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: