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Chapter 7.doc

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York University
ECON 4400

CHAPTER 7INTEREST RATES AND BOND VALUATIONLearning ObjectivesLO1Important bond features and types of bondsLO2 Bond values and yields and why they fluctuateLO3Bond ratings and what they meanLO4How are bond prices quotedLO5The impact of inflation on interest ratesLO6The term structure of interest rates and the determinants of bond yieldsAnswers to Concepts Review and Critical Thinking Questions1LO1 No As interest rates fluctuate the value of a government security will fluctuate Longterm government securities have substantial interest rate risk 2LO2 All else the same the government security will have lower coupons because of its lower default risk so it will have greater interest rate risk3LO4 No If the bid were higher than the ask the implication would be that a dealer was willing to sell a bond and immediately buy it back at a higher price How many such transactions would you like to do4LO4 Prices and yields move in opposite directions Since the bid price must be lower the bid yield must be higher5LO1 There are two benefits First the company can take advantage of interest rate declines by calling in an issue and replacing it with a lower coupon issue Second a company might wish to eliminate a covenant for some reason Calling the issue does this The cost to the company is a higher coupon A put provision is desirable from an investors standpoint so it helps the company by reducing the coupon rate on the bond The cost to the company is that it may have to buy back the bond at an unattractive price6LO1 Bond issuers look at outstanding bonds of similar maturity and risk The yields on such bonds are used to establish the coupon rate necessary for a particular issue to initially sell for par value Bond issuers also simply ask potential purchasers what coupon rate would be necessary to attract them The coupon rate is fixed and simply determines what the bonds coupon payments will be The required return is what investors actually demand on the issue and it will fluctuate through time The coupon rate and required return are equal only if the bond sells for exactly par7LO5 Yes Some investors have obligations that are denominated in dollars ie they are nominal Their primary concern is that an investment provides the needed nominal dollar amounts Pension funds for example often must plan for pension payments many years in the future If those payments are fixed in dollar terms then it is the nominal return on an investment that is important8LO3 Companies pay to have their bonds rated simply because unrated bonds can be difficult to sell many large investors are prohibited from investing in unrated issues 9LO3 Government bonds have no credit risk so a rating is not necessary Junk bonds often are not rated because there would no point in an issuer paying a rating agency to assign its bonds a low rating its like paying someone to kick you10LO6 The term structure is based on pure discount bonds The yield curve is based on couponbearing issues S71S72
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