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Copyright © 2012 Pearson Prentice Hall. All rights reserved.

Chapter 6

BondsAlso includes Ch. 5(sections 3 & 4)

Interest Rates

In Class



Copyright © 2012 Pearson Prentice Hall. All rights reserved. 6-2

Chapter Quiz

1. What types of cash flows does a bond buyer receive?

2. How are the periodic coupon payments on a bonddetermined?

3. Why would you want to know the yield to maturity of a

bond?

4. What is the relationship between a bond’s price and itsyield to maturity?

5. What cash flows does a company pay to investors holdingits coupon bonds?

6. What do we need in order to value a coupon bond?




Chapter Quiz

7. Why do interest rates and bond prices move inopposite directions?

8. If a bond’s yield to maturity does not change,

how does its cash price change between couponpayments?

9. What is a junk bond?

10. How will the yield to maturity of a bond vary

with the bond’s risk of default?




Fisher Equation Example:

• If we require a 10% real return and weexpect inflation to be 8%, what is thenominal rate?

• R = (1.1)(1.08) – 1 = .188 = 18.8%• Approximation: R = 10% + 8% = 18%

• Because the real return and expectedinflation are relatively high, there issignificant difference between the actualFisher Effect and the approximation.




Calculating the Real Interest Rate

• In the year 2000, short-term U.S.government bond rates were about 5.8%and the rate of inflation was about 3.4%.

• In 2003, interest rates were about 1% andinflation was about 1.9%.

• What was the real interest rate in 2000and 2003?




Using the Term Structure toCompute Present Values

• Compute the present value of a risk-free five-yearannuity of $2,500 per year, given the followingyield curve for July 2009.

Term Date

Years July-09

1 0.54%

2 1.05%

3 1.57%

4 2.05%

5 2.51%




Time Line Coupon Interest Par Value

0 Jan. 1, 1863

1 July 1, 1863 20

2 Jan. 1, 1864 20

3 July 1, 1864 20

4 Jan. 1, 1865 20

5 July 1, 1865 20

6 Jan. 1, 1866 20

7 July 1, 1866 20

8 Jan. 1, 1867 20

9 July 1, 1867 20

10 Jan. 1, 1868 20

11 July 1, 1868 20 500




The Bond Pricing Equation

t

t

r)(1

FV

r r)(1

1-1

CValueBond




Interest Rate Risk (Review)

• Price Risk– Change in price due to changes in interest rates

– Long-term bonds have more price risk than short-term bonds

– Low coupon rate bonds have more price risk thanhigh coupon rate bonds

• Reinvestment Rate Risk– Uncertainty concerning rates at which cash flows

can be reinvested

– Short-term bonds have more reinvestment raterisk than long-term bonds

– High coupon rate bonds have more reinvestmentrate risk than low coupon rate bonds




Current Yield vs. Yield to Maturity

• Current Yield = annual coupon / price• Yield to maturity = current yield + capital gains

yield• Example: 10% coupon bond, with semiannual

coupons, face value of 1,000, 20 years tomaturity, $1,197.93 price– Current yield = 100 / 1,197.93 = .0835 = 8.35%

– Price in one year, assuming no change in YTM = 1,193.68

– Capital gain yield = (1,193.68 – 1,197.93) / 1,197.93 =

-.0035 = -.35%– YTM = 8.35 - .35 = 8%




Bond Prices with a Spreadsheet

• There is a specific formula for findingbond prices on a spreadsheet – PRICE(Settlement,Maturity,Rate,Yld,Redemption,

Frequency,Basis)

– YIELD(Settlement,Maturity,Rate,Pr,Redemption,Frequency,Basis)

– Settlement and maturity need to be actual dates

– The redemption and Pr need to be input as % of parvalue

• Click on the Excel icon for an example




A 10-year, 10% semiannual coupon bondselling for $1,135.90 can be called in 4 years

for $1,050, what is its yield to call (YTC)?

The bond’s yield to maturity can be determined tobe 8%. Solving for the YTC is identical to solving

for YTM, except the time to call is used for N andthe call premium is FV.

INPUTS

OUTPUT

N I/YR PMTPV FV

8

3.568

50 1050- 1135.90




YTM and YTC

• A 20-year, 12% semiannual $1,000 par valuecoupon bond selling for $1,235 can be called in 4years for $1,060

• What is its yield to maturity (YTM)?• What is its yield to call (YTC)?

• What is the current yield of the bond?

• What is its capital gains yield?




Discussion: Zero Coupon Bonds

• What type of investor would buyzero-coupon bonds? Coupon bonds?

• Conversely, what do firms considerwhen choosing between the issuanceof a zero-coupon issue and an issuewith coupon payments?




Discussion: Bond PriceAvailability

• As indicated in the chapter and highlightedin the chapter interview, the bond marketis huge, yet bond prices are rarelyaccessible in the printed press and onlinequotes are available only through limitedsites.

• Stock quotes, on the other hand, are

widely available.• If the bond market is that big and that

important, why is there such “secrecy,” orlimited access to price information?




Discussion: Yield to MaturityAssumptions

• The current price of a bond rests on theassumption that the coupons will bereinvested at the YTM.

• In reality, by the time the coupons begin toarrive, interest rates will most likely havechanged.

• Is the price paid for the bond its true priceor is there a way of reconciling theuncertainty of future interest rates with theprice of the bond?




Discussion: Valuation Principle

• After reading the first six chapters of thistext, you should be developing, anunderstanding of the Valuation Principle

and, now the Law of One Price.• Do these principles now make sense to

you?

• How would you explain them to someonewith little or no financial background?




Discussion: Discount Bonds

• Explain why the yield of a bond that tradesat a discount (premium) is greater than(less than) the bond’s coupon rate.




Discussion: Bond Pricing

• Explain the relationship between interestrates and bond prices.




Discussion: Interest RateSensitivity

• Explain why longer term bonds are moresensitive to changes in interest rates thanshorter term bonds




Discussion: Expected bondreturn

• Explain why the expected return of acorporate bond does not equal its yield tomaturity

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