Chapter 4 Interest Rate Measurement and Behavior Chapter 5 The Risk and Term Structure of Interest Rates

Size: px
Start display at page:

Download "Chapter 4 Interest Rate Measurement and Behavior Chapter 5 The Risk and Term Structure of Interest Rates"

Transcription

1 Chapter 4 Interest Rate Measurement and Behavior Chapter 5 The Risk and Term Structure of Interest Rates Fisher Effect (risk-free rate) Interest rate has 2 components: (1) real rate (2) inflation premium I = r+ IP LEVEL OF INTEREST RATES STRUCTURE OF INTEREST RATES Term Structure of Interest Rates - defines the relationship between maturity & annualized yield, holding other factors such as risk, taxes, etc., constant. Graphic presentation is the yield curve. Curve shifts and twists through time. Four Basic Shapes: Positive Yield Curve: upward sloping Negative Yield Curve: downward sloping Flat Yield Curve Humped Yield Curve Level of Interest Rates: Loanable Funds Theory -- market interest rate is determined by the factors that control the supply of and demand for loanable funds. Demand Factors Household: Y increases then installment debt increases R increases then installment debt falls

2 Business: NPV = - I n CFt + t (1+i ) T =1 if i decrease _ NPV (?) Government: interest inelastic 1980: debt/gnp =25% 1987: debt/gnp=42% Foreign Foreign interest rates vs. U.S. rates Supply Households - largest suppliers Very steep slope for supply. Why? What happens if expect higher inflation? Savers -

3 Liquidity Preference Theory - Market rate of interest is determined by demand/supply of money balances. Demand of Money Transaction Precautionary Speculative + f(y) + f(y) - f(r) Supply of Money Fed basically determines supply Few uncontrollable factors (1) banks lending (2) public's preference for cash Letting D=S then solve for interest rate: r = f _ (,, ) y m p e

4 THEORIES ON SHAPE OF YIELD CURVE Unbiased Expectations - shape of yield curve is determined solely by current & expected future short-term interest rates. A 2 year security should offer a return that is similar to the anticipated return from investing in 2 consecutive one-year securities. 2 (1+ t R2 ) = (1+ t R1 )(1+ t+1 r1 ) 3 (1+ t R3 ) = (1+ t R1 )(1+ t+1 r1 )(1+ t+2 r1 ) t+1r 1 / one year interest rate that is anticipated as of time t+1. t+2r 1 / one year interest rate that is anticipated as of time t+2. R 1 } R 2 } Known annualized rate on 1 year security, 2 year security, 3 year security. R 3 }

5 Eg.. t 2 R =.10 if. t 1 R =.08 2 (1+.1 ) =(1.08)(1+ t+1r1 ) then 2 (1.1 ). t+1r1= Expect interest rates to rise: investor (saver) wants s-t security borrowers want L-T security Risk neutral Borrowers are the suppliers of securities (IOU's) therefore s-t demand > supply then increase in Price which results in a decrease in yield and we have an upward sloping curve. Liquidity Premium Investor becomes risk averse prefer s-t security over L-T security. Inducement to buy L-T must add premium. Segmented Markets Unlike first 2 theories which treat market as a whole - this theory treats market as if made up of segments. Investors/borrowers choose security with maturities that satisfy their forecasted cash needs. Therefore, need rather than expectations of s-t rates determine where a person invests. Demand/Supply within segments drive rates. rate Upward Pension Life Ins. Thrifts Bank Time

6 Downward Bank Thrifts Pension Demand for L-T increases or D>S for S-T Prices increases for L-T and yield for L-T decreases Preferred Habitat Combines Expectations & Segmented Investors may have a preferred investment horizon (habitat) but their expectations on int. rates move them within or even out of their habitat. Which Theory is Correct? Research by Meiselman on interest rate expectations found they strongly influence on the term structure-- they have looked at how accurate forward rates are--not very accurate--therefore other factors also influence interest rates Kessel found that liquidity premium caused forward rates to have a positive bias Other research on liquidity premium have found that the size of the premium varies inversely with interest rate levels and yet others have found the opposite to be true Elliot and Echols have examined the segmented market idea--they found discontinuities in the yield maturity relationship--may be due to supply and demand of segments All of the theories have some evidence on their validity Integrating the theories Example: 1. Borrowers and investors expect rates to rise they invest (expectation theory) 2. Borrowers need long term funds while investors prefer short-term (segmentation theory) 3. Investors prefer more liquidity than less (liquidity premium theory) In this example, all theories suggest an upward sloping curve ---domination of the views would determine the slope--ie. If #1 was dominate but the expectation was for declining rates then might have a slightly downward sloping curve

7 Other factors that affect yield on Sec. (1) Default risk (2) Liquidity (3) Tax Status (4) Term-to-Maturity (5) Special Provisions Call Convertibility Yield on Sec r = R / + DP + LP + Special Provision

8 INTEREST RATES/BOND PRICES Appropriate price of a sec. is the PV of remaining cash flows PV considers (1) size of cash flow (2) timing of cash flow (3) required rate of interest. which includes adj. for risk Price of m Ct Bond = t (1+i ) t =1 Two Cash Streams Annuity (interest) PV a i 1-(1+ = A [ m i m ) -nm ] Single Sum S PV s = i (1+ m ) nm Semiannually therefore need to adjust interest rate and period.

