Lecture Note 4.

Interest Rates and Bonds

Financial Management
Main Contents

Interest Rate Quotes and Adjustments

Application: Discount Rates and Loans

The Determinants of Interest Rates

The Opportunity Cost of Capital

Bond Valuation
Bond Terminology
Zero-Coupon Bonds
Coupon Bonds

Why Do Bond Prices Change?

Corporate Bonds

Financial Management 2 Lecture Note 4. Interest Rates and Bonds

Learning Objectives

Understand the different ways interest rates are quoted

Use quoted rates to calculate loan payments and balances

Know how inflation, expectations, and risk combine to determine interest

rates

See the link between interest rates in the market and a firm’s opportunity
cost of capital

Understand bond terminology and compute the price and yield to maturity
of a zero-coupon bond and a coupon bond

Analyze why bond prices change over time

Know how credit risk affects the expected return from holding a corporate
bond

Financial Management 3 Lecture Note 4. Interest Rates and Bonds

1. Interest Rate Quotes and Adjustments

Interest rate is the price of using money

Interest rates may be quoted for different time intervals such as daily, monthly,
semiannual, or annual
It is often necessary to adjust the interest rate to a time period that matches that of our cash
flows

Effective annual rate (EAR) or annual percentage yield (APY)

The total amount of interest that will be earned at the end of one year
With an EAR of 5%, a $100 investment grows to $100  (1 + r) = $100  (1.05) = $105
After two years it will grow to $100  (1 + r)2 = $100  (1.05)2 = $110.25
 Earning an EAR of 5% for two years is equivalent to earning 10.25% in total interest over the
entire period

Financial Management 4 Lecture Note 4. Interest Rates and Bonds

1. Quotes and Adjustments (Cont.)

Adjusting the discount rate to different time periods

In general, by raising the interest rate factor (1 + r) to the appropriate power, we can
compute an equivalent interest rate for a longer (or shorter) time period

We can use the same method to find the equivalent interest rate for periods shorter than
one year
In this case, we raise the interest rate factor (1+r) to the appropriate fractional power
Ex: (1.05)0.5 = $1.0247, so an annual rate of 5%, is equivalent to a rate of 2.47% every half of a
year

A discount rate of r for one period can be converted to an equivalent discount rate for n
periods
Equivalent n-period discount rate = (1+r)n – 1 (4.1)

When computing present or future values, you should adjust the discount rate to match
the time period of the cash flows

Financial Management 5 Lecture Note 4. Interest Rates and Bonds

1. Quotes and Adjustments (Cont.)

Problem for EAR

Suppose your bank account pays interest monthly with an effective annual rate of 6%.
What amount of interest will you earn each month?
From Eq. 4.1, a 6% EAR is equivalent to earning (1.06)1/12 – 1 = 0.4868% per month
 The exponent in this equation is 1/12 because the period is 1/12th of a year (a month)

If you have no money in the bank today, how much will you need to save at the end of
each month to accumulate $100,000 in 10 years?
Timelines for the above saving plan

 We can view the savings plan as a monthly annuity with 10  12 = 120 monthly payments
We have the future value of the annuity ($100,000), the length of time (120 months), and the
monthly interest rate (0.4868% per month) from the first question, therefore,
FV (annuity) $100, 000
C   $615.47 per month
1 [(1 
r
r )  1]
n 1
0.004868
[(1.004868)120  1]

Financial Management 6 Lecture Note 4. Interest Rates and Bonds

1. Quotes and Adjustments (Cont.)

Annual Percentage Rates (APR)

It indicates the amount of simple interest earned in one year, that is, the amount of
interest earned without the effect of compounding
It is the most common way to quote interest rates
Because it does not include the effect of compounding, the APR quote is typically less than the
actual amount of interest that you will earn
To compute the actual amount you will earn in one year, you must convert the APR to an EAR

Because the APR does not reflect the true amount you will earn over one year, the
APR itself cannot be used as a discount rate
Instead, the APR is a way of quoting the actual interest earned each compounding period
Interest rate per compounding period = APR / m
 where, m is the number of compounding period per year

Converting an APR to an EAR

1 EAR 1

Financial Management 7 Lecture Note 4. Interest Rates and Bonds

1. Quotes and Adjustments (Cont.)

Problem: converting the APR to a discount rate

Your firm is purchasing a new telephone system that will last for four years
You can purchase the system for an upfront cost of $150,000, or you can lease the system from
the manufacturer for $4,000 paid at the end of each month
The lease price is offered for a 48-month lease with no early termination—you cannot end the
lease early and your firm can borrow at an interest rate of 6% APR with monthly compounding.
Should you purchase the system outright or pay $4,000 per month?
Solution
 The cost of leasing the system is a 48-month annuity of $4,000 per month

