1.

Valuing a stream of cash flow

[Link] and Annuities

●​ perpetuities and annuities refer to cash flows, which can be either inflows
(income) or outflows (expenses) depending on the context.

Real-Life Examples:

●​ Perpetuity:
○​ A scholarship fund that pays $1,000 every year forever.
○​ Government bonds with no maturity date, paying fixed interest indefinitely.
●​ Annuity:
○​ A car loan with fixed monthly payments for 5 years.
○​ A retirement pension that pays $2,000 per month for 20 years.
For perpetuity, the first cash flow C starts at period 1, not period 0.
→ For perpetuity, the key idea is that the interest earned each year should be exactly
equal to the cash flow C you want to receive forever
It's just like depositing money in a bank and living off the interest forever, without ever
touching the initial deposit.

→ annuity, you deposit an initial amount and withdraw a fixed amount over a set number
of years. By the end of that period, your account balance reaches zero because you have
withdrawn both your principal and interest earned.

Annuity
3. PV of growing annuities and perpetuities
Why? explain the concept

-​ so at first that amount is 20000, and then when the value of money grow 3%, that
means the 5% at first now only worth 2% after growth,
-​ Annuity
4. Discount rate vs interest rate
Key Rule to Remember:

●​ If you're valuing cash flows → discount rate is used.

●​ If you're talking about borrowing/lending → interest rate is used.

5. Internal rate of return ( IRR)

1. Definition of IRR

●​ IRR is the discount rate that makes the Net Present Value (NPV) = 0.
●​ In other words, it is the rate at which the present value of future cash flows exactly
equals the initial investment.

3. Can There Be Multiple IRRs?

✅ Yes, multiple IRRs can exist when a project has changing cash flows (positive and
✅ If a project has multiple sign changes (e.g., negative → positive → negative), it can
negative at different times).​

have more than one IRR, leading to confusion.

4. Can IRR Be Misleading?

✅ Yes, IRR can be misleading in cases like:

●​ Non-conventional cash flows (where the sign of cash flows changes multiple
times).
●​ Projects with different scales (a higher IRR does not always mean a better
project).
 ●​ Mutually exclusive projects (choosing based only on IRR can lead to wrong
decisions).

💡 Better alternative? Use NPV for decision-making rather than relying only on IRR.
Would you like a practice question on IRR? 😊

Example: Bank Deposit & Withdrawals (Annuity IRR Case)

Scenario:

●​ You deposit $10,000 in a bank.

●​ You withdraw $2,500 per year for 5 years.
●​ After 5 years, your balance becomes zero.
●​ Question: What is the IRR (interest rate) that makes this possible?

Step 4: Interpretation

●​ If the bank pays 7.93% interest, your withdrawals exactly use up the $10,000
deposit in 5 years.
●​ If the interest rate were higher, money would remain in the account after 5 years.
●​ If the interest rate were lower, you would run out of money before 5 years.
✅ IRR is the rate that makes the present value of withdrawals exactly match the initial
deposit.

✅IRR = 7.5%

✅IRR = 9.61%

✅IRR = 10.93%

6. Discount rate and maturity

1. What is the Term Structure?
 ●​ The term structure shows how interest rates change based on the maturity (length
of time) of an investment.
●​ In simple terms, it explains why short-term and long-term interest rates are
different.

✅ Key Idea: Longer maturities usually have higher interest rates due to risks like
inflation and uncertainty.

2. Yield Curve - The Graph of Term Structure

●​ The yield curve is a graph that shows the relationship between interest rates
and time to maturity.
●​ It plots interest rates (Y-axis) vs. maturity (X-axis).
●​ The shape of the curve helps predict economic conditions.

3. Three Types of Yield Curves

1.​ Normal Yield Curve (Most common)

○​ Upward-sloping (longer-term rates are higher than short-term).
○​ Suggests economic growth.
2.​ Inverted Yield Curve
○​ Downward-sloping (short-term rates are higher than long-term).
○​ Suggests economic recession.
3.​ Flat Yield Curve
○​ Little difference between short-term and long-term rates.
○​ Suggests economic uncertainty.
What Does a Humped Yield Curve Mean?

