6-1

6-2
Key Concepts and Skills
Know the important bond features and
bond types
Understand:
Bond values and why they fluctuate
Bond ratings and what they mean
The impact of inflation on interest rates
The term structure of interest rates and
the shape of the yield curve
determinants of bond yields
6-3
Chapter Outline
6.1 Bonds and Bond Valuation
6.2 More on Bond Features
6.3 Bond Ratings
6.4 Some Different Types of Bonds
6.5 Bond Markets
6.6 Inflation and Interest Rates
6.7 Determinants of Bond Yields
6-4
Bond Definitions
Bond
Debt contract
Normally a interest-only loan
Par value (face value) ~ $1,000 (repaid at end)
Coupon payment = (interest payment on bond)
Coupon rate = (annual coupon / face value)
Maturity date = (time until face value repaid)
Yield to maturity = (market interest rate required on bond)
6-5
Key Features of a Bond
Par value:
Face amount
Re-paid at maturity
Assume $1,000 for corporate bonds
Coupon interest rate:
Stated interest rate
Usually = YTM at issue
YTM = Yield to Maturity
Multiply by par value to get coupon payment
Bond Calculations
6-6
Coupon Payment = Coupon Rate Par Value





Coupon Rate = Coupon Payment / Par Value





Par Value = Coupon Payment / Coupon Rate
CP = CR * PRV
CR =
CP
PRV

PRV =
CP
CR

6-7
Key Features of a Bond
Maturity:
Years until bond must be repaid
Yield to maturity (YTM):
The market required rate of return for bonds of
similar risk and maturity
The discount rate used to value a bond
Return if bond held to maturity
Usually = coupon rate at issue
Quoted as an APR
6-8
Bond Value
Bond Value = PV(coupons) + PV(par)
Bond Value = PV(annuity) + PV(lump sum)
Remember:
As interest rates increase present values
decrease ( r PV )
As interest rates increase, bond prices
decrease and vice versa
6-9
The Bond-Pricing Equation
t
t
YTM) (1
F
YTM
YTM) (1
1
1-
C Value Bond
+
+
(
(
(
(

+
=
PV(Annuity)
PV(lump sum)
C = Coupon payment; F = Face value
Return
to Quiz
What is the relationship between bond prices and yields?
6-10
Spreadsheet Formulas
=FV(Rate,Nper,Pmt,PV,0/1)
=PV(Rate,Nper,Pmt,FV,0/1)
=RATE(Nper,Pmt,PV,FV,0/1)
=NPER(Rate,Pmt,PV,FV,0/1)
=PMT(Rate,Nper,PV,FV,0/1)

Inside parens: (RATE,NPER,PMT,PV,FV,0/1)
0/1 Ordinary annuity = 0 (default)
Annuity Due = 1 (must be entered)
6-11
Pricing Specific Bonds in Excel
=PRICE(Settlement,Maturity,Rate,Yld,Redemption,
Frequency,Basis)
=YIELD(Settlement,Maturity,Rate,Pr,Redemption,
Frequency,Basis)
Settlement = actual date as a serial number; date
settled after security issued.
Maturity = actual date as a serial number; maturity date
of bond.
Redemption and Pr(ice) = % of par value
Rate (coupon) and Yld = annual rates as decimals
Frequency = # of coupons per year
Basis = day count convention (enter 2 for ACT/360)

Basis: Type of day count basis to use.
6-12
Bond Cash Flows
6-13
What is the present value of the face (par) value?
What is the present value of the annual coupon payments?
What is the total bond value?
Using Excel: =PV(0.08, 10, 80, 0, 0) = 536.81
Using Excel: =PV(0.08, 10, 0, 1000, 0) = 463.19
TV = PV Par + PV Coupons = 463.19 + 536.81 = 1,000
6-14
NOTE: Coupon Rate and
Market Rate are Equal
6-15
The amount lost due to rising rates.
6-16
The amount gained due to falling rates.
6-17
Valuing a New Bond with Annual
Coupons Issued at Market
Coupon rate = 10%
Annual coupons
Par = $1,000
Maturity = 5 years
YTM = 10%
5
5
10 1
1000
10 0
10 1
1
1
100
) . (
.
) . (
+
(
(
(
(
(