9 As interest rates rise, bond prices lower, but this is not 1-1 relationship. Coupon Rate - YTM Relationship Coupon Rate > YTM Ψ sell at premium Coupon Rate < YTM Ψ sell at discount Coupon Rate = YTM Ψ sell at par or face value Coupon Rate = Interest in dollars Par Value Current Yield = Interest in dollars Price of Bond YTM= Capital gain (loss) + income from interest payments YTM (Exact) Bond C1 Price= (1+YTM C2 + 1 ) (1+YTM Cm + Par ) (1+YTM ) m Solve for YTM YTM (approximate) = YTM app Par - Price Annual Interest dollars + number of yrs maturity Price + Par 2 YTM (Exact) Bond C1 Price= (1+YTM C2 + 1 ) (1+YTM Cm + Par ) (1+YTM ) m Solve for YTC Rate Maturity Bid Ask Bid Chg Yld 81/4s * May 105:25 106: * * May Bond matures on 2005 but is callable starting in 2000 ** Yld For callable bonds the YTM is calculated in one of two ways a. to first call date when the asked price is above par b. to maturity date when the asked price is equal to or below par

10 YTC 1. Substitute the Call Price for Par 2. Substitute the number of years to first call for maturity years Effective Yields: Realized r Yield = (1+ ) m mn - 1 r Continuous Compounding = e - 1 e Point of interest: Difference between nominal rate and add-on and discount. Add-On 36 months, r = 10% $5000 borrowed monthly payment: Interest Payment: 1) 5000 x.10 x 3 = $1500 2) ( )/36 = Actual Interest Rate 5000 = [PVIFA x,36 ] = x x = 1.5%/month Ψ Annual 18% Discount 36 months Interest $1500 Pay $5000 Receive $3500 Payment 5000 = $ = (PVIFA x, 36 ) 25.2 = x x = 2%/month 24% Annual

11 Valuation of Zero Coupoin Securities: Price = Maturity Value ( PVIF %,n) If the security is sold on a discount then the price is equal to the PV of a lump sum. Money market instruments sold on a discount basis are sensitive to changes in interest rates but not to the same degree as bonds with coupon payments. Treasury Bill Yields P Discount Yield = [ ] n 100 Equivalent Yield 365 = [ n P P ] i.e. Discount yield on bill 8.6% with 80 days till maturity..086 = Price = 4.5 [ Price ] 4.5 [Price] = P = Price.086 = 80 Price Equivalent Yield = 8.6%.0188 = Price Price [Price] = 100 Price = 98.15

12 Factors Affecting Bond Prices Strong economic growth tends to place upward pressure on interest rates Weak economic growth tends to place downward pressure on interest rates Money supply increase (demand not affected) downward pressure on rates Money supply increase ( demand increases for funds) upward pressure--inflation Oil prices have major impact upon prices drop in oil prices--lower interest rates Weaker dollar ( everything else constant) increase inflationary expectations ( prices of imports increase); thus increase in rates Default risk Exchange Rates and Foreign Bonds Risk that currency will depreciate and more than offset any coupon rate advantage when the interest payments are converted into US dollars International Diversification Reduce exchange rate risk by diversifying among foreign securities denominated in various foreign currencies. Diversify internationally to reduce exposure to interest rate risk and default risk. By investing in many countries avoid only one country=s economy and interest rates to affect the bond portfolio. Measurement of timing of Cash Flows (1) Term to Maturity - Number of years to final payment - Ignores interim cash flows - Ignores Time Value Duration (2) Weighted Average Term to Maturity - Computes the proportion of each individual payment as a percentage of all payments and makes this proportion the weight for the year the payment is made. CF1 CF 2 CFm WATM = (1)+ (2)+...+ (m) TCF TCF TCF Cf t = the cash flow in year t m = maturity TCF = Total Cash Flow e.g. 10 year 4% bond TCF = WATM = (2)+ (3)+...+ (9)+ (10)= 8.71 yrs Considers timing of all cash flow - Does not consider time value of the flows

13 DURATION Duration: Weighted Average number of years until an initial cash investment is recovered with the wight expressed as the relative present value of each payment of interest and principle. In order for a bond to be protected from the changes in interest rates after purchase the price risk and coupon reinvestment must offset each other. Duration is the time period at which the price risk and coupon reinvestment risk of a bond are of equal magnitude but opposite in direction. Assume a 8% coupon on 1000 Face Value bond with 2 years to maturity and a YTM of 20%. Duration Calculation (1) (2) (3) (4) (5) Periods Coupon 1 (1+i) n where i=10% 2 x 3 Unweighted PV 1 x 4 Weighted PV 1 $ $ $ $ Duration Calculation: = 3.75 semi -annual periods Present Value Interest Factor, is obtained by using the formula 1 where n is the number of compound periods. (1+i) n P P = - D (1+r) (1+r) If you know a bond's duration you know how much its price will change as its yield changes. D: duration; P: initial price; r: initial YTM P 100%= r( P - D (1+r) )100%

14 Ex. Yield on 8% 5 year bond selling at par has duration of 4.31 years rates go to 82% Price decline will be of its initial price % [.005( )] = % 1.08 Yield Differential Yields vary according to factors such as default risk, marketability, & tax status. Bond Risks (1) Interest Rate Risk Factors influencing change in interest rate: a) Money Supply Growth Rate b) Impact of Oil Prices c) Dollar Value d) Event Risk e) Default Risk

15 15

FIN 6160 Investment Theory. Lecture 9-11 Managing Bond Portfolios

FIN 6160 Investment Theory. Lecture 9-11 Managing Bond Portfolios FIN 6160 Investment Theory Lecture 9-11 Managing Bond Portfolios Bonds Characteristics Bonds represent long term debt securities that are issued by government agencies or corporations. The issuer of bond

More information

INTEREST RATES Overview Real vs. Nominal Rate Equilibrium Rates Interest Rate Risk Reinvestment Risk Structure of the Yield Curve Monetary Policy

INTEREST RATES Overview Real vs. Nominal Rate Equilibrium Rates Interest Rate Risk Reinvestment Risk Structure of the Yield Curve Monetary Policy INTEREST RATES Overview Real vs. Nominal Rate Equilibrium Rates Interest Rate Risk Reinvestment Risk Structure of the Yield Curve Monetary Policy Some of the following material comes from a variety of

More information

Pricing Fixed-Income Securities

Pricing Fixed-Income Securities Pricing Fixed-Income Securities The Relationship Between Interest Rates and Option- Free Bond Prices Bond Prices A bond s price is the present value of the future coupon payments (CPN) plus the present

More information

CHAPTER 15: THE TERM STRUCTURE OF INTEREST RATES

CHAPTER 15: THE TERM STRUCTURE OF INTEREST RATES CHAPTER : THE TERM STRUCTURE OF INTEREST RATES. Expectations hypothesis: The yields on long-term bonds are geometric averages of present and expected future short rates. An upward sloping curve is explained

More information

CHAPTER 14. Bond Characteristics. Bonds are debt. Issuers are borrowers and holders are creditors.

