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1 Chapter Outline
Chapter 7
Interest Rates and Bond Valuation
Chapter Organization
7.1 Bonds and Bond Valuation
7.2 More on Bond Features
7.3 Bond Ratings
7.4 Some Different Types of Bonds
7.5 Bond Markets
7.6 Inflation and Interest Rates
7.7 Determinants of Bond Yields
7.8 Summary and Conclusions
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Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 1
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd.
T7.2 Bond Features
Time 0 1 2 3 4 5
Coupons $80 $80 $80 $80 $80
Face Value $ 1000
Market Price $____
3. The yield to maturity (or YTM) is the rate that makes the
market price of the bond equal to the present value of its
future cash flows. It is the unknown r in the equation below:
$924.18 = $80 [1 - 1/(1 + r)5]/r + $1000/(1 + r)5
Bond price
$1,800
Coupon = $100
20 years to maturity
$1,600
$1,000 face value
$1,000
$ 800
Amount of issue $200 million The company issued $200 million worth
of bonds.
Date of issue 8/4/94 The bonds were sold on 8/4/94.
Maturity 8/1/24 The principal will be paid 30 years after the issue date.
Face Value $1,000 The denomination of the bonds is $1,000.
Annual coupon 8.375 Each bondholder will receive $83.75 per bond per year
(8.375% of the face value).
Offer price 100 The offer price will be 100% of the $1,000 face value per bond.
Term Explanation
Moodys DBRS
Aaa AAA Debt rated Aaa and AAA has the highest rating. Capacity to pay
interest and principal is extremely strong.
Aa AA Debt rated Aa and AA has a very strong capacity to pay interest and
repay principal. Together with the highest rating, this group comprises
the high-grade bond class.
A A Debt rated A has a strong capacity to pay interest and repay
principal, although it is somewhat more susceptible to the adverse effects of
changes in circumstances and economic conditions than debt in high rated
categories.
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide
18
T7.14 Bond Ratings (concluded)
Baa BBB Debt rated Baa and BBB is regarded as having an adequate
capacity to pay interest and repay principal. Whereas it normally exhibits
adequate protection parameters, adverse economic conditions or
changing circumstances are more likely to lead to a weakened
capacity to pay interest and repay principal for debt in this category
than in higher rated categories. These bonds are medium-grade
obligations.
Example:
Suppose we have $1000, and Diet Coke costs $2.00 per six
pack. We can buy 500 six packs. Now suppose the rate of
inflation is 5%, so that the price rises to $2.10 in one year. We
invest the $1000 and it grows to $1100 in one year. Whats our
return in dollars? In six packs?
1 + R = (1 + r) (1 + h)
From the example, the real return is 4.76%; the nominal return is 10%,
and the inflation rate is 5%:
(1 + R) = 1.10
Key Issue:
What factors affect observed bond yields?
The real rate of interest
Expected future inflation
Interest rate risk
Default risk premium
Taxability premium
Liquidity premium
1. Under what conditions will the coupon rate, current yield, and yield to
maturity be the same?
A bonds coupon rate, current yield, and yield-to-maturity be the same
if and only if the bond is selling at par.
2. What does it mean when someone says a bond is selling at par? At a
discount? At a premium?
A par bond is selling for its face value (typically $1000 for corporate
bonds); the price of a discount bond is less than par, and the price of a
premium bond is greater than par.
3. What is a transparent market?
A market is transparent if it is possible to easily observe its prices and
trading volumes.
Bond
Value = C/2 [1 - 1/(1 + r )t] / r + F / (1 + r )t
$850 = C/2 [1 - 1/(1 + .04)21] / .04 + $1000/(1.04)21
$850 = C/2 14.0291 + $438.83
C/2 = $29.31
Bond K:
PV = $50 [1 - 1/(1.055)16]/.055 + $1000/(1.055)16 = $947.69
Bond K:
PV = $50 [1 - 1/(1.035)16]/.035 + $1,000/(1.035)16 = $1181.41