= B
Using the formula:
B = PV(annuity) + PV(lump sum)
B = 379.08 + 620.92 = 1000

Using Excel: =PV(0.10, 5, 100, 1000, 0) = $1000
Note: When YTM = Coupon rate Price = Par Value
6-18
Valuing a Discount Bond with
Annual Coupons
Coupon rate = 10%
Annual coupons
Par = $1,000
Maturity = 5 years
YTM = 11%
5
5
) 11 . 1 (
1000
11 . 0
) 11 . 1 (
1
1
100 B +
(
(
(
(

=
Using the formula:
B = PV(annuity) + PV(lump sum)
B = 369.59 + 593.45 = 963.04

Note: When YTM > Coupon rate Price < Par = Discount Bond
Using Excel: =PV(0.11, 5, 100, 1000, 0) = $963.04
6-19
Valuing a Premium Bond with
Annual Coupons
Coupon rate = 10%
Annual coupons
Par = $1,000
Maturity = 20 years
YTM = 8%
20
20
) 08 . 1 (
1000
08 . 0
) 08 . 1 (
1
1
100 +
(
(
(
(

= B
Using the formula:
B = PV(annuity) + PV(lump sum)
B = 981.81 + 214.55 = 1196.36

Note: When YTM < Coupon rate Price > Par = Premium Bond
Using Excel: =PV(0.08, 20, 100, 1000, 0) = $1,196.36
6-20
Graphical Relationship Between Price
and Yield-to-maturity
600
700
800
900
1000
1100
1200
1300
1400
1500
0% 2% 4% 6% 8% 10% 12% 14%
B
o
n
d

P
r
i
c
e

Yield-to-maturity
What is par value of the bond and what is the coupon rate?
6-21
Bond Prices:
Relationship Between Coupon and Yield
Coupon rate = YTM Price = Par
Coupon rate < YTM Price < Par
Discount bond Why?
Because the bond pays less than the market rate of interest.
Coupon rate > YTM Price > Par
Premium bond Why?
Because the bond pays more than the market rate of interest.

6-22
M
Premium
1,000
Discount
30 25 20 15 10 5 0
CR>YTM
CR<YTM
YTM

= Coupon Rate (CR)
Bond Value ($) vs Years
remaining to Maturity
6-23
The Bond-Pricing Equation
Adjusted for Semi-annual Coupons
2t
2t
YTM/2) (1
F
YTM/2
YTM/2) (1
1
- 1
2
C
Value Bond
+
+
(
(
(
(

+
=
C = Annual coupon payment C/2 = Semi-annual coupon
YTM = Annual YTM (as an APR) YTM/2 = Semi-annual YTM
t = Years to maturity 2t = Number of 6-month
periods to maturity

6-24
Semiannual Bonds
Example 6.1
Coupon rate = 14% - Semiannual
YTM = 16% (APR)
Maturity = 7 years
Number of coupon payments? (t)
14 = 2 x 7 years
Semiannual coupon payment? (C)
$70 = (14% x Face Value)/2
Semiannual yield? (YTM)
8% = 16%/2
6-25
Example 6.1
Semiannual coupon = $70
Semiannual YTM = 8%
Periods to maturity = 14

