Chapter 7

Interest Rates and Bond Valuation

Prepared by Anne Inglis, Ryerson University

McGraw-Hill Ryerson Copyright © 2010 McGraw-Hill Ryerson Limited

Bond Valuation Week 5:Summer
2024
factor that affect bond price
duration
case speicfic (contract base)
liquidity
rating
interest rate (long bond more affected)

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 Key Concepts and Skills
• Know the important bond features and bond
types
• Understand bond values and why they
fluctuate
• Understand bond ratings and what they
mean
• Know how bond prices are quoted
• Understand the impact of inflation on interest
rates
• Understand the term structure of interest
rates and the determinants of bond yields
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LO2
Present Value of Cash Flows as
Rates Change
• Bond Value = PV of coupons + PV of face
• Bond Value = PV annuity + PV of lump
sum
• Remember, as interest rates increase the
PV’s decrease and vice versa
• So, as interest rates increase, bond prices
decrease and vice versa

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LO2
Valuing a Discount Bond with
Annual Coupons
• Consider a bond with a coupon rate of 10%
and coupons paid annually. The par value is
$1000 and the bond has 5 years to maturity.
The yield to maturity is 11%. What is the
value of the bond?
• Using the formula:
• B = PV of annuity + PV of lump sum
• B = 100[1 – 1/(1.11)5] / .11 + 1000 / (1.11)5
• B = 369.59 + 593.45 = 963.04
• Using the calculator:
• N = 5; I/Y = 11; PMT = 100; FV = 1000
• CPT PV = -963.04
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 Valuing a Premium Bond with
LO2
Annual Coupons
• Suppose you are looking at a bond that
has a 10% annual coupon and a face
value of $1000. There are 20 years to
maturity and the yield to maturity is 8%.
What is the price of this bond?
• Using the formula:
• B = PV of annuity + PV of lump sum
• B = 100[1 – 1/(1.08)20] / .08 + 1000 / (1.08)20
• B = 981.81 + 214.55 = 1196.36
• Using the calculator:
• N = 20; I/Y = 8; PMT = 100; FV = 1000
• CPT PV = -1196.36
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LO2
The Bond-Pricing Equation

é 1 ù
1 -
ê (1 + r) t ú F
Bond Value = C ê ú+
ú (1 + r)
t
ê r
êë úû

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LO2
Example – Semiannual Coupons
• Most bonds in Canada make coupon
payments semiannually.
• Suppose you have an 8% semiannual-pay
bond with a face value of $1,000 that
matures in 7 years. If the yield is 10%,
what is the price of this bond?
• The bondholder receives a payment of $40
every six months (a total of $80 per year)
• The market automatically assumes that the
yield is compounded semiannually
• The number of semiannual periods is 14
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LO2
Example – Semiannual Coupons
continued
é 1 ù
êë1 - 1.0514 úû 1,000
Bond Price = 40 ´ + 14
= 901.01
0.05 1.05

• Or PMT = 40; N = 14; I/Y = 5; FV = 1000; CPT PV =

-901.01

7-8
LO2
Interest Rate Risk
• Arises from fluctuating interest rates
• Two things determine how sensitive a
bond will be to interest rate risk:
1. Time to Maturity – All other things being
equal, the longer the time to maturity, the
greater the interest rate.
2. Coupon rate – All other things being equal,
the lower the coupon rate, the greater the
interest rate risk.

7-9
LO2
Figure 7.2 – Interest Rate Risk and
Time to Maturity

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LO2
Computing Yield-to-Maturity
• Yield-to-maturity is the rate implied by the
current bond price
• Finding the YTM requires trial and error if
you do not have a financial calculator and
is similar to the process for finding r with
an annuity
• If you have a financial calculator, enter N,
PV, PMT and FV, remembering the sign
convention (PMT and FV need to have the
same sign, PV the opposite sign)
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LO2
Example – Finding the YTM
• Consider a bond with a 10% annual
coupon rate, 15 years to maturity and a
par value of $1000. The current price is
$928.09.
• Will the yield be more or less than 10%?
• N = 15; PV = -928.09; FV = 1000; PMT = 100
• CPT I/Y = 11%

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LO2
YTM with Semiannual Coupons
• Suppose a bond with a 10% coupon rate
and semiannual coupons has a face value
of $1000, 20 years to maturity and is
selling for $1197.93.
• Is the YTM more or less than 10%?
• What is the semiannual coupon payment?
• How many periods are there?
• N = 40; PV = -1197.93; PMT = 50; FV = 1000;
CPT I/Y = 4% (Is this the YTM?)
• YTM = 4%*2 = 8%
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LO3
Differences Between Debt and
Equity 7.2
• Debt
• Not an ownership interest
• Bondholders do not have voting rights
• Interest is considered a cost of doing
business and is tax deductible
• Bondholders have legal recourse if
interest or principal payments are
missed
• Excess debt can lead to financial
distress and bankruptcy
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LO3
Differences Between Debt and
Equity Continued
• Equity
• Ownership interest
• Common shareholders vote for the board of
directors and other issues
• Dividends are not considered a cost of doing
business and are not tax deductible
• Dividends are not a liability of the firm and
shareholders have no legal recourse if
dividends are not paid
• An all equity firm can not go bankrupt
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 Figure 7.5 – Government of Canada Yield
LO6 Curve
February 13, 2009

7-16
7-17
 Government of Canada bond
yield curve
• Government of Canada Bond Yield Curve
(ustreasuryyieldcurve.com)

7-18