Chapter 7: Interest Rates and Bond

Valuation
FINA1310 Corporate Finance
Faculty of Business and Economics
University of Hong Kong
Dr. Tao Lin

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 Chapter Outline
 Bond basics and valuation
 Interest Rate Risk
 Current yield,YTM and HPR
 More about Bond (read the book)
 Interest Rate and Inflation
 Interest rate determinants

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 Bond Basics: Terminology
 Bond - Security that obligates the issuer to make specified
payments to the bondholder.
 Face Value (Par Value or Maturity Value) – Principal payment at the
maturity of the bond. (Often default 1000)
 Maturity - The specified date on which the Face value is paid.
 Coupon - The stated interest payments made to the bondholder.
 Coupon Rate - Annual interest payment, as a percentage of face
value.
 Zero coupon bond
 Fixed rate bond
 Floating rate bond

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 Bond Pricing
 Bond Price: Present Value of all cash flows generated by the
bond (i.e. coupons and face value) discounted at the required
rate of return.
 Yield To Maturity – APR, Interest rate for which the present
value of the bond’s payments equal the price.

cpn cpn (cpn  par )

PV    .... 
(1  r ) (1  r )
1 2
(1  r ) t

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 Bond Pricing
WARNING
The coupon rate IS NOT the interest rate used in the Present
Value calculations.

Coupon Rate vs. Interest Rate

Since the coupon rate is listed as a %, this misconception is

quite common.

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 Present Value & Interest Rates
 Bond Value = PV of coupons + PV of par
 Bond Value = PV (annuity) + PV (Face)
 Remember, as interest rates increase the PV’s decrease
 So, as interest rates increase, bond prices decrease and vice
versa

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 Bond Pricing: Par Bond
Example
What is the price of a 6.5 % annual coupon bond, with
a $1,000 face value, which matures in 3 years? Assume
a required return of 6.5%.

65  1  1,000
PV  1  3 

0.065  1.065  (1.065) 3

PV  $1,000

PMT=65, N=3, FV =1000, I/Y =6.5, CPT PV

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 Bond Pricing: Premium Bond
Example
What is the price of the bond if the required rate of
return is 3.9 %?
65  1  1,000
PV  1  3 

0.039  1.039  (1.039)3
PV  $1,072.29

PMT=65, N=3, FV =1000, I/Y =3.9, CPT PV

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 Bond Pricing: Discount Bond
Example (continued)
What is the price of the bond if the required rate of
return is 15 %?

65  1  1,000
PV  1  3 

0.15  1.15  (1.15) 3

PV  $805.93
PMT=65, N=3, FV =1000, I/Y =15, CPT PV

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 Bond Pricing
Example (continued)
What is the price of the bond if the required rate of
return is 3.9% AND the coupons are paid semi-
annually?
Note: Bond yields are quoted like APRs; the quoted rate is
equal to the actual rate per period multiplied by the
number of periods.
32.50 32.50 32.50 1,032.50
PV  1
 2
 ...  5

(1.0195) (1.0195) (1.0195) (1.0195) 6
PV  $1,072.94

10 PMT=65/2, N=6, FV =1000, I/Y =3.9/2, CPT PV

 Bond Pricing
Example (continued)
Q:What happened when the required return is less than the coupon
rate?

Q:What happened when the required return is greater than the

coupon rate?

Q: How did the calculation change, given semi-annual coupons versus

annual coupon payments?

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 Bond Pricing
Example (continued)
Q: How did the calculation change, given semi-annual coupons versus
annual coupon payments?

Time Periods Interest Rate and CF

Paying coupons twice a year, Since the time periods are
instead of once doubles the now half years, the discount
total number of cash flows to rate and cash flow are also
be discounted in the PV changed from the annual rate
formula. to the half year rate.

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 The Bond Pricing Formula

 1 
1 -
 (1  r) t  FV
Bond Value  C  
 (1  r)
t
 r
 

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 Interest Rate Risk
 Price Risk
 Change in price due to changes in interest rates
 Long-term bonds have more price risk than short-term bonds
 All other things being equal, the larger the coupon rate, the
smaller the price risk.
 Price risk is greater when the yield-to-maturity is low than when
the yield-to-maturity is high.
 Reinvestment Rate Risk
 Uncertainty concerning rates at which cash flows can be
reinvested
 All other things being equal, the larger the coupon rate, the
greater the reinvestment rate risk.

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 Figure 7.2

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 Interest Rate Risk & Coupon Rate

Coupon Price on Price on % Change Price on % Change

Maturity Rate 12/31/95 7/31/96 95-96 7/02/01 96-01
2095 7% $1,000.00 $800.00 -20 $900 12.50%
2033 6.75 976.25 886.25 -9.2 957.5 8.04
2033 7.50 1040.00 960.00 -7.7 1036.25 7.94

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 Bond Yields
 Current Yield – Annual coupon payments divided by bond
price.
 Yield To Maturity – APR, Interest rate for which the present
value of the bond’s payments equal the price.

AnnualCouponInterest
Current Yield 
Current BondPrice

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 Computing Yield-to-maturity
 Yield-to-maturity is the rate (APR) implied by the current bond
price
 It is also the rate of return that investors can actually earn (APR)
if
 Interest rate stay unchanged or
 The bond is zero coupon and held to maturity
 Finding the YTM requires trial and error if you do not have a
financial calculator and is similar to the process for finding r
with an annuity
 If you have a financial calculator, enter N, PV, PMT and FV and
compute I/Y.You need to remember the sign convention (PMT
and FV need to have the same sign, PV the opposite sign)
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 Example: YTM
 Find the YTM for a bond with $1000 face value, a remaining
time to maturity of 10 years and a coupon rate of 10% paid
semi-annually. The bond is currently selling at $1135.9.