Bond value =
70[1 1/(1.08)
14
] / .08 +
1000 / (1.08)
14
= 917.56

t
t
YTM) (1
F
YTM
YTM) (1
1
1-
C Value Bond
+
+
(
(
(
(

+
=
14
14
) 08 . 1 (
1000
08 . 0
) 08 . 1 (
1
1
70 +
(
(
(
(

= B
Using Excel: =PV(0.08, 14, 70, 1000, 0)
Bond Prices: 3
2-26
Using Excel: =PV(0.08, 9, 60, 1000, 0) = $875.06
Using Excel: =10*PRICE(settlement,maturity,0.06,0.08,100,1) = $875.06
Bond Yields: 4
2-27
Using Excel: =RATE(9,70,-1038.5,1000,0) = 6.42%
Using Excel: =YIELD(settlement,maturity,0.7,103.85,100,1) = 6.42%
Coupon Rates: 5
2-28
Using Excel: =PMT(0.075,12,-963,1000,0) = $70.22
7.022% .
,
.
= = = = 07022 0
000 1
22 70
PRV
CP
CR
Using Excel: =RATE(12,70.22,-963,1000,0) = 7.50%
6-29
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
Low coupon rate bonds have more price
risk than high coupon rate bonds
Bonds with a higher coupon has a larger cash flow early in its life,
so its value is less sensitive to changes in the discount rate.
6-30
Interest Rate Risk
Reinvestment Rate Risk
Uncertainty concerning rates at which cash
flows coupons can be reinvested at same rate
Short-term bonds have more reinvestment rate
risk than long-term bonds
High coupon rate bonds have more
reinvestment rate risk than low coupon rate
bonds
6-31
Figure 6.2
The longer the time to maturity, the greater
the interest rate risk; ceteris paribus. Small
changes in interest rates can lead to large
changes in the bonds value.
6-32
Computing Yield-to-Maturity YTM
Yield-to-maturity (YTM) = the market
required rate of return implied by the
current bond price
With a financial calculator or Excel,
Enter ,, /, . and 0
Remember the sign convention
/ and 0 need to have the same sign (+)
. the opposite sign (-)
6-33
YTM with Annual Coupons
Consider a bond with a 10% annual
coupon rate, 15 years to maturity and a
par value of $1000. The current price is
$928.09.
Will the yield be more or less than 10%?

Using Excel: =RATE(15, 100, -928.09, 1000, 0) = 11% = YTM

6-34
YTM with Semiannual Coupons
Suppose a bond with a 10% coupon rate
and semiannual coupons, has a face value
of $1000, 20 years to maturity and is
selling for $1,197.93.
Is the YTM more or less than 10%?
The bond is trading at a premium, YTM < CR
What is the semiannual coupon payment?
CP = 10% * $1,000 = $100 / 2 = $50
How many periods are there?
T*2 = 20 * 2 = 40

6-35
YTM with Semiannual Coupons
Suppose a bond with a 10% coupon rate and
semiannual coupons, has a face value of $1,000,
20 years to maturity and is selling for $1,197.93.

