FIN3403 LECTURE GUNTER Wednesday October 1st 2014 1 Disclaimer These notes were prepared by a student enrolled in Melody Gunter s FIN3403 Fall 2014 course and were compiled for Exam 2 These notes contain all materials discussed during lecture on October 1st 2014 and aim to serve as a partial conceptual review for strictly Exam 2 Studying these notes alone will not guarantee you a passing grade It is highly recommended you combine the review of these notes with the review of notes from other lecture dates that you may have missed in addition to extensive practice using your TI BA II Plus on calculation problems Happy studying A brief review of last lecture coupon payments each period N 1 2 3 4 5 6 7 8 9 10 20 Coupon payments Face value principal payment Bond Price PV ordinary annuity PV lump sum Value PV Variables needed Variables needed Calculator shortcut as long as you have the variable N I Y PMT and FV you can compute the PV in one shot You don t need to perform two separate calculations in your calculator and then add them together as if you were doing the calculations on paper using the PV annuity and PV lump sum formulas N I Y PMT N I Y FV CPT PV CPT PV Important notes about bonds Most bonds pay interest semiannually When doing PV calculations for bonds make sure you pay attention to the compounding periods o i e monthly 12 periods per year quarterly 4 periods per year semiannually 2 periods per year annually 1 period per year o Example if a 10 year bond pays coupons semiannually at 8 you have to adjust some of the variables N 10x2 20 I Y 8 2 4 2 FIN3403 LECTURE GUNTER Wednesday October 1st 2014 Understanding Yields Yield to maturity is the same thing as the market rate Current yield annual coupons current market price o This tells us what return we are making on the coupon payments relative to the market return on an annual basis Coupon rate annual coupons face value o This will give us our return An important note at issuance the coupon rate current yield and yield to maturity will be equal o Remember the coupon rate is set at the market rate yield to maturity at issuance meaning that the two are equal Yield to first call represents the yield where N is the number of periods left until the company can call in the bonds o In the bond price value formula on the top of the previous page notice that the second part of the formula requires the variable FV o FV must be adjusted to equal PAR 1 premium Remember there is a penalty the company will face when they call in bonds because it s not favorable to bondholders This penalty is called the premium and is usually represented in terms of a percentage of the face value that was borrowed and thus would be paid at the call date in addition to the face Since we are trying to calculate the yield to call we would adjust N to be the periods left until that call date and we would adjust FV to be PAR 1 premium o In summary the yield to call is the yield or rate at a shorter term and with a higher face value i e the original face value with the addition of the premium under the call provision Nominal rates the real rate of interest plus the inflation premium or discount o If there is deflation over time there would be an inflation discount attached to the real rate o If there is inflation over time which is usually the case there would be an inflation premium attached to the real rate o Fisher Effect Nominal rate 1 real rate 1 inflation OR Nominal rate Real rate inflation rate This can be adjusted to say Real rate Nominal rate inflation rate If the nominal interest rate is 4 and the inflation rate is 3 then the real rate is 1 purchasing power has increased If the nominal interest rate is 3 and the inflation rate is 4 however the real rate has eroded by 1 purchasing power has decreased o Real rate is constant throughout time Add inflation premium and you have the nominal rate FIN3403 LECTURE GUNTER Wednesday October 1st 2014 3 Length of Term in Comparison to Interest Rates In general longer term rates are higher than shorter term rates o This idea is called a term structure o Since there is more risk of interest rates changing over a longer time period the relationship between term length and interest rate is upward sloping i e as the term gets longer interest rates get higher o The term structure is upward sloping during inflationary periods and downward sloping during deflationary periods In summary interest rate risk is higher on bonds with more time until maturity and with low coupon payments lower coupon rate I usually wouldn t have a reader refer to a textbook explanation however page 197 of the textbook gives a very clear explanation of why interest rate risk is higher under these two auspices o Referring to the graph on page 197 of the textbook the point at which the lines intersect is the PAR value of the bonds o To the left of the point is the premium o To the right of the point is the discount Things That Determine Bond Yields Term structure of interest rates o Includes inflation premium and interest rate premium Risk premiums credit ratings o Default risk chance you re not going to get paid back takes into account o Liquidity risk risk that on the day you want to sell no one is willing to buy Very liquid bonds get lower interest rates because they can be easily sold and don t represent a risky investment to the bondholder o Tax status laws set in place when it comes to taxes Government can change tax laws to make tax rates higher etc An important note the book value of debt and the market value of debt on then balance sheet is usually or basically the same An important note as you will see however this is not the case for equity on the balance sheet o Valuing equity stock valuation will be discussed in the next lecture
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