Ch 8 - Interest Rates and Bond Valuation

Maturity

the number of years until the face value is paid

Dirty price

the price you actually pay, including accrued interest

Clean price

the quoted price on a bond

Interest Rate Risk

the risk that arises for bond owners from fluctuating interest rates you should keep the following in mind when looking at a bond: 1. All other things being equal, the longer the time to maturity, the greater the interest rate risk 2. All other things being equal, the lower the coupon rate, the greater the interest rate risk

Coupons

the stated interest payment on a debt instrument sometimes called a level coupon bond if it is consistent and paid every year

How to calculate rates

1 + R = (1 + r) x (1 + h) where R = nominal rate, r = real rate, h = inflation

Fisher effect

A rise in the rate of inflation causes the nominal rate to rise just enough so that the real rate of interest is unaffected. In other words, the real rate is invariant to the rate of inflation.

Determinants of bond yields

Interest rate risk premium, inflation premium, real rate, nominal interest rate, time to maturity

How are bonds bought and sold?

Most trading in bonds take place over the counter or OTC

A bond has a quoted price of $1,080.42. It has a face value of $1,000, a semiannual coupon of $30, and a maturity of five years. What is its current yield? What is its yield to maturity? Which is bigger? Why?

Notice that this bond makes semiannual payments of $30, so the annual payment is $60. The current yield is thus $60/1,080.42 = 5.55 percent. Now, in this case, the bond pays $30 every six months and it has 10 six-month periods until maturity. So, we need to find r as follows: $1,080.42 = $30 × [1 − 1/(1 + r)^10]/r + 1,000/(1 + r)^10 r = 2.1% per 6 months, so YTM is 4.2%

Inflation risk

Risk faced by Investors due to uncertainty about future inflation.

Coupon rate

The annual coupon a bond pays divided by its face value

Yield to Maturity

The interest rate required in the market on a bond It is the discount rate that equates the present value of the interest payments and redemption value of a bond with the present price of a bond.

Par Value

The nominal or face value of stocks or bonds. For stock, it is a relatively unimportant value except for bookkeeping purposes.

Nominal rate

The percentage change in the number of dollars you have.

Real Rate

The real rate on an investment is the percentage change in how much you can buy with your dollars. In other words, the real rate is the percentage change in your buying power.

Face Value

The value of a bond that appears on its face. Also referred to as par value or principal.

Current yield

a bond's annual coupon divided by its current market

Bond

debt securities - normally an interest-only loan, meaning the borrower will pay the interest every period, but none of the principal will be repaid until the end of the loan