Bonds and Interest Rates Presentation PDF

Bonds Bond. Security that obligates the issuer to make specified payments to the bondholder. Face Value (a.k.a. Par Value or Principal Value). Payment at the maturity of the bond. Coupon. The interest payments made to the bondholder. Coupon Rate. Annual intere...

Bonds Bond. Security that obligates the issuer to make specified payments to the bondholder. Face Value (a.k.a. Par Value or Principal Value). Payment at the maturity of the bond. Coupon. The interest payments made to the bondholder. Coupon Rate. Annual interest payment as a percentage of face value. © McGraw Hill, LLC 1  Interest Rates and Bond Prices 1 WARNING. The coupon rate IS NOT the discount rate used in the Present Value calculations. The coupon rate merely tells us what cash flow the bond will produce. Since the coupon rate is listed as a %, this misconception is quite common. © McGraw Hill, LLC 2  Interest Rates and Bond Prices 2 The price of a bond is the present value of all cash flows generated by the bond (that is, interest and principal) discounted at the required rate of return. cpn cpn (cpn+par) PV  1  2 ...   (1  r ) (1  r ) (1  r ) t cpn is commonly used as an abbreviation for coupon. © McGraw Hill, LLC 3  Interest Rates and Bond Prices 6 The financial calculator functions used for the time value of money can be used for bond calculations as well. Notice how the keys map with the bond terminology. * These keys MUST reference the same time period (that is, annual, semi- annual, quarterly, monthly, etc.). Access the text alternative for slide images. © McGraw Hill, LLC 4  Interest Rates and Bond Prices 3 Cash flows to an investor in the 7.50% coupon bond maturing in 2024. Access the text alternative for these images. © McGraw Hill, LLC 5  Interest Rates and Bond Prices 4 Example. What is the price of a 7.50 % annual coupon bond, with a $1,000 face value, maturing in 4 years? Assume a required return of 3.00%. $75 $75 $75 $1,075 PV  1  2  3  1.03 1.03 1.03 1.034 PV  $1,167.27 © McGraw Hill, LLC 6  Interest Rates and Bond Prices 5 Example. What is the price of a 7.50 % annual coupon bond, with a $1,000 face value, which matures in 4 years? Assume a required return of 3.00 %. Bond prices are quoted as a percentage of par. Par Value × Price % = $ Price. 1,000 × Price % = $1,167.27. Price % = $116.727%. © McGraw Hill, LLC 7  Interest Rates and Bond Prices 8 Example. How do calculations if there are semi-annual coupons rather than annual coupon payments? Twice as many payments, cut in half, over the same time period. Access the text alternative for slide images. © McGraw Hill, LLC 8  Interest Rates and Bond Prices 12 Example. How did the calculation change, given semi-annual coupons versus annual coupon payments? Time Periods Discount Rate Paying coupons twice a Since the time periods are year, instead of once, now half years, the doubles the total number discount rate is also of cash flows to be changed from the annual discounted in the PV rate to the half year rate. formula. © McGraw Hill, LLC 9  Interest Rates and Bond Prices 9 Here are the cash flows to an investor in the 7.50% coupon bond maturing in 2024. The bond pays semiannual coupons, $37.50 twice each year. Access the text alternative for slide images. © McGraw Hill, LLC 10  Interest Rates and Bond Prices 10 Example. What is the price of the 7.50% coupon bond maturing in 4 years, if the annual required rate of return is 3.00% AND the coupons are paid semi- annually? $37.50 37.50 37.50 1,037.50 PV  1  2 ...  7  1.015 1.015 1.015 1.0158 PV  $1,168.43 © McGraw Hill, LLC 11  Interest Rates and Bond Prices 13 Example. Returning to our annual 7.50% coupon bond, maturing in 4 years, what is the price of this bond if interest rates fall from 3.00% to 2.00%? $75.00 75.50 75.50 1,075.50 PV  1  2  3  1.02 1.02 1.02 1.024 PV  $1, 209.43 © McGraw Hill, LLC 12  Interest Rates and Bond Prices 14 The 7.50% bond’s price is inversely related to interest rates. Access the text alternative for slide images. © McGraw Hill, LLC 13  Interest Rates and Bond Prices 15 Interest Rate Risk: A change in interest rates impacts long-term bonds more than short-term bonds. Access the text alternative for slide images. © McGraw Hill, LLC 14  Premium and Discount Bonds C=R ~ Selling at Par C>R ~ Premium C