Chapter 06 BUA321 Content Coordinator: Dr. Lawrence Byerly Chapter 6 Interest Rates and Bond Valuation 1) What is the real rate of interest? Can this rate be controlled? Base rate created by supply and demand Extremely low now (.3 to .5%) 2) What is the risk free rate? Can we find this interest rate? Rate on treasury securities Real rate + inflation Yahoo finance to find current rates a) The government offers I-Bonds. These bonds are identical to the usual government bonds, except that they are inflation adjusted. b) What does inflation adjusted mean? The value of the security and the cash flows keep pace with inflation Is this good or bad? c) What is the relation between the returns of the US Treasury Bond and the I-Bond? I bond has lower returns Why? d) What is the relationship between the prices? I bonds have higher prices 3) What is the Term Structure of Interest Rates? A table of the yields of treasury securities and their maturities. A yield curve is a picture of this.
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Chapter 06 BUA321
Content Coordinator: Dr. Lawrence Byerly
Chapter 6 Interest Rates and Bond Valuation
1) What is the real rate of interest? Can this rate be controlled?
Base rate created by supply and demand Extremely low now (.3 to .5%)
2) What is the risk free rate? Can we find this interest rate?
Rate on treasury securities Real rate + inflation Yahoo finance to find current rates
a) The government offers I-Bonds. These bonds are identical to the usual government
bonds, except that they are inflation adjusted.
b) What does inflation adjusted mean?
The value of the security and the cash flows keep pace with inflation Is this good or bad?
c) What is the relation between the returns of the US Treasury Bond and the I-Bond?
I bond has lower returns Why?
d) What is the relationship between the prices?
I bonds have higher prices
3) What is the Term Structure of Interest Rates?
A table of the yields of treasury securities and their maturities. A yield curve is a picture of this.
Chapter 06 BUA321
Content Coordinator: Dr. Lawrence Byerly
4) What is the relationship between the stock market and the bond market?
http://stockcharts.com/charts/yieldcurve.html
Inverse relationship Stock price up bond prices down Stock returns down bind returns up
5) How can you explain the two theories of how the yield curve is created?
a) Expectations Theory
Interest rates are created by the expectations of investors about future rates and inflation. The curve reflects expected future inflation. An upward sloping curve implies inflation increasing.
b) Liquidity Preference Theory
To get people to invest long term you must pay them.
6) The real rate of interest is 2.45%. The inflation premium is 3.13%. What is the approximate
nominal rate?
a) What is the Fisher Effect nominal rate?
This is the risk free rate based on economic theory. Only appropriate for Treasury securities.
Chapter 06 BUA321
Content Coordinator: Dr. Lawrence Byerly
b) Are these equal? Why or why not?
NO Fisher effect is theoretical; only reflects treasury securities Approximation is not mathematically correct (no time value) Reflects risky assets
7) Can you describe a corporate bond? What are its characteristics?
Interest only debt Fixed coupon; $1000 principal Typically pays interest semi-annually
8) How do the following factors impact interest rates? Prices of Bonds?
a) Length to maturity
b) the size of the offering
c) the default risk of the issuing firm
d) the cost of money in the capital market
a) longer ; higher
b) larger ; higher
c) higher; higher
d) higher ; higher
price the opposite
Chapter 06 BUA321
Content Coordinator: Dr. Lawrence Byerly
9) How does this table reflect risk? What is true in general about the prices of differently rated
bonds?
The higher in the table the lower the risk; lower chance of default Higher prices
10) Basic Valuation Model
11) Let’s review the basic investment rules
a) If Value >= Price, buy the asset
i) Price is known, so we must solve for value
What happens if CCF, rises What happens if r increases What is r
Chapter 06 BUA321
Content Coordinator: Dr. Lawrence Byerly
b) If Expected return >= required return, buy the asset
i) Expected return = return if we buy at the current price and the cash flows actually
occur
ii) Required return reflects risk, inflation, and real rates of return
12) You can buy a 30 year zero coupon bond with a required return of 8%. What is the value of
this bond?
13) A bond is selling for $900. It has a coupon of 3.5% and a maturity of 20 years. This bond
has a S&P rating of AA. What is the value of the bond? If you purchased this bond, what
would the YTM be?
14) What causes bond prices to change over time?
Interest rates (market risk) Risk of the company (company risk) time
Chapter 06 BUA321
Content Coordinator: Dr. Lawrence Byerly
15) What is a Bond? This might clear up some questions!!
http://www.youtube.com/watch?feature=player_detailpage&v=eE-vj43wHOQ
16) Final analysis let’s discuss the following questions:
a) If you buy a bond today for $900 that matures in 20 years, what will its value be in 10
years?
b) When it matures in 20 years, what is its value?
c) When you by a bond, how do you make money? Interest paid semi-annually Receive $1,00 when it matures What is the chance that you will not get these?