✅ Short-term yields decrease initially → Could indicate a temporary liquidity boost.​

✅ Medium-term yields rise → Suggests moderate economic growth expectations.​
✅ Long-term yields flatten or decline → Signals uncertainty or expected slowdown in
growth.

📌 Key Interpretation:
●​ It often occurs when there is uncertainty about future interest rates.
●​ It may indicate economic transition (moving from growth to slowdown).

4. Why Does This Matter?

●​ PV Calculations: When discounting future cash flows, we choose different

discount rates based on maturity.
●​ Investment Decisions: Companies and investors analyze the yield curve to make
financial decisions.
●​ Economic Signals: An inverted yield curve is often a warning sign of a
recession.

7. Next slide: Discount rate and maturity(2)

1. What’s Different in This Slide?

●​ Instead of using one fixed discount rate, we now use different discount rates for
different years.
 ●​ This is called the term structure of discount rates, which follows the yield curve.

2. How Is Present Value (PV) Calculated Here?

●​ Instead of using a single discount rate rrr for all years,​

each year has its own rate r1,r2,r3

✅ This means:
●​ Different cash flows (C₁, C₂, C₃, …) are discounted using different rates (r₁, r₂, r₃,
…) based on maturity.
●​ The longer the time, the higher the discount rate usually is (if the yield curve is
normal).

3. Why Is This Important?

●​ More accurate PV calculation → Matches real-world yield curves.

●​ Longer-term cash flows get higher discount rates → Reflects risk & inflation.
●​ In practice, many use a constant rate instead for simplicity.

Final Takeaway

📌 Instead of using one discount rate for all years, we apply different rates based on
📌 This aligns with the term structure of interest rates (yield curve).
maturity.​

8. APR vs EAR
1. What is APR (Annual Percentage Rate)?

●​ APR is the simple annual interest rate that banks and lenders quote.
●​ It does NOT account for compounding, meaning it just tells you the flat interest per
year.
 ●​

2. What is EAR (Effective Annual Rate)?

●​ EAR is the true interest rate per year after considering compounding effects.
●​ The more frequently interest compounds, the higher the EAR.

Example
4. Interpretation of the Answer

●​ APR (6%) is the quoted rate, but it does not account for compounding.
●​ EAR (6.17%) is the actual rate you will earn or pay in a year, considering monthly
compounding.
●​ The more frequent the compounding (daily, weekly, etc.), the higher the EAR.

📌 Key Takeaway:
●​ EAR gives the true cost of borrowing or true return on investment.
●​ Use EAR to compare loans/investments with different compounding periods.

Final Takeaway

✅ APR = A simple, flat rate → Like book value (doesn’t reflect true compounding
✅ EAR = True return or cost → Like market value (reflects the actual worth in real
effect).​

conditions).

9. Nominal vs Real interest rate

✔ Nominal Rate = "On Paper" Value

●​ Just like book value, it’s the stated rate before adjusting for external factors.
●​ Includes inflation but doesn’t account for how money actually changes in value over
time.
 ●​ Example: A bank advertises 6% interest, but that doesn’t mean your purchasing
power grows by 6%.

✔ Real Rate = "Actual" Value After Adjusting for External Factors

●​ Just like market value, it’s the adjusted rate after considering inflation and
economic conditions.
●​ Shows how much your purchasing power really changes.
●​ Example: If inflation is 2%, the real rate is only ~4% (since inflation erodes the
value of returns).
The €2,500 salary increase might look big on paper, but when you adjust for inflation,
its true present value (real value today) is only €970.

Key Takeaways:

●​ Nominal Increase = €2,500 (On Paper, Before Inflation)

●​ Real Increase = €970 (Actual Value Today, Adjusted for Inflation)
●​ Real Raise = 1.94%, not 5%, because inflation reduces purchasing power.