 The monthly compounding rate is 6%/12 = 0.5%, then it’s present value is
1  1 
PV  4000  1    $170,321.27
0.005  1.00548 
 The PV of the cost of the lease is greater than purchasing value, $150,000, so, you should
purchase the system outright

Financial Management 8 Lecture Note 4. Interest Rates and Bonds

2. Application: Discount Rates and Loans

Computing loan payments

Consider a $30,000 car loan which is an amortizing loan with these terms:
6.75% APR with monthly compounding for 5 years  6.75%/12 = 0.5625% per month
 Amortizing loan: a loan on which the borrower makes monthly payments that include interest
on the loan plus some part of the loan balance
The timeline for a $30,000 car loan

The monthly payment for a $30,000 car loan

Financial Management 9 Lecture Note 4. Interest Rates and Bonds

2. Application (Cont.)

Computing the outstanding loan balance

The outstanding balance (or principal) on an amortizing loan is different each time
It is equal to the PV of the remaining future loan payments
 We calculate the outstanding loan balance by determining the PV of the remaining loan
payments using the loan rate as the discount rate

Example
Let’s say that you are now 3 years into a $30,000 car loan (at 6.75% APR, originally for 60
months) and you decide to sell the car. When you sell the car, you will need to pay whatever
the remaining balance is on your car loan. After 36 months of payments, how much do you still
owe on your car loan?
 We have already determined that the monthly payments on the loan are $590.50
 The remaining balance on the loan is the present value of the remaining 2 years, or 24
months, of payments and the monthly discount rate is 0.5625%. The outstanding loan
balance, therefore, is
1  1 
Balance with 24 months remaining  $590.50  1    $13, 222.32
0.005625  1.00562524 

Financial Management 10 Lecture Note 4. Interest Rates and Bonds

3. The Determinants of Interest Rates

How are interest rates determined?

Fundamentally, interest rates are determined by market forces based on the relative
supply and demand of funds
There are various factors that may influence interest rates
Inflation, current economic activity, expectations of future growth, etc.

Inflation: real vs. nominal rates

Nominal interest rates
The rate at which your money will grow if invested for a certain period
Real interest rate
The rate of growth of your purchasing power, after adjusting for inflation

1 Nominal rate Growth of Money

Growth in purchasing power 1 Real rate
1 Inflation rate Growth of Prices
Real rate = (Nominal rate – Inflation rate)/(1+Inflation rate) ≈ Nominal rate – Inflation rate

Financial Management 11 Lecture Note 4. Interest Rates and Bonds

3. The Determinants (Cont.)

Investment and interest rate policy

Interest rates affect not only individual’s propensity to save, but also firms’ incentive
to raise capital and invest
When the costs of an investment precede the benefits, an increase in the interest rate will make
the investment less attractive

The central bank attempts to use the relationship between interest rates and investment
incentives when trying to guide the economy
The central bank will often lower or raise interest rates in an attempt to stimulate investment if
the economy is slowing or to reduce investment if the economy is overheating

Financial Management 12 Lecture Note 4. Interest Rates and Bonds

3. The Determinants (Cont.)

The yield curve and discount rates

The interest rates that banks offer on investments or charge on loans depend on the
horizon, or term, of the investment or loan

The relationship between the investment term and the interest rate is called the term
structure of interest rates
We can use the term structure to compute the PVs and FVs of a risk-free cash flow over
different investment horizons
 Yield curve: a plot of bond yields as a function of the bonds’ maturity date
 Risk-free interest rate: the interest rate at which money can be borrowed or lent without risk
over a given period

Present value of a cash flow stream using a term structure of discount rates
C1 C2 CN
PV = + + +
1+ 0 r1 (1+ 0 r2 )2 (1+ 0 rN )N

Financial Management 13 Lecture Note 4. Interest Rates and Bonds

3. The Determinants (Cont.)

Term structure of risk-free U.S. interest rates, November 2006, 2007, and 2008

Problem: compute the present value of a risk-free five-year annuity of $1,000 per year,
given the yield curve for November 2008 in the above term structure
1,000 1,000 1,000 1,000 1,000
PV $4,775
1.0091 1.0098 1.0126 1.0169 1.0201

