Chapter 16 Interest Rates And Bond Valuation

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Chapter 16Interest RatesAndBond Valuation
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Interest Rate Changes

• Causes
• Changes in SD for money
• Influences
• Individual
• Government
• Foreign investors
• Savings
• Phenomenon affecting savings next slide

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Phenomenon Affecting Savings

• Substitution Effect
• Substitute consumption for savings
• Allow for future consumption
• Income Effect
• Increased interest rates
• Save less for same consumption
• Wealth Effect
• Increased interest rates
• Implies a decrease in current wealth

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DS For Loans As A Function Of Interest Rates
Amount of Money
S
D
Interest Rate r
r0
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Yield Curve

• Interest Rates
• Are not constant
• Depend on length of
• Borrowing money
• Lending money
• Yield on Government Bonds
• Relationship Between
• Yield to maturity
• Time to maturity

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• Reinvestment Risk
• Risk of declining interest rates
• Price Risk
• Exposure to price decline
• Increase in interest rates
• Decrease in bonds price

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What Influences The Slope Of The Yield Curve?

• Lenders and Borrowers
• Want varying lengths of time
• Needs change over time
• Have different preferences regarding risk

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Term Structure Of Interest Rates

• Patterns
• Short-term rates are more variable than long-term
  rates
• Yield curve is usually upward sloping
• Inverted yield curves occur
• When the overall level of interest rates is
  relatively high

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• Spot Rate
• Yield to maturity of a zero
• Forward Rate
• Yield to maturity of a zero
• Investor purchases at some future date
• Forward Contract
• Agreement between buyers and sellers
• Holding Period Return
• Rate of return for next period

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Hypotheses Developed To Explain The Yield Curve

• LEH
• UEH
• LPH
• MSH
• Preferred Habitat Hypothesis (PHH)

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• LEH
• Holding period rates of return are the same
• UEH
• Forward rates are unbiased predictors of future
  spot rates
• LPH
• Investors prefer shorter maturities
• MSH
• The term structure is segmented
• PHH
• Change maturity preferences

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5 Different Definitions Of Yield

• Coupon or Nominal Yield
• Current Yield
• Yield to Maturity
• Yield to Call
• Realized Yield

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Pricing Bonds IN Practice

• Variables
• As the market interest rate changes
• The yield to maturity changes
• The bond price changes
• To adjust to the new yield to maturity
• The longer the maturity
• The more sensitive the bond price
• To changes in yield

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Bond Ratings

• Categories
• Next slide
• Rating Agencies
• Moody
• SP
• Fitch
• DP
• Indenture
• Loan agreement

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Categories

• Prime
• High Quality
• Upper Quality
• Medium
• Speculative
• Junk bonds
• Default

Investment Grade
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Junk Bonds

• Upper End of Speculative Grade
• Ba
• BB
• Fallen Angels 25
• Original Issue 25
• Restructuring 50

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International Bond Market

• Benefits
• Enhanced returns
• Diversification
• Risk
• Currency exchange
• Reduced Risk
• Hedging
• Forward contract
• Foreign exchange options

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Embedded Options

• Call Feature
• Sweeteners
• Flexibility
• Conversion Feature
• Conversion price
• Conversion ratio
• Conversion value

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• Why Do Investors Buy Callable Bonds?
• Sweeteners
• Why Do Firms Issue Callable Bonds?
• Flexibility