RWJ Chapter 8

Bonds, Interest Rates, and

Inflation
The value of a bond is combination of an annuity and future value.

BOND VALUATION
 Bonds and Bond Valuation
• A bond is a legally binding agreement
between a borrower and a lender that
specifies the:
– Par (face) value
– Coupon rate
– Coupon payment
– Maturity Date
• The yield to maturity is the required market
interest rate on the bond.
 Bond Cash Flows
0 1 2 3 4 …… T-1 T

V C C C C C C +Face

Definitions:
C  Coupon with m coupons payments per year
F  Face of Bond (Also know as PAR)
r  Equivalent to IRR
YTM  Yield to Maturity (2r if semi-annual coupons)
BondValue  Present value of Bond Cash Flows
CR * F
CR  Coupon Rate  C 
m
 Interpreting Bond Cash Flows
0 1 2 3 4 …… T-1 T

V C C C C C C +Face

• C – Annuity of bond coupon payments

• F – The Face of the Bond, which is paid at
maturity
• V – The present value of the bond has two
components:
– PV Annuity of coupon payments C
– PV of Face F
 What is the price of the bond?
0 1 2 3 4 …… T-1 T

V C C C C C C +Face

CR * Face  1 1  Face
BondValue(C , F , r , T )    
m  r r (1  r ) m*T
 (1  r ) m*T

Annuity of Coupon Payments PV of Bond Face

• CR is the coupon rate

• m is the number of coupon payments per year
• T is the time to maturity in years
• YTM=m*r => YTM is like APR (see example page 241-242)
 Case I: Zero Coupon Bonds
• No periodic interest payments (coupon rate = 0%)
• YTM is only a function of price and par value (face)
• Zero Coupon Bonds sell for less than par value
• Sometimes called zeroes, deep discount bonds, or
original issue discount bonds (OIDs)
• Treasury Bills and principal-only Treasury strips are
good examples of zeroes
 Case I: Zero Coupon Bond
0 1 2 3 4 …… T-1 T

V Face Face
BondValue( F , r , T ) 
(1  r )T
• Zero Coupon Bonds pay out at maturity
• Yield to maturity – Interest rate demanded by investors
• Suppose Bond is Riskless (no chance of default)
– Investors will generally demand a small premium above expected inflation
– General rule doesn’t currently hold with US bonds.

Given these assumptions let:

F=100, r  .05, and T=5
Face 100
BondValue( F , r , T )    78.35
(1  r )T
(1  .05) 5
 Case II: Coupon Bond
0 1 2 3 4 …… T-1 T

V C C C C C C +Face

• Let Coupon Rate = 6% with annual payments

• Coupons = (.06)*(100)=6
• Keep other assumptions so that F=100, r=.05, and T=5
1 1  Face
BondValue(C , F , r , T )  C   T 

 r r (1  r )  (1  r )
T

 1 1  100
BondValue(C , F , r , T )  6   5 

 .05 .05(1  .05)  (1  .05)
5

 25.98  78.35
 104.33
 Bond Prices, Value, and Yield to
Maturity (YTM)
• The price at which bonds trade represents the
value of the bond.
• For any bond, we generally know the:
– Coupon Rate and hence the coupon;
– Bond’s Face Value; and
– Time to Maturity.
• To find the rate demanded by our investors,
we need to find the YTM
 Case II: Finding YTM for a Coupon Bond
0 1 2 3 4 …… T-1 T

V C C C C C C +F

• Let Bond Value=Traded Price = 110

• Keep other assumptions the same:
– Coupon Rate equal 6% so that Coupons = (.06)*(100)=6
– Face=100 and T=5
1 1  Face
BondValue(C , F , r , T )  C    
 r r (1  r )  (1  r )
T T

