FINE2005 Financial Management

Lecture 3 and 4
Bonds II

1
 Reference

Essentials of Corporate Finance: Ross, Westerfield and

3
 Overview
•Real versus Nominal Rates
•The Fisher Effect
•The Term Structure of Interest Rates

4
 Cash Flows Associated with a Bond

Maturity
0 1 2 3 t
Coupon Coupon Coupon Coupon
正在載入⋯ +
Face Value

5
 Cash Flows Associated with a Bond

Maturity
0 1 2 3 t
Coupon Coupon Coupon Coupon

+ Maturity
0 1 2 3 t
Face Value

6
 Bond Valuation
•

7
 Bond Valuation
A bond’s yield to maturity (YTM) is the rate required in the market for the
bond.

8
 Bond Valuation
Suppose Xanth Company were to issue a bond with 10 years to maturity.
The Xanth bond has an annual coupon of $80 and coupons are paid
annually. Similar bonds have a yield to maturity of 8% per annun. In 10
years, Xanth will pay $1000 to the owner of the bond. What would this
bond sell for?

9
 Bond Valuation
•

10
 Bond Valuation
Refer to the previous example about Xanth bond. Suppose a year has gone
by. The Xanth bond now has nine years to maturity. If the yield to
maturity has risen to 10% a year. What is the price of the bond?
正在載入⋯

11
 Bond Valuation
•

12
 Bond Valuation
Refer to the previous example about Xanth bond. Suppose a year has gone
by. The Xanth bond now has nine years to maturity. If the yield to
maturity has dropped to 6% a year. What is the price of the bond?

13
 Bond Valuation
•

14
 Bond Valuation
Consider a bond with a coupon rate of 14% and semiannual coupons. The
par value is $1,000, and the bond has 7 years to maturity. The yield to
maturity is 16%. What is the value of the bond?

15
 Bond Valuation
•

16
 Bond Valuation
Eight-Inch Nails Company issues a $1000 face value, five year zero coupon
bond. The bond’s yield to maturity is 14%. What is the initial price?

17
 Bond Valuation
•

18
 Interest Rate Risk
• The risk that arises for bond owners from fluctuating interest rates is called
interest rate risk.
- As interest rates increase (decrease), bond prices decrease (increase).

19
 Interest Rate Risk
• All other things being equal, the longer the time to maturity, the greater the
interest rate risk.
Value of a bond with a 10% Coupon Rate, Annual Coupon, Face value = 1000 for
Different Interest Rates and Maturities
Time to Maturity: 5 Years Time to Maturity: 10 Years
Interest Rates Price Price Change Price Price Change
5% 1216.47 +216.47 1386.09 +386.09
10% 1000 1000
15% 832.39 -167.61 749.06 -250.94
20% 700.94 -299.06 580.75 -419.25 20
 Default Risk
• Default risk (credit risk) is the risk that a borrower may not repay on a
timely basis.
• Treasury securities (Treasury Bills, Exchange Fund Bills) are backed by
the respective government.
• Other types of bonds (e.g. Corporate bonds) are subjected to possibility of
default.

21
 Bond Ratings
Standard & Moody’s
Poor’s
High Grade AAA Aaa
Investment Quality AA Aa
Bond Ratings
Medium Grade A A
BBB Baa
Low Grade BB Ba
B B
Low Quality,
Speculative, and/or Very Low Grade CCC Caa
“Junk” Bond CC Ca
Ratings
C C
D 22
 Liquidity Risk
• Liquidity risk is the potential loss that could occur as a result of converting
an investment into cash.

23
 Inflation and Time Value of Money
• If you deposit $1000 in a saving account that pays 6% a year, you will
receive $1060 at the end of the year.
• You will be worst off (in terms of the goods you can buy) if the value of
your investment increases by 6% while the prices of goods and services
increase by 10%.

24
 Inflation
• Inflation is the rate at which prices as a whole are increasing.
• Consumer Price Index (CPI) is one of the price indexes used to track the
general level of prices.
• The CPI measures the number of dollars that it takes to buy a specific
basket of goods and services generally purchased by households.

25
 Inflation
Hong Kong Composite Consumer Price Index
(October 2019 - September 2020 (base period): 100)
Year 2016 2017 2018 2019 2020 2021 2022
Composite CPI 93.2 94.6 96.8 99.6 99.9 101.4 103.3

• The composite CPI in 2016 is 93.2. This means that on average, $93.2 in
2016 would have brought the same quantity of goods and services as $100
in the base period.
26
 Inflation
• Changes in the CPI are widely used as indicator of the inflation or deflation
affecting consumers.
- Example: The inflation rate between 2018 and 2019 is 2.89%
• The table suggests that the prices has been increasing since 2016.

27
 Real versus Nominal Rates
Nominal Rates
• Interest rates or rates of return that have not been adjusted for inflation.
• The nominal rate on an investment is the percentage change in the number
of dollars you have.

28
 Real versus Nominal Rates
Real Rates
• Interest rates or rates of return that have been adjusted for inflation.
• The real rate on an investment is the percentage change in how much you
正在載入⋯
can buy with your dollars – the percentage change in your
purchasing/buying power.

29
 The Fisher Effect
•

30
 The Fisher Effect
•

31
 The Term Structure of Interest Rates
• The term structure of interest rates shows the relationship between the time
to maturity and the nominal interest rates on default free, pure discount
securities
• When the long-term nominal rates are higher than the short-term nominal
rates, the term structure is upward sloping.
• When the short-term nominal rates are higher than the long-term nominal
rates, the term structure is downward sloping.

32
 The Term Structure of Interest Rates
Three basic components determine the shape of the term structure:
1. Real rate of Interest
• Influences the overall level of the interest rates.
2. Inflation premium
• Compensation for expected future inflation.
• Upward-sloping term structure may reflect anticipated increases in
inflation.
33
 The Term Structure of Interest Rates
3. Interest rate risk premium
• The compensation investor demand for bearing interest rate risk.
• The longer the term to maturity, the greater the interest rate risk, so the
interest rate risk premium increases with maturity.

34
The Term Structure of Interest Rates

35
The Term Structure of Interest Rates

36