NOTE: Solving a semi-annual payer
for YTM results in a 6-month YTM.
Excel will solve what you enter.
Using Excel: =RATE(40, 50, -1197.93, 1000, 0) = 4%
4% or YTM * 2 = 8% YTM
Using Excel: =RATE(40, 50, -1197.93, 1000, 0)*2 = 8%
6-36
Table 6.1
6-37
Debt versus Equity
Debt
Not an ownership interest
No voting rights
Interest is tax-deductible
(issuer, sometimes by holder)
Creditors have legal recourse
if interest or principal
payments are missed
Debt can result in higher
returns to the firm (tax
benefits to debt), but
Excess debt can lead to
financial distress and
bankruptcy
Equity
Ownership interest
Common stockholders
vote to elect the board of
directors and on other
issues
Dividends are not tax
deductible (by firm or
stockholder)
Dividends are not a
liability of the firm until
declared. Stockholders
have no legal recourse if
dividends are not declared
Equity holders are paid
after debt holders, but not
required
An all-equity firm cannot
go bankrupt
6-38
The Bond Indenture
Deed of Trust
Contract between issuing company and
bondholders includes:
Basic terms of the bonds
Total amount of bonds issued
Secured versus Unsecured
Sinking fund provisions
Call provisions
Deferred call
Call premium
Details of protective covenants
Return
to Quiz
6-39
6-40
Bond Classifications
Registered vs. Bearer Bonds
Registered: company records ownership, payments made to
and information sent to owner.
Bearer: Issued without record of owner name, payments made
to holder after receipt of detachable coupon. May be difficult to
recover if lost or stolen, bondholders cannot be notified of
important event.
Security
Collateral: secured by financial securities (bonds and stocks)
Mortgage: secured by real property, normally land or buildings
Debentures: unsecured
Notes: unsecured debt with original maturity less than 10 years
6-41
Bond Classifications
Seniority
Senior versus Junior, Subordinated
Debt cannot be subordinated to equity.
Repayment
Can be repaid at maturity, or sinking fund
established to retire or repurchase bonds
Call Provision
Repurchase or call part or all of bond issue
at a specific price prior to maturity, usually at
a premium, the call may be deferred and the
bondholder protected during the prohibition
period.
6-42
Bond Classifications
Protective Covenants
Indenture provision that limit certain actions
that might be taken during the term of the
loan, usually to protect the lender.
Negative Covenants: Thou Shalt Not
Limit amount of dividends to prescribed formula
No pledging of any assets to other lenders
No merger with another firm
No issuance of additional long-term debt
Positive Covenants: Thou Shalt
Maintain working capital at or above a certain level
Furnish financial statements to lender
Maintain collateral in good condition
6-43
Bond Characteristics and
Required Returns
Coupon rate
](risk characteristics of the bond when issued)
Usually yield at issue
Which bonds will have the higher coupon,
all else equal?
Secured debt versus a debenture
Subordinated debenture versus senior debt
A bond with a sinking fund versus one without
Sinking funds can retire a portion of the debt or call some bonds
A callable bond versus a non-callable bond
6-44
Bond Ratings
Bond ratings are concerned only with the
possibility of default.
Bond ratings do not address interest rate risk,
the risk of a change in the value (i.e. price) of a
bond resulting from a change in interest rates.
The price of a highly rated bond can still be quite
volatile given interest rate risk.
Return
to Quiz
6-45
Investment-grade bonds are bonds rated at least BBB by S&P or Baa by
Moodys.
A bonds credit rating can change as the issuers financial strength improves
or deteriorates.
Credit ratings are important because defaults really do occur, and if they do,
investors can lose heavily.
6-46
6-47
Bond Ratings Investment Quality
High Grade
Moodys Aaa and S&P AAA capacity to pay is
extremely strong
Moodys Aa and S&P AA capacity to pay is very
strong
Medium Grade
Moodys A and S&P A capacity to pay is strong,
but more susceptible to changes in circumstances
Moodys Baa and S&P BBB capacity to pay is
adequate, adverse conditions will have more
impact on the firms ability to pay
Return
to Quiz
6-48
Bond Ratings - Speculative
Low Grade
Moodys Ba, B, Caa and Ca
S&P BB, B, CCC, CC
Considered speculative with respect to capacity
to pay. The B ratings are the lowest degree
of speculation.
Very Low Grade
Moodys C and S&P C income bonds with no
interest being paid
Moodys D and S&P D in default with
principal and interest in arrears
6-49
6-50
Government Bonds
Treasury Securities = Federal government debt
Treasury Bills (T-bills)
Pure discount bonds
Original maturity of one year or less
Treasury notes
Coupon debt
Original maturity between one and ten years
Treasury bonds
Coupon debt
Original maturity greater than ten years
Exempt from state but not federal taxation.
6-51
Government Bonds
Municipal Securities
Debt of state and local governments
Varying degrees of default risk, rated similar to
corporate debt
Interest received is tax-exempt at the federal
level
Interest usually exempt from state tax in
issuing state
Yields usually lower than treasury or corporate
bonds since advantage of not being taxed.
6-52
Example 6.4
A taxable bond has a yield of 8% and a
municipal bond has a yield of 6%
If you are in a 40% tax bracket, which bond do you prefer?
What is the after tax return on a taxable bond?
8%(1 - .4) = 4.8%
The after-tax return on the corporate bond is 4.8%, compared to a 6%
return on the municipal
At what tax rate would you be indifferent between the two
bonds?
8%(1 T) = 6%
T = 25%
At what municipal yield would you be indifferent to a taxable
bond?
8%(1-0.40)=M
M=4.8
6-53
Zero Coupon Bonds
Make no periodic interest payments (coupon rate = 0%)
Entire yield-to-maturity comes from the difference
between the purchase price and the par value (capital
gains)
Cannot sell for more than par value
Sometimes called zeroes, or deep discount bonds
Treasury Bills and U.S. Savings bonds are good
examples of zeroes
Zero Coupon Bond Interest
EIN Company issues a $1,000 face value, five-year zero
coupon bond. What should the bond sell for at issue, assuming
a 14 percent yield to maturity using semiannual periods?
6-54
Using Excel: =PV(0.07, 10, 0, 1000, 0) = $508.35
What is the amount of interest paid over the life of the bond?
$1000 - $508.35 = $491.65
What is the annual interest deduction calculated on a
straight-line basis?
$491.65 / 5 = $98.33
NOTE: The issuer of a zero must deduct interest every year even though no interest is actually paid. Also,
the owner must pay taxes on interest accrued every year even though no interest is received. Current tax
law requires interest to be determined by amortizing the loan as opposed to straight line.
Zero Coupon Implicit Bond Interest
6-55
6-56
Floating Rate Bonds
Coupon rate floats depending on some index
value
Examples adjustable rate mortgages and
inflation-linked Treasuries (TIPS)
Less price risk with floating rate bonds
Coupon floats, so is less likely to differ
substantially from the yield-to-maturity
Coupons may have a collar the rate
cannot go above a specified ceiling or
below a specified floor
6-57
Other Bond Types
Income bonds
Coupon dependent on company income
Convertible bonds
Convertible to shares of stock
Put bonds
Holder forces issues to buy back at stated price, the
reverse of a call provision
Many types of provisions can be added to a bond
Important to recognize how these provisions affect
required returns
Who does the provision benefit?
6-58
Bond Markets
Primarily over-the-counter transactions with
dealers connected electronically
Extremely large number of bond issues
(compared to equity), but generally low daily
volume in single issues and little transparency
Getting up-to-date prices difficult, particularly
on small company or municipal issues
Treasury securities are an exception
What is the largest securities market in the
world?
U.S. Treasury Market not the NYSE.

