%)
462
463 7.00
464
465
466
467 6.00
468
469
470 5.00
471 BAA − T-
472
473 4.00 bond
474
475
476 3.00
477
478
479 2.00
480
481
482 1.00
483
484 AAA − T-
485 0.00 bond
2001-01

2002-03
2002-10

2003-12

2005-02
2005-09
2006-04

2007-06
2008-01

2009-03
2009-10

2010-12

2012-02
2001-08

2003-05

2004-07

2006-11

2008-08

2010-05

2011-07

486
487
488
489
490
 A B C D E F G H
491
492

493

BofA Merrill Lynch US High Yield Master II Effective Yield and TED Spread
494 Data to Right of Chart
495
496 Hi-Yield Spread TED Spread (%)
497 (%)
498
499 25 4
500
501
502 20
3
503
504 15
505 Hi-Yield
506 2
507 10
508
509 1
510 5
511 TED
512
513 0 0
200
200
200
200
200
200

200
200
201
201
200

201

514
515
516
517 5-12 The Liquidity Premium (LP)
518
519
A differential of at least 2 percentage points (and perhaps up to 4 or 5 percentage points) exists
520 between the least liquid and the most liquid financial assets of similar default risk and maturity.
521
522
523 5-13 The Maturity Risk Premium (MRP)
524
Bonds are exposed to interest rate risk and reinvestment rate risk. The net effect is the
525 maturity risk premium.
526
527 Interest Rate Risk
528
529 Interest Rate Risk is the risk of a decline in a bond's price due to an increase in interest rates.
Price sensitivity to interest rates is greater (1) the longer the maturity and (2) the smaller the
530 coupon payment. Thus, if two bonds have the same coupon, the bond with the longer maturity
531 will have more interest rate sensitivity, and if two bonds have the same maturity, the one with
532 the smaller coupon payment will have more interest rate sensitivity.
533
534 Compare the interest rate risk of two bonds, both of which have a 10% annual coupon and a
535 $1,000 face value. The first bond matures in 1 year, the second in 25 years.
 A B C D E F G H
536
537 Use the PV function, along with a two variable Data Table, to show the bonds' price sensitivity.
538 Coupon rate: 10%
539 Payment $100.00
540 Par value $1,000.00
541 Maturity 1
542 Going rate = r = YTM 10%
543
544 Value of bond: $1,000.00
545
546
547 Value of the Bond Under Different Conditions
548 Going rate, r Years to Maturity
549 $1,000.00 1 25
550 0%
551 5%
552 10%
553 15%
554 20%
555 25%
556
557 Figure 5-4
558 Value of Long- and Short-Term 10% Annual Coupon Bonds at
559 Different Market Interest Rates
560
561 Bond Value
562 ($)
563 1,800
564
565 1,600
566 25-Year
567 Bond
1,400
568
569 1,200
570
571 1,000 1-Year
572 Bond
573 800
574
575 600
576
577 400
578
579 200
580
581 0
582 0% 5% 10% 15% 20% 25%
583
584 Interest Rate, rd
585
586
587
588 5-14 The Term Structure of Interest Rates
589
 A B C D E F G H
590
591 The term structure describes the relationship between long-term and short-term interest rates.
Graphically, this relationship can be shown in what is known as the yield curve. In practice, the yield
592 curve is relatively easy to obtain. It is published daily in the Wall Street Journal and can be accessed
593 through the internet, via www. bloomberg.com. However, the "building block approach" to generating a
594 yield curve is more complicated. We will see that later when we build our own yield curve.
595
596 Before jumping into the creation of our own yield curve, let's look at some historical interest rate data and
597 draw some historical yield curves.
598
599 Maturity (yrs) Mar-80 Feb-00 Mar-12
600 0.5 15.0% 6.0% 0.14%
601 1 14.0% 6.2% 0.17%
602 5 13.5% 6.7% 1.02%
603 10 12.8% 6.7% 2.18%
604 30 12.3% 6.3% 3.30%
605
606 From this data, we can plot three line graphs. Each line graph represents the U.S. Treasury yield
607 curve at a different point in time.
608
609 Figure 5-5
610 U.S. Treasury Bond Interest Rates on Different Dates
611
612 Inte rest R ate

613 16%
(% )

YY

614 14%
ii
ee
l
ld
615 12% d
C

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u
Y
r
u
Y
r
i
v
e

617
i
8% v
e
e
l
ed
lf
6%
618 4%
d
f
Y
o
o
C
r
u

Yield Curve for March 1980

C
619
r
i
rM
Y
uv
a
i
2% e
re
r
e

620
l
M
vc
l
d
af
0% eh
d
o
r

621 0 5 10 r 15 20 25 30
C
c1
C
f
u
h9
u Yea rs to Ma tu ri ty
oF
r
8
r
622
S I
I re
S v
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ef
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t m r
m o
(r T

624
T e ry T
e e
e e
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F
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r
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e at
e m
r

625
m a
i A
r0
r rb m
t 0
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r
yR
r
m e 0
t g
eu
a

626
(
ua
t

Yield Curve for February 2000

e
T n
2C
sr
e
e t
0u
y

627
r
T tr
0o
m
e Rr
02
f
e
r 1
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628 m 9
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9
I
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629
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631 e
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632
t
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2
f
t
et
%
l
R
ie
)