17) Bond Examples
What is the value of a 15 year, 5% coupon bond with a required return of 8%?
Chapter 06 BUA321
Content Coordinator: Dr. Lawrence Byerly
18) What is the value of a 15 year, 10% coupon bond with a required return of 8%?
19) If you bought the bond in (a) for its value, what is your YTM? Would you buy this bond?
20) If you bought the bond in (b) for its value, what is your YTM? Would you buy it?
21) Describe the return earned on bond (a)? bond (b)?
Both return 8% How the return comes is different Which will the investor want if the risks are equal?
a) How can you reconcile this?
Discuss different types of investors. Wealthy retired
Par Value $1,000.00 Bond Value $743.22
Annual Coupon 5.00%
Coupon per Period 5.00% Yield to Maturity 8.00%
Required Return 8.00% if semi-annual, multiply by 2
Time to Maturity 15 Yield to Call 9.92%
Compounding Frequency 1
Price 743.22$ Realized Yield to Maturity#NUM!
Current Yield 6.73%
Chapter 06 BUA321
Content Coordinator: Dr. Lawrence Byerly
Homework (39 points) ______ Research (22 points) ________
Chapter 6 Homework assignment (Problems are from the textbook.)
1) The current interest rate for a 5 year Treasury note is .75%. IF the current inflation rate is .1% what is the real rate.
.65%
2) The current rate on a 30 year Treasury bond is 3.2%. If the real rate is approximately 2%, what is the inflation rate.
1.2%
3) If a corporate AAA rated bond yields 5.6%, what is the risk premium given the 30 year treasury rate in question 2?
2.4%
4) Valuation (time value worksheets) (6)
Cash flow Discount rate Value
0
1 2000
2 2000
3 2000
10% 4973
0
1 250
2 350
3 450
4 750
8% 1440
0
1 – 19 0
20 2,750
7.75% 618
Chapter 06 BUA321
Content Coordinator: Dr. Lawrence Byerly
5) Business finance / bond valuation (5) Bond Valuation spreadsheet
6) Complete the following table: (5)
The following are 2 points each (14)
7) What is the nominal rate of return if the real rate is 3%, the inflation premium is 6%, and the risk premium is 0??
9%
8) What type of asset is in question 7?
Risk free
Bond Maturity Coupon Required return
Value
A 10 5 7 859
B 25 6.5 4.5 1296
C 30 3.75 5 807
D 95 1.75 8 219
E 100 0 6.5 1.84
Bond Maturity Coupon Price YTM
A 12 5 $987 5.15%
B 20 6.5 $1,016 6.36%
C 15 3.75 $1,000 3.75%
D 40 1.75 $378 5.76%
E 100 0 $176 1.75%
Chapter 06 BUA321
Content Coordinator: Dr. Lawrence Byerly
9) A corporation is issuing a AA rated bond. The average return for a AA bond is 7%. The coupon rate is 9% with a 25 year maturity. What is the value of this bond?
1233
10) If you can buy the bond in question 9 now at 1100, what would your YTM be?
8.06
11) If the company issuing the bond in question 9 undergoes some bad times and in 5 years the rating drops to BB, what will the value be in 5 years if the yield on BB bonds at that time is 10%?
914
12) If you waited and then purchased the above bond in 5 years for 850, what would your YTM be then?
10.87
13) The bond in question 9 is callable in 10 years. The price is currently $1,100. If the call premium is the par value and one years interest what is the yield to call?
8.12
Chapter 06 BUA321
Content Coordinator: Dr. Lawrence Byerly
Chap 6 Web Exercise
Go to www.finra.org / investors / market data
For company data input your company’s ticker symbol
Does your company have bonds? If not, choose one of its competitors.
Click on the hyperlink to see “more bond information”
How many bonds are listed? (1)
Complete the next tasks. Click on the bonds hyperlink to find the number of bonds outstanding.
Highest coupon
maturity Callable
Yes / no
Rating S&P
Price Yield Outstanding bonds
Sort by coupon
Sort by maturity
Sort by price
Sort by yield
Chapter 06 BUA321
Content Coordinator: Dr. Lawrence Byerly
Go back to www.zacks.com (click on the todays market/ composite bond rates What are the
yields on the following issues? (9pts)
Treasury Yields 3 month
5 year
30 year
Municipal AAA 5 year
10 year
20 year
Municipal A 5 year
10 year
20 year
Corporate AAA 5 year
10 year
20 year
Corporate A 5 year
10 year
20 year
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