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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

    700

    800

    900

    1000

    1100

    1200

    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