Financial Markets and Institutions

9th Edition
by Jeff Madura

2010 South-Western/Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

8
Bond Valuation and Risk
Chapter Objectives
The specific objectives of this chapter are to:
explain how bonds are priced,
identify the factors that affect bond prices,
explain how the sensitivity of bond prices to interest rates is dependent on
particular bond characteristics,
describe common strategies used to invest in bonds, and
explain the benefits of diversifying bonds internationally.

2010 South-Western/Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Bond Valuation Process

1. Current price of a bond (PV)

C
C
C par
PV

...
1
2
n
1 k 1 k
1 k
where C = coupon payment paid in each period
Par = par value
k = required rate of return
n = number of period to maturity
2010 South-Western/Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Bond Valuation Process

2. Impact of the Discount Rate on Bond Valuation
a. Critical to accurate bond valuation
b. High risk securities have higher discount rates

2010 South-Western/Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Bond Valuation Process

3. Impact of the Timing of Payments on Bond
Valuation
a. Timing affects the market price of a bond
b. Funds received sooner can be reinvested to earn additional
returns

4. Impact of Bonds with Semiannual Coupons

a. Coupon = C/2
b. Number of payments = doubled
c. Annual discount = k/2

2010 South-Western/Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Relationship between Coupon Rate, Required

Return, and Bond Price
1. Bonds selling below par
a. If coupon rate is below required rate, present value of the bond is
below par
b. Known as a discount bonds

2. Bonds selling at par

a. If coupon rate equals the required rate, the price of the bond is
equal to par value
2010 South-Western/Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Relationship between Coupon Rate, Required

Return, and Bond Price
3. Bonds selling above par
a. If the coupon rate is above the required rate, the price of the
bond
is above the par
b. known as a premium bond

2010 South-Western/Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Explaining Bond Price Movements

1. Factors That Affect the Risk-Free Rate
a. Inflationary Expectations
b. Economic Growth
c. Money Supply Growth
d. Federal Government Budget Deficit

2010 South-Western/Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Explaining Bond Price Movements

2. Factors That Affect the Credit (Default) Risk
Premium
a. Impact of the Credit Crisis on Credit Risk
b. Changes in the Credit Risk Premium over Time
c. Changes in Bond Ratings over Time
d. Impact of Issuer-Specific Characteristics on Credit Risk

2010 South-Western/Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Sensitivity of Bond Prices to Interest Rate

Movements
1. Bond Price Elasticity
a. Influence of Coupon Rate on Bond Price Sensitivity
b. Influence of Maturity on Bond Price Sensitivity

2. Duration
a. Duration of a Portfolio
b. Modified Duration
c. Estimation Errors from Using Modified Duration
d. Bond Convexity
2010 South-Western/Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

10

Sensitivity of Bond Prices to Interest Rate

Movements
3. Bond Investment Strategies
a. Matching Strategy
b. Laddered Strategy
c. Barbell Strategy
d. Interest Rate Strategy

2010 South-Western/Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

11

Valuation and Risk of International Bonds

1. Influence of Foreign Interest Rate Movements
2. Influence of Credit Risk
3. Influence of Exchange Rate Fluctuations
4. International Bond Diversification
a. Reduction of Interest Rate Risk
b. Reduction of Credit Risk
c. Reduction of Exchange Rate Risk
2010 South-Western/Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

12