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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin 0
Chapter 6
Interest Rates andBond Valuation
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Key Concepts and Skills Know the important bond features and
bond types Understand bond values and why they
fluctuate
Understand bond ratings and what theymean
Understand the impact of inflation on
interest rates Understand the term structure of interest
rates and the determinants of bond yields
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Chapter Outline
Bonds and Bond Valuation
More on Bond Features
Bond Ratings Some Different Types of Bonds
Bond Markets
Inflation and Interest Rates Determinants of Bond Yields
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Bond Definitions
Bond
Par value (face value)
Coupon rate Coupon payment
Maturity date
Yield or Yield to maturity
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PV of Cash Flows as RatesChange
Bond Value = PV of coupons + PV of par
Bond Value = PV annuity + PV of lumpsum
Remember, as interest rates increase, thePVs decrease
So, as interest rates increase, bond pricesdecrease, and vice versa
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Valuing a Discount Bond withAnnual Coupons
Consider a bond with a coupon rate of 10%and coupons paid annually. The par valueis $1,000 and the bond has 5 years tomaturity. The yield to maturity is 11%.
What is the value of the bond?
Using the formula:
B = PV of annuity + PV of lump sum
B = $100[1 1/(1.11)5] / .11 + $1,000 /(1.11)5
B = $369.59 + 593.45 = $963.04
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Valuing a Premium Bond withAnnual Coupons
Suppose you are looking at a bond thathas a 10% annual coupon and a facevalue of $1,000. There are 20 years tomaturity and the yield to maturity is 8%.What is the price of this bond?
Using the formula:
B = PV of annuity + PV of lump sum
B = $100[1 1/(1.08)20] / .08 + $1,000 /(1.08)20
B = $981.81 + 214.55 = $1,196.36
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Graphical Relationship BetweenPrice and YTM
600
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1000
1100
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1300
1400
1500
0% 2% 4% 6% 8% 10% 12% 14%
YTM
Price
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Bond Prices: RelationshipBetween Coupon and Yield
If YTM = coupon rate, then par value =bond price
If YTM > coupon rate, then par value >bond price Why?
Price below par = discount bond
If YTM < coupon rate, then par value