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CHAPTER 4Bonds and Their Valuation Key features of bonds Bond valuation Measuring yield Assessing risk Key Features of a Bond How does adding a call provision affect a bond? Issuer can refund if rates decline. That helps the issuer but hurts the investor. Therefore, borrowers are willing to pay more, and lenders require more, on callable bonds. Most bonds have a deferred call and a declining call premium. What’s a sinking fund? Provision to pay off a loan over its life rather than all at maturity. Similar to amortization on a term loan. Reduces risk to investor, shortens average maturity. But not good for investors if rates decline after issuance. Financial Asset Valuation The discount rate (ri) is the opportunity cost of capital, i.e., the rate that could be earned on alternative investments of equal risk. What’s the value of a 10-year, 10% coupon bond if rd = 10%? What would happen if inflation fell, and rd declined to 7%? Suppose the bond was issued 20 years ago and now has 10 years to maturity. What would happen to its value over time if the required rate of return remained at 10%, or at 13%, or at 7%? At maturity, the value of any bond must equal its par value. The value of a premium bond would decrease to $1,000. The value of a discount bond would increase to $1,000. A par bond stays at $1,000 if rd remains constant. What’s “yield to maturity”? YTM is the rate of return earned on a bond held to maturity. Also called “promised yield.” What’s the YTM on a 10-year, 9% annual coupon, $1,000 par value bond that sells for $887? If coupon rate < rd, bond sells at a discount. If coupon rate = rd, bond sells at its par value. If coupon rate > rd, bond sells at a premium. If rd rises, price falls. Price = par at maturity. Find YTM if price were $1,134.20. Definitions Find current yield and capital gains yield for a 9%, 10-year bond when the bond sells for $887 and YTM = 10.91%. What’s interest rate (or price) risk? Does a 1-year or 10-year 10% bond have more risk
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