1 1  100
110  6   5 

 r r (1  r )  (1  r )
5

Solving for r is analogous to solving an IRR. If there is one coupon payment

per year then r=YTM. Use Excel or a Financial Calculator.
 RWJ Question 8.2 – Valuing bonds
• Information
– Par = 1,000
– Time to Maturity = 15 Years
– Coupon Rate = 7% (APR)
– Semi-Annual Payments
• Valuation
– Periods = 15*2 = 30 .07 *1, 000
– Coupon payment Coupon   35
2
• Question – Bond Prices at 7%, 9%, and 5% YTM
35 35 35 1000
BondValue(7%YTM )     
(1  .035) (1  .035) 2 (1  .035)30 (1.035)30
1000
 35* A.035
30
 30
 1,000
(1.035)
1000
BondValue(9%YTM )  35* A.045
30
  837.11
(1.045)30
1000
BondValue(5%YTM )  35* A.025
30
 30
 1,209.30
(1.025)
 Tutorial Problem 8.5
• Information
– Par Value 1,000 Euro
– 15 Years to Maturity
– Coupon Rate is 4.5%
– Annual Payments
– YTM is 3.9%
• Valuation
– Periods = 15
– Coupon Payments = (.045)(1,000)=45 Annually
• What is the current market price?

1000
MarketPrice  45* A 15
.039  15
 1079.48
(1.039)
Changes in interest rates, default risk, and liquidity all affect bond prices.

AFTERMARKET BOND PRICES

 Factors affecting the required return
of bonds
• Interest rate changes
• Default risk premium
• Liquidity premium
– Frequent trading implies it is easier for an investor
to sell the bonds
– Investors pay more for liquidity
– Yields decrease, and
– Bid-ask spreads decline (less dealer risk)
• Tax changes
 Interest rates affect bond prices
• Bonds are issued at Par so that firms raise funds equal to
par value
• Bonds then trade and interest rates affect prices
• Inverse relationship between Bond prices and market
interest rates
• Bond prices relative to Face
– When coupon rate = YTM, price = par value
– When coupon rate > YTM, price > par value (premium bond)
– When coupon rate < YTM, price < par value (discount bond)
• Interest Rate Risk (Change in bond price from a change in
the interest rate)
– Increases with the Time to Maturity
– Decreases with the Coupon Rate
 Maturity and Bond Price Volatility
Bond Value

Consider two otherwise identical bonds.

The long-maturity bond will have much more
volatility with respect to changes in the
discount rate.

Par

Short Maturity Bond

C Discount Rate
Long Maturity Bond
 Duration and Interest Rate Risk—not
examinable
• Duration measures
– The sensitivity of a bonds price to changes in the interest rate
– Higher duration implies a bond has more interest rate risk
• Duration definition – PV weighted measure of when receive
payments (Coupons and Face)
• Zero Coupon Bond
– Only the Face is received at the bond expiration date
– Example: 20 Year zero coupon has a duration of 20 years
• Coupon Bonds
– Example: 20 year coupon bond has a duration less than 20 years
– The higher the coupons, the lower the duration (and interest
rate risk).
Case I: Zero Coupon Bond with Default Risk
0 1 2 3 4 …… T-1 T

V Face F
BondValue( F , r , T ) 
(1  r )T
• Previous example
– Bond is Riskless (no chance of default)
– Riskless implies a 100% probability of $100 dollar Face eventuating
• Adding Risk
– Suppose there is a 90% probability of the $100 Face eventuating.
– To keep things simple, assume the bond payout equals zero in case of default
– There a large number of assumptions underlying this solution

1* Face 100
BondValue( F , r , T ) Riskless    78.35
(1  r ) T
(1  .05) 5

90% * Face 90
BondValue( F , r , T ) Risky    70.517
(1  r )T
(1  .05) 5
 Default Risk and YTM
• In previous example we assumed a 90% probability of
collecting the Face ($100)
• We discounted the expected value ($90) by the riskless rate
of 5%
• In practice, we observe the traded bond price and not the
default probability
• Higher Yields to Maturity reflect a higher chance of default

DefaultProb * Face 90
BondValue( F , r , T ) Risky    70.517
(1  r ) T
(1  .05) 5

