Lecture 4

INTEREST RATE AND BOND

VALUATION
- Chapter 6
M: Finance 3rd Edition
(p.141-p.153)
&7
Cornett, Adair, and Nofsinger
Copyright 2016 by McGraw-Hill Education. All rights reserved.

Interest Rates
Many interest rates that are appropriate

in various conditions or situations.

Nominal rates are most often quoted.
Interest rate changes influence
investment performance and trigger buy
or sell decisions for individual investors,
businesses, and government units.

Nominal Interest Rate

Factors that affect the rate :
Inflation
Real risk-free interest rate
Default and liquidity risk
Provisions regarding the use of funds raised

by a particular security issuer

Time to maturity

Inflation
Percentage increase in the price of a

standardized basket of goods and services

over a given period of time.
Actual inflation rate or Expected inflation
rate.
Positive relationship between interest rates and
inflation rates.
When inflation raises the general price level,

investors who buy financial assets must earn a

higher interest rate to compensate for continuing to
hold the investment.

Inflation
Annual inflation calculation using

Consumer Price Index (CPI) :

Inflation

Nominal Rates vs. Inflation

Real Risk-Free Rates

The rate that a risk-free security would

pay if no inflation were expected over

its holding period.
It measures only the societys relative
time preference for consuming today
rather than tomorrow.
Concept of TVM.

Fisher Effect
Theorizes that nominal risk-free rates must compensate

investors for :
Inflation
An additional premium above the expected rate of
inflation for forgoing present consumption.
i = Expected Inflation + Real Risk-Free Rate
In other textbooks, it may be written as :
(1 + R) = (1 + r)(1 + h)
R = Nominal Rate; r = Real Rate; h = Expected
inflation rate.
Or it may be approximated as : R = r + h

Inflation and Interest Rates

In general :
Real Rate of Interest
= Change in purchasing power.
Nominal Rate of Interest
= Quoted rate of interest
= Change in purchasing power and inflation

Default or Credit Risk

Risk that issuer fails to pay promised interest and

principal.
Investors demand higher interest rate with higher
default risk.
U.S. Treasury securities are generally considered to
be free of default risk. So they are generally
considered as risk-free assets.
Investors must charge issuers other than the U.S.
Government a premium for any perceived probability
of default and the cost of potentially recovering the
amount loaned built into their regular interest
premium.

Corporate Bond Default Risk Premiums

Liquidity Risk
A highly liquid asset can be sold at a

predictable price with low transaction costs.

The interest rate on a security reflects its
relative liquidity, with highly liquid assets
carrying the lowest interest rates (all other
characteristics remaining the same).
If the security is illiquid, investors add a
liquidity risk premium to the interest rate on
the security.

Special Provisions (or

Covenants)
Examples : Taxability, Convertibility, and Callability.
Investors pay no federal taxes on interest

payments from municipal bonds so the holder may

demand a lower interest rate than a comparable
taxable bond.
A convertible bond offers the holder the opportunity
to exchange the bond for another type of the
issuers securities so that convertible bond buyers
require lower interest rates than a comparable nonconvertible bond holder would require.

Time to Maturity
Term structure of interest rates or the yield curve.
The term structure of interest rates compares

interest rates on debt securities based on their

time to maturity, assuming that all other
characteristics are equal.
The longer the time to maturity, the higher the
required interest rate buyers will demand ----Maturity Premium (the difference between the
required return on long- versus short-term
securities of the same characteristics except
maturity, can be positive, negative, or zero).

Three Yield-Curve Theories

Unbiased Expectations Theory
Liquidity Premium Theory
Market Segmentation Theory

Unbiased Expectation Theory

At any given point in time, the yield curve reflects

the markets current expectations of future shortterm rates.

For example, if investors have a 4-year
investment horizon, they could either buy current
4-year bonds and earn the current yield on a 4year bond each year, or they could invest in 4
successive 1-year bonds.

Unbiased Expectation Theory

So, if the market expects future 1-year

rates to rise each successive year into

the future, then the yield curve will
slope upward, or vice versa.

Liquidity Premium Theory

Short-term securities provide greater marketability

and have less price risk than long-term securities

do.
Investors prefer to hold shorter-term securities
because these securities can be converted into
cash with little market risk.
So, a liquidity premium is needed to attract
investors to buy longer-term securities that carry
higher risk of capital loss.
And, liquidity premium increases as maturity
increases.

Liquidity Premium Theory

It states that long-term rates are equal

to the geometric averages of current

and expected short-term rates, plus
liquidity premium.

Yield Curves :
Unbiased Expectation vs. Liquidity
Premium

UET :
Unbiased
Expectation Theory
LPT :
Liquidity Premium
Theory

Market Segmentation Theory

It argues that individual investors and

financial institutions have specific

maturity preferences (dictated by the
dates when their liabilities will come
due), and convincing them to hold
securities with maturities other than
their most preferred ones requires a
higher interest rate.

Market Segmentation and Slopes of

Yield Curve

VALUING BONDS
- CHAPTER 7
M: Finance 3rd Edition
Cornett, Adair, and Nofsinger
Copyright 2016 by McGraw-Hill Education. All rights reserved.

Bond Characteristics
Debt Obligations
Repayment of Principal.
Interest Payments (Coupons).

Known as Fixed-Income Securities

because the bondholders know how

much they will receive in interest
payments (coupons) and when their
principal will be repaid.

Bond Characteristics
Indenture Agreement
a legal contract that outlines the precise terms

between the bond issuer and the bondholders.

Maturity Date
Par Value (or Face Value) typically $1,000
Time to Maturity (e.g. 10 years, 30 years etc)
Call / Convertible Feature (only some bonds have

these features)
Coupon Rate (but the coupons are usually paid to
the holders semi-annually).