633
a
a
o
ot
t
n
f
e
o
i
f Yield Curve for March 2012
634
:o
n
II
:
o
1
nn

635 f
2
f
%
I
)
f
3
l
la
%

636
a)
t
n
ti
f
io

637 l
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638
:
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35

639
n
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:
))

640 2
%
)
641
 I J K L M N O P
1
2
3
4
5
6
7
8
9
10
11
12
13
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15
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20
21
22
23
24
25

26

27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
 I J K L M N O P
50
51
52
53
54
55
 I J K L M N O P
56
57
58
59
60
61
62
63
64
65
66
67
68

69

70
71
72
73
74
75
76
77
78
79
80
81
82
,DATE(2028,1,5),9%,9%,100,1,1)
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
 I J K L M N O P
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
147
148
149
 I J K L M N O P
150
151
152
153
154
155
156
157
158
159
160
161
162
163
164
165
166
167
168
169
170
171
172 Series Titles:
173 rd Falls and Stays at 4% (Premium Bond)
174 rd = Coupon Rate = 9% (Par Bond)
175 rd Rises and Stays at 14% (Discount Bond)
176
177
178
179
180
181
182
183
184
185
186
187
188
189
190
191
192
193
194
195
196
197
198
199
200
201
202
 I J K L M N O P
393
394
395
396
397
398
399
400
401
402
403
404
405
406
407
408
409
410
411
412
413
414
415
416
417
418
419
420
421
422
423
424
425
426
427

428

429
Yieldd
430 (9)
431
432###
433 3.38
434 3.37
435 6.24
436
437 6.28
438 7.02
439 9.98
440
441
442
nd Fitch use a plus and minus
oody’s uses a 1, 2, or 3 designation,
gory, Aa1 is the best, Aa2 is average,
 I J K L M N O P
443
444
445
and Default Study, March 16, 2012:
29. 446
ril 23, 2007: see
447
_2006.pdf. 448
449

presentative yields for450

10-year BB, B,
451
452
453
454
455
456
457
458
459
Data460
for chart to rig Data for chart to rig Data for chart to rig Data for chart to right Data for chart to right
461
462
463
464
465
466
467
468
469
470
471
472
473
474
475
476
477
478
479
480
481
482
483
484
485
486
487
488
489
490
 I J K L M N O P
491
492 Data for

BofA
Merrill
493 Lynch US
High Yield
Master II TED Spread: 3-
Effective Hi-Yield 3-month month LIBOR -
Month 10-Year T-bond Yield Spread LIBOR 3-month T-Bill 3-month T-Bill
494 2012-02 1.97 7.31 5.34 0.50 0.09 0.41
495 2012-01 1.97 7.90 5.93 0.57 0.03 0.54
496 2011-12 1.98 8.60 6.62 0.56 0.01 0.55
497 2011-11 2.01 8.70 6.69 0.48 0.01 0.47
498 2011-10 2.15 9.15 7.00 0.41 0.02 0.39
499 2011-09 1.98 8.77 6.79 0.35 0.01 0.34
500 2011-08 2.30 8.26 5.96 0.29 0.02 0.27
501 2011-07 3.00 7.26 4.26 0.25 0.04 0.21
502 2011-06 3.00 7.33 4.33 0.25 0.04 0.21
503 2011-05 3.17 6.89 3.72 0.26 0.04 0.22
504 2011-04 3.46 6.99 3.53 0.28 0.06 0.22
505 2011-03 3.41 7.12 3.71 0.31 0.10 0.21
506 2011-02 3.58 7.06 3.48 0.31 0.13 0.18
507 2011-01 3.39 7.31 3.92 0.30 0.15 0.15
508 2010-12 3.29 7.67 4.38 0.30 0.14 0.16
509 2010-11 2.76 7.47 4.71 0.29 0.14 0.15
510 2010-10 2.54 7.45 4.91 0.29 0.13 0.16
511 2010-09 2.65 8.01 5.36 0.29 0.15 0.14
512 2010-08 2.70 8.33 5.63 0.36 0.16 0.20
513 2010-07 3.01 8.64 5.63 0.51 0.16 0.35
514 2010-06 3.20 9.13 5.93 0.54 0.12 0.42
515 2010-05 3.42 8.79 5.37 0.46 0.16 0.30
516 2010-04 3.85 8.23 4.38 0.31 0.16 0.15
517 2010-03 3.73 8.63 4.90 0.27 0.15 0.12
518 2010-02 3.69 9.14 5.45 0.25 0.11 0.14
519 2010-01 3.73 8.72 4.99 0.25 0.06 0.19
520 2009-12 3.59 9.33 5.74 0.25 0.05 0.20
521 2009-11 3.40 9.83 6.43 0.27 0.05 0.22
522 2009-10 3.39 10.04 6.65 0.28 0.07 0.21
523 2009-09 3.40 10.77 7.37 0.30 0.12 0.18
524 2009-08 3.59 11.51 7.92 0.42 0.17 0.25

525 2009-07 3.56 12.71 9.15 0.52 0.18 0.34

526 2009-06 3.72 13.42 9.70 0.62 0.18 0.44
527 2009-05 3.29 14.68 11.39 0.82 0.18 0.64
528 2009-04 2.93 17.50 14.57 1.11 0.16 0.95
529 2009-03 2.82 19.72 16.90 1.27 0.21 1.06
530 2009-02 2.87 18.47 15.60 1.24 0.30 0.94
531 2009-01 2.52 18.36 15.84 1.21 0.13 1.08
532 2008-12 2.42 21.82 19.40 1.83 0.03 1.80
533 2008-11 3.53 20.32 16.79 2.28 0.19 2.09
534 2008-10 3.81 17.79 13.98 4.06 0.67 3.39
535 2008-09 3.69 12.18 8.49 3.12 1.13 1.99
 I J K L M N O P
536 2008-08 3.89 11.46 7.57 2.81 1.72 1.09
537 2008-07 4.01 11.18 7.17 2.79 1.63 1.16
538 2008-06 4.10 10.34 6.24 2.77 1.86 0.91
539 2008-05 3.88 10.02 6.14 2.69 1.73 0.96
540 2008-04 3.68 10.41 6.73 2.79 1.29 1.50
541 2008-03 3.51 10.82 7.31 2.78 1.26 1.52
542 2008-02 3.74 10.31 6.57 3.09 2.12 0.97
543 2008-01 3.74 10.02 6.28 3.92 2.75 1.17
544 2007-12 4.10 9.40 5.30 4.98 3.00 1.98
545 2007-11 4.15 9.15 5.00 4.96 3.27 1.69
546 2007-10 4.53 8.48 3.95 5.15 3.90 1.25
547 2007-09 4.52 8.76 4.24 5.49 3.89 1.60
548 2007-08 4.67 8.88 4.21 5.48 4.20 1.28
549 2007-07 5.00 8.30 3.30 5.36 4.82 0.54
550 2007-06 5.10 7.68 2.58 5.36 4.61 0.75
551 2007-05 4.75 7.32 2.57 5.36 4.73 0.63
552 2007-04 4.69 7.41 2.72 5.35 4.87 0.48
553 2007-03 4.56 7.43 2.87 5.35 4.94 0.41
554 2007-02 4.72 7.37 2.65 5.36 5.03 0.33
555 2007-01 4.76 7.55 2.79 5.36 4.98 0.38
556 2006-12 4.56 7.59 3.03 5.36 4.85 0.51
557 2006-11 4.60 7.76 3.16 5.37 4.94 0.43
558 2006-10 4.73 7.99 3.26 5.37 4.92 0.45
559 2006-09 4.72 8.15 3.43 5.38 4.81 0.57
560 2006-08 4.88 8.30 3.42 5.42 4.96 0.46
561 2006-07 5.09 8.47 3.38 5.50 4.95 0.55
562 2006-06 5.11 8.40 3.29 5.38 4.79 0.59
563 2006-05 5.11 8.09 2.98 5.19 4.72 0.47
564 2006-04 4.99 8.04 3.05 5.07 4.60 0.47
565 2006-03 4.72 8.03 3.31 4.92 4.51 0.41
566 2006-02 4.57 7.96 3.39 4.76 4.43 0.33
567 2006-01 4.42 7.96 3.54 4.61 4.24 0.37
568 2005-12 4.47 8.12 3.65 4.49 3.89 0.60
569 2005-11 4.54 8.14 3.60 4.35 3.88 0.47
570 2005-10 4.46 8.00 3.54 4.17 3.71 0.46
571 2005-09 4.20 7.74 3.54 3.91 3.42 0.49
572 2005-08 4.26 7.56 3.30 3.80 3.44 0.36
573 2005-07 4.18 7.57 3.39 3.61 3.22 0.39
574 2005-06 4.00 7.77 3.77 3.43 2.97 0.46
575 2005-05 4.14 8.20 4.06 3.27 2.84 0.43
576 2005-04 4.34 7.91 3.57 3.15 2.78 0.37
577 2005-03 4.50 7.27 2.77 3.02 2.74 0.28
578 2005-02 4.17 6.97 2.80 2.82 2.54 0.28
579 2005-01 4.22 7.11 2.89 2.67 2.33 0.34
580 2004-12 4.23 6.95 2.72 2.50 2.19 0.31
581 2004-11 4.19 7.06 2.87 2.31 2.07 0.24
582 2004-10 4.10 7.34 3.24 2.08 1.76 0.32
583 2004-09 4.13 7.49 3.36 1.90 1.65 0.25
584 2004-08 4.28 7.79 3.51 1.73 1.48 0.25
585 2004-07 4.50 7.92 3.42 1.63 1.33 0.30
586 2004-06 4.73 8.18 3.45 1.50 1.27 0.23
587 2004-05 4.72 8.30 3.58 1.25 1.02 0.23
588 2004-04 4.35 7.60 3.25 1.15 0.94 0.21
589 2004-03 3.83 7.47 3.64 1.11 0.94 0.17
 I J K L M N O P
590 2004-02 4.08 7.55 3.47 1.12 0.93 0.19
591 2004-01 4.15 7.31 3.16 1.13 0.88 0.25
592 2003-12 4.27 7.78 3.51 1.17 0.90 0.27
593 2003-11 4.30 8.13 3.83 1.17 0.93 0.24
594 2003-10 4.29 8.35 4.06 1.16 0.92 0.24
595 2003-09 4.27 8.79 4.52 1.14 0.94 0.20
596 2003-08 4.45 9.40 4.95 1.13 0.95 0.18
597 2003-07 3.98 8.96 4.98 1.11 0.90 0.21
598 2003-06 3.33 8.90 5.57 1.12 0.92 0.20
599 2003-05 3.57 9.39 5.82 1.28 1.07 0.21
600 2003-04 3.96 10.16 6.20 1.30 1.13 0.17
601 2003-03 3.81 11.05 7.24 1.29 1.13 0.16
602 2003-02 3.90 11.50 7.60 1.34 1.17 0.17
603 2003-01 4.05 11.41 7.36 1.37 1.17 0.20
604 2002-12 4.03 12.19 8.16 1.40725 1.19 0.22
605 2002-11 4.05 12.87 8.82 1.45588 1.23 0.23
606 2002-10 3.94 13.86 9.92 1.78454 1.58 0.20
607 2002-09 3.87 13.08 9.21 1.80461 1.63 0.17
608 2002-08 4.26 13.3 9.04 1.77485 1.62 0.15
609 2002-07 4.65 13.3 8.65 1.84845 1.68 0.17
610 2002-06 4.93 12.23 7.30 1.87761 1.7 0.18
611 2002-05 5.16 11.58 6.42 1.90455 1.73 0.17
612 2002-04 5.21 11.85 6.64 1.96696 1.72 0.25
613 2002-03 5.28 12.15 6.87 1.98788 1.79 0.20
614 2002-02 4.91 12.46 7.55 1.90319 1.73 0.17
615 2002-01 5.04 12.63 7.59 1.8206 1.65 0.17
616 2001-12 5.09 12.85 7.76 1.92431 1.69 0.23
617 2001-11 4.65 12.92 8.27 2.10298 1.87 0.23
618 2001-10 4.57 13.81 9.24 2.40005 2.16 0.24
619 2001-09 4.73 13.51 8.78 3.03456 2.64 0.39
620 2001-08 4.97 12.71 7.74 3.56602 3.36 0.21
621 2001-07 5.24 13.17 7.93 3.75114 3.51 0.24
622 2001-06 5.28 13.03 7.75 3.83408 3.49 0.34
623 2001-05 5.39 12.78 7.39 4.10366 3.62 0.48
624 2001-04 5.14 13.37 8.23 4.61388 3.87 0.74
625 2001-03 4.89 12.74 7.85 4.96398 4.42 0.54
626 2001-02 5.10 12.66 7.56 5.34816 4.88 0.47
627 2001-01 5.16 13.56 8.40 5.69818 5.15 0.55
628
629
630
631
632
633
634
635
636
637
638
639
640
641
 Q R S T U V W
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25