Financial Management 14 Lecture Note 4. Interest Rates and Bonds

4. The Opportunity Cost of Capital

Opportunity cost of capital

The best available expected return offered in the market on an investment of
comparable risk and term to the cash flow being discounted
The opportunity cost of capital is the return the investor forgoes when the investor takes on a
new investment and it is the minimum return required by investor for an investment with the
same risk and term
For a risk-free project, it will typically correspond to interest rate on Treasury securities with a
similar term (or risk-free interest)
But, for a risky project, it will determined by risk-free interest rate plus risk premium required
by investor for taking a risk

Problem
Suppose a friend offers to borrow $100 from you today and in return pay you $110 one year
from today. Looking in the market for other options for investing your money, you find your
best alternative option for investing the $100 that view as equally risky as lending it to your
friend. That option has an expected return of 8%. What should you do?
Your decision depends on what the opportunity cost is of lending your money to your friend
 Your opportunity cost is at best an 8% expected return and it is less than the expected return
of your friend’s offer. So, you will better off to make the loan for your friend

Financial Management 15 Lecture Note 4. Interest Rates and Bonds

5.1 Bond Terminology

Bond
A security sold by government and corporations to raise funds from investors today in
exchange for promised future payments (interests and principal)
It is simply a loan. When an investor buys a bond from an issuer, the investor is lending money
to the bond issuer and will receive promised interests and principal in the future

Bond terminology
Bond certificate
 It states the terms of a bond as well as the amounts and dates of all payments to be made
Face value, par value or principal amount: the notional amount
 The face value is used to compute the interest payments and typically, it is repaid at maturity
Maturity date: the final repayment date of a bond
 Term: the time to maturity or the time remaining until the final repayment date of a bond
Coupons: the promised interest payments of a bond
 It is determined by multiplying the face value and the coupon rate of a bond and dividing it
with the number of coupon payments in a year
 It is paid periodically until the maturity date of the bond

Financial Management 16 Lecture Note 4. Interest Rates and Bonds

5.1 Bond Terminology (Cont.)

Types of bonds
According to coupon payment ways
Perpetuity bond, coupon bond (fixed or floating) and zero-coupon bond (pure discount bond)
According to issuing prices
Premium bond, par bond and discount bond
According to issuers
Government bond and public bond, corporate bond, financial bond, specific laws bond, private
loan
Whether or not there is a collateral or a guarantee
Secured bond / unsecured bond, guaranteed bond / non-guaranteed bond
According to option type embedded in a bond
Callable bond and puttable bond
Convertible bond (CB), Exchange bond (EB), Bond with warrant (BW)

Financial Management 17 Lecture Note 4. Interest Rates and Bonds

5.2 Zero-Coupon Bonds

Zero-coupon bonds or zeros

Bonds not paying a coupon during the life of bonds
That means the coupon rate of them is zero
In trading a zeros, there are only two cash flows
The bond’s market price at the time of purchase
The bond’s face value at maturity
Timeline for a zeros and its valuation
0 (Today) 1 2  T (Maturity)

FV
FV
 B0 
1 0 rT T
Problem
What is the fair price of a one-year(from now), risk-free, zero-coupon bond with a $100,000
face value if the corresponding risk-free interest rate (or market interest rate) is 3.5% APR?
FV 100,000
B0 =
(1+ 0 r1 ) (1.035) = $96,618.36
=

Financial Management 18 Lecture Note 4. Interest Rates and Bonds

5.2 Zero-Coupon Bonds (Cont.)

Yield to maturity (YTM) of a zero-coupon bond

The rate of return of an investment in a bond that is held to its maturity date
The discount rate that sets the present value of the promised bond payments equal to
the current market price of the bond
YTM of an n-year zeros
1/n
FV
1 YTMn
Market price
Problem
Suppose the following zero-coupon bonds are trading at the prices shown below per $100 face
value. Determine the corresponding yield to maturity for each bond

Maturity 1 year 2 years 3 years 4 years

Price $96.62 $92.45 $87.63 $83.06

 YTM1 = (100/96.62) – 1 = 3.50%, YTM2 = (100/92.45)1/2 - 1 = 4.00%

 YTM3 = (100/87.63)1/3 - 1 = 4.50%, YTM4 = (100/83.06)1/4 - 1 = 4.75%

Financial Management 19 Lecture Note 4. Interest Rates and Bonds

5.2 Zero-Coupon Bonds (Cont.)

Risk-free interest rates

A default-free zero-coupon bond that matures on date n provides a risk-free return over
that period
We often refer to the YTM of a default-free zero-coupon bond that matures on date n as the
risk-free interest rate for that period

