Chapte r7 Interest Rates and Bond
Valuation

7-1
McGraw-Hill/Irwin

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline
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7-2

Bond Definition
Bond Features
Valuation of a Bond
Bond Relationships
Inflation and Interest Rates
Determinants of Bond Yields
Bond Ratings
Bond Markets

Chapter Outline
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7-3

Bond Definition
Bond Features
Valuation of a Bond
Bond Relationships
Inflation and Interest Rates
Determinants of Bond Yields
Bond Ratings
Bond Markets

What is a bond? 7-4

7-5

A bond is a contract between two parties: one is the investor
(you) and the other is a company or a

Chapter Outline
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7-6

Bond Definition
Bond Features
Valuation of a Bond
Bond Relationships
Inflation and Interest Rates
Determinants of Bond Yields
Bond Ratings
Bond Markets

You are the investor

7-7

The company (or government A bond contains three key items:
1. The par value
(usually $1,000)
2. The length of time
(often 10 or 20 years) 7-8

3. A coupon interest rate You lend money to the borrower and you will get back your original investment plus interest. 7-9

The interest is determined by the coupon interest rate.

For example:
A 6% coupon interest rate yields:
(the coupon interest rate) x ( the par value)
(6%) x ($1,000) = $60 per year for each year of the bond.
7-10

Let’s look at this visually using the time line:

1

2

3

4

5

$60 $60 $60 $60 $60

7-11

Let’s look at this visually using the time line:
Now let’s add the maturity value…
1

2

3

4

5

$60 $60 $60 $60 $60
$1,000
7-12

So the investor receives the principle ($1,000) and earned interest ($60 per year) as payment for loaning the company money.

7-13

Types of Bonds
1. Government Bonds
2. Zero Coupon Bonds
3. Floating-Rate
Bonds
4. Catastrophe (Cat)
Bonds
5. Income Bonds
6. Convertible Bond
7. Put Bond
8. Sukuk
9. James Bond
7-14

Chapter Outline
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7-15

Bond Definition
Bond Features
Valuation of a Bond
Bond Relationships
Inflation and Interest Rates
Determinants of Bond Yields
Bond Ratings
Bond Markets

Our task:
To Value a
Bond
7-16

And how will we accomplish this task?

7-17

7-18

B
A
E
F
E
I
P
V
T

Bring
All
Expected
Future
Earnings
Into
Present
Value
Terms

Just remember:

BAEFEIPVT
7-19

From the previous chapters on the time value of money you know how to bring back a single payment
(lump sum) and an annuity. To value a bond, just put both pieces together!
7-20

Let’s look at this visually using the time line:
1.The annuity
2.The single
0
1
2
3(lump
4
5 payment sum)

$60 $60 $60 $60 $60
$1,000

7-21

Now bring each back into present value terms:
First the annuity…
Secondly, the lump sum…
0

1

2

3

4

5

$60 $60 $60 $60 $60
$1,000
7-22

1


1
t
F
V
(
 r )
B
ondV alue C

t
(
1 r )

The Bond Pricing
Equation

Notice that r = the discount rate used to bring back the future dollars.
This discount rate has a name in bonds:
The Yield to Maturity (YTM).
7-23

Your finance calculator can compute both parts (the annuity and the lump sum) simultaneously 7-24

A bond valuation example: 7-25

• 5 year bond
• 14% as the discount rate (YTM)
• 6% coupon interest rate • $1,000 maturity

TI BA II Plus

5 years = N

-725.35
14% = Discount rate (YTM)

$60 = Payment (PMT)
$1,000 = FV

1st
2nd
7-26

PV = ?

A bond valuation example: 7-27

• 5 year bond
• 14% as the discount rate (YTM)
• 6% coupon interest rate • $1,000 maturity

Using Excel to value a bond

• There is a specific formula for finding bond prices on a spreadsheet – PRICE(Settlement,Maturity,Rate,Yld,Redemption
, Frequency,Basis)
– YIELD(Settlement,Maturity,Rate,Pr,Redemption,
Frequency,Basis)
– Settlement and maturity need to be actual dates – The redemption and Pr need to be input as % of par value

• Click on the Excel icon for an example: 7-28

Student alert!

7-29

Notice that we have two
“interest numbers” in our bond problem:
1. The coupon interest rate (6% in our example) and
2. The