10. Risk and discount rates

●​ Expected cash flows: Since the future is uncertain, we calculate the expected
value using probabilities.
●​ Risk-adjusted discount rate: Higher risk means investors demand higher returns,
so the discount rate increases to reflect the uncertainty.
●​ Impact on PV: Higher discount rates reduce the present value (PV), meaning risky
investments are worth less today compared to risk-free ones.
●​ The concept of opportunity cost is also mentioned. Instead of using a risk-free
rate, we use the cost of capital, which is the return investors could earn elsewhere
(e.g., stocks, bonds, or other investments).
 Example 2: Choosing Between Investments

You have €10,000 to invest. You can either:

●​ Deposit in a bank with a risk-free interest rate of 3%.

●​ Invest in stocks, which have higher risk but a 7% expected return.

If you choose to deposit in a bank, the opportunity cost is the extra 4% (7% - 3%) return
you could have earned from stocks.

👉 Final answer: Your understanding is solid! Just keep in mind that higher interest rates
are used to compensate for both risk and opportunity cost.

Example 3: Lending Money

You’re lending €10,000 to two people:

●​ Person A (low risk): Has a stable income and great credit. You charge them 5%
interest.
●​ Person B (high risk): Might lose their job and have bad credit. You charge them
10% interest.

11. Net Present Value (NPV) with Risk

introduces Net Present Value (NPV) with Risk by incorporating uncertain future cash
flows and discounting them using the opportunity cost of capital.

Key Takeaways from the Slide:

1.​ Investment & Risky Cash Flow:

○​ You invest €10 today (I₀ = 10) in a project.
○​ The future cash flow (C₁ at time 1) depends on the economy:
■​ Good: €150
■​ Normal: €100
■​ Poor: €50
○​ Each outcome is equally likely (1/3 probability each).
2.​ How to Value the Project?
○​ First, calculate the expected value of future cash flows
 Key Insights:

✅ Why discount the expected value?​

Because future cash flows are uncertain, we take their weighted average (expected value).

✅ Why use a higher discount rate?

●​ A higher discount rate reflects risk and opportunity cost.
●​ If the project is risky, investors demand higher returns.

✅ What does the NPV tell us?

●​ If NPV > 0, the investment is profitable (go for it).
●​ If NPV < 0, the investment destroys value (reject it).
Conclusion: ✅ Accept the project, as it creates additional value.

12. Bonds terminologies

1️⃣ Bond

●​ A debt security where an issuer (government, corporation) borrows money and

agrees to pay periodic interest and return the principal at maturity.
●​ Think of it like a loan: The issuer is borrowing money from bondholders and
promises to pay them back with interest.

2️⃣ Face Value (Par Value / Principal Value)

●​ The amount the bondholder gets at maturity (usually €1,000 per bond).
●​ Example: If you buy a bond with a €1,000 face value, you’ll receive €1,000 at the
end of the bond’s life. ( you buy at 700, then receive 1000 at maturity, profit is 300)

3️⃣ Coupon

●​ The interest payment made to the bondholder at regular intervals

(annually/semi-annually).
 Example:

●​ You buy a bond with a face value of €1,000 and a 5% coupon rate.
●​ The bond pays €50 per year (5% of €1,000).
●​ If the maturity is 20 years, you receive €50 × 20 = €1,000 in total coupon
payments.
●​ At the end of 20 years, you get back the original €1,000.
●​ Total earnings = €1,000 + €1,000 = €2,000.

4️⃣ Coupon Rate

●​ The annual interest rate the bond pays, expressed as a percentage of the face
value.

●​ Example: A bond with a face value of €1,000 and an annual coupon of €50 has a
coupon rate of 5%.

💡 Key Takeaway:
Bonds provide fixed-income payments and are used by governments & corporations to
raise funds. Coupon rates determine how much interest investors receive.

✅ 5. What’s the Price of the Bond?

●​ Bonds are not always sold at face value (€1,000).
●​ Bond price changes based on interest rates & market conditions.
●​ If market interest rates increase, bond prices decrease (and vice versa).