Bond Issuers
US Treasury (US Government bonds)
Other examples :
Gilts : UK Government bonds
Bunds : Germany Government bonds
Corporations
Municipalities (State or local

governments)

Annual Bond Issuance Data

Other Bonds and Securities

Treasury Inflation-Protected Securities

(TIPS)
Indexed to inflation; similar to i-Bonds in HK.

U.S. government agency securities

Fannie Mae, Freddie Mac, Student Loans
Mortgage-Backed Securities (MBS)
Complicated financial products which are

deemed to be the cause of financial tsunami in

2008-09.

Reading Bond Quotes

Premium bond sells for higher price

than the par value. (coupon rate is

higher than the current rate)
Discount bond sells for lower price
than the par value. (coupon rate is
lower than the current rate)

Reading Bond Quotes

Coupon rate set at time of bond issue.
Factors that determine the coupon

rate :
Uncertainty whether the issuer will be

able to make all the future payments.

Maturity of the bond.
Current interest rate level in the economy.
And many others..

Bond Valuation
Uses Time Value of Money (TVM)

concepts
Price/Value of Bond :
Determined by the future cash flows from the

bond, which are known to the bondholders.

Equal to the sum of the Present Values of all
future cash flows, discounted at prevailing
market interest rate.

Bond Valuation
Zero Coupon Bond
No interest payments.
Only pays par value at maturity.
Sells at a substantial discount from the par

value.

Computing Price of Zero Coupon Bond

Assumptions : 20-year zero coupon

bond
Compute the zeros price by finding present

value of the $1,000 cash flow (par value)

received in 20 years.
40 semi-annual periods at 3% interest.
Use Present Value equation :

Present Value of Bond

Present Value of Interest Payments +

Present Value of Par Value

Bond Price and Interest Rate

Risk

At time of purchase, the bonds interest

payments and par value at maturity are
fixed and known.
Over time, interest rates change but the
bonds coupon rate remains fixed.
Bond price will change in response to
change in interest rate.
Market interest rates and bond prices are
inversely related.

Bond Price and Interest Rate

Risk

Example :
Interest rates rise.
Newly-issued bonds offer higher interest
rates than the rates offered by existing
bonds.
Existing bonds with lower coupon rate
must drop the price so that the buyer can
expect a profit similar to that offered by
the newly-issued bonds.

Bond Price and Interest Rate

Risk

Interest Rate Risk :

During periods when interest rates
change substantially (and quickly),
bondholders experience distinct gains
and losses in their bond inventories.

Bond Yields
Current Yield
Yield to Maturity
Yield to Call

Bond Yields
Current Yield
The bonds annual coupon rate divided by the
bonds current market price.
Measures the rate of return a bondholder
would earn annually from the coupon
payments alone if the bond was purchased at
a stated price.
Does not measure the total expected return
since it does not consider any capital gain or
loss from the bond.

Bond Yields
Yield to Maturity (YTM)
Discount rate that equates the present value of

future cash flows with current bond price.

More meaningful for bondholders.
Tells bondholders the total rate of return that
they might expect if the bonds were bought at a
particular price and held to maturity.

Bond Yields
Yield to Call
A particular bond may have a call provision such

that the issuer can buy back the bonds after from
the bondholders prior to the maturity date after
large drops in market interest rates at a prespecified call price.
Price of Callable Bond = Present Value of interest
payments to call date + Present Value of call price

Summary of Interest Rates

Credit Risk
Bond Ratings
Credit Risk and Yield

Bond Ratings
Credit quality risk is the chance the

issuer will not be able to repay on a

timely basis.
Credit rating agencies such as Moodys,
Standard & Poors monitor corporations,
government agencies or municipal
developments during the bonds lifetime
and report their findings as a grade or
rating.

Bond Ratings
The ratings are based on detailed analyses of

issuers financial condition, general economic

and credit market conditions, and the economic
value of any underlying collateral.
For example, based on Standard & Poors
ratings :
Investment-grade bonds are rated AAA, AA, A
or BBB.
Junk bonds (high-yield) are rated BB and
below.

Bond Ratings

Credit Risk and Yield

Yield is affected by credit risk
Lower quality bonds (such as junk bonds) offer

higher yields.
Higher quality bonds (such as Government
bonds) offer lower yields.

Yield to Maturity Long Term

Bonds

Credit Risk and Yield

Investors only purchase higher risk

bonds when higher returns are

possible.
Junk bonds, because of their higher
risk, are high-yield bonds.
Yield spread between high- and lowquality bonds varies over time.

Bond Markets
Decentralized, over-the-counter

trading
Most trades occur between bond
dealers and large institutions
Bond prices have inverse relationship
to interest rates

Example : Zero-Coupon Bond

INPUT
OUTPUT

40
N

3
I/YR

PV
306.56

0
PMT

FV

At what price could we purchase a bond with a

par value of $1,000, maturing in 20 years with a
6% annual rate of interest ?

Yield to Maturity Falling Interest

Rates
6%
intere
st rate

5.5%
intere
st rate

INPUT

40
N

3
I/YR

38
N

2.75
I/YR

OUTPUT
INPUT
OUTPUT

PV
1057.79

PV
1116.97

32.50
PMT

FV

32.50
PMT

FV

In a period of falling interest rates (from 6% to 5.5%),

what is the total return for a 20-year, 6.5% coupon bond
through the interest-rate decline ?

Yield to Call

INPUT
OUTPUT

10
N

2.875
I/YR

PV
1106.38

35
PMT

FV

At what price would a bond (paying 5.75% annual

interest) be called at five years, rather than at the
original maturity of 20 years ?

End of Lecture 4