26

27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
 Q R S T U V W
50
51
52
53
54
55
 Q R S T U V W
443
444
445
446
447
448
449
450
451
452
453
454
455
456
457 Data for Figure 5-3
458 Sources: FRED monthly data
459
Data for 460
chart to right DATE AAA-Bond BAA Bond 10-Year T-bond AAA - T-bond BAA - T-bond
461 2012-02 3.85 5.14 1.97 1.88 3.17
462 2012-01 3.85 5.23 1.97 1.88 3.26
463 2011-12 3.93 5.25 1.98 1.95 3.27
464 2011-11 3.87 5.14 2.01 1.86 3.13
465 2011-10 3.98 5.37 2.15 1.83 3.22
466 2011-09 4.09 5.27 1.98 2.11 3.29
467 2011-08 4.37 5.36 2.30 2.07 3.06
468 2011-07 4.93 5.76 3.00 1.93 2.76
469 2011-06 4.99 5.75 3.00 1.99 2.75
470 2011-05 4.96 5.78 3.17 1.79 2.61
471 2011-04 5.16 6.02 3.46 1.70 2.56
472 2011-03 5.13 6.03 3.41 1.72 2.62
473 2011-02 5.22 6.15 3.58 1.64 2.57
474 2011-01 5.04 6.09 3.39 1.65 2.70
475 2010-12 5.02 6.10 3.29 1.73 2.81
476 2010-11 4.87 5.92 2.76 2.11 3.16
477 2010-10 4.68 5.72 2.54 2.14 3.18
478 2010-09 4.53 5.66 2.65 1.88 3.01
479 2010-08 4.49 5.66 2.70 1.79 2.96
480 2010-07 4.72 6.01 3.01 1.71 3.00
481 2010-06 4.88 6.23 3.20 1.68 3.03
482 2010-05 4.96 6.05 3.42 1.54 2.63
483 2010-04 5.29 6.25 3.85 1.44 2.40
484 2010-03 5.27 6.27 3.73 1.54 2.54
485 2010-02 5.35 6.34 3.69 1.66 2.65
486 2010-01 5.26 6.25 3.73 1.53 2.52
487 2009-12 5.26 6.37 3.59 1.67 2.78
488 2009-11 5.19 6.32 3.40 1.79 2.92
489 2009-10 5.15 6.29 3.39 1.76 2.90
490 2009-09 5.13 6.31 3.40 1.73 2.91
 Q R S T U V W
491 2009-08 5.26 6.58 3.59 1.67 2.99
492 2009-07 5.41 7.09 3.56 1.85 3.53