CHAPTER 14. Bond Characteristics. Bonds are debt. Issuers are borrowers and holders are creditors. Bond Characteristics 14-2 CHAPTER 14 Bond Prices and Yields Bonds are debt. Issuers are borrowers and holders are creditors. The indenture is the contract between the issuer and the bondholder. The indenture

More information

BOND ANALYTICS. Aditya Vyas IDFC Ltd.

BOND ANALYTICS. Aditya Vyas IDFC Ltd. BOND ANALYTICS Aditya Vyas IDFC Ltd. Bond Valuation-Basics The basic components of valuing any asset are: An estimate of the future cash flow stream from owning the asset The required rate of return for

More information

Bond Prices and Yields

Bond Prices and Yields Bond Characteristics 14-2 Bond Prices and Yields Bonds are debt. Issuers are borrowers and holders are creditors. The indenture is the contract between the issuer and the bondholder. The indenture gives

More information

FINS2624 Summary. 1- Bond Pricing. 2 - The Term Structure of Interest Rates

FINS2624 Summary. 1- Bond Pricing. 2 - The Term Structure of Interest Rates FINS2624 Summary 1- Bond Pricing Yield to Maturity: The YTM is a hypothetical and constant interest rate which makes the PV of bond payments equal to its price; considered an average rate of return. It

More information

INTRODUCTION TO YIELD CURVES. Amanda Goldman

INTRODUCTION TO YIELD CURVES. Amanda Goldman INTRODUCTION TO YIELD CURVES Amanda Goldman Agenda 1. Bond Market and Interest Rate Overview 1. What is the Yield Curve? 1. Shape and Forces that Change the Yield Curve 1. Real-World Examples 1. TIPS Important

More information

1. Parallel and nonparallel shifts in the yield curve. 2. Factors that drive U.S. Treasury security returns.

1. Parallel and nonparallel shifts in the yield curve. 2. Factors that drive U.S. Treasury security returns. LEARNING OUTCOMES 1. Parallel and nonparallel shifts in the yield curve. 2. Factors that drive U.S. Treasury security returns. 3. Construct the theoretical spot rate curve. 4. The swap rate curve (LIBOR

More information

Bond Analysis & Valuation Solutions

Bond Analysis & Valuation Solutions Bond Analysis & Valuation s Category of Problems 1. Bond Price...2 2. YTM Calculation 14 3. Duration & Convexity of Bond 30 4. Immunization 58 5. Forward Rates & Spot Rates Calculation... 66 6. Clean Price

More information

Part III : Debt Securities. o Bond Prices and Yields o Managing Bond Portfolios

Part III : Debt Securities. o Bond Prices and Yields o Managing Bond Portfolios Part III : Debt Securities o Bond Prices and Yields o Managing Bond Portfolios Bond Prices and Yields Chapter 0 Bond Characteristics A long-term debt instrument in which a borrower agrees to make payments

More information

1. The real risk-free rate is the increment to purchasing power that the lender earns in order to induce him or her to forego current consumption.

1. The real risk-free rate is the increment to purchasing power that the lender earns in order to induce him or her to forego current consumption. Chapter 02 Determinants of Interest Rates True / False Questions 1. The real risk-free rate is the increment to purchasing power that the lender earns in order to induce him or her to forego current consumption.

More information

CHAPTER 5 Bonds and Their Valuation

CHAPTER 5 Bonds and Their Valuation 5-1 5-2 CHAPTER 5 Bonds and Their Valuation Key features of bonds Bond valuation Measuring yield Assessing risk Key Features of a Bond 1 Par value: Face amount; paid at maturity Assume $1,000 2 Coupon

More information

Lecture 20: Bond Portfolio Management. I. Reading. A. BKM, Chapter 16, Sections 16.1 and 16.2.

Lecture 20: Bond Portfolio Management. I. Reading. A. BKM, Chapter 16, Sections 16.1 and 16.2. Lecture 20: Bond Portfolio Management. I. Reading. A. BKM, Chapter 16, Sections 16.1 and 16.2. II. Risks associated with Fixed Income Investments. A. Reinvestment Risk. 1. If an individual has a particular

More information

Chapter. Bond Basics, I. Prices and Yields. Bond Basics, II. Straight Bond Prices and Yield to Maturity. The Bond Pricing Formula

Chapter. Bond Basics, I. Prices and Yields. Bond Basics, II. Straight Bond Prices and Yield to Maturity. The Bond Pricing Formula Chapter 10 Bond Prices and Yields Bond Basics, I. A Straight bond is an IOU that obligates the issuer of the bond to pay the holder of the bond: A fixed sum of money (called the principal, par value, or

More information

Chapters 10&11 - Debt Securities

Chapters 10&11 - Debt Securities Chapters 10&11 - Debt Securities Bond characteristics Interest rate risk Bond rating Bond pricing Term structure theories Bond price behavior to interest rate changes Duration and immunization Bond investment

More information

DEBT VALUATION AND INTEREST. Chapter 9

DEBT VALUATION AND INTEREST. Chapter 9 DEBT VALUATION AND INTEREST Chapter 9 Principles Applied in This Chapter Principle 1: Money Has a Time Value. Principle 2: There is a Risk-Return Tradeoff. Principle 3: Cash Flows Are the Source of Value

More information

Foundations of Finance

Foundations of Finance Lecture 7: Bond Pricing, Forward Rates and the Yield Curve. I. Reading. II. Discount Bond Yields and Prices. III. Fixed-income Prices and No Arbitrage. IV. The Yield Curve. V. Other Bond Pricing Issues.