Spot interest rates

Default-free, zero-coupon yields
In the yield curve, which plots the risk-free interest rate for different maturities, rates are the
yields of risk-free zero-coupon bonds

Financial Management 20 Lecture Note 4. Interest Rates and Bonds

5.3 Coupon Bonds

Coupon bonds
The value of coupon bond is the sum of PV of all future coupon payments and PV of
the face value at maturity date
Coupon bonds make regular coupon interest payments and pay the face value at maturity date

Timeline for a coupon bond and its valuation

0 (Today) 1 2  T (Maturity)

I1 I 2
 I T  FV
I1 I2 IT FV
 B0      
10 r1 1 10 r2 2 10 rT T 10 rT T
Return on a coupon bond comes from the difference between the purchase price and
the principal value and periodic coupon payments

To compute the YTM of a coupon bond, we need to know the coupon interest
payments and when they are paid
Financial Management 21 Lecture Note 4. Interest Rates and Bonds
5.3 Coupon Bonds (Cont.)

Coupon bonds (Cont.)

Problem
Assume that it is May 15, 2010 and the U.S. Treasury has just issued securities with May 2015
maturity, $1,000 par value and a 2.2% coupon rate with semiannual coupons. The first coupon
payment will be paid on November 15, 2010. What cash flows will you receive if you hold this
note until maturity?
 The annual coupon amount = $1,000 0.022 = $22
 The semiannual coupon means the bond pays the coupon every 6 months (two times in a
year). So, each coupon amount for every 6 months is a half of the annual coupon amount, $11

The timeline of future cash flows from the bond

Financial Management 22 Lecture Note 4. Interest Rates and Bonds

5.3 Coupon Bonds (Cont.)

Valuation of a coupon bond

Using the following term structure information, computing the fair value of a coupon
bond
Maturities Rates (APR, %) Maturities Rates (APR, %)
6 months (0r0.5) 5.8% 24 months (0r2.0) 6.4%
12 months (0r1.0) 6.0% 30 months (0r2.5) 6.6%
18 months (0r1.5) 6.2% 36 months (0r3.0) 6.8%

A 3-year(from now), 5% coupon bond with a $1,000 face value

If the coupon rate is annual rate and interest rates in the term structure are also annual rates,
then the fair price of the coupon bond is
50 50 1,050 50 50 1,050
B0 = + + = + + = $953.27
(1+ 0 r1 ) (1+ 0 r2 ) 2 (1+ 0 r3 ) 3 (1.06)1 (1.064)2 (1.068)3

Financial Management 23 Lecture Note 4. Interest Rates and Bonds

5.3 Coupon Bonds (Cont.)

Valuation of a coupon bond (Cont.)

Using the following term structure information, computing the fair value of a coupon
bond
Maturities Rates (APR, %) Maturities Rates (APR, %)
6 months (0r0.5) 5.8% 24 months (0r2.0) 6.4%
12 months (0r1.0) 6.0% 30 months (0r2.5) 6.6%
18 months (0r1.5) 6.2% 36 months (0r3.0) 6.8%

A 3-year(from now), 5% coupon bond with a $1,000 face value

If the coupon rate and interest rates in the term structure are all semiannual rates, how to
change the fair price of the coupon bond?
 In this case, coupon payment is $25(=$1,000 5% 2) per 6 months (0.5 years)

25 25 25 25 25 1,025
0 .
1 1 0 .
1 0 .
1 0 .
1 0 .
1 0 .
2 2 2 2 2 2
$952.66

Financial Management 24 Lecture Note 4. Interest Rates and Bonds

5.3 Coupon Bonds (Cont.)

Coupon bond price quotes

Prices and yields are often used interchangeably

Bond traders usually quote yields rather than prices

One advantage is that the yield is independent of the face value of the bond

When prices are quoted in the bond market, they are conventionally quoted per $100
face value in U.S and per ₩10,000 face value in Korea

Financial Management 25 Lecture Note 4. Interest Rates and Bonds

6. Why Do Bond Prices Change?

After the issue date, the market price of a bond generally changes over time
At any point in time, changes in market interest rates affect the bond’s YTM and its
price
As time passes, the bond gets close to its maturity date and the price converge to the
face value

