Recording 1 : Announcement

FIN222 Lecture 2
CH5: Interest Rates
CH6: Bond Valuation

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• Tutorials start this week. Hope you will enjoy your

class.

Recording 2 : EAR and determinants of interest rate

Week 3 Homework Due
• You are required to prepare Week 3 homework and
submit your work to Moodle by the start time of your
assigned tutorial in Week 3.

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 Lecture 2 Reading Lecture 3 Reading Learning Outcome 1 – continued
• 5.1 • 7.1
• 5.2 1. Demonstrate an understanding of how financial system works and
• 7.2 calculate the value of different types of cash flow streams
• 5.3 including financial assets such as shares and bonds.
• 7.3
-Inflation and real vs nominal rates
-Yield curve and Discount rates • 7.4
-Yield curve and The economy • 7.5 Notations
• 6.1 • 7.6 • APR= Annual Percentage Rate
• 6.2 • EAR = Effective Annual Rate
-Zero-coupon bond cash flows • m= frequency of compounding per year
• 6.3
• 6.4
-Interest rate changes and bond
prices
-Interest rate risk and bond prices
-Bond prices in practice
• 6.5
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INTEREST QUOTES AND ADJUSTMENT
APR vs EAR
• The most common way to quote interest rates is in
terms of an Annual Percentage Rate (APR)
• APR represents
– The amount of simple interest earned in one year = the
amount of interest earned without the effect of
compounding
• APR < the ACTUAL interest rate being applied if m > 1
– The total ACTUAL amount of interest that will be earned
by the end of one year determines an effective annual
rate or EAR.
– Both APR and EAR are expressed in % not in $.
– EAR > APR when m > 1
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• You want to borrow $100 on bank credit card.
The credit card’s stated interest is 1% per month.
– Annual percentage rate is the simple interest rate
charged per period multiplied by the number of
periods per year. In this case APR=1%
_______________.
x 12= 12%
– Using APR of 12%, you would expect your credit card
balance at the end of one year to be $100x1.12=$112.
Wrong.
– The bank’s actual rate is 1% per month meaning that
the bank will compound your credit card balance
12
monthly, ___times over the year
$100x(1.01)12=$112.68
– The bank’s calculation is ____________________
12.68 per year.
– The bank is actually charging you _____%
(=EAR)
– Total interest paid for the one-year loan is $_____
12.68
rather than $____
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– Then what is the correct way to annualise an interest
rate?
– Effective annual rate (EAR) is annual growth rate that
takes compounding into account.
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 APR vs EAR Example 1. Effective Annual Rate (EAR)
10%
$1.1
• Suppose you are offered an automobile loan at an APR
$1
10%,compounding annually of 6% per year. What does that mean, and what is the
0 1.1 - 1 = 10% 1
true rate of interest, given monthly payments?
1

5% 5%
10%,compounding semi- $1 1*(1.05)= $1.05 1.05*(1.05)= $1.1025
 APR 
m

annually 0 0.5 1 EAR =  1 +  −1

1.1025 - 1 = 10.25%  m 
1
2.5% 2.5% 2.5% 2.5% 12
10%,compounding quarterly  0.06 
$1 $1.025 $1.0506 $1.0769 $1.1038 EAR =  1 +  − 1 = 0.0617or6.17%
0 0.25 0.5 0.75 1  12 
m 1.1038 - 1 = 10.38% (1+ 0.1)4 - 1=10.38%
 APR  1
EAR = 1 +  −1 4
 m 
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DETERMINANTS OF INTEREST RATES Inflation and Real vs Nominal

Nominal Interest rates Nominal rate
• The interest rates quoted by banks and other Real rate
financial institutions
$100 5.6% $105.6
• Those interest rates we have used for discounting
0 1 105.6 -103
cash flows so far! = 2.6%
Inflation $100 $103 100
Inflation
• Measures how the purchasing power of a given 3%
amount of currency declines due to increasing
prices.
• The reason why “A dollar just doesn’t buy what it
used to”?
Real Interest rates
• The rate of growth of your purchasing power after Nominal rate ≈ Real rate + Inflation rate
adjusting for inflation
(1+Nominal) = (1+Real)*(1+ Inflation)
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 Nominal = Real + Inflation
What does this tell us?
• Inflation
– Prices of goods and service increase over time! Implication?
– With $100, you will buy fewer goods (or service) at a later time.
– That’s why investors need to be compensated for inflation.
• Real rate of interest
– When you give up your consumption to save, what do you
expect? Recording 3 : Bond Valuation
– Real rate measures compensation for deferring consumption
– Inflation-adjusted return (cost) earned by lenders (borrowers)
• Nominal rate of interest
– The rate that we actually observe in the marketplace at a given
time
– Nominal rate reflects compensation for inflation +
compensation for inability to use invested money for a given
period

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Notations How would we value debt securities?

