BRUNEL UNIVERSITY LONDON

 
Department of Economics and Finance
 
EC1030 LECTURE 3

The relationship between interest rates and bond prices

Dr. Woo-Young Kang

 Contents
1. Time Value of Money (TVM), Compounding, and Discounting
2. Bonds: Valuation, Pricing Factors, and Relations to Interest Rates
3. Special Types of Bonds
4. Lecture 3 Summary
 Time Value of Money (TVM),
Compounding, and Discounting
What is meant by the Time Value of
Money (TVM)?
• An important principle in economics and finance is that the
value of money is time dependent - £1 now is worth more than
£1 tomorrow or at some future date.

• Four reasons can be given for this:

(a) Inflation.
(b) Risk.
(c) Personal Consumption Preference.
(d) Investment Opportunities.
Compounding
• In general, an investment in the capital market of £V0 now gives
rise to a cash flow of £V0(1+r) after one year, £V0(1+r)2 after two
years, and so on.
• The general formula for the future value (FVn) of £V0 invested
for n years at a compound rate of interest of r% will be:
=
 Compounding (cont.)
0 1 2 3 4 5 6

£100 £100 £100

×(1+ 0.10) ×(1+ 0.10)

Future value of £100 invested for 2 years at

a compound rate of interest of 10%
Compounding Example
What is the future value of £100 invested for six years at a
compound rate of interest of 10%, using the compounding
formula?
Discounting
• Also of interest to investors is the present value of a future stream of income
i.e. the value of a future stream of income expressed in today’s prices.
• If we turn the previous example around and ask ‘what is the present value
(value today) of £177.16 to be received in six years’ time?’ the answer should
be obvious. £100!
• The general formula which finds the present value (PV) of a cash flow FV
receivable in n years’ time is;

 This is the process of discounting future sums to their present values.

 Discounting (cont.)
0 1 2 3 4 5 6

£100 £100
1
£100
(1+0.10)2 (1+0.10)

÷(1+0.10) ÷(1+0.10)

Present value of £100 invested for 2 years

at a compound rate of interest of 10%
Discounting Example
• Applying the PV formula to check the previous compounding
example, the PV of £( ) receivable six years from now,
discounted at 10%, should be?
 Bonds:
Valuation, Pricing Factors, and
Relations to Interest Rates
 What is a bond?
• A bond is essentially an IOU (I owe you) issued by a borrower to
a lender.
• They usually take the form of fixed-income securities issued by
governments, local authorities or corporations. They are one
way of raising finance - issuing a bond is a substitute to
borrowing money.
• Typically, the investor (the person who buys the bond) receives:
+
What is a bond? (cont.)
• Coupon payment is a fraction of the principal amount expressed
in terms of money unit (£) or percentage (%) .
• For instance, if a bond with a principal amount of £1000 has
annual coupon payment of £137.50, the coupon rate is 13.75%
(=£137.50 /£1000)
• The principal amount is the one-time payment the borrower
make to the lender at the maturity date.
 How do we value bonds?
• In general, the market price of a bond should reflect the
discounted PV of all the cash flows which the investor is going to
receive, PV of Coupon
Payment +
PV of Coupon Principal
Payments Payment
(before maturity) (at the maturity)

where, C = coupon (interest) payment provided in each period

P = face (par) value (also principal)
r = discount rate or opportunity cost of capital
n = number of periods before maturity.
Bond Valuation Example
• For instance, consider the following 6-year bond whose
redemption (par) value is £1000 and has an annual coupon rate
of 13.75%. Also, assume investor’s required rate of return
(discount rate) is 7.6%.
• This means that in each year until the maturity of the bond
there is a cash (coupon) payment of 13.75% of the face value
(£1000) and on maturity the principal amount is also paid back.
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
£137.50 £137.50 £137.50 £137.50 £137.50 £1137.50
Bond Valuation Example (cont.)
• What is the Present Value (PV) of this £1000 bond which
matures in 6 years, with an annual coupon rate of 13.75% and
discount rate of 7.6%?
 How do we value bonds? (cont.)
• The price of a bond should reflect the present value of the cash flows to be
received.
• In the above example we clearly know (with certainty) the set of cash flows
that the investor will receive.
 Therefore, to calculate the PV of these cash flows we simply have to
discount them.

• Q:What is the appropriate discount rate (investor’s required rate of return) to

use?
A:?
How do we value bonds? (cont.)
Present Value of the bond

Interest rate (or discount rate) “r”

that equates these two is called
“Yield
Current Market Price of the bondto Maturity (or redemption yield)”

discount rate
that equates
PV of all the bond’s Current market price
future cash flows = of the bond
Yield to Maturity
(or redemption yield)
What factors affect the price of a bond?
As we have seen the market price of a bond is determined by

(a) The size of the coupon payment.

The higher the coupon rate the higher will be the market price of the bond, other things
being equal.

(b) The time to maturity of the bond i.e. its redemption date.

(c) The discount rate.

There is a negative relationship between a bond’s price and its discount rate.
What is the relationship between
interest rates and bond prices?
What is the relationship between
interest rates and bond prices? (cont.)
• Market interest rates determine what the appropriate discount rate
to use when valuing bonds.
• This is because interest rates on other assets with similar
characteristics determine the return the investor requires to invest in
a particular bond, which in turn determines the discount rate.
Discount rates, we know, effect bond prices.
• ‘s in interest rates  ‘s in discount rates  ‘s in bond prices
• Interest rate risk?
Special Types of Bonds
Special types of bonds
• Bonds with semi-annual payments
Most bonds do not pay interest annually but semi-annually.
To value such bonds we need to
(i) Divide the annual coupon payment into two equal payments since two payments
are to be made a year.
(ii) Divide the annual discount rate by two to reflect two six-month periods.
(iii) Double the number of periods in which interest is received.
With these adjustments, the general formula becomes:

PV of bond with semi-annual payments = ++ +

where
- C/2 is the semi-annual coupon payment
- r/2 is the discount rate used to discount the semi-annual coupon payment
- 2n reflects the doubling of periods.
Special types of bonds (cont.)
• Zero-coupon bonds
Zero-coupon bonds pay no coupon during the life of the bond. All
that is paid to the bondholder is the principal amount on the
maturity of the bond.
To value zero-coupon bonds, we use the following formula:
PV of zero-coupon bond=
where P is the principal amount (par value) to be paid on
maturity and n is the number of years to maturity.
Lecture 3 Summary
1. Time Value of Money (TVM): the value of money is time
dependent affected by: Inflation, Risk, Personal Consumption
Preference, and Investment Opportunities.
2. Compounding:
=
3. Discounting:
Lecture 3 Summary (cont.)
• Bond: IOU (I owe you) issued by a borrower to a lender.
Bond Price = +
•

discount rate
that equates
PV of all the bond’s Current market price
future cash flows = of the bond
Yield to Maturity
(or redemption yield)
Lecture 3 Summary (cont.)
• Market price of a bond is determined by
(1) size of coupon payment (+)
(2) time to maturity
(3) discount rate (-)

• Interest rate risk: The risk of market price falling in response to

a rise in interest rates
• Special types of bonds: Bonds with semi-annual payments and
zero-coupon bonds