Chapter 8
Interest Rates and Bond Valuation
Dr. Le Anh Tuan
Key Concepts and Skills
• Know the important bond features and bond types.
• Understand bond values and why they fluctuate.
• Understand bond ratings and what they mean.
• Understand the impact of inflation on interest rates.
• Understand the term structure of interest rates and the
determinants of bond yields.
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Chapter Outline
• Fixed income securities
• Bond and Bond valuation
• Types of bond
• Bond markets
• Determinants of Bond Yields
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Fixed income securities
• Treasury Securities:
• holder a fixed stream of cash flows.
• This security promises to pay fixed coupon payments at a
specified dates and a fixed principal amount at the
maturity date.
• Typical assets:
• Bond (coupon payment, face value)
• Zero-coupon bond (face value)
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Fixed income securities
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Bond
• Bonds are long-term debt obligations issued by corporations
and government units.
• A bond is normally an interest-only loan, meaning that the
borrower will pay the interest every period, but none of the
principal will be repaid until the end of the loan
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Bond
• Par (Face Value): The principal amount of a bond that is
repaid at the end of the term
• Coupon: The stated interest payment that the bond issuer
promise to pay.
• Coupon rate: The annual coupon divided by the face value
of a bond, which disclose in percentage.
• Maturity date: The date on which the par value must be
repaid.
• Yield (YTM): The rate required in the market on a bond.
• Credit rating: The classification of the bond in term of its
risk, executed by credit rating agency
• Call provision: The provision whereby the issuer may pay
bonds off prior to maturity.
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Bond valuation
Bond value = PV of the coupons (annuity) + PV of the face value
𝟏
𝟏− 𝒕 𝑭
𝟏+𝑹
Bond value = 𝑪× +
𝑹 (𝟏 + 𝑹)𝒕
• Bond prices and market interest rates move in opposite
directions.
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Bond Example
Suppose the company issues a bond with 10 years to
maturity. The bond has an annual coupon of $80. Similar
bonds have a yield to maturity of 8 percent. Based on our
preceding discussion, the bond will pay $80 per year for the
next 10 years in coupon interest. In 10 years, will pay $1,000
to the owner of the bond. What would this bond sell for?
𝟏
𝟏− 𝟏𝟎 𝟏𝟎𝟎𝟎
𝟏 + 𝟎. 𝟎𝟖
𝐏𝐕 = 𝟖𝟎× + = 𝟏𝟎𝟎𝟎
𝟎. 𝟎𝟖 (𝟏 + 𝟎. 𝟎𝟖)𝟏𝟎
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YIELD TO MATURITY
• YTM also called required rate of return / market rate /
internal rate of return.
• The coupon rate is often different from the yield.
When the value = principal, however, the coupon rate
equals the yield.
• The YTM can be thought of as the EAR.
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Bond Concepts
Bond prices and market interest rates move in opposite
directions.
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)
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YTM and Bond Value
When the YTM > coupon, the bond trades at a discount.
Access the text alternative for slide images
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Interest Rate Risk
• Interest Rate Risk: the risk that arises for bond owners from
fluctuating interest rates.
• How much interest rate risk a bond has depends on how
sensitive its price is to interest rate changes.
• Two components:
• Price risk
• Re-investment risk
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Price Risk
• This is the risk that the price of a bond will fall due to a rise 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.
• Low coupon means the value of bond depend mostly on Par
value.
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Reinvestment Rate Risk
• This is the risk that cash flows (like coupon payments or
matured principal) will be reinvested at lower interest rates if
rates fall.
• 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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Maturity and Bond Price Volatility
face value
Consider two otherwise
identical bonds.
The long-maturity bond
will have much more
volatility with respect to
changes in the discount
rate.
A large portion of the
bond’s value comes from
the face value => The PV
of the face value will be
much more volatile with a
longer-term bond
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Coupon Rates and Bond Prices
Consider two otherwise
identical bonds.
The low-coupon bond
will have more volatility
with respect to changes
in the discount rate.
Access the text alternative for slide images
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Computing Yield to Maturity
Yield to maturity is the rate implied by the current bond
price.
Finding the YTM requires trial and error if you do not
have a financial calculator, and it is similar to the
process for finding r with an annuity.
If you have a financial calculator, enter N, PV, PMT, and
FV, remembering the sign convention (PMT and FV
need to have the same sign, PV the opposite sign).