Three variables we need!!!
• CPN = Coupons payment on a bond
• P = initial price of a bond Cn
• n = Periods remaining to maturity PV =  n3
2
1
4
C1 C2 C3 Cn
• y= YTM = return from holding bonds =Yield to
Maturity
(1+ r)
• What are the three key variables needed
in asset valuation?
– Future Cash flows (C)
– Discount rate (r)
– No of periods (n)

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 Debt vs Equity
Characteristics Debt Equity
Cash Flow Interest, principal Dividend

-Tax deductible? Yes No

Issue Securities
- Legally enforceable? Yes No

- Size Variable? No. Fixed Yes. Variable

Ordinary Shares Preference Shares Bond Maturity Fixed Indefinite
(Debt)
Asset Claim First Residual

Voting Right No Yes

Example Bonds Shares

BOND TERMINOLOGY
Interests & • What is a Bond?
CFs
Available for Principal – A security sold by governments and corporations to
PV= •Discount rate raise money from investors today in exchange for a
Debt-holders (1+y)n •Market interest rate
promised future payment.
•Cost of debt
•Required rate of return
for debt-holders
TAX •Yield to Maturity
Lend $50 mil by purchasing bonds
Issued by the borrower
Borrower
=Issuer Lenders
Eg. =bondholders
CFs Dividends
Corporations Eg. Individuals
Available for government
Shareholders In exchange, borrower pays
-Periodic interest payments (=coupons)
-Principal(=face value) of $50 mil at maturity
 COUPON BONDS COUPON BONDS
Yield to Maturity = discount rate (y)
• Terms: Market interest rate= Cost of debt = Required rate of return fo
$C $C $C $C $C $C $C $C $C $C+$FV debt-holders=Yield to maturity (YTM)
Cash flows • Annual y needs to be adjusted based on the number of coupon
payments per year
• Coupon Payments (CPN) ** – Example 3. 8% T-bond paying interest semi-annually with a
– Periodic interest payments made to bondholders current market interest rate of 10%
• Pay attention to frequency of coupon payment: Annual? Semi- y= 0.1/2=5%
annual?
– Size of C is FIXED for the life of bond
Number of Periods (n)
• Face Value (=Par Value=Principal) (FV) • Depends on the number of coupon payments per
– The principal amount owed to the bondholder at maturity
year and years to maturity
** $CPN= Coupon rate per period X Face value – Example 4. 8% T-bond with 4 years to maturity paying
Example 2. 8% Treasury bond (T-bond) paying interest semi-annuall interest semi-annually
with a face value of $1000 n= 4X2=8
0.08
CPN = x$1000 = $40
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Bond Valuation Formula Example 5

What is the market value of a Treasury bond which has a
1000
PV =
(1+ y)n
face value of $1,000 and pays coupons at the rate of 10%
per annum, semi-annually. This bond has four years to
annuity 1000 maturity and similar securities are yielding 12%?
40 40 40 40 40 40 40 40
|____ |__ __|_____ |____ _|__ _|______| _|______|
CPN  1  FV
0 1 2 3 4 5 6 7 8 P= 1- +
CPN=40 y  (1+ y)n  (1+ y)n
CPN  1  FV
y=0.05 P = 1- n
+
FV=1000 y  (1+ y)  (1+ y)n
Coupon rate per period? 10%/ 2=5% Face value? $1,000
n=8
40  1  1000 CPN= 0.05*1,000=50 y? 12%/2=6% n? 4X2=8
P = 1- 8
+ = $935.37
0.05  (1+ 0.05)  (1+ 0.05)8
50  1  1000
P= 1- + =937.9
0.06  (1.06)8  (1.06)8
 ZERO-COUPON BONDS
• No coupon payment but promise a single payment at
maturity
– What is the price of a zero coupon bond with a $1,000 face value,
4-year maturity and semi-annual compounding when the
market interest rate is 12%?