6-59
Work the Web Example
Bond information is available online
One good site:
http://cxa.marketwatch.com/finra/BondCenter
Click on the web surfer to go to the site
Use Quick Bond Search to observe the
yields for various bond types, and the
shape of the yield curve.
6-60
Bond Yields: 7
2-61
Using Excel: =RATE(26, 34.50, -940, 1000, 0) = 3.82%
3.82% or YTM * 2 = 7.64% YTM
Using Excel: =2*RATE(21, 34.50, -945, 1000, 0) = 7.64%
Coupon Rates: 8
2-62
Using Excel: =PMT(0.042, 21, -945, 1000, 0) = $38.01
$38.01*2 = $76.02; $76.02 / $1,000 = 7.60%
Bond Yields: 19
2-63
Using Excel: =2*RATE(40, 39, -1125, 1000, 0) = 6.66%
6-64
Treasury Quotations
6-65
Treasury Quotations
Highlighted quote in Figure 6.3


5/15/2030 6.250 150.7188 150.7500 .8906 2.713

When does the bond mature?

What is the coupon rate on the bond?


What is the bid price? What does this mean?

May 15, 2030
6.25% per year on semiannual basis, $62.50/2 = $31.25 on a $1,000
face value bond
Bid amount dealer offers to buy from you, 150.7188% (i.e.,
1.507188) of the par or face value, therefore the bid is $1,570.188 =
(1, 000 * 1.507188)
6-66
Treasury Quotations
Highlighted quote in Figure 6.3


5/15/2030 6.250 150.7188 150.7500 .8906 2.713

What is the ask price? What does this mean?