493

2009-06 5.61 7.50 3.72 1.89 3.78

494 2009-05 5.54 8.06 3.29 2.25 4.77
495 2009-04 5.39 8.39 2.93 2.46 5.46
496 2009-03 5.50 8.42 2.82 2.68 5.60
497 2009-02 5.27 8.08 2.87 2.40 5.21
498 2009-01 5.05 8.14 2.52 2.53 5.62
499 2008-12 5.05 8.43 2.42 2.63 6.01
500 2008-11 6.12 9.21 3.53 2.59 5.68
501 2008-10 6.28 8.88 3.81 2.47 5.07
502 2008-09 5.65 7.31 3.69 1.96 3.62
503 2008-08 5.64 7.15 3.89 1.75 3.26
504 2008-07 5.67 7.16 4.01 1.66 3.15
505 2008-06 5.68 7.07 4.10 1.58 2.97
506 2008-05 5.57 6.93 3.88 1.69 3.05
507 2008-04 5.55 6.97 3.68 1.87 3.29
508 2008-03 5.51 6.89 3.51 2.00 3.38
509 2008-02 5.53 6.82 3.74 1.79 3.08
510 2008-01 5.33 6.54 3.74 1.59 2.80
511 2007-12 5.49 6.65 4.10 1.39 2.55
512 2007-11 5.44 6.40 4.15 1.29 2.25
513 2007-10 5.66 6.48 4.53 1.13 1.95
514 2007-09 5.74 6.59 4.52 1.22 2.07
515 2007-08 5.79 6.65 4.67 1.12 1.98
516 2007-07 5.73 6.65 5.00 0.73 1.65
517 2007-06 5.79 6.70 5.10 0.69 1.60
518 2007-05 5.47 6.39 4.75 0.72 1.64
519 2007-04 5.47 6.39 4.69 0.78 1.70
520 2007-03 5.30 6.27 4.56 0.74 1.71
521 2007-02 5.39 6.28 4.72 0.67 1.56
522 2007-01 5.40 6.34 4.76 0.64 1.58
523 2006-12 5.32 6.22 4.56 0.76 1.66
524 2006-11 5.33 6.20 4.60 0.73 1.60

525 2006-10 5.51 6.42 4.73 0.78 1.69

526 2006-09 5.51 6.43 4.72 0.79 1.71
527 2006-08 5.68 6.59 4.88 0.80 1.71
528 2006-07 5.85 6.76 5.09 0.76 1.67
529 2006-06 5.89 6.78 5.11 0.78 1.67
530 2006-05 5.95 6.75 5.11 0.84 1.64
531 2006-04 5.84 6.68 4.99 0.85 1.69
532 2006-03 5.53 6.41 4.72 0.81 1.69
533 2006-02 5.35 6.27 4.57 0.78 1.70
534 2006-01 5.29 6.24 4.42 0.87 1.82
535 2005-12 5.37 6.32 4.47 0.90 1.85
 Q R S T U V W
536 2005-11 5.42 6.39 4.54 0.88 1.85
537 2005-10 5.35 6.30 4.46 0.89 1.84
538 2005-09 5.13 6.03 4.20 0.93 1.83
539 2005-08 5.09 5.96 4.26 0.83 1.70
540 2005-07 5.06 5.95 4.18 0.88 1.77
541 2005-06 4.96 5.86 4.00 0.96 1.86
542 2005-05 5.15 6.01 4.14 1.01 1.87
543 2005-04 5.33 6.05 4.34 0.99 1.71
544 2005-03 5.40 6.06 4.50 0.90 1.56
545 2005-02 5.20 5.82 4.17 1.03 1.65
546 2005-01 5.36 6.02 4.22 1.14 1.80
547 2004-12 5.47 6.15 4.23 1.24 1.92
548 2004-11 5.52 6.20 4.19 1.33 2.01
549 2004-10 5.47 6.21 4.10 1.37 2.11
550 2004-09 5.46 6.27 4.13 1.33 2.14
551 2004-08 5.65 6.46 4.28 1.37 2.18
552 2004-07 5.82 6.62 4.50 1.32 2.12
553 2004-06 6.01 6.78 4.73 1.28 2.05
554 2004-05 6.04 6.75 4.72 1.32 2.03
555 2004-04 5.73 6.46 4.35 1.38 2.11
556 2004-03 5.33 6.11 3.83 1.50 2.28
557 2004-02 5.50 6.27 4.08 1.42 2.19
558 2004-01 5.54 6.44 4.15 1.39 2.29
559 2003-12 5.62 6.60 4.27 1.35 2.33
560 2003-11 5.65 6.66 4.30 1.35 2.36
561 2003-10 5.70 6.73 4.29 1.41 2.44
562 2003-09 5.72 6.79 4.27 1.45 2.52
563 2003-08 5.88 7.01 4.45 1.43 2.56
564 2003-07 5.49 6.62 3.98 1.51 2.64
565 2003-06 4.97 6.19 3.33 1.64 2.86
566 2003-05 5.22 6.38 3.57 1.65 2.81
567 2003-04 5.74 6.85 3.96 1.78 2.89
568 2003-03 5.89 6.95 3.81 2.08 3.14
569 2003-02 5.95 7.06 3.90 2.05 3.16
570 2003-01 6.17 7.35 4.05 2.12 3.30
571 2002-12 6.21 7.45 4.03 2.18 3.42
572 2002-11 6.31 7.62 4.05 2.26 3.57
573 2002-10 6.32 7.73 3.94 2.38 3.79
574 2002-09 6.15 7.40 3.87 2.28 3.53
575 2002-08 6.37 7.58 4.26 2.11 3.32
576 2002-07 6.53 7.90 4.65 1.88 3.25
577 2002-06 6.63 7.95 4.93 1.70 3.02
578 2002-05 6.75 8.09 5.16 1.59 2.93
579 2002-04 6.76 8.03 5.21 1.55 2.82
580 2002-03 6.81 8.11 5.28 1.53 2.83
581 2002-02 6.51 7.89 4.91 1.60 2.98
582 2002-01 6.55 7.87 5.04 1.51 2.83
583 2001-12 6.77 8.05 5.09 1.68 2.96
584 2001-11 6.97 7.81 4.65 2.32 3.16
585 2001-10 7.03 7.91 4.57 2.46 3.34
586 2001-09 7.17 8.03 4.73 2.44 3.30
587 2001-08 7.02 7.85 4.97 2.05 2.88
588 2001-07 7.13 7.97 5.24 1.89 2.73
589 2001-06 7.18 7.97 5.28 1.90 2.69
 Q R S T U V W
590 2001-05 7.29 8.07 5.39 1.90 2.68
591 2001-04 7.20 8.07 5.14 2.06 2.93
592 2001-03 6.98 7.84 4.89 2.09 2.95
593 2001-02 7.10 7.87 5.10 2.00 2.77
594 2001-01 7.15 7.93 5.16 1.99 2.77
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Tool Kit Web 5A 5/6/2013
Zero Coupon Bonds

