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Chapter 6

Bonds
Also includes Ch. 5
(sections 3 & 4)
Interest Rates

In Class
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6-2
Chapter Quiz
1. What types of cash flows does a bond buyer receive?
2. How are the periodic coupon payments on a bond
determined?
3. Why would you want to know the yield to maturity of a
bond?
4. What is the relationship between a bond’s price and its
yield to maturity?
5. What cash flows does a company pay to investors holding
its coupon bonds?
6. What do we need in order to value a coupon bond?
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6-3
Chapter Quiz
7. Why do interest rates and bond prices move in
opposite directions?
8. If a bond’s yield to maturity does not change,
how does its cash price change between coupon
payments?
9. What is a junk bond?
10. How will the yield to maturity of a bond vary
with the bond’s risk of default?

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6-4
Fisher Equation Example:
• If we require a 10% real return and we
expect inflation to be 8%, what is the
nominal rate?
• R = (1.1)(1.08) – 1 = .188 = 18.8%
• Approximation: R = 10% + 8% = 18%
• Because the real return and expected
inflation are relatively high, there is
significant difference between the actual
Fisher Effect and the approximation.
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6-5
Calculating the Real Interest Rate
• In the year 2000, short-term U.S.
government bond rates were about 5.8%
and the rate of inflation was about 3.4%.
• In 2003, interest rates were about 1% and
inflation was about 1.9%.
• What was the real interest rate in 2000
and 2003?
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6-6
Normal Upward-Sloping Yield Curve
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6-7
Using the Term Structure to
Compute Present Values
• Compute the present value of a risk-free five-year
annuity of $2,500 per year, given the following
yield curve for July 2009.
Term Date
Years July-09
1 0.54%
2 1.05%
3 1.57%
4 2.05%
5 2.51%
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6-8
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6-9
Time Line Coupon Interest Par Value
0 Jan. 1, 1863
1 July 1, 1863 20
2 Jan. 1, 1864 20
3 July 1, 1864 20
4 Jan. 1, 1865 20
5 July 1, 1865 20
6 Jan. 1, 1866 20
7 July 1, 1866 20
8 Jan. 1, 1867 20
9 July 1, 1867 20
10 Jan. 1, 1868 20
11 July 1, 1868 20 500
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6-10
The Bond Pricing Equation
t
t
r) (1
FV
r
r) (1
1
- 1
C Value Bond
















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6-11
Interest Rate Risk (Review)
• Price Risk
– Change in price due to changes in interest rates
– Long-term bonds have more price risk than short-
term bonds
– Low coupon rate bonds have more price risk than
high coupon rate bonds
• Reinvestment Rate Risk
– Uncertainty concerning rates at which cash flows
can be reinvested
– Short-term bonds have more reinvestment rate
risk than long-term bonds
– High coupon rate bonds have more reinvestment
rate risk than low coupon rate bonds
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6-12
Current Yield vs. Yield to Maturity
• Current Yield = annual coupon / price
• Yield to maturity = current yield + capital gains
yield
• Example: 10% coupon bond, with semiannual
coupons, face value of 1,000, 20 years to
maturity, $1,197.93 price
– Current yield = 100 / 1,197.93 = .0835 = 8.35%
– Price in one year, assuming no change in YTM = 1,193.68
– Capital gain yield = (1,193.68 – 1,197.93) / 1,197.93 =
-.0035 = -.35%
– YTM = 8.35 - .35 = 8%
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6-13
13
Comprehensive Problem
• What is the price of a $1,000 par value
bond with a 6% coupon rate paid
semiannually, if the bond is priced to yield
5% YTM, and it has 9 years to maturity?
• What would be the price of the bond if the
yield rose to 7%.
• What is the current yield on the bond if the
YTM is 7%?
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6-14
Change in Bond Prices
• You own a semi annual, 10 year, 8%
coupon bond with a face value of $1,000.
• The yield to maturity of the bond is 6.5%.
Interest rates decline by ¾ of a percent.
• What is the percent price change in the
bond after the change in interest rates?
• Same info as above, except the bond is a
two year, not a 10 year bond.
• What is the % price change after the
change in interest rates?

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6-15
Bond Prices with a Spreadsheet
• There is a specific formula for finding
bond prices on a spreadsheet
– PRICE(Settlement,Maturity,Rate,Yld,Redemption,
Frequency,Basis)
– YIELD(Settlement,Maturity,Rate,Pr,Redemption,
Frequency,Basis)
– Settlement and maturity need to be actual dates
– The redemption and Pr need to be input as % of par
value
• Click on the Excel icon for an example
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6-16
A 10-year, 10% semiannual coupon bond
selling for $1,135.90 can be called in 4 years
for $1,050, what is its yield to call (YTC)?
 The bond’s yield to maturity can be determined to
be 8%. Solving for the YTC is identical to solving
for YTM, except the time to call is used for N and
the call premium is FV.
INPUTS
OUTPUT
N I/YR PMT PV FV
8
3.568
50 1050
- 1135.90
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6-17
YTM and YTC
• A 20-year, 12% semiannual $1,000 par value
coupon bond selling for $1,235 can be called in 4
years for $1,060
• What is its yield to maturity (YTM)?
• What is its yield to call (YTC)?
• What is the current yield of the bond?
• What is its capital gains yield?

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6-18
Ethics Issues
• In 1996, allegations were made against
Moody’s that it was issuing ratings on
bonds it had not been hired to rate, in
order to pressure issuers to pay for their
service.
• The government conducted an inquiry, but
charges of antitrust violations were
dropped.
• Even though no legal action was taken,
does an ethical issue exist?
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6-19
Discussion: Zero Coupon Bonds
• What type of investor would buy
zero-coupon bonds? Coupon bonds?
• Conversely, what do firms consider
when choosing between the issuance
of a zero-coupon issue and an issue
with coupon payments?

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6-20
Discussion: Bond Price
Availability
• As indicated in the chapter and highlighted
in the chapter interview, the bond market
is huge, yet bond prices are rarely
accessible in the printed press and online
quotes are available only through limited
sites.
• Stock quotes, on the other hand, are
widely available.
• If the bond market is that big and that
important, why is there such “secrecy,” or
limited access to price information?

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6-21
Discussion: Yield to Maturity
Assumptions
• The current price of a bond rests on the
assumption that the coupons will be
reinvested at the YTM.
• In reality, by the time the coupons begin to
arrive, interest rates will most likely have
changed.
• Is the price paid for the bond its true price
or is there a way of reconciling the
uncertainty of future interest rates with the
price of the bond?

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6-22
Discussion: Valuation Principle
• After reading the first six chapters of this
text, you should be developing, an
understanding of the Valuation Principle
and, now the Law of One Price.
• Do these principles now make sense to
you?
• How would you explain them to someone
with little or no financial background?

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6-23
Discussion: Discount Bonds
• Explain why the yield of a bond that trades
at a discount (premium) is greater than
(less than) the bond’s coupon rate.

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6-24
Discussion: Bond Pricing
• Explain the relationship between interest
rates and bond prices.
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6-25
Discussion: Interest Rate
Sensitivity
• Explain why longer term bonds are more
sensitive to changes in interest rates than
shorter term bonds
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6-26
Discussion: Expected bond
return
• Explain why the expected return of a
corporate bond does not equal its yield to
maturity