Interest Rates and Bond

Valuation

Corporate Bonds
• A bond is a long-term debt instrument indicating that a
corporation has borrowed a certain amount of money and
promises to repay it in the future under clearly defined
terms.
• The bond’s coupon interest rate is the percentage of a
bond’s par value that will be paid annually, typically in two
equal semiannual payments, as interest.
• The bond’s par value, or face value, is the amount
borrowed by the company and the amount owed to the
bond holder on the maturity date.
• The bond’s maturity date is the time at which a bond
becomes due and the principal must be repaid.

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 Financial Asset Values

0 1 2 t
r ...
Value CF1 CF2 CFt

CF 1 CF 2 CF t
V0 = + + ... + .
(1+ r )1 (1 + r )2 (1 + r )t

•The discount rate (r) is the opportunity cost

of capital, i.e., the rate that could be
earned on alternative investments of equal
risk.

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Determinants of interest rates

rd = r* + IP + MRP + DRP + LP

rd = required return on a debt security

r* = real rate of interest
IP = inflation premium
MRP = maturity risk premium
DRP = default risk premium
LP = liquidity premium

Impact of Inflation

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 Risk Premiums added to r* for
different types of debt

IP MRP DRP LP
S-T Treasury

L-T Treasury

S-T Corporate

L-T Corporate

Basic Bond Valuation

The basic model for the value, VB, of a bond is given by

the following equation:

Where
VB = value of the bond at present time
C = coupon interest paid each period
t = number of years to maturity
F = Face or par value in dollars
r = required return on a bond

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 What’s the value of a 10-year, 10%
coupon bond if rd = 10%?

0 10% 1 2 10
...
V=? 100 100 100 + 1,000

VB = $1001 + . . . + $10010 + $1,000

(1+ r d ) (1+ r d) (1+ r d )10
=

The bond consists of a 10-year, 10%

annuity of $100/year plus a $1,000 lump
sum at t = 10:

PV annuity =
PV maturity value =
PV Bond =

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What would happen if expected inflation
rose by 3%, causing rd=13%?

PV =
When rd rises, above the coupon rate, the
bond’s value falls below par, so it sells at
a discount.

What would happen if inflation fell,

and rd declined to 7%?

PV =
Price rises above par, and bond sells at a
premium, if coupon > rd.

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 The bond was issued 20 years ago and
now has 10 years to maturity. What
would happen to its value over time if
the required rate of return remained
at 10%, or at 13%, or at 7%?

Bond Value ($)

1,372 rd = 7%.

1,211

rd = 10%. F
1,000

837 rd = 13%.

775

30 25 20 15 10 5 0
Years remaining to Maturity

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 What’s “yield to maturity”?

•Yield to maturity (YTM) is the rate of

return earned on a bond held to
maturity. Also called “promised yield.”

What’s the YTM on a 10-year, 9%

annual coupon, $1,000 par value bond
that sells for $887?

0 1 9 10
rd=? ...
90 90 90
PV1 1,000
.
.
.
PV10
PVF
887 Find rd that “works”!

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 Find rd

VB = C ... + C F
(1+ r d)1 + +
(1+ r d) (1 + r d )t
N

887= ( 90 )1 + ... + ( 90 )10+ ( 1,000

1+ rd 1+rd 1+ r d)10

rd =

Find YTM if price were $1,134.20.

rd =

Sells at a premium. Because

coupon = 9% > rd = 7.08%,
bond’s value > par.

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 •If coupon rate < rd, discount.

•If coupon rate = rd, par bond.

•If coupon rate > rd, premium.

•If rd rises, price falls.

•Price = par at maturity.

What’s interest rate (or price) risk?

Does a 1-year or 10-year 10% bond
have more risk?

Interest rate risk: Rising rd causes

bond’s price to fall.
rd 1-year Change 10-year Change
5%
10%
15%

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 Value
1,500

1,000

500

0 rd
0% 5% 10% 15%

Interest Rate Risk

• Price Risk
✓Change in price due to changes in interest rates
✓Long-term bonds have more price risk than short-
term bonds
• Reinvestment Rate Risk
✓Uncertainty concerning rates at which cash flows
can be reinvested
✓Short-term bonds have more reinvestment rate
risk than long-term bonds

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Bond Ratings

• Bond ratings are designed to reflect the probability of a bond issue going
into default.

Term Structure of Interest Rates

• Term structure is the relationship between time to

maturity and yields, all else equal
• Yield curve – graphical representation of the term
structure
✓Normal – upward-sloping, long-term yields are
higher than short-term yields
✓Inverted – downward-sloping, long-term yields
are lower than short-term yields

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 Yield curve and the term
structure of interest rates
• Term structure –
relationship between
interest rates (or yields)
and maturities.
• The yield curve is a graph
of the term structure.
• An example of a Treasury
yield curve can be viewed
at the right.

Pure Expectations Hypothesis

•The PEH contends that the shape of the

yield curve depends on investor’s
expectations about future interest rates.

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Treasury Yield Curves

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