100
70.517   r  YTM  7.2361%
(1  r ) 5
Bond Ratings – Investment Quality
• High Grade
– Moody’s Aaa and S&P AAA – capacity to pay is
extremely strong
– Moody’s Aa and S&P AA – capacity to pay is very
strong
• Medium Grade
– Moody’s A and S&P A – capacity to pay is strong, but
more susceptible to changes in circumstances
– Moody’s Baa and S&P BBB – capacity to pay is
adequate, adverse conditions will have more impact
on the firm’s ability to pay
 Bond Ratings - Speculative
• Low Grade
– Moody’s Ba and B
– S&P BB and B
– Considered speculative with respect to capacity to
pay.
• Very Low Grade
– Moody’s C
– S&P C & D
– Highly uncertain repayment and, in many cases,
already in default, with principal and interest in
arrears.
 Inflation and Interest Rates
• Real rate of interest – change in purchasing
power
• Nominal rate of interest (Quoted rate)
• Nominal rate includes both
– Expected change in purchasing power
– Expected inflation
 The Fisher Equation
Definitions
R  Nominal rate of interest,
r  Real rate of interest, and
h  Inflation rate.
The Fisher equation defines the relationship between
interest rates and inflation where:
(1  R)  (1  r )(1  h)
Implying the nominal rate is:
R  1  h  r  rh  1
R  r  h  rh
And the real rate is:
(1  R )
(1+r) 
(1  h)
(1  R ) Rh
r 1 
(1  h) 1 h
 RWJ Question 8.10
• Information
– Own as asset for last year
– Total Return R=12.5
– Inflation Rate h=5.3%
• What is the real return?
(1  R)  (1  r )(1  h)
(1  R)
r 1
(1  h)
1.125 Difference of
r  1  .0684
1.053 0.36%
r  R  h  .125  .053  .072
 RWJ Question 8.30
• Information
– Joe to purchase flowers for $8 weekly for 30 years or 1,560 weeks
– EAR=6.9%
– Inflation=h=3.2% per year
• Preliminaries annual 1  R 1.069
rEAR  1   1  .03585271
1 h 1.032
 APR  1 1
rweekly     1  EAR   1  1.03585271  1  0.000677633
m 52
 m  Real
 APR  1 1
Rweekly     1  EAR  m  1  1.069   1  0.00128397
52
 m  Nominal
Inflation
 APR  1 1
hweekly    1  EAR   1  1.032   1  0.000605927
m 52
 m  Nominal

• Question – What is the PV of the flower commitment?

• Approaches
I. Real – discount at the real rate
II. Nominal – like a growing annuity
 RWJ Question 8.30
Approach I – use real interest rates
8  1 
PVannuity   1  
0.000677633  (1.000677633)1,560 
 11,805.81*.65422
 7,702.30

Approach II – use nominal interest rates

Some
C1  (1  g )  Rounding
PV growing
 1   Error
(1  r ) 
annuity
rg
C0 (1  h)  (1  h) 
 1  
R  h  (1  R ) 
8(1  0.000605927)  (1.000605927)1,560 
 1  
0.00128397  0.000605927  (1.00128397)1,560 
 11,805.81* 0.65241  7,702.23

FVannuity = C {(1 + r )t− 1] / r}

Interest rates change over time

TERM STRUCTURE OF INTEREST

RATES
 Term Structure
• The relationship between short and long term
interest rates
• Derived from default-free, pure discount (zero
coupon) bonds
• Slope of Term Structure
– Upward sloping – most common
– Hump – long term rates decline after short term
increase
– Downward sloping – often seen as warning of
recession
 Theories of Term Structure
1. Inflationary Expectations – Expected higher
inflation in future periods results in a upward
sloping yield curve
2. Liquidity Premium – Investor demand a
premium for holding a longer maturity bond
3. Habitat –
– Investor demand for bonds at certain maturities
affects price
– Plausible in short run – but over time hedge funds
will arbitrage away miss-pricing.
 Yield Curve
• Term structure
– Relationship between time to maturity and yields,
all else equal
– We pull out the effect of default risk, different
coupons, etc.
• Treasure Yield curve
– Very close to term structure, but based on coupon
bonds (not zero coupon)
– But treasury bonds are liquid and risk free (?)
– Graphical approximation to the term structure
 Yield Curve for US Treasuries

Federal Reserve open

market committee
sets the targeted
Federal funds rate.

