Interest Rates and Bond Valuation
Bond Value =C r + (1+r) t
C = Coupon payment
R = yield-to-maturity
F = face/par value
T= number of periods
If the YTM is greater than the coupon rate, the par value is greater than the bond price and it is
a discount bond/bond price.
If the YTM is less than the coupon rate, the par value is less than the bond price and it is a
premium bond/bond price.
The longer the term to maturity, the greater the interest rate risk.
The lower the coupon rate, the greater the interest rate risk.
C + F − B
F = face value
B = bond price
C = coupon
T = periods
The Fisher effect
(1+R) = (1+r)(1+h)
R ≈ r + h R = nominal rate of interest
r = real rate of interest
h= expected inflation rate
Factors affecting required return:
• Default risk premium – bond rating
• Liquidity premium – bonds that have more frequent trading will generally have lower
• Maturity risk premium – because of interest rate risk, there is a rising maturity risk
premium as term to maturity increases
• Anything else that affects the risk of the cash flows to the bondholders, wi