More information

INTRODUCTION TO YIELD CURVES. Amanda Goldman

INTRODUCTION TO YIELD CURVES. Amanda Goldman INTRODUCTION TO YIELD CURVES Amanda Goldman Agenda 1. Bond Market and Interest Rate Overview 1. What is the Yield Curve? 1. Shape and Forces that Change the Yield Curve 1. Real-World Examples 1. TIPS Important

More information

INTEREST RATE FORWARDS AND FUTURES

INTEREST RATE FORWARDS AND FUTURES INTEREST RATE FORWARDS AND FUTURES FORWARD RATES The forward rate is the future zero rate implied by today s term structure of interest rates BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 1 0 /4/2009 2 IMPLIED FORWARD

More information

Fixed income security. Face or par value Coupon rate. Indenture. The issuer makes specified payments to the bond. bondholder

Fixed income security. Face or par value Coupon rate. Indenture. The issuer makes specified payments to the bond. bondholder Bond Prices and Yields Bond Characteristics Fixed income security An arragement between borrower and purchaser The issuer makes specified payments to the bond holder on specified dates Face or par value

More information

DUKE UNIVERSITY The Fuqua School of Business. Financial Management Spring 1989 TERM STRUCTURE OF INTEREST RATES*

DUKE UNIVERSITY The Fuqua School of Business. Financial Management Spring 1989 TERM STRUCTURE OF INTEREST RATES* DUKE UNIVERSITY The Fuqua School of Business Business 350 Smith/Whaley Financial Management Spring 989 TERM STRUCTURE OF INTEREST RATES* The yield curve refers to the relation between bonds expected yield

More information

ACF719 Financial Management

ACF719 Financial Management ACF719 Financial Management Bonds and bond management Reading: BEF chapter 5 Topics Key features of bonds Bond valuation and yield Assessing risk 2 1 Key features of bonds Bonds are relevant to the financing

More information

CHAPTER 17: MORTGAGE BASICS (Ch.17, sects.17.1 & 17.2 only)

CHAPTER 17: MORTGAGE BASICS (Ch.17, sects.17.1 & 17.2 only) CHAPTER 17: MORTGAGE BASICS (Ch.17, sects.17.1 & 17.2 only) The Four Rules of Loan Payment & Balance Computation... Rule 1: The interest owed in each payment equals the applicable interest rate times the

More information

INVESTMENTS. Instructor: Dr. Kumail Rizvi, PhD, CFA, FRM

INVESTMENTS. Instructor: Dr. Kumail Rizvi, PhD, CFA, FRM INVESTMENTS Instructor: Dr. KEY CONCEPTS & SKILLS Understand bond values and why they fluctuate How Bond Prices Vary With Interest Rates Four measures of bond price sensitivity to interest rate Maturity

More information

CHAPTER 14. Bond Prices and Yields INVESTMENTS BODIE, KANE, MARCUS. Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

CHAPTER 14. Bond Prices and Yields INVESTMENTS BODIE, KANE, MARCUS. Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER 14 Bond Prices and Yields McGraw-Hill/Irwin Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 14-2 Bond Characteristics Bonds are debt. Issuers are borrowers and holders are

More information

Managing Interest Rate Risk(II): Duration GAP and Economic Value of Equity

Managing Interest Rate Risk(II): Duration GAP and Economic Value of Equity Managing Interest Rate Risk(II): Duration GAP and Economic Value of Equity Pricing Fixed-Income Securities and Duration The Relationship Between Interest Rates and Option- Free Bond Prices Bond Prices

More information

KEY CONCEPTS AND SKILLS

KEY CONCEPTS AND SKILLS Chapter 5 INTEREST RATES AND BOND VALUATION 5-1 KEY CONCEPTS AND SKILLS Know the important bond features and bond types Comprehend bond values (prices) and why they fluctuate Compute bond values and fluctuations

More information

Fin 5633: Investment Theory and Problems: Chapter#15 Solutions

Fin 5633: Investment Theory and Problems: Chapter#15 Solutions Fin 5633: Investment Theory and Problems: Chapter#15 Solutions 1. Expectations hypothesis: The yields on long-term bonds are geometric averages of present and expected future short rates. An upward sloping

More information

MFE8812 Bond Portfolio Management

MFE8812 Bond Portfolio Management MFE8812 Bond Portfolio Management William C. H. Leon Nanyang Business School January 16, 2018 1 / 63 William C. H. Leon MFE8812 Bond Portfolio Management 1 Overview Value of Cash Flows Value of a Bond

More information

Economics 173A and Management 183 Financial Markets

Economics 173A and Management 183 Financial Markets Economics 173A and Management 183 Financial Markets Fixed Income Securities: Bonds Bonds Debt Security corporate or government borrowing Also called a Fixed Income Security Covenants or Indenture define

More information

Chapter 16. Managing Bond Portfolios

Chapter 16. Managing Bond Portfolios Chapter 16 Managing Bond Portfolios Change in Bond Price as a Function of Change in Yield to Maturity Interest Rate Sensitivity Inverse relationship between price and yield. An increase in a bond s yield

More information

Foundations of Finance

Foundations of Finance Lecture 9 Lecture 9: Theories of the Yield Curve. I. Reading. II. Expectations Hypothesis III. Liquidity Preference Theory. IV. Preferred Habitat Theory. Lecture 9: Bond Portfolio Management. V. Reading.