How much did the price change from the previous day?

What is the YTM based on Ask price and why?
Ask amount dealer is willing to sell to you, 150.7500% of the par or
face value (i.e., 1.507500), therefore the ask is = $1,507.50 = ($1,000
* 1.507500)
Asked price up by 0.890% from the previous day
Asked yield is 2.713%, lower than coupon rate since this is a premium
bond and sells for more than the face value.
6-67
Treasury Quotations
Highlighted quote in Figure 6.3


5/15/2030 6.250 150.7188 150.7500 .8906 2.713

What is bid-ask spread, what does this represent?



Ask Bid = $1,507.500 - $1,507.188 - = $0.312 and represents the
dealers profit.
6-68
Quoted Price vs. Invoice Price
Quoted bond prices = clean price
Net of accrued interest
Invoice Price = dirty or full price
Price actually paid
Includes accrued interest
Accrued Interest
Interest earned since last coupon payment is
owed to bond seller at time of sale
The Bellwether Bond
6-69
The very last
bond, usually
quoted on the
evening news as
to the direction of
long-term interest
rates. If bond
yield went up
(down), bond
price went down
(up). This is
known as the
bellwether bond.
6-70
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
6-71
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 (Quoted rate)
r = real rate
h = expected inflation rate





R = r + h + rh
= real + inflation + compounding
Approximation: R = r + h
only if r or h not high



Return
to Quiz
rh h r R
rh h r R
rh h r R
h r R
+ + =
+ + + =
+ + + = +
+ + = +
1 1
1 1
1 1 1 ) )( ( ) (
6-72
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 (Quoted rate)
r = real rate
h = expected inflation rate







Return
to Quiz
h
h R
r
h r h R
rh r h R
rh h r R
rh h r R
rh h r R
h r R
+

=
+ =
+ =
+ + =
+ + + =
+ + + = +
+ + = +
1
1
1 1
1 1
1 1 1
) (
) )( ( ) (
1
1
1
1
1
1
1 1 1

+
+
=
+
+
= +
+ + = +
h
R
r
h
R
r
h r R ) )( ( ) (
6-73
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 (Quoted rate)
r = real rate
h = expected inflation rate







Return
to Quiz
r
r R
h
r R r h
r R rh h
rh h r R
rh h r R
rh h r R
h r R
+

=
= +
= +
+ + =
+ + + =
+ + + = +
+ + = +
1
1
1 1
1 1
1 1 1
) (
) )( ( ) (
1
1
1
1
1
1
1 1 1

+
+
=
+
+
= +
+ + = +
r
R
h
r
R
h
h r R ) )( ( ) (
6-74
Calculating The Fisher Effect
If the nominal interest rate is 15.50% and the
inflation rate is 5%, what is the real rate?

(1 + R) = (1 + r)(1 + h)
(1 + 0.1550) = (1+ r)(1 + 0.05)
(1 + r) = 1.1550 / 1.05 = 1.10
r = 1.10 1 = 0.10 or 10%
Return
to Quiz
10 0
05 1
105 0
05 0 1
05 0 155 0
1
.
.
.
.
. .
=
=
+

=
+

=
r
r
h
h R
r
10 0 1 10 1
1
05 0 1
155 0 1
1
1
1
. .
.
.
= =

+
+
=

+
+
=
r
r
h
R
r
6-75
Example 6.6
If we require a 10% real return and we
expect inflation to be 8%, what is the
nominal rate?
R = (1.1)(1.08) 1 = .188 = 18.8%
Approximation: R = 10% + 8% = 18%
Because the real return and expected inflation are
relatively high, there is significant difference between
the actual Fisher Effect and the approximation.
Calculating Real Rates of Return: 9
2-76
% . .
.
.
.
) . (
) . (
) (
) (
) (
) (
) (
) )( (
) )( ( ) (
46 2 0246 0
1 0246 1 1
016 1
041 1
1
016 0 1
041 0 1
1
1
1
1
1
1
1 1 1
1 1 1
= =
= =
+
+
=

