PowerPoint PresentationKey Concepts and SkillsChapter Outline5.1 Bonds and Bond ValuationBond ValuationConceptual Cash Flow of a 10 Year BondThe Bond-Pricing EquationFrequency of Coupon PaymentsBond ExampleSlide 10Bond Example: CalculatorSlide 12YTM and Bond ValueBond ConceptsInterest Rate RiskMaturity and Bond Price VolatilityCoupon Rates and Bond PricesComputing Yield to MaturityYTM with Annual CouponsYTM with Semiannual CouponsCurrent Yield vs. Yield to MaturityBond Pricing TheoremsBond Pricing with a Spreadsheet5.2 More on Bond FeaturesDebt versus EquityThe Bond IndentureSample Bond FeaturesBond ClassificationsBond Classifications (Cont.)Required Yields5.3 Bond Ratings – Investment QualityBond Ratings - Speculative5.4 Some Different Types of BondsGovernment BondsAfter-tax YieldsZero Coupon BondsPure Discount BondsPure Discount Bonds: ExampleFloating Rate BondsOther Bond Types5.5 Bond MarketsTreasury QuotationsClean versus Dirty Prices5.6 Inflation and Interest RatesThe Fisher EffectThe Fisher Effect: Example5.7 Determinants of Bond YieldsSample Treasury Yield CurveFactors Affecting Required ReturnQuick Quiz5-1INTEREST RATES AND BOND VALUATIONChapter 5Copyright © 2014 McGraw-Hill Education. 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No reproduction or distribution without the prior written consent of McGraw-Hill Education.5-2KEY CONCEPTS AND SKILLS•Know the important bond features and bond types•Comprehend bond values and why they fluctuate•Compute bond values and fluctuations•Appreciate bond ratings, their meaning, and relationship to bond terms and value•Understand the impact of inflation on interest rates•Grasp the term structure of interest rates and the determinants of bond yields5-3CHAPTER OUTLINE5.1 Bonds and Bond Valuation5.2 More on Bond Features5.3 Bond Ratings5.4 Some Different Types of Bonds5.5 Bond Markets5.6 Inflation and Interest Rates5.7 Determinants of Bond Yields5-45.1 BONDS AND BOND VALUATION•A bond is a legally binding agreement between a borrower and a lender that specifies the:•Par (face) value•Coupon rate•Coupon payment•Maturity date•The yield to maturity is the required market interest rate on the bond.•Do not confuse the coupon rate with the required market interest rate5-5BOND VALUATION •Primary Principle:•Value of financial securities = PV of expected future cash flows •Bond value is, therefore, determined by the present value of the coupon payments plus the present value of the par, or face, value•Interest rates are inversely related to present (i.e., bond) values.5-6CONCEPTUAL CASH FLOW OF A 10 YEAR BOND•Xanth Co. has issued a 10 year bond with an 8% annual coupon. The cash flows from the bond would be paid as follows:5-75-7THE BOND-PRICING EQUATIONTTr)(1Frr)(11-1C Value BondNotice that:•The first term is the present value of the coupon payments (an annuity); and,•The second term is the present value of the bond’s par value5-8FREQUENCY OF COUPON PAYMENTS•Bond terms dictate the frequency of coupon payments•The coupon rate is expressed in annual terms•If the rate is expressed annually and the payments are more frequent, calculation of bond value requires:•Dividing the annual coupon payment by the number of compounding periods per year to arrive at the value of each coupon payment (C);•Dividing the annual required rate of return by the number of compounding periods per year to arrive at the desired periodic yield (r);•Multiplying the remaining years of the bond’s life by the number of compounding periods per year to arrive at the remaining number of coupon payments (T).5-9BOND EXAMPLE•Consider a U.S. government bond with a 6-3/8% coupon that expires in December 2014.•The Par Value of the bond is $1,000.•Coupon payments are made semi-annually (June 30 and December 31 for this particular bond).•Since the coupon rate is 6 3/8%, the payment is $31.875.•On January 1, 2010 the size and timing of cash flows are:10/1/1875.31$6 / 30 /10875.31$12 / 31 /10875.31$6 / 30 /14875.031,1$12 / 31 /145-10BOND EXAMPLE•On January 1, 2010, the required yield is 5%.•The size and timing of the cash flows are:1 /1 /10875.31$6 / 30 /10875.31$12 / 31 /10875.31$6 / 30 /14875.031,1$12 / 31 /1417.060,1$)025.1(000,1$)025.1(11205.875.31$1010PV5-11BOND EXAMPLE: CALCULATORPMTI/YFVPVNPV31.875 =2.51,000– 1,060.17101,000×0.063752Find the present value (as of January 1, 2010), of a 6-3/8% coupon bond with semi-annual payments, and a maturity date of December 2014 if the YTM is 5%.5-12BOND EXAMPLE•Now assume that the required yield is 11%. •How does this change the bond’s price?1 /1 /10875.31$6 / 30 /10875.31$12 / 31 /10875.31$6 / 30 /14875.031,1$12 / 31 /1469.825$)055.1(000,1$)055.1(11211.875.31$1010PV5-135-13YTM AND BOND VALUE80010001100120013000 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1Discount RateBond Value6 3/8%When the YTM < coupon, the bond trades at a premium.When the YTM = coupon, the bond trades at par.When the YTM > coupon, the bond trades at a discount.5-14BOND CONCEPTS•Bond prices and market interest rates move in opposite directions.•When coupon rate = YTM, price = par value•When coupon rate > YTM, price > par value (premium bond)•When coupon rate < YTM, price < par value (discount bond)5-15INTEREST RATE RISK•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 than high coupon rate bonds.•Reinvestment Rate Risk•Uncertainty concerning rates at which cash flows can be reinvested•Short-term bonds have more reinvestment rate risk than long-term bonds.•High coupon rate bonds have more reinvestment rate risk than low coupon rate bonds.5-165-16MATURITY AND BOND PRICE VOLATILITYCConsider two otherwise identical bonds.The long-maturity bond will have much more volatility with respect to changes in the discount rate.Discount RateBond ValueParShort Maturity BondLong Maturity Bond5-175-17COUPON RATES AND BOND PRICESConsider two otherwise identical bonds.The low-coupon bond will have more volatility with respect to changes in the discount rate.Discount RateBond ValueHigh Coupon BondLow Coupon BondParC5-18COMPUTING YIELD TO MATURITY•Yield to maturity is the rate implied by the