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20703423 Chapter 4 Interest Rates and Bond Pricing TED

20703423 Chapter 4 Interest Rates and Bond Pricing TED

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Published by Somesh Painuli

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Published by: Somesh Painuli on Jul 21, 2010
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CHAPTER 4: INTEREST RATES AND BOND PRICING
4.1 BONDS
A
bond
is a debt instrument that provides a periodic stream of interest payments toinvestors while repaying the borrowed principal on a specified maturity date. The bond's
face value
or
par value
is the price at which the bond is issued. The
coupon rate
is thepercentage of the face value paid to investors each year; the
coupon
is the dollar value of these payments. A bond's
maturity
is the time until the bond is redeemed; i.e., the timeat which investors are repaid the bond's face value.Bonds are issued by federal, state and local governments to finance budget deficits.Corporations issue bonds to raise investment capital. Foreign governments andcorporations may also issue bonds in the domestic market.A bond may be issued as a
zero coupon bond
; this is a bond that is sold to investors at adiscounted price and then redeemed at face value in the future. If an investor holds thebond until maturity, he earns a
capital gain
equal to the difference between thediscounted price and the face value. Short-maturity bonds (with maturities of one year orless) are often issued as zero coupon bonds. Longer-maturity bonds are usually issued ascoupon-bearing bonds.
4.2 BOND PRICING
The price of a bond equals the
present value
of its expected future cash flows. The cashflows are
discounted
with a rate of interest that is appropriate to the maturity and risk of the bond.The bond pricing formula is:where:P = the bond's priceC = the coupon paymentF = the face value of the bondr = the periodic rate of interestt = a time indexT = the maturity date of the bond
116
 
EXAMPLE
Suppose that a bond has a face value of $1,000 and a coupon rate of 4%; the bond willmature in four years. The bond makes annual coupon payments. The appropriate rate of interest for discounting this bond's cash flows is assumed to be 3%. The price of thebond is determined as follows:P = 38.8350 + 37.7038 + 36.6057 + 924.0265 = $1,037.17This is known as a
premium bond
since its market price exceeds its face value.If the rate of interest is 4%, the price of the bond is:P = 38.4615 + 36.9822 + 35.5599 + 888.9964 = $1,000.00This is known as a
par bond
since its market price equals its face value.If the rate of interest is 5%, the price of the bond is:P = 38.0952 + 36.2812 + 34.5535 + 855.6106 = $964.54This is known as a
discount bond
since its market price is less than its face value.
116
 
SUMMARY
INTEREST RATEPRICE
3%1,037.174%1,000.005%964.54These results show that there is an
inverse
relationship between bond prices and interestrates. Whenever the market rate of interest is less than a bond's coupon rate, the price of the bond exceeds its face value. If the market rate of interest equals a bond's coupon rate,the bond sells for its face value. If the market rate of interest is greater than a bond'scoupon rate, the price of the bond is less than its face value.This relationship is summarized in the following table:
INTEREST RATEPRICE
market rate < coupon ratemarket price > face valuemarket rate = coupon ratemarket price = face valuemarket rate > coupon ratemarket price < face value
4.3 COMPOUNDING CONVENTIONS AND THE PRICING OFBONDS
In actual practice, most coupon-bearing bonds in the United States pay coupons on asemi-annual basis. In order to price these bonds, the formula must be adjusted asfollows:1) the semi-annual rate of interest is used to discount cash flows2) the number of time periods is doubled; each time period is now a semi-annual periodinstead of a full year3) semi-annual coupons are used instead of annual coupons
EXAMPLE
Using the previous example, the bond's price can be computed using semi-annualcoupons as follows:
116

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