Dr.

Steve Beach

Radford University Business Finance$

Updated: May 7, 2012

Chapter 6: Interest Rates and Bond Valuation How the time value equations can be used for the valuation of Bonds Zero coupon bonds / Pure Discount Bonds Example of Pure Discount Loan: Treasury Bills. Describe them and draw time line. Q: What equation do we use here? Present value of a future cashflow PV = FV/ (1 + R) N

Example: Consider a 10-year zero coupon bond, it is priced to yield 9%. What is the current price? PV = 1,000 / (1.09)10 = 1,000 x (1.09)-10 = $422.41 On financial calculator: N=10, I=9, PMT=0, FV=1000, CPT PMT = 422.41 Note that I said priced to yield What I am implying is that the market forces have determined that 9% is required on a particular security with its particular risk and payment structure. That required return is established in the market place. YTM is the IRR on a bond. Well discuss IRR in detail a little later.

Example: Say we have a 20-year zero-coupon bond that is selling for $275. What is its yield-to-maturity? 275 = 1,000(1 + ytm)-20 .275 = ( 1 + ytm )-20 1.06668= 1 + ytm 6.668% = ytm On financial calculator: N=20, PV=-275, FV=1000, PMT=0, CPT I=6.668

Dr. Steve Beach

Radford University

Updated: May 7, 2012

Pricing and YTM for Coupon-Paying Corporate Bonds Coupon paying bonds pay an interest payment every 6 months and return the principle (usually $1,000) at the end of the loan.

Example: Assume we have a 20-year bond paying a 10.25% annual coupon rate (=> .1025*1000/2 =) or $51.25 every six months. If it is priced to yield 11%, what is its price?

PMT= 51.25 | | | | |

FV = 1,000 ||

|-------- |-------- |-------- |-------- |---.....................----- |-------- | | | PV=? 1 2 3 4 I = 11%/2 39 40 = N periods

For equations:

use (1) pv of annuity and (2) pv of future cash flow. :General solution for Bond

PV = Coupon (PVIFAR,N) + 1000 (PVIFR,N) Price

PV = $51.25(1-[1/(1.055)40])/.055 + $1000/(1.055)40 PV = 822.36 + 117.46 = 939.82

For calculator: N=40, I=5.5, pmt=51.25, fv = 1000 CPT pv => $-939.83

What if the required return goes up? Say to 12%, then PV = 868.34 Bond is at a discount (price < 1000)!! What if required return goes down? Say to 10%, then PV = 1,021.49 Bond is at a premium (price > 1000)!!

Current yield = Annual Coupon PMT \ Current Price = 102.50 / 939.83 = 10.91% The annual return due to the coupon payments: NOT total return!

Dr. Steve Beach Solving for yield:

Radford University

Updated: May 7, 2012

However, when we try to calculate the YTM for a coupon paying corporate bond, we do not have a closed form solution. We must solve for YTM using trial-anderror or have our financial calculator solve for us.

If the PV = 1035, What is the YTM? First, we know the YTM < 10.25%, since the price is at a premium. Try: 9.75% => I = 4.875% PV = 1043.64 Now, the present value of cash flows indicates a price above $1,035, so need to increase I. Try: 9.9% => I = 4.95% PV = 1030.24 Now, the present value of cash flows indicates a price below $1,035, so need to lower I. Try: 9.85% => I = 4.925% PV = 1034.67 Close enough!

Now the easy way, using calculator: N=40, PV= -1035, pmt=51.25, fv=1000 CPT I/Y => 4.92% every six months or 9.85% annually

Also, some financial calculators are set to perform corporate bond valuation. Different calculators follow different conventions, so if you want to use the bond valuation function, you need to read your users manual.

Dr. Steve Beach

Radford University Interest Rate Risk Example

Updated: May 7, 2012

Interest rate risk: The risk that bond price will fall with increase in interest rates 1. Longer time to maturity (ceteris paribus) => Greater interest rate risk

Price is more volatile for bonds further from maturity 2. Lower coupon rate(ceteris paribus) => Greater interest rate risk

Price is more volatile for bonds with lower coupon rates

ABC bond has 10 years to maturity, 10% coupon rate, and a YTM = 10%. XYZ bond has 20 years to maturity, 10% coupon rate, and a YTM = 10%. STU bond has 10 years to maturity, 6% coupon rate, and a YTM = 10%. What happens to each bond with an increase in YTM to 12%?