Vandenburg Corporation needs to issue $50 million to finance a project, and it has decided to raise the
funds by issuing $1,000 par value, zero coupon bonds. The going interest rate on such debt is 6%, and
the corporate tax rate is 40%. Find the issue price of Vandenburg's bonds, construct a table to analyze
the cash flows attributable to one of the bonds, and determine the after-tax cost of debt for the issue.
Then, indicate the total par value of the issue.

This example analyzes the after-tax cost of issuing zero coupon debt.

Figure 5A-1
Analysis of a Zero Coupon Bond from Issuer’s Perspective
Input Data
Amount needed = $50,000,000
Maturity value= $1,000
Pre-tax market interest rate, rd = 6%
Maturity (in years) = 5
Corporate tax rate = 40%
Coupon rate = 0%
Coupon payment (assuming annual payments) = $0

Analysis:

Issue Price = PV of payments at rd = $747.26

Years 0 1 2 3 4 5
(1) Remaining years 5 4 3 2 1 0
(2) Year-end accrued value $747.26 $792.09 $839.62 $890.00 $943.40 $1,000.00
(3) Interest payment $0.00 $0.00 $0.00 $0.00 $0.00
(4) Implied interest
deduction on discount $44.84 $47.53 $50.38 $53.40 $56.60
(5) Tax savings $17.93 $19.01 $20.15 $21.36 $22.64
(6) Cash flow $747.26 $17.93 $19.01 $20.15 $21.36 ($977.36)

After-tax cost of debt = 3.60%

Number of $1,000 zeros the

company must issue to raise $50 million = Amount needed/Price per bond
= 66,911.279 bonds
Face amount of bonds = # bonds x $1,000 = $66,911,279
 A B C D E F
1 Tool Kit Web 5C
2
3 Duration
4
5 Duration is a measure of risk for bonds. The following example illustrates its calculation.
6
7 Figure 5C-1
8 Duration
9 Inputs
10 Years to maturity = 20
11 Coupon rate = 9.00%
12 Annual payment = $90.0
13 Par value = FV = $1,000
14 Going rate, r = 9.00%
15 Analysis:
t CFt PV of CFt t(PV of CFt)
16 (1) (2) (3) (4)
17 1 $90 $82.57 82.57
18 2 $90 $75.75 151.50
19 3 $90 $69.50 208.49
20 4 $90 $63.76 255.03
21 5 $90 $58.49 292.47
22 6 $90 $53.66 321.98
23 7 $90 $49.23 344.63
24 8 $90 $45.17 361.34
25 9 $90 $41.44 372.95
26 10 $90 $38.02 380.17
27 11 $90 $34.88 383.66
28 12 $90 $32.00 383.98
29 13 $90 $29.36 381.63
30 14 $90 $26.93 377.05
31 15 $90 $24.71 370.63
32 16 $90 $22.67 362.69
33 17 $90 $20.80 353.54
34 18 $90 $19.08 343.43
35 19 $90 $17.50 332.58
36 20 $1,090 $194.49 3,889.79
37 ↓ ↓
Sum of
38 VB = $1,000.00 t(PV of CFt) = $9,950.11
39
40 Duration = Sum of t(PV of CFt) / VB = 9.95
41
42
43 Finding Duration with the Excel Formula
44
45 Settlement date = 1/1/2011
46 Maturity 12/31/2030
47 Coupon = 9%
48 Yield = 9%
49 Frequency = 1
50
51 Duration = 9.95
 A B C D E F
52
53
54 Consider the amount that would accumulate during the first 10 years, if all coupons are reinvested at the
55 original interest rate of 9%. To do this, first find the amount that would be in the account at 10 years (including
56 the 10-year coupon). Then we find the value of the bond at year 10 based on the payments from 11 and on.
57
58 Duration of Bond = 9.95011
59 Target value
60 at year 10 = $10,000.00
61 FV of reinvested coupons at year 10 if no change in rates = $1,367.36
62 PV at year 10 of remaining payments if no change in rates = $1,000.00
63 Total value at year 10 if no change in rates = $2,367.36
64 Value of bonds to be purchased to provide target at 10 years = $4,224.11
65 Number of bonds purchased = 4.22
66
67
68 Now find the value at year 10 if the market interest rate (shown below) changes immediately after time zero,
69 based on the total number of bonds that were purchased.
70
71 Interest rate = 9.00%
72
73
74 FV at year 10 = $5,775.89
75 PV of payments beyond year 10 discounted back to year 10 = $4,224.11
76 The total value of the position at time 9.95011 is the value of the reinvested coupon and the current value of the
77 bond.
78
79 Value of reinvested coupons: $5,775.89
80 Current value of bond: $4,224.11
81 Total value of position = $10,000.00
82
83
84
85 As the table below shows, the total value of a position at a future time equal to the orginal duration will not fall if
86 interest rates change. For example, if rates go up, the value of reinvested coupons increases and the value of the
bond at the future date (t=duration) falls, but the net affect is an increase in total value. If rates go down, the
value of reinvested coupons goes down, but the future value of the bond goes up, for a net increase in value.
87 Thus, if the desired time horizon is equal to the bond's duration, the value of the position will not fall if interest
rates change.
88