More information

Reading. Valuation of Securities: Bonds

Reading. Valuation of Securities: Bonds Valuation of Securities: Bonds Econ 422: Investment, Capital & Finance University of Washington Last updated: April 11, 2010 Reading BMA, Chapter 3 http://finance.yahoo.com/bonds http://cxa.marketwatch.com/finra/marketd

More information

Chapter 5. Managing Interest Rate Risk: Duration Gap and Market Value of Equity

Chapter 5. Managing Interest Rate Risk: Duration Gap and Market Value of Equity Chapter 5 Managing Interest Rate Risk: Duration Gap and Market Value of Equity Duration and price volatility Maturity simply identifies how much time elapses until final payment. It ignores all information

More information

Term Structure of Interest Rates. For 9.220, Term 1, 2002/03 02_Lecture7.ppt

Term Structure of Interest Rates. For 9.220, Term 1, 2002/03 02_Lecture7.ppt Term Structure of Interest Rates For 9.220, Term 1, 2002/03 02_Lecture7.ppt Outline 1. Introduction 2. Term Structure Definitions 3. Pure Expectations Theory 4. Liquidity Premium Theory 5. Interpreting

More information

FIN 683 Financial Institutions Management Interest-Rate Risk

FIN 683 Financial Institutions Management Interest-Rate Risk FIN 683 Financial Institutions Management Interest-Rate Risk Professor Robert B.H. Hauswald Kogod School of Business, AU Interest Rate Risk FIs (financial institutions or intermediaries) face two core

More information

BBK3413 Investment Analysis

BBK3413 Investment Analysis BBK3413 Investment Analysis Topic 4 Fixed Income Securities www.notes638.wordpress.com Content 7.1 CHARACTERISTICS OF BOND 7.2 RISKS ASSOCIATED WITH BONDS 7.3 BOND PRICING 7.4 BOND YIELDS 7.5 VOLATILITY

More information

Chapter 5. Interest Rates and Bond Valuation. types. they fluctuate. relationship to bond terms and value. interest rates

Chapter 5. Interest Rates and Bond Valuation. types. they fluctuate. relationship to bond terms and value. interest rates Chapter 5 Interest Rates and Bond Valuation } Know the important bond features and bond types } Compute bond values and comprehend why they fluctuate } Appreciate bond ratings, their meaning, and relationship

More information

UNIT III BONDS AND DERIVATIVES

UNIT III BONDS AND DERIVATIVES UNIT III BONDS AND DERIVATIVES IMPORTANT 1. Dear students, please go through unit I and II carefully before starting on this unit. The terms and concepts discussed under this unit take their inputs from

More information

I. Interest Rate Sensitivity

I. Interest Rate Sensitivity University of California, Merced ECO 163-Economics of Investments Chapter 11 Lecture otes I. Interest Rate Sensitivity Professor Jason Lee We saw in the previous chapter that there exists a negative relationship

More information

[Image of Investments: Analysis and Behavior textbook]

[Image of Investments: Analysis and Behavior textbook] Finance 527: Lecture 19, Bond Valuation V1 [John Nofsinger]: This is the first video for bond valuation. The previous bond topics were more the characteristics of bonds and different kinds of bonds. And

More information

CHAPTER 16: MANAGING BOND PORTFOLIOS

CHAPTER 16: MANAGING BOND PORTFOLIOS CHAPTER 16: MANAGING BOND PORTFOLIOS 1. The percentage change in the bond s price is: Duration 7.194 y = 0.005 = 0.0327 = 3.27% or a 3.27% decline. 1+ y 1.10 2. a. YTM = 6% (1) (2) (3) (4) (5) PV of CF

More information

BOND & STOCK VALUATION

BOND & STOCK VALUATION Chapter 7 BOND & STOCK VALUATION Bond & Stock Valuation 7-2 1. OBJECTIVE # Use PV to calculate what prices of stocks and bonds should be! Basic bond terminology and valuation! Stock and preferred stock

More information

Corporate Finance. Dr Cesario MATEUS.

Corporate Finance. Dr Cesario MATEUS. Corporate Finance Dr Cesario MATEUS www.cesariomateus.com Session 1 06.02.2015 Module Introduction to Corporate Finance The Objective Function in Corporate Finance Present Value and Related Metrics Risk

More information

Chapter 2 Determination of Interest Rates

Chapter 2 Determination of Interest Rates Chapter 2 Determination of Interest Rates 1. According to the loanable funds theory, market interest rates are determined by the factors that control the supply of and demand for loanable funds. 2. The

More information

Mark to Market. The Impact of Interest Rate Changes on Portfolio Market Value. John F. Grady III Managing Director February 2, 2018

Mark to Market. The Impact of Interest Rate Changes on Portfolio Market Value. John F. Grady III Managing Director February 2, 2018 Mark to Market The Impact of Interest Rate Changes on Portfolio Market Value John F. Grady III Managing Director February 2, 2018 Housing Market 30 year mortgage rates declined during the third quarter

More information

Investments. Session 10. Managing Bond Portfolios. EPFL - Master in Financial Engineering Philip Valta. Spring 2010

Investments. Session 10. Managing Bond Portfolios. EPFL - Master in Financial Engineering Philip Valta. Spring 2010 Investments Session 10. Managing Bond Portfolios EPFL - Master in Financial Engineering Philip Valta Spring 2010 Bond Portfolios (Session 10) Investments Spring 2010 1 / 54 Outline of the lecture Duration

More information

Monetary Economics Fixed Income Securities Term Structure of Interest Rates Gerald P. Dwyer November 2015

Monetary Economics Fixed Income Securities Term Structure of Interest Rates Gerald P. Dwyer November 2015 Monetary Economics Fixed Income Securities Term Structure of Interest Rates Gerald P. Dwyer November 2015 Readings This Material Read Chapters 21 and 22 Responsible for part of 22.2, but only the material