🔹 Case 1: Buying at a Discount (Good Deal)

●​ If a bond's face value is €1,000, but it’s sold for €950, you buy it for €950.
●​ At maturity, you get €1,000, making a profit of €50 (plus any coupon payments).

🔹 Case 2: Buying at a Premium (Expensive)

●​ If interest rates drop, bond prices rise.
●​ A bond with €1,000 face value may sell for €1,050.
●​ You pay €1,050 but still get €1,000 at maturity.
●​ You might still earn from coupon payments, but the bond was more expensive.
✅ 6 . Buying a Bond at a Premium: Can You Still Make a Profit?

For a zero-coupon bond, buying at a premium (paying more than face value) is always
a loss.

✅ 7. When Should You Buy a Bond at a Premium?

✔ If the coupon payments are high enough to compensate for the extra price.​
✔ If you plan to hold the bond until maturity and don’t mind the extra cost.​
✔ If you need stable income from coupons and don’t worry about price fluctuations.

❌ If you buy at a premium and interest rates rise, new bonds will be more attractive with
higher rates, making your bond less valuable.

💡 Key Takeaways
●​ Buying at a discount (below face value) is usually a good deal.
●​ Buying at a premium can still be good if coupon payments make up for the extra cost.
●​ If coupon payments are too low, buying at a premium can lead to a loss.
●​ Market interest rates affect bond prices—if rates go up, bond prices go down.

✅8. Warning
common misconception in bond valuation:
 1.​ The coupon rate is NOT the discount rate used in present value calculations.
2.​ Coupon rate: fixed percentage of the bond’s face value that the issuer promises to
pay yearly
3.​ Discount rate (or required return) : rate investors expect based on market
conditions, used to evaluate the bond’s present value (PV) today

📌 Summary Rule
●​ Discount Rate > Coupon Rate → Bond price ↓ (trades at a discount).
●​ Discount Rate < Coupon Rate → Bond price ↑ (trades at a premium).

📌 Example to Clarify
You buy a €1,000 bond with:

●​ Coupon rate = 5% → You receive €50 annually.

●​ Market interest rate = 6% → This is the discount rate investors use to value the
bond.

Misconception: Many assume the bond price is €1,000 because the coupon rate is 5%.​
Reality: Since the market rate (6%) is higher than the coupon rate (5%), the bond's price
must be lower than €1,000 to compensate investors for the higher required return.

✅ Key Takeaway: The market determines the bond price based on the required return
(discount rate), NOT the coupon rate.

13. Interest rates and bond prices

calculate the price of a bond using the present value (PV) formula for all cash flows
(coupon payments + face value).

Or the Step-by-Step Approach:

 1.​ PV of Coupon Payments → Discount each coupon separately.
2.​ PV of Face Value → Discount the par value separately.
3.​ Total PV = Sum of both.

What This Formula Means:

●​ Each year, you receive a fixed coupon payment, which is discounted back to
today’s value using the market interest rate.
●​ At maturity, you get both the last coupon payment and the face value, which is
also discounted back.
●​ The bond price is simply the sum of all these present values.

Example Calculation:

A bond has:

●​ Face value = €1,000

●​ Coupon rate = 5%
●​ Market interest rate (discount rate) = 6%
●​ Time to maturity = 3 years

Example
14. Understanding Price % in Bond Pricing
In bond markets, bond prices are often quoted as a percentage of their face value (par
value). This helps investors quickly see whether a bond is trading at a premium, discount,
or at par.

Why Use Price %?

1.​ Easier Comparison: Instead of stating the actual price, quoting in percentages
makes it easier to compare bonds of different face values.
2.​ Quick Market Pricing: Investors can quickly see if a bond is trading below, at, or
above face value.
○​ Price % < 100% → Bond is at a Discount (e.g., 99.596%)
○​ Price % = 100% → Bond is at Par
○​ Price % > 100% → Bond is at a Premium

Key Takeaways

●​ Price % tells you how the bond price compares to its face value.
●​ In this case, the bond is selling at a slight discount (99.596% of its face value)
because the required return (2.391%) is slightly higher than the coupon rate (2.25%).