89 Change in Total
Reinvested Current Price Value from
Coupons at t=Duration Total Value Original Target
90 $5,775.89 $4,224.11 $10,000.00
91 1% $11,402.15 $1,402.15
92 2% $11,042.90 $1,042.90
93 3% $10,744.28 $744.28
94 4% $10,501.53 $501.53
95 5% $10,310.54 $310.54
96 6% $10,167.74 $167.74
97 7% $10,070.07 $70.07
98 8% $10,014.90 $14.90
99 9% $10,000.00 $0.00
 A B C D E F
100 10% $10,023.48 $23.48
101 11% $10,083.77 $83.77
102 12% $10,179.59 $179.59
103 13% $10,309.90 $309.90
104 14% $10,473.89 $473.89
105 15% $10,670.98 $670.98
106 16% $10,900.76 $900.76
107
108
109 Using Duration to Measure Risk
110
111 If the term structure is flat and the change in r is fairly small, then the change in the bond’s price (∆V
112
113 ∆VB = (−Duration)(Percentage change in 1 + r)(V B)
114
115 Suppose r changes to 9.10%
116
117 −Duration before change in r = -9.95
118 Percentage change in 1 + r = 0.0917%
119 ∆VB before change in r= $1,000.00
120 Predicted change in VB = -$9.13
121
122 Actual VB after change in r= $990.94
123 Actual change in VB after change in r= -$9.06
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if all coupons are reinvested
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Tool Kit Web 5A 5/6/2013

The Pure Expectations Theory and Estimation of Forward Rates

The shape of the yield curve depends primarily on two key factors: (1) expectations about future inflation and (2)
perceptions about the relative riskiness of securities of different maturities. The first factor is the basis for the Pure
Expectations Hypothesis. If the relationship between expectations for future inflation and bond yields is controlling, i. e., if
no maturity premiums existed, then the pure expectations theory posits that forward interest rates can be predicted by
"backing them out of the yield curve." Essentially, under the pure expectations theory, long-term security rates are a
weighted average of the yields on all the shorter maturities that make up the longer maturity. This calculation will hold
true, providing that the MRP=0 assumption is valid.

For instance, if the yield on a 1-year bond is 5% and that on a 2-year bond is 6%, the rate on a 1-year bond one year from
now should be 7%, because (1.06) 2 = (1.05)(1.07).

Generally, r designates the rate, or yield, and our notation involves two subscripts. The first subscript denotes when in the
future we expect the yield to exist, and the second denotes the maturity of the security. For instance, the rate expected 3
years from now on a 2-year bond would be denoted by 3r2.

Assuming that expectations theory holds, use the yield information below to back out the following forward rates from the
yield curve.

Expected forward rates, in words: Symbol:

Yield on 1-year bond 1 year from now = r
1 1

Yield on 1-year bond 2 years from now = r

2 1

Yield on 1-year bond 3 years from now = r

3 1

Yield on 1-year bond 4 years from now = r

4 1

Yield on 5-year bond 5 years from now = r

5 5

Yield on 10-year bond 10 years from now = r

10 10

Yield on 20-year bond 10 years from now = r

10 20

Yield on 10-year bond 20 years from now = r

20 10

Maturity Maturity Yield

1 year 1 5.02%
2 year 2 5.31%
3 year 3 5.48%
4 year 4 5.65%
5 year 5 5.73%
10 year 10 5.68%
20 year 20 6.01%
30 year 30 5.92%

(1+ r2)2 = ( (1 + r1) x (1 + 1r1)

1.1090 = ( 1.0502 x (1 + 1r1)
r
1 1 = 5.60%

(1+ r3)3 = ( (1+ r2)2 x (1 + 2r1)

1.1736 = ( 1.1090 x (1 + 2r1)
r
2 1 = 5.82%

(1+ r4)4 = ( (1+ r3)3 x (1 + 3r1)

1.2459 = ( 1.1736 x (1 + 3r1)
r
3 1 = 6.16%

(1+ r5)5 = ( (1+ r4)4 x (1 + 4r1)

 1.3213 = ( 1.2459 x (1 + 4r1)
r
4 1 = 6.05%

(1+ r10)10 = ( (1+ r5)5 x (1 + 5r5)5

1.7375 = ( 1.3213 x (1 + 5r5)5
r
5 5 = 5.63%

(1+ r20)20 = ( (1+ r10)10 x (1 + 10r10)10

3.2132 = ( 1.7375 x (1 + 10r10)10
r
10 10 = 6.34%

(1+ r30)30 = ( (1+ r20)20 x (1 + 20r10)10

5.6149 = ( 3.2132 x (1 + 20r10)10
r
20 10 = 5.74%

The data used to construct the yield curve are readily available, and forward rates can be calculated as shown above. Bond
traders and corporate borrowers can use this information for hedging in the futures market. For example, if a company
plans to build a new plant two years from now and wants to be assured of getting the required funds at a specified rate, then
it can buy a bond futures contract that will enable it to "lock in" the cost of debt for the project. The treasurer would go
through the process described above to determine what the rate two years hence should be on bonds with the desired
maturity.