Source: WSJ Online

BNZ Fixed Interest Rates increase with
the term of the loan
Bond yields changed as inflationary expectations and
default probabilities change
 Summary
• The Value (price) of a bond is obtained by finding:
– The PV of the Annuity of Coupon Payments
– The PV of the Face (Par Value)
• The Yield to Maturity (YTM)
– Rate of interest where the PV of the Coupons and Face equals the Market Price of Bond
(Assuming annual coupons)
– Like IRR estimate YTM using Excel or financial calculator
• Firms issue bonds at PAR by setting the YTM equal to the estimated cost of capital
• Once bonds trade, the prices change (see NZ Market examples) and consequently
the YTM
– Discount Bonds trade below Face
– Premium Bonds above Face
– Interest rate risk increases with bond maturity and decreases with coupon size
– Higher default probability => lower price and higher expected YTM
• Inflation affects interest rates
– Nominal rates – include effect of inflation
– Real rate – doesn’t include effect of inflation
– Fisher equation – shows relationship between real and nominal rates
• Term Structure
– Relationship between interest rates and time
– Yield curve – derived from US treasuries (Could construct NZ term structure using RBNZ data)
FLOATING VERSUS FIXED RATE
EXAMPLE
 Example: Floating vs. Fixed Rate Home Loans
• PSIS offers a Fixed-4 year loan and the Floating loan.
• As of 14 July 2011
– The floating loan rate is 5.7%.
– The fixed rate stays at 7.10% for the four years.
• These rates suggest that PSIS expects interest rates to rise.
• Rising interest rates are reflected in an upward sloping
term structure.
• To illustrate the effects:
– Compare the fixed rate vs. floating rate loans.
– Assumptions
• Loan value = $100,000
• Interest rate resets (increases) by 1% per year.
– Find the annual payments so that after 4 years there is an
ending balance of $70,000.
• Fixed Rate Scenario
Beginning Total Interest Principal Ending
Year Balance Payment Paid Paid Balance
1 $100,000.00 $13,846.85 $7,100.00 $6,746.85 $93,253.15
2 $93,253.15 $13,846.85 $6,620.97 $7,225.87 $86,027.28
3 $86,027.28 $13,846.85 $6,107.94 $7,738.91 $78,288.37
4 $78,288.37 $13,846.85 $5,558.47 $8,288.37 $70,000.00

• Floating Rate Scenario

Beginning Total Interest Interest Principal Ending
Year Balance Payment Rate Paid Paid Balance
1 $100,000.00 $13,764.35 5.70% $5,700.00 $8,064.35 $91,935.65
2 $91,935.65 $13,764.35 6.70% $6,159.69 $7,604.66 $84,330.99
3 $84,330.99 $13,764.35 7.70% $6,493.49 $7,270.87 $77,060.12
4 $77,060.12 $13,764.35 8.70% $6,704.23 $7,060.12 $70,000.00

Comment – This back of envelop analysis suggests PSIS has baked-in an ~1% increase
per year into its fixed rate home loan.
MORE FORMAL TREATMENT
2 Period Term Structure Example
0 1 2

R0,1  Nominal 1 Period E[ R1,2 ]  Expected Nominal

Rate at t=0 (earn in period 1) 1 Period Rate at t=1 (earn in period 2)

R0,2  Nominal 2 Period Rate at t=0

R0,2  (1  R0,1 )(1  E[ R1,2 ])  1
1/2

if the real rate of interest is stable then using Fisher equation

R0,2  (1  r )(1  h0,1 )(1  E[r ])(1  E[h1,2 ])  1
1/2

and upward term structure if h0,1  E[h1,2 ]

2 Period Term Structure w/ Liquidity
1
Premium 2
0

R0,1  Nominal 1 Period E[ R1,2 ]  L  Expected Nominal Rate + Liquidity Premium

Rate at t=0 (earn in period 1) 1 Period Rate at t=1 (earn in period 2)

R0,2  Nominal 2 Period Rate at t=0

R0,2  (1  R0,1 )(1  E[ R1,2 ]  L)  1
1/2

if the real rate of interest is stable then using Fisher equation

R0,2  (1  r )(1  h0,1 )(1  E[r ])(1  E[h1,2 ]  L)  1
1/2

if L  0  upward term structure even if h0,1  E[h1,2 ]