PMT FV I N PV YTM increases to 12%: I PV

XYZ 50 1000 5% 40 -1000

ABC 50 1000 5% 20 -1000

STU 30 1000 5% 20 -750.76

6% -849.54

6% -885.30

6% -655.90

ABC: % = 885.30 1000 / 1000 = -11.47% XYZ: % = 849.54 1000 / 1000 = -15.05% STU: % = 665.90 1000 / 1000 = -12.64%

Dr. Steve Beach Interest Rate Levels

Radford University

Updated: May 7, 2012

What is a rate of return (or interest rate)? Simple: I offer to give you $115 in one year if you give me $100 now.

Return on your $100 investment: $115 - $100 / $100 = .15 = 15%

i.e. Given a $100 investment and a 15% rate of return we have:

$100 *(1.15) = $115

What elements contribute to your required return? 1. Compensation for not consuming now 2. Keep up with rising costs (expected inflation) 3. Risk of the investment INFLATION IS A COSTLY THING EXAMPLE: Your usual basket of groceries cost $150 last year, this year the same basket costs $160.

If that basket is used to measure inflation, then inflation was

($160 - $150) / $150 = .066667 = 6.6667% for the year.

We see that inflation reduces the purchasing power of money, i.e. the dollar. Note in the example that one dollar last year bought 1/150 of your basket, while now one dollar only buys 1/160 of your basket.

Dr. Steve Beach

Radford University

Updated: May 7, 2012

NOMINAL VERSUS REAL RATES Nominal rates of return an observed rate of return that is not adjusted for inflation, like the 15% mentioned in the preceding discussion. Although the investment yielded a 15% return, if inflation was 15%, we cannot buy any more goods than before.

Real rates of return - are inflation adjusted. In the example above, our nominal rate was 15% but, since we can only buy the same amount of goods, we received a 0% real return from that investment.

The relationship between nominal and real interest rates is given in the Fischer Equation: Nominal Interest Rate = real rate + expected inflation

r = r* + E(h)
Which is often used to show the real rate of return as: r* = r h Real risk-free rate is the compensation for deferring consumption (instead of spending!)

The exact formulation that is much more useful in more complex analysis is:

(1 + r) = (1+r*) (1+h)
The real rate was about 3% for much of the 1900s. Nominal rates have fluctuated from 4% to 18% over the time, though. As a result, much of the variation in nominal interest rates is due to changes in expected inflation.

In the example where you lend me $100, your nominal rate of return was 15% but, your real return on that investment was: r*loan to SLB = rloan to SLB h r*loan to SLB = .15 .066667 = .0833333

Dr. Steve Beach

Term Structure of Interest Rates Rf = r* + InfPrem + IntPrem (Default) risk-free rate of return =

Radford University

Updated: May 7, 2012

Real rate of return + Inflation Premium + Interest Rate Risk Premium Term structure of interest rates considers Rf for pure discount bonds. Rf is compared for different maturities. Inflation Premium based on expected inflation, investors must be compensated for inflation Interest Rate Risk the risk that higher interest rates will reduce the value of the security (alternatives) Yield curve looks at Rf for securities of similar default risk, usually Treasury Yield Curve. Upward sloping yield curve:

Downward sloping yield curve:

Define R1 as the required return (YTM) on security 1 r1 = Rf + RP1 Specifically a risk premium is the return required on a risky investment in excess of the return required on a riskless investment. For any particular investment, required rate of return can be defined as: r1 = return on U.S. Treasury Security + risk premium1 Why? 1. The treasury securities are considered default risk free 2. Investors require a higher return for various risks (default, taxes, liquidity)

Dr. Steve Beach

Radford University

Updated: May 7, 2012

Assume you had accurately used the 6.667% as your estimate of inflation (your inflation premium):

rloan to SLB = r* + IP + RPloan to SLB .15 = .03 + .066667 + RPloan to SLB .15 - .03 - .066667 = RPloan to SLB .0533 = RPloan to SLB Note that this example implies a risk-free rate of 9.667%, there is no interest rate risk premium since it is a one-year loan.

Inflation impacts other investors in the same way. Thus, investors must be compensated for expected inflation in their investments. For example, if I make an investment that I know has no possibility of default (I know Ill get my money), and inflation is expected to be 10%, then I will demand at least a 10% return on my investment so that I expect to maintain the purchasing power of my invested money.