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YTM with Annual Coupons
Consider a bond with a annual coupon rate of 10%. 15
years to maturity, and a par value of $1,000. The current
price is $928.09. What is a YTM?
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YTM with Annual Coupons
Consider a bond with a annual coupon rate of 10%. 15
years to maturity, and a par value of $1,000. The current
price is $928.09. What is a YTM?
!𝟏𝟓
𝟏− 𝟏+𝒓 𝟏𝟎𝟎𝟎
𝟗𝟐𝟖. 𝟎𝟗 = 𝟏𝟎𝟎 ∗ + +
𝒓 (𝟏 + 𝒓)𝟏𝟓
𝒀𝑻𝑴 = 𝒓 = 𝟏𝟏%
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YTM with Semiannual Coupons
Consider a bond with a coupon rate of 10%, semiannual
coupons. 20 years to maturity, and a par value of
$1,000. The current price is $1,197.93. What is a YTM?
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YTM with Semiannual Coupons
Consider a bond with a coupon rate of 10%, semi-
annual coupons. 20 years to maturity, and a par value of
$1,000. The current price is $1,197.93. What is a YTM?
!𝟒𝟎
𝟏− 𝟏+𝒓 𝟏𝟎𝟎𝟎
𝟏, 𝟏𝟗𝟕. 𝟗𝟑 = 𝟓𝟎 ∗ + +
𝒓 (𝟏 + 𝒓)𝟒𝟎
𝒓 = 𝟒%
𝒀𝑻𝑴 = 𝟐 ∗ 𝒓 = 𝟐 ∗ 𝟒% = 𝟖%
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Major terms of bond
• Coupon rate: fixed annual interest the bond pays based on its
face value.
• YTM: total expected return if the bond is held to maturity,
considering: all coupon payments, the difference between price
and par value, time value of money
• Current yield: annual coupon divided by its current price.
𝐚𝐧𝐧𝐮𝐚𝐥 𝐜𝐨𝐮𝐩𝐨𝐧
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐲𝐢𝐞𝐥𝐝 =
𝐩𝐫𝐢𝐜𝐞
Yield to maturity = Current yield + Capital gains
yield
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Current Yield versus Yield to Maturity
Example: 10 percent coupon bond, with semi-annual coupons,
face value of 1,000, 20 years to maturity, $1,197.93 price.
a. What is the current yield and YTM?
Current yield = 100/1197.93 = 8.35%
a. What will be the price of the bond is one year’s time?
Assuming no change in YTM = 8% (previous example)
𝟓𝟎 𝟏 𝟏𝟎𝟎𝟎
𝑷𝒓𝒊𝒄𝒆 𝒊𝒏 𝒐𝒏𝒆 𝒚𝒆𝒂𝒓 = . 𝟏− 𝟑𝟖
+
𝟎. 𝟎𝟒 𝟏+. 𝟎𝟒 𝟏+. 𝟎𝟒 𝟑𝟖
= 𝟏, 𝟏𝟗𝟑. 𝟔𝟖
1,193.68 −1,197.93
𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐠𝐚𝐢𝐧 𝐨𝐫 𝑷𝒓𝒊𝒄𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 = = −𝟎. 𝟑𝟓%
1,197.93
=> YTM = 8.35% – 0.35% = 8%
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Zero Coupon Bonds
• Make no annual interest payments (coupon rate = 0%)
• The entire yield to maturity comes from the difference
between the purchase price and the par value
• Cannot sell for more than par value
• Sometimes called zeroes, deep discount bonds, or original
issue discount bonds (OIDs)
• Good examples of zeroes:
• T-bills: short-term debt instruments issuedby the U.S.
government to finance government spending
• STRIPS: longer term zerocoupon bonds created by
investment banks.
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Zero Coupon Bonds: Example
Find the value of a 15-year zero coupon bond with a
$1,000 par value and a YTM of 12 percent. Assume
semiannual compounding.
𝐹 $1000
𝑃𝑉 = (
= )*
= $174.11
(1 + 𝑟) (1 + 6%)
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Types of Bond
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Type of bonds
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US Government Bonds
Issued by the US government, the largest borrower in the
world.
• T-bills: pure discount bonds with original maturity less than one
year.
• T-notes: coupon debt with original maturity between one and
ten years.
• T-bonds: coupon debt with original maturity greater than ten
years.
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Municipal Bonds (Munis)
• Issued by local governments to fund imbalances between
expenditures and receipts or to finance long-term capital
projects
• Can default, varying degrees of default risk, rated similar to
corporate debt.