SOLUTIONS TO SELF-TEST QUESTIONS

Assume the interest rate on a 1-year T-bond is currently 7% and the rate on a 2-year bond is 9%. If the maturity risk
premium is zero, what is a reasonable forecast of the rate on a 1-year bond next year?

1-year Treasury yield 7.0%

2-year Treasury yield 9.0%
Maturity Risk Premium 0.0%

1-year rate, 1 year from now 11.04%

What would the forecast be if the maturity risk premium on the 2-year bond were 0.5% and it was zero for the 1-year bond?

1-year Treasury yield 7.0%

2-year Treasury yield 9.0%
Maturity Risk Premium 0.5%

1-year rate, 1 year from now 10.02%

SECTION 5-3
SOLUTIONS TO SELF-TEST

A bond that matures in six years has a par value of $1,000, an annual coupon payment of
$80, and a market interest rate of 9%. What is its price?

Years to Maturity 6
Annual Payment $80
Par value $1,000
Going rate, rd 9%

Value of bond = $955.14

A bond that matures in 18 years has a par value of $1,000, an annual coupon of 10%, and
a market interest rate of 7%. What is its price?

Years to Maturity 18
Coupon rate 10%
Annual Payment $100
Par value $1,000
Going rate, rd 7%

Value of bond = $1,301.77

SECTION 5-4
SOLUTIONS TO SELF-TEST

Last year a firm issued 30-year, 8% annual coupon bonds at a par value of $1,000. (1)
Suppose that one year later the going rate drops to 6%. What is the new price of the bonds,
assuming that they now have 29 years to maturity?

Years to Maturity 29
Coupon rate 8%
Annual Payment $80
Par value $1,000
Going rate, rd 6%

Value of bond = $1,271.81

Suppose instead that one year after issue the going interest rate increases to 10% (rather
than 6%). What is the price?

Years to Maturity 29
Coupon rate 8%
Annual Payment $80
Par value $1,000
Going rate, rd 10%

Value of bond = $812.61

SECTION 5-5
SOLUTIONS TO SELF-TEST

A bond has a 25-year maturity, an 8% annual coupon paid semiannually, and a face value of $1,000. The
going nominal annual interest rate (rd) is 6%. What is the bond's price?

Coupons per year 2

Annual values Semiannual Inputs

Years to Maturity 25 50
Coupon rate 8% 4%
Annual Payment $80 $40
Par value $1,000 $1,000
Going rate, rd 6% 3.0%

Value of bond = $1,255.67 $1,257.30

of $1,000. The
SECTION 5-6
SOLUTIONS TO SELF-TEST

A bond currently sells for $850. It has an eight-year maturity, an annual coupon of $80, and a
par value of $1,000. What is its yield to maturity? What is its current yield?

Years to Maturity 8
Annual Payment $80.00
Current price $850.00
Par value = FV $1,000.00

Going rate, rd =YTM: 10.90%

Annual Payment $80.00

Current price $850.00

Current yield: 9.41%

A bond currently sells for $1,250. It pays a $110 annual coupon and has a 20-year maturity,
but it can be called in 5 years at $1,110. What are its YTM and its YTC? Is it likely to be called
if interest rates don't change?
Years to Maturity 20 Years to Call 5
Annual Payment $110 Annual Payment $110
Current price $1,250 Current price $1,250
Par value = FV $1,000 Call price $1,110

YTM 8.38% YTC 6.85%

The company will probably call the bond, because the YTC is less than the YTM.
SECTION 5-9
SOLUTIONS TO SELF-TEST

The yield on a 15-year TIPS is 3 percent and the yield on a 15-year Treasury bond is 5
percent. What is the inflation premium for a 15-year security

Yield on T-Bond 5%
Yield on TIPS 3%

Inflation premium 2%
SECTION 5-11
SOLUTIONS TO SELF-TEST

A 10-year T-bond has a yield of 4.5 percent. A corporate bond with a rating of AA has
a yield of 6.0 percent. If the corporate bond has excellent liquidty, what is an estimate
of the corporate bond’s default risk premium?

Yield on T-Bond 4.5%

Yield on corporate bond 6.0%

Default risk premium 1.5%

SECTION 5-13
SOLUTIONS TO SELF-TEST QUESTIONS

Assume that the real risk-free rate is r* = 3% and the average expected inflation rate is 2.5%
for the foreseeable future. The DRP and LP for a bond are each 1%, and the applicable MRP
is 2%. What is the bond’s yield?

r* 3.0%
Inflation Premium 2.5%
Default Risk Premium 1.0%
Liquidity Premium 1.0%
Maturity Risk Premium 2.0%

Yield 9.5%