15. Bond prices with semi-annual coupon

Intuition Using an Example
Imagine two bonds:

●​ Bond A (Annual Coupon): Pays $22.50 once per year.

●​ Bond B (Semi-Annual Coupon): Pays $11.25 every six months.

Since Bond B's cash flow arrives earlier, its present value (PV) is higher, leading to a
higher bond price.

Key Takeaways

✅ More frequent coupon payments mean investors get their money back earlier,
✅ Less discounting = Higher PV = Higher bond price.​
reducing the discounting effect.​

✅ Semi-annual payments benefit investors more than annual payments (for the same
total amount of interest). ( as higher PV)

16. Bond prices with different opportunity cost ( required rate of

return)
This slide demonstrates a key concept:

📌 When the required rate of return (discount rate) equals the coupon rate, the bond
price is equal to its face value (par value).

Key Takeaways:

✅ If the required rate of return = coupon rate → Bond price = face value (par).​
✅ This means investors are satisfied with the return offered by the bond.​
✅ No premium or discount is needed to adjust the bond's return to match market
expectations.

This explains why the previous examples showed bond prices either above or below par
when the required return was different from the coupon rate.

Conclusion: What Does This Mean in the Economy?

📌 If bonds are trading at par, it signals market stability where investors' expectations
📌 It reflects that the overall interest rate environment is in equilibrium.​
align with reality.​

📌 This often happens in low-volatility conditions, where inflation and economic

📌 Governments and companies issuing bonds don’t have to offer a premium or
uncertainty are minimal.​

discount to attract investors.

🔹 Summary:​
👉 When coupon rate = required return, investors see the bond as fairly priced.​
👉 There’s no excess demand or oversupply, so the bond price stays at its face value.​
👉 It reflects economic balance, where investors’ required return aligns with market interest
rates.

17. What happen if the required rate is high ( 10%)

the coupon rate remains at 2.25%, but the required return increases to 10%. This
causes the bond's price to fall below par ($1,000) to $807.27. Here’s why:

1. Required Return vs. Coupon Rate

●​ The coupon rate (2.25%) is much lower than the required return (10%).
●​ Investors expect a higher return (10%) to compensate for market risks.
●​ Since the bond only pays a low fixed coupon (2.25% of $1,000 = $22.50 per year),
it becomes less attractive.
●​ To compensate for the lower coupon, the bond price falls so that buyers can still
earn the market-required return of 10%.

2. Present Value Effect

●​ Higher discount rates reduce the present value of future cash flows.
●​ Since investors are using 10% instead of 2.25% to discount future payments, the
bond's present value drops.

3. Market Reaction: Discount Bond

●​ Since the bond’s price is below the face value ($1,000), this is called a discount
bond.
●​ Investors who buy it at $807.27 will earn additional returns when the bond matures at
$1,000 (capital gain).
●​ This price adjustment ensures that the total return (capital gain + coupon
payments) equals the required 10%.

4. Economic Meaning: Why Does This Happen?

📉 High interest rates make existing bonds less attractive.

 ●​ If new bonds are issued at higher rates (e.g., 10%), no one wants old bonds
paying just 2.25%.
●​ So, to attract buyers, the price drops.

📌 Conclusion:
●​ When required return > coupon rate, the bond price falls below face value
(discount bond).
●​ Investors demand a higher yield, and price adjusts downward to match the market
rate.
●​ This happens in rising interest rate environments, where newer bonds offer
better returns.

18. Bond Prices and Interest Rate Risk

visual representation of how a bond's price changes when interest rates fluctuate.

1. Relationship Between Bond Price & Interest Rate

●​ The red line shows an inverse relationship between bond prices and interest rates.
●​ As the interest rate increases, the bond price decreases.
●​ As the interest rate decreases, the bond price increases.