+
+
=
+
+
= +
+ + =
+ + = +
r
r
h
R
r
h
R
r
h r R
h r R
% . .
.
.
.
. .
) (
) )( (
) )( ( ) (
46 2 0246 0
016 1
025 0
016 0 1
016 0 041 0
1
1
1 1
1 1 1
1 1 1
= =
=
+

=
+

=
= +
= +
+ + =
+ + + =
+ + =
+ + = +
r
r
h
h R
r
h R h r
h R rh r
rh h r R
rh h r R
h r R
h r R
% . .
.
.
.
.
.
. ) ( .
) . )( ( ) . (
) )( ( ) (
46 2 0246 0
1 0246 1 1
016 1
041 1
016 1
041 1
1
016 1 1 041 1
016 0 1 1 041 0 1
1 1 1
= =
= =
= +
+ +
+ + = +
+ + = +
r
r
r
r
r
h r R
% . .
. .
: ion Approximat
5 2 025 0
016 0 041 0
= =
+ =
+ =
r
r
h r R
Inflation and Nominal Returns: 10
2-77
% . .
.
. ) . )( . (
) . )( . (
) )( ( ) (
30 6 06295 0
1 06295 1
06295 1 034 1 028 1 1
034 0 1 028 0 1 1
1 1 1
= =
=
= = +
+ + = +
+ + = +
R
R
R
R
h r R
% . .
. .
) . * . ( . .
) )( (
) )( ( ) (
3 6 062952 0
000952 0 062 0
034 0 028 0 034 0 028 0
1 1
1 1 1
1 1 1
= =
+ =
+ + =
+ + =
+ + + =
+ + =
+ + = +
R
R
R
rh h r R
rh h r R
h r R
h r R
Nominal and Real Returns: 11
2-78
% . .
.
.
.
) ( . .
) )( . ( ) . (
) )( ( ) (
64 3 03636 0
1 03636 1
10 1
14 1
1
1 10 1 14 1
1 10 0 1 14 0 1
1 1 1
= =
=
= +
+ =
+ + = +
+ + = +
h
h
h
h
h
h r R
% . .
.
) . (
) . (
) . (
) . (
) (
) (
) (
) )( ( ) (
64 3 03636 0
1 03636 1 1
10 1
14 1
1
10 0 1
14 0 1
1
1
1
1 1 1
= =
= =

+
+
=
+
+
= +
+ + = +
h
h
h
r
R
h
h r R
% . .
.
.
.
. .
) (
) )( (
) )( ( ) (
64 3 03636 0
10 1
04 0
10 0 1
10 0 14 0
1
1
1 1
1 1 1
1 1 1
= =
=
+

=
+

=
= +
= +
+ + =
+ + + =
+ + =
+ + = +
h
h
r
r R
h
r R r h
r R rh h
rh h r R
rh h r R
h r R
h r R
% .
. .
: ion Approximat
4 04 0
10 0 14 0
= =
+ =
+ =
h
h
h r R
6-79
Term Structure of Interest Rates
Term structure: The relationship between
time to maturity and yields, all else equal
(Ceteris Paribus):
The effect of default risk, different coupons,
etc. has been removed.
Shape of term structure determined by:
Real Rate of Interest
Inflation Premium
Interest Rate Risk Premium
Increases with maturity length