More information

CHAPTER 5 THE COST OF MONEY (INTEREST RATES)

CHAPTER 5 THE COST OF MONEY (INTEREST RATES) CHAPTER 5 THE COST OF MONEY (INTEREST RATES) 1 Learning Outcomes LO.1 Describe the cost of money and factors that affect the cost of money. LO.2 Describe how interest rates are determined. LO.3 Describe

More information

4. D Spread to treasuries. Spread to treasuries is a measure of a corporate bond s default risk.

4. D Spread to treasuries. Spread to treasuries is a measure of a corporate bond s default risk. www.liontutors.com FIN 301 Final Exam Practice Exam Solutions 1. C Fixed rate par value bond. A bond is sold at par when the coupon rate is equal to the market rate. 2. C As beta decreases, CAPM will decrease

More information

CHAPTER 16. Managing Bond Portfolios INVESTMENTS BODIE, KANE, MARCUS. Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

CHAPTER 16. Managing Bond Portfolios INVESTMENTS BODIE, KANE, MARCUS. Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER 16 Managing Bond Portfolios INVESTMENTS BODIE, KANE, MARCUS McGraw-Hill/Irwin Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved. INVESTMENTS BODIE, KANE, MARCUS 16-2 Bond Pricing

More information

Measuring Interest Rates. Interest Rates Chapter 4. Continuous Compounding (Page 77) Types of Rates

Measuring Interest Rates. Interest Rates Chapter 4. Continuous Compounding (Page 77) Types of Rates Interest Rates Chapter 4 Measuring Interest Rates The compounding frequency used for an interest rate is the unit of measurement The difference between quarterly and annual compounding is analogous to

More information

Global Financial Management

Global Financial Management Global Financial Management Bond Valuation Copyright 24. All Worldwide Rights Reserved. See Credits for permissions. Latest Revision: August 23, 24. Bonds Bonds are securities that establish a creditor

More information

MS-E2114 Investment Science Lecture 2: Fixed income securities

MS-E2114 Investment Science Lecture 2: Fixed income securities MS-E2114 Investment Science Lecture 2: Fixed income securities A. Salo, T. Seeve Systems Analysis Laboratory Department of System Analysis and Mathematics Aalto University, School of Science Overview Financial

More information

FINA 1082 Financial Management

FINA 1082 Financial Management FINA 1082 Financial Management Dr Cesario MATEUS Senior Lecturer in Finance and Banking Room QA259 Department of Accounting and Finance c.mateus@greenwich.ac.uk www.cesariomateus.com Contents Session 1

More information

I. Asset Valuation. The value of any asset, whether it is real or financial, is the sum of all expected future earnings produced by the asset.

I. Asset Valuation. The value of any asset, whether it is real or financial, is the sum of all expected future earnings produced by the asset. 1 I. Asset Valuation The value of any asset, whether it is real or financial, is the sum of all expected future earnings produced by the asset. 2 1 II. Bond Features and Prices Definitions Bond: a certificate

More information

Equity Valuation APPENDIX 3A: Calculation of Realized Rate of Return on a Stock Investment.

Equity Valuation APPENDIX 3A: Calculation of Realized Rate of Return on a Stock Investment. sau4170x_app03.qxd 10/24/05 6:12 PM Page 1 Chapter 3 Interest Rates and Security Valuation 1 APPENDIX 3A: Equity Valuation The valuation process for an equity instrument (such as common stock or a share)

More information

II. Determinants of Asset Demand. Figure 1

II. Determinants of Asset Demand. Figure 1 University of California, Merced EC 121-Money and Banking Chapter 5 Lecture otes Professor Jason Lee I. Introduction Figure 1 shows the interest rates for 3 month treasury bills. As evidenced by the figure,

More information

Money and Banking. Lecture I: Interest Rates. Guoxiong ZHANG, Ph.D. September 12th, Shanghai Jiao Tong University, Antai

Money and Banking. Lecture I: Interest Rates. Guoxiong ZHANG, Ph.D. September 12th, Shanghai Jiao Tong University, Antai Money and Banking Lecture I: Interest Rates Guoxiong ZHANG, Ph.D. Shanghai Jiao Tong University, Antai September 12th, 2017 Interest Rates Are Important Source: http://www.cartoonistgroup.com Concept of

More information

Introduction. Why study Financial Markets and Institutions? Primary versus Secondary Markets. Financial Markets

Introduction. Why study Financial Markets and Institutions? Primary versus Secondary Markets. Financial Markets Why study Financial Markets and Institutions? Introduction Markets and institutions are primary channels to allocate capital in our society Proper capital allocation leads to growth in: Societal Wealth

More information

2. A FRAMEWORK FOR FIXED-INCOME PORTFOLIO MANAGEMENT 3. MANAGING FUNDS AGAINST A BOND MARKET INDEX

2. A FRAMEWORK FOR FIXED-INCOME PORTFOLIO MANAGEMENT 3. MANAGING FUNDS AGAINST A BOND MARKET INDEX 2. A FRAMEWORK FOR FIXED-INCOME PORTFOLIO MANAGEMENT The four activities in the investment management process are as follows: 1. Setting the investment objectives i.e. return, risk and constraints. 2.

More information

Chapter 5. Bonds, Bond Valuation, and Interest Rates

Chapter 5. Bonds, Bond Valuation, and Interest Rates Chapter 5 Bonds, Bond Valuation, and Interest Rates 1 Chapter 5 applies Time Value of Money techniques to the valuation of bonds, defines some new terms, and discusses how interest rates are determined.

