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Interest Rate & Bond

Valuation

Interest Rate Fundamentals

Interest rate is usually applied to debt


instruments as the compensation paid
by the borrower of funds. So for
borrower it is the cost of fund.
It is decided by supply and demand.

Nominal Interest Rate


Real

rate of return
Inflation premium
Risk free rate of return
Risk premium

Term Structure of Interest Rate


Yield

Curve

Inverted
Normal

Flat

Yield Curve

Yield Curve

Yield Curve

Theories of Term Structure

Expectation Theory: The theory that the


yield
curve
reflects
investors
expectations about future interest rates;
an expectation of rising interest rates
results in an upward slopping yield
curve, and an expectation of declining
rate results in a downward slopping
yield curve.

Theories of Term Structure

Liquidity Preference Theory: Theory suggesting that


long term rates are generally higher than short term
rates because investors perceive short term
investments to be more liquid and less risky than
long term investments.
On the other hand borrowers must offer higher
interest rate on long term bonds to motivate
investors, decrease risk of fund unavailability and to
reduce the risk of future interest rate increase.

Theories of Term Structure

Market Segmentation Theory: Theory


suggesting that the market for loans is
segmented on the basis of maturity
and that the supply of and demand for
loans within each segment determines
its prevailing interest rate.

Corporate Bonds

A long term debt instrument indicating


that a corporation has borrowed a
certain amount of money and promises
to repay it in the future under clearly
defined terms.

Legal Aspects of Corporate


Bonds
Bond

Indenture

Standard Provision

Restrictive Provision

Restrictive Provision

Require a minimum level of liquidity


Prohibit the sale of account receivables
Imposed fixed asset restriction
Constraint subsequent borrowing
Limit the firms annual cash dividend
payment
Sinking fund requirement

General Features of a Bond


Issue
Conversion
Call

feature

feature

Stock

purchase warrant

Common Types of Bond

Unsecured Bond:

Secured Bond: