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Chapter 6

ECON 2560 - Chapter 6.docx

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ECON 2560
Nancy Bower

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Theory of Finance – Chapter 6 INTEREST RATES AND BOND PRICES Bond: Government and corporations borrow money from investors by selling them bonds o The money governments or companies collect when bonds are issued is the amount of their debt o As borrowers, they promise to make a series of interest payments and then to repay the debt at the maturity date  A bond is a debt security, under which the issuer (government or companies) owes the holders (investors) a debt, and is obligated to pay them interest (coupon) and to repay when the maturity level expires. Coupon: Interest payment paid to the bondholder from the government or corporations; coupon payments = interest payments o At maturity, the debt is repaid, when the borrower pays the bond’s face value to the bondholders o Before computers, a typical bond had paper coupons that the investors (bondholders) had to clip off and mail to the bond issuer to claim the interest payment Coupon Rate = Bond’s Coupon/Face Value Face Value: Payment due at the bond’s maturity Maturity: The date at which the loan will be paid off (when you will get your interest payment) Coupon Rate: The annual interest payment divided by the face value of the bond o How much the interest the company is paying out o Calculated as a percentage of face value o Stays the same throughout the life of the bond Example: Telus bond has a fixed coupon payment, based on its 5.05 percent coupon rate, and the bond will mature in July 2020. Telus has to make coupon payments for 10 years and then has to repay the $1 billion face value. Dividend: Your return of the money you invested in stock o It is your payout from stock shares Interest Rate (Discount Rate): The rate at which the cash flows from the bond are discounted to determine its present value  The coupon rate and the discount rate are NOT necessarily the same! When they are not, the price of the bond is NOT the same as its face value  The price of a bond is the present value of all its future cash flows  it is the present value of the coupon payments and the face value of the bond. In calculating the PV, the ‘appropriate’ opportunity cost has to be used  Buyer needs to compensate seller for interest earned between last coupon payment and purchase date Accrued Interest: Coupon interest earned from the last coupon payment to the purchase date of the bond Accrued Interest = Coupon Payment x # of days from last coupon to purchase # of days in coupon period Assume 180 days in a coupon period – every month has 30 days Quoted bond prices are clean bond prices o They do not include any interest accrued since last coupon payment o Excluding accrued interest  When the coupon rate is equal to the required return, the bond sells at face value (at par)  When the coupon rate is higher than the required return, the bond sells above face value (at a premium)  When the coupon rate is lower than the required return, the bond sells below face value (at a discount)  when cash flows are discounted at a rate that is higher than the bond’s coupon rate it is less than its face value  Bond is an annuity of coupon payments + repayment of face value at maturity Calculating PV of Bonds  When you calculate the PV of bonds, remember that you are calculating the PRICE OF THE BOND o The price of the bond is the PV of all its future coupon payments that are to be paid to the beholder, plus its face value o Coupon payments are an annuity  PV = PV (coupon payments) + PV (face value): t t Price of a bond = C x [1/r – 1/r(1+r) ] + Face Value/(1+r) o Use formula to calculate price of a bond or coupon rate Relationship Between: Coupon Rate, YTM, Current Yield, ROR  When the interest rate increases, the price of the bond decreases  When the coupon rate and the market rate are the same, the price of the bond is face value  Coupon rate > interest rate; bond is selling at a premium  Coupon rate < interest rate; bond is selling at a discount Semi – Annual Payments: Implies that the annual coupon payment is paid in two equal installments, every 6 months o This, the time line must be in six – month periods o You need to compute the six – month required return If they are semi – annual coupon payments: 1. Divide coupon payments by 2 2. Multiply the number of years by 2 3. Divide the discount rate by 2 Current Yield: Annual coupon payment divided by the bond price o The return on one particular coupon payment of a bond o If a bond sells at par, current yield = coupon rate o If a bond sells at a premium, current yield < coupon rate (increase denominator making it less for the coupon rate o If a bond sell
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