More information

Review Material for Exam I

Review Material for Exam I Class Materials from January-March 2014 Review Material for Exam I Econ 331 Spring 2014 Bernardo Topics Included in Exam I Money and the Financial System Money Supply and Monetary Policy Credit Market

More information

Valuing Bonds. Professor: Burcu Esmer

Valuing Bonds. Professor: Burcu Esmer Valuing Bonds Professor: Burcu Esmer Valuing Bonds A bond is a debt instrument issued by governments or corporations to raise money The successful investor must be able to: Understand bond structure Calculate

More information

MIDTERM EXAMINATION FALL

MIDTERM EXAMINATION FALL MIDTERM EXAMINATION FALL 2010 MGT411-Money & Banking By VIRTUALIANS.PK SOLVED MCQ s FILE:- Question # 1 Wider the range of outcome wider will be the. Risk Profit Probability Lose Question # 2 Prepared

More information

CHAPTER 8. Valuing Bonds. Chapter Synopsis

CHAPTER 8. Valuing Bonds. Chapter Synopsis CHAPTER 8 Valuing Bonds Chapter Synopsis 8.1 Bond Cash Flows, Prices, and Yields A bond is a security sold at face value (FV), usually $1,000, to investors by governments and corporations. Bonds generally

More information

Corporate Finance. Dr Cesario MATEUS.

Corporate Finance. Dr Cesario MATEUS. Corporate Finance Dr Cesario MATEUS www.cesariomateus.com Session 1 13.03.2015 Module Introduction to Corporate Finance The Objective Function in Corporate Finance Present Value and Related Metrics Risk

More information

Fixed Income Securities: Bonds

Fixed Income Securities: Bonds Economics 173A and Management 183 Financial Markets Fixed Income Securities: Bonds Updated 4/24/17 Bonds Debt Security corporate or government borrowing Also called a Fixed Income Security Covenants or

More information

Investment Analysis & Portfolio Management FIN 630 Fall Quiz # 3 SOLUTION

Investment Analysis & Portfolio Management FIN 630 Fall Quiz # 3 SOLUTION Investment Analysis & Portfolio Management FIN 630 Fall - 2007 Quiz # 3 SOLUTION 1) The current yield on a bond is equal to A) The internal rate of return. B) The yield to maturity. C) Annual interest

More information

FNCE 302, Investments H Guy Williams, Equilibrium Rates (how changes in world effect int rates)

FNCE 302, Investments H Guy Williams, Equilibrium Rates (how changes in world effect int rates) Overview Real vs. Nominal Rate (consumable vs. financial) Equilibrium Rates (how changes in world effect int rates) Structure of the Yield Curve (will review 3 theories) Some of the following material

More information

CHAPTER 16. Managing Bond Portfolios INVESTMENTS BODIE, KANE, MARCUS. Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

CHAPTER 16. Managing Bond Portfolios INVESTMENTS BODIE, KANE, MARCUS. Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER 16 Managing Bond Portfolios McGraw-Hill/Irwin Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 16-2 Bond Pricing Relationships 1. Bond prices and yields are inversely related.

More information

CHAPTER 8 INTEREST RATES AND BOND VALUATION

CHAPTER 8 INTEREST RATES AND BOND VALUATION CHAPTER 8 INTEREST RATES AND BOND VALUATION Answers to Concept Questions 1. No. As interest rates fluctuate, the value of a Treasury security will fluctuate. Long-term Treasury securities have substantial

More information

SAMPLE FINAL QUESTIONS. William L. Silber

SAMPLE FINAL QUESTIONS. William L. Silber SAMPLE FINAL QUESTIONS William L. Silber HOW TO PREPARE FOR THE FINAL: 1. Study in a group 2. Review the concept questions in the Before and After book 3. When you review the questions listed below, make

More information

Chapter 11. Portfolios. Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 11. Portfolios. Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11 Managing Bond Portfolios McGraw-Hill/Irwin Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved. 11.1 Interest Rate Risk 11-2 Interest Rate Sensitivity 1. Inverse relationship

More information

Bonds and Their Valuation

Bonds and Their Valuation Chapter 7 Bonds and Their Valuation Key Features of Bonds Bond Valuation Measuring Yield Assessing Risk 7 1 What is a bond? A long term debt instrument in which a borrower agrees to make payments of principal

More information

International Finance

International Finance International Finance FINA 5331 Lecture 2: U.S. Financial System William J. Crowder Ph.D. Financial Markets Financial markets are markets in which funds are transferred from people and Firms who have an

More information

Econ 100B: Macroeconomic Analysis Fall 2008

Econ 100B: Macroeconomic Analysis Fall 2008 Econ 100B: Macroeconomic Analysis Fall 2008 Problem Set #7 ANSWERS (Due September 24-25, 2008) A. Small Open Economy Saving-Investment Model: 1. Clearly and accurately draw and label a diagram of the Small

More information

Midterm Review. P resent value = P V =

Midterm Review. P resent value = P V = JEM034 Corporate Finance Winter Semester 2017/2018 Instructor: Olga Bychkova Midterm Review F uture value of $100 = $100 (1 + r) t Suppose that you will receive a cash flow of C t dollars at the end of

More information

Before and After Book COR1-GB Foundations of Finance

Before and After Book COR1-GB Foundations of Finance Before and After Book For COR1-GB.2311 Foundations of Finance William L. Silber Homepage: www.stern.nyu.edu/~wsilber Fall 2017 Contents of This Pamphlet For each topic in the syllabus this pamphlet provides:

More information

BOND NOTES BOND TERMS

BOND NOTES BOND TERMS BOND NOTES DEFINITION: A bond is a commitment by the issuer (the company that is borrowing the money) to pay a rate of interest for a pre-determined period of time. By selling bonds, the issuing company

More information

FUNDAMENTALS OF THE BOND MARKET

FUNDAMENTALS OF THE BOND MARKET FUNDAMENTALS OF THE BOND MARKET Bonds are an important component of any balanced portfolio. To most they represent a conservative investment vehicle. However, investors purchase bonds for a variety of