Interest rate changes and bond prices

If a bond sells at par the only return investors will earn is from the coupons that the
bond pays
Therefore, the bond’s coupon rate will exactly equal its yield to maturity
As interest rates in the economy fluctuate, the yields that investors demand will also
change
There is a inverse relation between changes of interest rates and changes of bond
prices

Financial Management 26 Lecture Note 4. Interest Rates and Bonds

6. Why Do Bond Prices Change? (Cont.)

The relation of interest rate and bond price

1,000,000

900,000
B
o 800,000
n
700,000
d
600,000
P
r 500,000
i 400,000
c
e 300,000

200,000
(

₩
)

100,000

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Interest rates or YTM (%)

Financial Management 27 Lecture Note 4. Interest Rates and Bonds

6. Why Do Bond Prices Change? (Cont.)

Time and bond prices

The bond price slowly rising as a coupon payment nears and then dropping abruptly
after the payment is made
This pattern continues for the life of the bond and finally the bond price converges to the face
value as the time goes to maturity date
Figure: the effect of time on bond prices

Financial Management 28 Lecture Note 4. Interest Rates and Bonds

6. Why Do Bond Prices Change? (Cont.)

Interest rate risk and bond prices

Effect of time on bond prices is predictable, but unpredictable changes in interest rates
also affect prices
Bonds with different characteristics will respond differently to changes in interest rates
Investors view long-term bonds to be riskier than short-term bonds because the price changes
of long-term bonds due to interest rate changes are more sensitive than those of short-term
bonds
Bonds with higher coupon rates are less sensitive to interest rate changes then otherwise
identical bonds with lower coupon bond because bonds with higher coupon rates pay higher
cash flows upfront

Bond prices in practice

Bond prices are subject to the effects of both passage of time and changes in interest
rates
Prices converge to face value due to the time effect, but simultaneously move up and
down because of changes in bond yields

Financial Management 29 Lecture Note 4. Interest Rates and Bonds

7. Corporate Bonds

Credit Risk
Credit risk is the risk of default by the issuer of any bond that is not default free
It is an indication that the bond’s cash flows are not known with certainty
Treasury bonds issued by government are widely regarded to be risk-free but corporate
bonds are not
Corporate bonds may fail to pay the promised cash flows due to the financial distress of issuing
firms. We call this possibility credit risk, default risk or counterparty risk
Corporations with higher default risk will need to pay higher coupons to attract buyers
to their bonds

Corporate bond yields

How does the credit risk of default affect bond prices and yield?
YTM of a defaultable bond is not equal to the expected return of investing in the bond
 YTM is calculated under an assumption that all promised cash flows are normally paid but
corporate bonds with credit risk cannot guarantee this assumption
A higher YTM does not necessarily imply that a bond’s expected return is higher

Financial Management 30 Lecture Note 4. Interest Rates and Bonds

7. Corporate Bonds (Cont.)

Bond ratings or credit ratings

Several companies rate the creditworthiness of bonds
Three best-known bond-rating companies are Standard & Poor’s, Moody’s and Fitch Ratings

These ratings help investors assess creditworthiness

The bond rating depends on the risk of bankruptcy and bondholders’ claim to assets in the
event of bankruptcy
Investment-grade bonds: bonds in the top 4 categories of credit worthiness with a low risk of
default (Ex: AAA, AA, A, and BBB)
Speculative bonds, junk bonds or high-yield bonds: bonds in below investment grade, having a
high risk of default (Ex: BB, B, CCC, CC, C)

Financial Management 31 Lecture Note 4. Interest Rates and Bonds

7. Corporate Bonds (Cont.)

The definition of Long-term issue credit ratings - S&P

Financial Management 32 Lecture Note 4. Interest Rates and Bonds

7. Corporate Bonds (Cont.)

The definition of Short-term issue credit ratings - S&P

Financial Management 33 Lecture Note 4. Interest Rates and Bonds

7. Corporate Bonds (Cont.)

The definition of short- and long-term credit ratings suggested by S&P’s

Financial Management 34 Lecture Note 4. Interest Rates and Bonds

7. Corporate Bonds (Cont.)

Corporate yield curves

We can plot a yield curve for corporate bonds just as we can for Treasury bonds
Default spread or credit spread
The difference between the yields of corporate bonds and Treasuries
The magnitude of the credit spread will depend on investors’ assessment of the likelihood that a
particular firm will default
Figure: corporate yield curves for various ratings, March 2010

Financial Management 35 Lecture Note 4. Interest Rates and Bonds