📉 Why?
●​ When market interest rates rise, newly issued bonds offer higher returns.
●​ Older bonds with lower coupon rates become less attractive.
●​ Investors will only buy the old bonds at a discount, which lowers their price.

📈 Vice Versa:
 ●​ When market rates fall, old bonds with higher coupon payments become more
attractive.
●​ Investors are willing to pay a premium for these bonds.
●​ This increases their price.

2. Key Insight: Opportunity Cost & Bond Pricing

●​ The opportunity cost is the return investors expect from other investments (stocks,
bonds, etc.).
●​ If market rates go up, the opportunity cost increases, so bonds become less
valuable.
●​ If market rates go down, opportunity cost decreases, and bond values rise.

💡 Example from Graph:

●​ When the required return (interest rate) is 2.25%, the bond price is $1,000 (par).
●​ When the interest rate rises to 10%, the bond price drops to $807.27.

3. Interest Rate Risk

●​ This price fluctuation is known as interest rate risk.

●​ If you hold bonds and rates increase, the value of your bond drops.
●​ If rates fall, your bond gains value.

📌 Conclusion:
●​ Bondholders face risk because market rates constantly change.
●​ Long-term bonds have higher interest rate risk since future cash flows are
affected more.
●​ Short-term bonds are less sensitive to rate changes.

19. YTM

Yield to Maturity (YTM) is the interest rate that makes the present value (PV) of all bond
payments (coupons + face value) equal to its current market price.
YTM (Yield to Maturity) = The Investor’s Expected Return if Holding the Bond Until
Maturity

What Does This Mean in Simple Terms?

●​ If you buy a bond today at its market price and hold it until maturity, your
annual return will be the YTM.
●​ YTM represents the actual return an investor gets if they hold the bond until
the maturity date and reinvest all coupon payments at the same rate.
For a 5-year bond with:

●​ Face value €1,000

●​ Annual coupon €60 (since coupon rate = 6%)
●​ Current market price €950
●​ Maturity in 5 years

20. Interest Rate risk

1️⃣ Longer Maturity = Higher Interest Rate Risk 📉📈

●​ The 30-year bond experiences a much larger price change compared to the 1-year
bond when interest rates fluctuate.
●​ Why? A longer-term bond has more future cash flows that must be discounted at the
new interest rate. When rates rise, these cash flows are worth less today, causing the
bond price to drop significantly.

🔹 Example:
●​ At a 5% interest rate:
○​ 30-year bond = €1,768.62
○​ 1-year bond = €1,047.62
●​ If rates increase to 10%:
○​ 30-year bond drops to €502.11 (huge loss! as current bonds have higher
interest rate, so you have to decrease the price if you want to sell it)
○​ 1-year bond only drops to €916.67 (small loss)

📌 Conclusion:​
Investors in long-term bonds take on more risk because their prices react more sharply to
changes in interest rates.

2️⃣ Lower Coupon Rate = Higher Interest Rate Risk ⚠️

●​ A lower coupon rate means the bondholder receives less money periodically,
so the bond's value depends more on the face value at maturity.
 ●​ If interest rates rise, future cash flows (including the face value) are discounted
more heavily, leading to a greater price drop.
●​ Bonds with higher coupon payments cushion the price impact because more of the
bond's value is paid out earlier.

🔹 Example:
●​ A 5% coupon bond is less sensitive to interest rate changes than a 1% coupon
bond.
●​ Why? The 5% bond gives you higher interest payments sooner, reducing the
reliance on the final face value.

Key Takeaways:

1️⃣ If you're afraid of interest rate fluctuations, short-term bonds are safer because they
are less sensitive to rate changes.​
2️⃣ If you invest in low-coupon bonds, you take on more interest rate risk because most
of the bond’s value is tied to the distant future.

20. Time and bond price

Key Idea: Bond Prices Converge to Par Value Over Time

●​ Over time, regardless of whether a bond starts at a premium or a discount, its

price gradually moves toward its face value (par value) as it nears maturity.
 ●​ This happens because at maturity, the issuer must repay the full face value, so the
bond price naturally adjusts.