CPN  1  FV
P= 1- n
+
y  (1+ y)  (1+ y)n
Recording 4 : Relation between P and y

CPN = 0 FV= 1000 y= 12%/2=6% n= 4x2=8

1000
P= = $627.41
(1.06)8

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Bond Yields WHY BOND PRICES CHANGE

Interest rate changes and bond prices
• Yield to Maturity (YTM)
1. Bond prices are negatively related to interest rate
– Yield that investors earn if the bond is held to maturity and all
the coupon and principal payments are made as promised movement.
– Discount rate which makes PV of Cs & FV= Price of bond
y=?
CPN  1  FV
-$960.99 $60 $60 $60+$1000 P = 1- +
$60 $60 $1,060 Finding y for coupon y  (1+ y)n  (1+ y)n
$960.99 = + + bonds is
1 + y (1 + y )2 (1 + y)3 not examinable but
learn y represents
YTM.
1.Think about “What is the coupon rate?”___________
2. Is this bond at discount or at premium? ___________
3. Then y must be ___________________.
4. Easily solvable by financial calculator! y = ___________

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 WHY BOND PRICES CHANGE Prices of 8% bond

Interest rate changes and bond prices

• Imagine your company issues a bond when market
interest rates imply a yield to maturity of 8%, setting the
coupon rate to be 8%.
• Suppose interest rates then rise so that new bonds have
a yield to maturity (& coupon rate )of 9% and sell for
$1000.
• So for $1000, the investor would get $90 per year until
the bond matured.
• Your existing bond was issued when rates were lower
such that its coupon was fixed at 8% so it offers payment Coupon 8% < YTM 9%
of $80 per year until maturity. P=$960 <$1000
 Discount bond
• Because its cash flows are lower, the 8% bond must have
a lower price than the 9% bond.

WHY BOND PRICES CHANGE Prices of 8% bond

Interest rate changes and bond prices

• Imagine your company issues a bond when market
interest rates imply a yield to maturity of 8%, setting the
coupon rate to be 8%.
• Suppose interest rates then fall so that new bonds have
a yield to maturity (&coupon rate) of 7% and sell for
$1000. Coupon 8% > YTM 7%
P=$1040 >$1000
• So for $1000, the investor would get $70 per year until  Premium bond
the bond matured.
• Your existing bond was issued when rates were higher
such that its coupon was fixed at 8% so it offers payment
of $80 per year until maturity.
• Because its cash flows are higher, the 8% bond must
have a higher price than the 7% bond.
 Par, Premium & Discount Bonds Bond Yields
• Yield to Maturity (YTM)
– Yield that investors earn if the bond is held to maturity and all
the coupon and principal payments are made as promised
– Discount rate which makes PV of Cs & FV= Price of bond
FV Coupon rate Discount Price of the PRICED AT
rate, y bond y=?
-$960.99 $60 $60 $60+$1000
$1000 8% 9% $ 960 DISCOUNT
$60 $60 $1,060 Finding y for coupon
$1000 8% 7% $1040 PREMIUM $960.99 = + 2
+ bonds is
1 + y (1 + y ) (1 + y)3 not examinable but
learn y represents
$1000 8% 8% $1000 PAR 6%
1.Think about “What is the coupon rate?”___________ YTM.
Discount
2. Is this bond at discount or at premium? ___________
> 6%
3. Then y must be ___________________.
7.5%
4. Easily solvable by financial calculator! y = ___________

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WHY BOND PRICES CHANGE

Interest rate risk and bond prices

2. The Impact of n on P (assuming a constant coupon)

For a given change in interest rates, the prices of long-
term bonds will change more than the prices of short-
term bonds. = For a given change in interest rates, the
longer time to maturity, the higher interest rate risk.

What is Interest rate risk?