Return
to Quiz
6-80
Term Structure of Interest Rates
Yield curve: Graphical representation of
the term structure
Normal = upward-sloping L/T > S/T
Inverted = downward-sloping L/T < S/T
Return
to Quiz
6-81
Figure 6.5 A Upward-Sloping
Yield Curve
RISING
CONSTANT
RISING
Inflation Premium higher in long than short run.
6-82
Figure 6.5 B Downward-
Sloping Yield Curve
FALLING
CONSTANT
RISING
Inflation Premium higher in short than long run.
6-83
Figure 6.6 Treasury Yield Curve
Based on data
in Figure 6.3
6-84
6-85
Factors Affecting Required Return
Default risk premium bond ratings
Taxability premium municipal versus taxable
Liquidity premium bonds that have more
frequent trading will generally have lower
required returns
Maturity premium longer term bonds will tend
to have higher required returns.
Anything else that affects the risk of the cash flows to
the bondholders will affect the required returns
Return
to Quiz
Interest Rate Risk: 17
2-86
Using Excel: =PV(0.04, 20, 20, 1000, 0) = $728.19
Using Excel: =PV(0.05, 20, 20, 1000, 0) = $626.13
% .
.
.
.
. .
% 02 14
19 728
06 102
19 728
19 728 13 626
=

= AJ
BOND J
BOND S
Using Excel: =PV(0.04, 20, 70, 1000, 0) = $1,407.71
Using Excel: =PV(0.05, 20, 70, 1000, 0) = $1,249.24
% .
. ,
.
. ,
. , . ,
% 26 11
71 407 1
47 158
71 407 1
71 407 1 24 249 1
=

= AS
The lower the coupon rate,
the greater the price
sensitivity of the bond to
changes in interest rates.
6-87
Quick Quiz
How do you find the value of a bond and why
do bond prices change? (Slide 6.8)
What is a bond indenture and what are some
of the important features? (Slide 6.30)
What are bond ratings and why are they
important? (Slide 6.33)
How does inflation affect interest rates?
(Slide 6.48)
What is the term structure of interest rates?
(Slide 6.50)
What factors determine the required return on
bonds? (Slide 6.54)
End of Chapter Questions to Review
Question Topic
1 Interpreting Bond Yields
2 Interpreting Bond Yields
3 Bond Prices
4 Bond Yields
5 Coupon Rates
6 Bond Prices
7 Bond Yields
8 Coupon Rates
9 Calculating Real Rates of Return
10 Inflation and Nominal Returns
11 Nominal and Real Returns
5-88
End of Chapter Questions to Review
Question Topic
12 Nominal versus Real Returns
13 Using Treasury Quotes
17 Interest Rate Risk
18 Bond Yields
19 Bond Yields
5-89
6-90
Chapter 6
END
6-91
Previous Treasury Quotations
Highlighted quote in Figure 6.3


2020 Feb 15 8.5 145.12 145.15 +64 3.4730

When does the bond mature?

What is the coupon rate on the bond?


What is the bid price? What does this mean?

February 15, 2020
8.5% per year on semiannual basis, $85/2 = $42.50 on a $1,000 face
value bond
Bid amount dealer offers to buy from you, quoted in 32nds, 145 and
12/32 % of par = 145.375% (i.e., 1.45375) of the face value, therefore
the bid is $1,453.75 = (1, 000 * 1.45375)
Treasury prices were
previously quoted in
32nds.
6-92
Previous Treasury Quotations
Highlighted quote in Figure 6.3


2020 Feb 15 8.5 145.12 145.15 +64 3.4730

What is the ask price? What does this mean?



How much did the price change from the previous day?

What is the YTM based on Ask price and why?
Ask amount dealer is willing to sell to you, quoted in 32nds, 145 and
15/32 % of par cent = 145.46875 % (i.e., 1.4546875) of the face
value, therefore the ask is = $1,454.69 = ($1,000 * 1.4546875)
+64/32 of 1 percent or 2 percent; a tick size = 1/32
Asked yield is 3.4730%, lower than coupon rate since this is a
premium bond and sells for more than the face value.
Treasury prices were previously
quoted in 32nds.
6-93
Previous Treasury Quotations
Highlighted quote in Figure 6.3


2020 Feb 15 8.5 145.12 145.15 +64 3.4730

What is bid-ask spread, what does this represent?



Ask Bid = $1,454.69 - 1,453.75 - = $0.94 and represents the
dealers profit.
Treasury prices were previously
quoted in 32nds.