Breaking Down the Graph:

🔵
●​ The graph shows four types of bonds with different coupon rates:

🔴
○​ 10% Coupon Bond (Premium Bond → price starts above par)

🟡
○​ 5% Coupon Bond (Par Bond → price stays constant)

🟣
○​ 3% Coupon Bond (Discount Bond → price starts below par)
○​ Zero Coupon Bond (Deep Discount → price far below par)

1️⃣ Premium Bonds (10% Coupon Rate)

●​ These bonds start above 100% of face value because their coupon payments are
higher than market rates.
●​ Investors are willing to pay more upfront because they will receive higher interest
payments over time.
●​ Over time → The price falls toward face value as it approaches maturity.

2️⃣ Par Bonds (5% Coupon Rate)

●​ These bonds are priced exactly at face value (100%) because the coupon rate =
market rate.
●​ Their price remains stable over time.

3️⃣ Discount Bonds (3% Coupon Rate)

●​ These bonds start below 100% of face value because their coupon payments are
lower than market rates.
●​ Investors pay less initially to compensate for the lower interest income.
●​ Over time → The price rises toward face value.

4️⃣ Zero Coupon Bonds

●​ These bonds start at a deep discount because they do not pay periodic interest
(no coupons).
●​ Instead, they are bought at a low price and repaid at full face value at maturity.
●​ Over time → The price steadily increases toward face value.

Why Are the Curves "Kinky"?

●​ The zig-zag pattern (kinkiness) is caused by coupon payments.

●​ Each time a coupon is paid, the price drops slightly because the bondholder
receives cash, reducing the bond's value.
●​ Zero-coupon bonds do not have kinks because they do not pay periodic
interest—they just gradually increase toward par.

Key Takeaways
1️⃣ Premium bonds decline over time (since investors paid extra for high coupon
payments).​
2️⃣ Discount bonds increase over time (since they were initially underpriced due to lower
coupon payments).​
3️⃣ Zero-coupon bonds steadily increase because all value comes at maturity.​
4️⃣ All bonds, no matter the starting price, converge to par value at maturity.

As Time Passes, Future Payments Decrease in Value

●​ The closer we get to maturity, the fewer future coupon payments remain.
●​ Since coupon payments are already received year by year, the remaining value
shrinks.

By the time the bond reaches maturity, its price must be exactly $1,000 (face value).

Investors know they’ll only get $1,000 back at maturity, so no one will pay $1,200 for it in
year 29.

As a result, the bond’s price gradually declines over time.

21. Bond prices and default risk

🔹 Key Concepts:
1.​ Default Risk (Credit Risk):
○​ The risk that the issuer fails to make interest or principal payments on
time.
○​ Example: A company with financial problems might miss payments or go
bankrupt, leaving bondholders with losses
📌 Key Takeaways from the Slide:
✅ Higher credit risk → Lower bond price, Higher YTM
✅ Lower credit risk → Higher bond price, Lower YTM
✅ Credit risk is assessed by credit rating agencies (e.g., Moody’s, S&P, Fitch)

22. Bond credit ratings

Key Points:

●​ Higher ratings (AAA, AA, A, BBB) → Indicate strong ability to repay, lower risk of
default.
●​ Lower ratings (BB, B, CCC, CC, C) → Indicate higher risk of default, meaning
investors may demand a higher yield (YTM) as compensation.

Why It Matters?

●​ Bonds with higher ratings (AAA, AA) are considered safer, leading to lower
interest rates because investors are willing to accept lower returns in exchange for
safety.
●​ Bonds with lower ratings (BB and below, often called “junk bonds”) carry higher
default risk, meaning investors require a higher yield to compensate for the risk.

23. Default premium

Example Calculation

●​ 10-year U.S. Treasury Bond Yield = 4% (Risk-Free)

●​ 10-year Corporate Bond Yield = 7% (Higher Risk)
●​ Default Premium = 7% - 4% = 3%

This means investors demand an extra 3% yield to compensate for the default risk of the
corporate bond.