More information

Debt. Last modified KW

Debt. Last modified KW Debt The debt markets are far more complicated and filled with jargon than the equity markets. Fixed coupon bonds, loans and bills will be our focus in this course. It's important to be aware of all of

More information

AFM 371 Winter 2008 Chapter 26 - Derivatives and Hedging Risk Part 2 - Interest Rate Risk Management ( )

AFM 371 Winter 2008 Chapter 26 - Derivatives and Hedging Risk Part 2 - Interest Rate Risk Management ( ) AFM 371 Winter 2008 Chapter 26 - Derivatives and Hedging Risk Part 2 - Interest Rate Risk Management (26.4-26.7) 1 / 30 Outline Term Structure Forward Contracts on Bonds Interest Rate Futures Contracts

More information

Chapter 4. Characteristics of Bonds. Chapter 4 Topic Overview. Bond Characteristics

Chapter 4. Characteristics of Bonds. Chapter 4 Topic Overview. Bond Characteristics Chapter 4 Topic Overview Chapter 4 Valuing Bond Characteristics Annual and Semi-Annual Bond Valuation Reading Bond Quotes Finding Returns on Bond Risk and Other Important Bond Valuation Relationships Bond

More information

Alan Brazil. Goldman, Sachs & Co.

Alan Brazil. Goldman, Sachs & Co. Alan Brazil Goldman, Sachs & Co. Assumptions: Coupon paid every 6 months, $100 of principal paid at maturity, government guaranteed 1 Debt is a claim on a fixed amount of cashflows in the future A mortgage

More information

Bond Prices and Yields

Bond Prices and Yields Bond Prices and Yields BKM 10.1-10.4 Eric M. Aldrich Econ 133 UC Santa Cruz Bond Basics A bond is a financial asset used to facilitate borrowing and lending. A borrower has an obligation to make pre-specified

More information

Chapter 3: Debt financing. Albert Banal-Estanol

Chapter 3: Debt financing. Albert Banal-Estanol Corporate Finance Chapter 3: Debt financing Albert Banal-Estanol Debt issuing as part of a leverage buyout (LBO) What is an LBO? How to decide among these options? In this chapter we should talk about

More information

MS-E2114 Investment Science Lecture 3: Term structure of interest rates

MS-E2114 Investment Science Lecture 3: Term structure of interest rates MS-E2114 Investment Science Lecture 3: Term structure of interest rates A. Salo, T. Seeve Systems Analysis Laboratory Department of System Analysis and Mathematics Aalto University, School of Science Overview

More information

SECTION A: MULTIPLE CHOICE QUESTIONS. 1. All else equal, which of the following would most likely increase the yield to maturity on a debt security?

SECTION A: MULTIPLE CHOICE QUESTIONS. 1. All else equal, which of the following would most likely increase the yield to maturity on a debt security? SECTION A: MULTIPLE CHOICE QUESTIONS 2 (40 MARKS) 1. All else equal, which of the following would most likely increase the yield to maturity on a debt security? 1. Put option. 2. Conversion option. 3.

More information

Chapter 7: Interest Rates and Bond Valuation, Part II

Chapter 7: Interest Rates and Bond Valuation, Part II Chapter 7: Interest Rates and Bond Valuation, Part II Faculty of Business Administration Lakehead University Spring 2003 May 15, 2003 Outline 7A-C Review Questions 7.2 More on Bond Features 7.3 Bond Ratings

More information

Copyright 2009 Pearson Education Canada

Copyright 2009 Pearson Education Canada Taking the financial incentives from the governments into account, the NPV of the plant in the Ontario location will be: $442.06 million + $9.93 million + $67.53 million $519.52 million As $519.52 million

More information

Prob(it+1) it+1 (Percent)

Prob(it+1) it+1 (Percent) I. Essay/Problem Section (15 points) You purchase a 30 year coupon bond which has par of $100,000 and a (annual) coupon rate of 4 percent for $96,624.05. What is the formula you would use to calculate

More information

Financial Market Analysis (FMAx) Module 2

Financial Market Analysis (FMAx) Module 2 Financial Market Analysis (FMAx) Module 2 Bond Pricing This training material is the property of the International Monetary Fund (IMF) and is intended for use in IMF Institute for Capacity Development

More information

Answers to Chapter 2 Questions:

Answers to Chapter 2 Questions: Answers to Chapter 2 Questions: 1. The household sector (consumers) is the largest supplier of loanable funds. Households supply funds when they have excess income or want to reinvest a part of their wealth.

More information

1) Which one of the following is NOT a typical negative bond covenant?

1) Which one of the following is NOT a typical negative bond covenant? Questions in Chapter 7 concept.qz 1) Which one of the following is NOT a typical negative bond covenant? [A] The firm must limit dividend payments. [B] The firm cannot merge with another firm. [C] The

More information

BOND VALUATION. YTM Of An n-year Zero-Coupon Bond

BOND VALUATION. YTM Of An n-year Zero-Coupon Bond BOND VALUATION BOND VALUATIONS BOND: A security sold by governments and corporations to raise money from investors today in exchange for promised future payments 1. ZERO COUPON BONDS ZERO COUPON BONDS:

More information

Savings and Investment. July 23, 2014

Savings and Investment. July 23, 2014 Savings and Investment July 23, 2014 Personal Financial Planning Process The personal financial planning process includes four main elements: Setting financial goals; Financial assessment; Developing and

More information

WEEK 3 LEVE2 FIVA QUESTION TOPIC:RISK ASSOCIATED WITH INVESTING IN FIXED INCOME

WEEK 3 LEVE2 FIVA QUESTION TOPIC:RISK ASSOCIATED WITH INVESTING IN FIXED INCOME WEEK 3 LEVE2 FIVA QUESTION TOPIC:RISK ASSOCIATED WITH INVESTING IN FIXED INCOME 1 Which of the following statements least accurately describes a form of risk associated with investing in fixed income securities?

More information