Uncertainty about future bond values that is caused by
the unpredictability of interest rates.
The impact of n on P The impact of CPN on P (assuming a constant n)
(assuming a constant coupon)
3. The impact of CPN on P (assuming a constant n)
Yield to 5-year, 5% Annual 40-year, 5% Annual For a given change in interest rates, the prices of lower
Maturity Coupon Bond Coupon Bond
coupon bonds change more than prices of higher-
coupon bonds. = For a given change in interest rates,
1  1  100 1  1  100 the lower coupon rate, the higher interest rate risk.
5× 1 − + = $100 5 × 1 − + = $100
5% .05  1.055  1.055 .05  1.0540  1.0540

1  1  100 1  1  100
6% 5× 1 − + = $95.79 5× 1 − + = $84.95
.06  1.065  1.065 .06  1.06 40  1.06 40

CORPORATE BONDS
• Bonds issued by a corporation
Credit risk
• Australian Treasury securities are widely regarded to be
risk-free.
Recording 5 : – Risk free rate = the rate on Australian Treasury
Corporate Bonds & securities
What affects y? • Credit risk is the risk of default, so that the bond’s cash
flows are not known with certainty.
• To compensate for the risk that the firm may default,
investors demand a higher interest rate than the rate
on Australian Treasury securities.

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 CORPORATE BONDS CORPORATE BONDS
Bond ratings
• How do you assess a firm’s likelihood of default?
less Companies such as Standard & Poor’s and Moody’s rate
the creditworthiness of bonds.
•The highest quality bonds are rated
> Moody's S&P's
triple-A.
Investment Grade
Aaa AAA •Investment grade bonds have to be
> Aa AA equivalent of Baa or higher.
90% chance of $1000 A A •Bonds that don’t make this cut are
900 1000 900 950 10% chance of $500 Baa BBB called “Speculative bonds”, “high-
Expected cash flow yield” or “Junk” bonds.
=0.9*1000 + 0.1*500 Junk Bonds
=900+50=$950
•The rating depends on
Ba BB •The risk of bankruptcy
B B •bondholders ’ claim to assets in
Caa CCC the event of bankruptcy
Ca CC
C C ,D

CORPORATE BONDS Then what affects the yield of bonds?

Credit spreads
= Yields of corporate bonds – Yields of Treasury bonds • What are the two basic components in interest rates we
just learnt?
• Increase in credit spreads over 2008 and 2009 1. Inflation
– Uncertain economy? Risky assets Safe assets 2. Real rate of interest
– Expanding economy? Safe assets Risky assets
– During GFC, money moved to T-bond increasing PT-bonds
• When P increases, Yields decrease.
• Yields of Corporate Bond – Yields of Treasury Bond
• As the creditworthiness of corporate bonds ___,
the credit spread on the bonds ___, reflecting
the _______ return expected by investors as the
probability of default ____.
 Then what affects the yield of bonds? Then what affects the yield of bonds?
3. Interest rate risk (affected by term to maturity) • Upward-sloping yield curve – LT y > ST y
– Relationship between investment term (n) and the
interest rate (y) is called the term structure of interest
rates.
– We can plot this relationship on a graph called the
yield curve. There are three types.
• Upward-sloping yield curve – LT y > ST y
• Downward-sloping yield curve – LT y < ST y
• Flat yield curve - LT y = ST y
– Interest rate risk premium
• Remember that longer term bonds are more sensitive to a
change in interest rates? Riskier! You can earn or lose more. If investors believe that the rate of inflation will be higher in
• Investors recognise this risk and they demand extra the future, long-term nominal interest will tend to be
compensation in the form of higher rates for holding longer
higher than short-term rates. (Economy expansion)
term bonds.

Then what affects the yield of bonds? Summary

– What is the difference between an APR and an EAR?
• Downward-sloping yield curve – LT y < ST y
– Do you understand the relation between nominal interest
rate, real interest rate and inflation rate? What are those
rates?
– Can you compute the price of both coupon and zero-coupon
bonds?
– Can you distinguish between discount and premium bonds?
– What is Yield to Maturity (YTM)?
– Do you understand the relationship between the price of
bonds and interest rates? What types of bonds are more
sensitive to price movement?
– What are the characteristics of corporate bonds? How is its
creditworthiness measured?
– Can you explain 3 factors which affect the yield of bonds?
If investors believe that the rate of inflation will be lower in
• Inflation
the future, long-term nominal interest will tend to be lower
• Real rate of interest
than short-term rates. (Economy recession)
• Interest rate risk
– What
48 is the yield curve? What can you infer from its shape?