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BondValuationandtheStructureofInterestRates

S U M M A R Y O F LearningObjectives
1 Describethemarketforcorporatebondsandthreetypesofcorporatebonds.
Themarketforcorporatebondsisaverylargemarketinwhichthemostimportantinvestorsare
largeinstitutions.MosttradestakeplacethroughdealersintheOTCmarket,makingthecorporate
bondmarketrelativelythin.Pricesofcorporatebondstendtobemorevolatilethanpricesof
securitiesthattrademorefrequently,suchasstockandmoneymarketinstruments,andthecorporate
bondmarkettendstobelessefficientthanmarketsfortheseothersecurities.
Avanillabondpaysfixedregularcouponpaymentsoverthelifeofthebond,andtheentireprincipal
isrepaidatmaturity.Azerocouponbondpaysallinterestandallprincipalatmaturity.Sincethere
arenopaymentsbeforematurity,zerocouponbondsareissuedatpricesbelowtheirfacevalue.
Convertiblebondscanbeexchangedforcommonstockatapredeterminedratio.
2 Explainhowtocalculatethevalueofabondandwhybondpricesvarynegativelywith
interestratemovements.

Thevalueofabondisequaltothepresentvalueofthefuturecashflows(couponpaymentsand
principalrepayment)discountedatthemarketrateofinterestforbondswithsimilarrisk.Bond
pricesvarynegativelywithinterestratesbecausethecouponrateonmostbondsisfixedatthetime
thebondisissued.Asmarketinterestratesgoup,thepricesofbondswithfixedcouponpayments
willbebiddownbyinvestors,drivingtheyieldsofthosebondsuptomarketlevels.Wheninterest
ratesdecline,theyieldonfixedincomesecuritieswillbehigherrelativetoyieldonsimilarsecurities
pricetomarketthefavorableyieldwillincreaseinvestordemandforthesesecurities,increasing
theirpriceandloweringtheiryieldtothemarketyield.
3 Distinguishbetweenabond'scouponrate,yieldtomaturity,andeffectiveannualyield.
Abond'scouponrateistheinterestrateonthebond,relativetoitsfacevalue,whenitisissued.U.S.
bondstypicallypayinterestsemiannually,whereasEuropeanbondspayonceayear.Theyieldto
maturityistheexpectedreturnonabondifitisheldtoitsmaturitydate.Theeffectiveannualyield
istheyieldaninvestoractuallyearnsinoneyear,adjustingfortheeffectsofcompounding.Ifthe
bondpayscouponpaymentsmoreoftenthanannually,theeffectiveannualyieldwillbehigherthan
thesimpleannualyieldbecauseofcompounding.WorkthroughLearningbyDoingApplications
8.2,8.3,and8.4tomasterthesecalculations.
4 Explainwhyinvestorsinbondsaresubjecttointerestrateriskandwhyitisimportant
tounderstandthebondtheorems.

Becauseinterestratesarealwayschanginginthemarket,allinvestorswhoholdbondsaresubjectto
interestraterisk.Interestrateriskisuncertaintyaboutfuturebondvaluescausedbyfluctuationsin
interestrates.Threeofthemostimportantbondtheoremscanbesummarizedasfollows:
1.Bondpricesarenegativelyrelatedtointerestratemovements.
2.Foragivenchangeininterestrates,thepricesoflongtermbondswillchangemore
thanthepricesofshorttermbonds.
3.Foragivenchangeininterestrates,thepricesoflowercouponbondswillchangemore
thanthepricesofhighercouponbonds.
Understandingthesetheoremsisimportantbecauseithelpsinvestorsbetterunderstandwhybond
priceschangeand,thusmakebetterdecisionsregardingthepurchaseorsaleofbondsandother
fixedincomesecurities.
5 Discusstheconceptofdefaultriskandknowhowtocomputeadefaultriskpremium.
Defaultriskistheriskthattheissuerwillbeunabletopayitsdebtobligation.Sinceinvestorsare
riskaverse,theymustbepaidapremiumtopurchaseasecuritythatexposesthemtodefaultrisk.
Thedefaultriskpremiumhastwocomponents:(1)compensationfortheexpectedlossifadefault
occursand(2)compensationforbearingtheriskthatadefaultcouldoccur.Allfactorsheldconstant,
thedegreeofdefaultriskasecuritypossessescanbemeasuredasthedifferencebetweentheinterest
rateonariskysecurityandtheinterestrateonadefaultfreesecurity.Thedefaultriskisalso
reflectedinthecompany'sbondrating.Thehighestgradebonds,thosewiththelowestdefaultrisk,
areratedAaa(orAAA).Thedefaultriskpremiumoncorporatebondsincreasesasthebondrating
becomeslower.
6 Describethefactorsthatdeterminethelevelandshapeoftheyieldcurve.
Thelevelandshapeoftheyieldcurvearedeterminedbythreefactors:(1)therealrateofinterest,
(2)theexpectedrateofinflation,and(3)interestraterisk.Therealrateofinterestisthebase
interestrateintheeconomyandvarieswiththebusinesscycle.Therealrateofinterestaffectsonly
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BondValuationandtheStructureofInterestRates

theleveloftheyieldcurveandnotitsshape.Theexpectedrateofinflationdoesaffecttheshapeof
theyieldcurve.Ifinvestorsbelieveinflationwillbeincreasinginthefuture,forexample,thecurve
willbeupwardsloping,aslongtermrateswillcontainalargerinflationpremiumthanshortterm
rates.Finally,interestraterisk,whichincreaseswithasecurity'smaturity,addsanupwardbiastothe
slopeoftheyieldcurve.

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