• Interest received is tax-free at the federal level.
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Corporate Bonds
• Greater default risk relative to government bonds
• The promised yield (YTM) may be higher than the
expected return due to this added default risk.
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After-tax Yields
A taxable bond has a yield of 8 percent, and a municipal
bond has a yield of 6 percent. If you are in a 30 percent tax
bracket, which bond do you prefer?
• After-tax rate of return on a taxable corporate bond:
.08(1 − .3) = 5.6%
• The return on the municipal bond: 6 percent.
At what tax rate would you be indifferent between the two
bonds?
• .08(1 − T) = .6%
• T = 25%
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Bond Ratings
• The three major bond rating agencies are Moody’s,
Standard & Poor’s (S&P), and Fitch bonds are rated by
perceived default risk.
• Bonds may be either investment or speculative (i.e., junk)
grade
• Lenders generally require that bonds with low ratings pay
higher yields.
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Bond Ratings
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Bond Ratings
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Bond Markets
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Bond Markets
• Bonds are traded over the counter (OTC), meaning
that dealers buy and sell bonds from various
parties.
• Government Bonds are auctioned, and then traded
in secondary markets by dealers.
• BID - the price the dealer will pay you for a bond
• ASK - the price at which the dealer will sell you a
bond
• BID-ASK SPREAD - the positive difference between
the bid and ask prices, and it is how the dealer
makes money.
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Treasury Quotations
§ Bid price = 99.282. If
you want to sell $100
par value T-bonds, the
dealer is willing to pay
$99.282.
§ Ask price =99.292. If
you want to buy $100
par value T-bonds, the
dealer is willing to sell
them for $99.292.
§ This bond’s ask price
increase 0.01% from
yesterday
§ The yield is 6.643%.
[Link]
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Inflation and Interest Rates
Real rate of interest—change in purchasing power
• NOMINAL INTEREST RATES have not been adjusted for
inflation.
• REAL INTEREST RATE have been adjusted for inflation.
The nominal rate on an
investment is the percentage
change in the number of
The real rate on an dollars you have.
investment is the
percentage change in
how much you can
buy with your dollars
buying power
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Inflation and Interest Rates
In 2024, you deposit $1000 in the bank,
After 1 year in 2025, you get $1200
Þ Interest rate is 20% => this is a NOMINAL rate
However, in 2024, $1000 can buy 200 books ($5 for each)
In 2025, $1200 can buy 218 books ($5.5 for each)
Þ You can only buy 218 books equal to 9% increase in buying
power.
Þ The REAL RATE of return is 9%,
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THE FISHER EFFECT
(1 + R) = (1 + r) × (1 + h), where,
• R = nominal rate.
• r = real rate.
• h = expected inflation rate.
Approximation,
• R = r + h, r*h is very small (r is small, h is small)
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Inflation-Linked Bonds
• In 1997, the Treasury Department issued $7 billion of
the so-called inflation-indexed bonds.
• Key features:
• The principal amounts are adjusted for inflation
annually.
• Regular semi-annual interest payments are also
adjusted for inflation although the interest rate is
fixed for the entire life.
• 10-year notes with face value of $1,000
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Inflation-Linked Bonds
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Determinants of Bond Yields
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The Term Structure of Interest Rates
• The relation between the interest rates and time to
maturity of bonds that differ only in their time to maturity is
known as a term structure of interest.
• It is important to recognize that we pull out the effect of
default risk, different coupons, etc.
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Determinants of the shape
of the term structure
• The real rate of interest: is the compensation investors
demand for forgoing the use of their money.
• Inflation rate: the prospect of future inflation strongly
influences the shape of the term structure.
• The higher prospect of inflation mean that investors’
future money will less value. As a result, investors
demand compensation for this loss in the form of higher
nominal rates => inflation premium.
• Interest rate risk: longer-term bonds have much greater
risk of loss resulting from the more volatility of interest
rates in long-term than shorter-term bonds => interest
rate risk premium.
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Factors Affecting Required Return
• Default risk premium: based on bond ratings
• Taxability premium: Investors demand the extra
yield on a taxable bond as compensation for the
unfavorable tax treatment.
• Liquidity premium: bonds that have more frequent
trading will generally have lower required returns.
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Suggested exercises
Concept Questions
4, 17
Questions and Problems
7, 11, 12, 15, 16, 17, 18, 21, 29, 31
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