50 1 1000
1135.9 = 1− 20
+
𝑟 1+𝑟 1 + 𝑟 20

 PV(4.5%, 20, -50, -1000) = 1065.04

 PV(3.5%, 20, -50, -1000) = 1213.19
 PV(4%, 20, -50, -1000) = 1135.90

YTM = 8%. 4% per 6 months

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 Current Yield Example
 Current Yield – Annual coupon payments divided by bond
price. (did not consider compounding within the year)
 In the example: the 10% semi-annual coupon bond with a par
value of $1000 is selling for $1135.9. The remaining time to
maturity is 10 years.
 Its current yield is then 10%*1000/$1135.9 = 8.8%
 Assume the interest rate is unchanged. What is the actual return
earned after one year?
 Price next year = PV(8%/2, 18, -50,-1000) = 1126.59
 Capital Gain/Loss Yield = (1126.59-1135.9)/1135.9=-0.8196%
 Current yield + capital gains yield ~= yield to maturity

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 Holding Period Return
 If interest rate change, the holding period realized return
(holding period return) might be different from the yield to
maturity.
 In the example: the 10% semi-annual coupon bond with a par
value of $1000 is selling for $1135.9. The remaining time to
maturity is 10 years.
 Suppose that the yield to maturity decreases by 1% at year 1.

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 Holding Period Return
 New price:
 PV(7%/2, 18, -50, -1000) =1197.85
 Holding Period Return:
 Rate(2, -50, 1135.9, -1197.85) = 7.036%
 (1+7.036%)^2-1=14.567%
 Now suppose, the coupons are reinvested at 8% APR. What is
the holding period return?
 Coupon Proceeds: 50*1.04 +50 = 102
 (1197.85+102)/1135.9 -1 = 14.43%

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 More About Bond
 Issuers: Governments, Agencies, Corporations
 Trustee: appointed by the issuer to represent bondholders
 Indenture is followed.
 Manage sinking fund
 Represent bondholders in default
 Bond Indenture: the written agreement between the corporation and
the lender.
 Basic terms of the bond
 Total amount of bonds issued
 A description of property used as security
 The repayment arrangement
 The call provision
 Details of the protective covenants

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 Inflation and Interest Rates
 Real rate of interest – change in purchasing power
 Nominal rate of interest – quoted rate of interest, change in
purchasing power and inflation
 The ex ante nominal rate of interest includes our desired real
rate of return plus an adjustment for expected inflation

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 The Fisher Effect
 The Fisher Effect defines the relationship between real rates,
nominal rates and inflation
 (1 + R) = (1 + r)(1 + h)
 R = nominal rate
 r = real rate
 h = expected inflation rate
 Approximation
 R ~= r + h

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 Example: Real Rate
 What was the real rate on an investment that generated 10% return
and the inflation rate was 4%?

1 R 1.1
r 1   1  5.77%  6%
1 h 1.04

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 PV, Nominal Rate and Real Rate
 Either discount nominal CFs at nominal rate or discount real
CFs at real rate.
 Example: Suppose you want to withdraw money each year for
the next three years, and you want each withdrawal to have
$25,000 worth of purchasing power as measured in current
dollars. If the inflation rate is 4% each year to compensate.
What is the present value of the CFs if the appropriate nominal
discount rate is 10%?

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 0 1 2 3 0 1 2 3

CF1 CF2 CF3 CFR1 CFR2 CFR3

Nominal CFs: Real CFs:

CF1 = 25,000*1.04 CFR1 = CFR1 = CFR1 =25,000

CF2 = 25,000*1.04^2 Real rate =(1+10%)/(1+4%) – 1
CF3 = 25,000*1.04^3 = 5.77%

r=10%, g= 4%, N=3, C = CF1 r=5.77%, N=3, C = CFR1

Using growing annuity formula, Using ordinary annuity formula,

CPT PV = 67,111.65 CPT PV = 67,111.65

PVGA 
C 
1 
1 g  
n
 1 r 
1 R
r  g  1  r  
n
1 f

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 Term Structure of Interest Rates
 Term structure is the relationship between time to
maturity and yields, all else equal
 It is important to recognize that we pull out the effect of
default risk, different coupons, etc.
 Yield curve – graphical representation of the term
structure
 Normal – upward-sloping, long-term yields are higher than short-
term yields
 Inverted – downward-sloping, long-term yields are lower than
short-term yields

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 Upward-Sloping Yield Curve

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 Downward-Sloping Yield Curve

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 Figure 7.7

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 Factors Affecting Required Return
 Default risk premium – remember bond ratings
 Taxability premium – remember municipal versus taxable
 Liquidity premium – bonds that have more frequent trading
will generally have lower required returns
 Anything else that affects the risk of the cash flows to the
bondholders, will affect the required returns

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Ethics Issues
 In 1996, allegations were made against Moody’s that it was issuing
ratings on bonds it had not been hired to rate, in order to pressure
issuers to pay for their service.
 The government conducted an inquiry, but charges of antitrust
violations were dropped. Even though no legal action was taken, does
an ethical issue exist?
 Recap
 Bond Valuation
 Interest Rate Risk: coupon rate and maturity
 More about Bond
 Yield to Maturity; Current Yield; Holding Period Return
 Interest rate determinants

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Bond Basics Issuer of
Bonds Illustration 15-3

Maturity
Date

Contractual
Interest
Rate

Face or
Par Value LO 1 Explain why bonds are issued.