Chapter Five

Interest Rate Determination

and Bond Valuation
 Two major important risks for financial
institutions (Banks)

A. Credit Risk
• A major part of the business of financial
institutions is making loans, and the major risk
with loans is that the borrow will
not repay.
• Credit risk is the risk that a borrower
will nor repay a loan according to the terms of the
loan, either defaulting entirely or making late
payments of interest
or principal.
 Cont’d

• Once again, the concepts of adverse selection

and moral hazard will provide our framework
to understand the principles financial managers
must follow to minimize credit risk, yet make
successful loans.
• Adverse selection is a problem in the market
for loans because those with the highest credit
risk have the biggest incentives to borrow from
others.
 Cont’d

• Moral hazard plays as role as well. Once a

borrow has a loan, she / he may engage in risky
projects to produce the highest payoffs, especially
if the project is financed mostly with debt.
• Solving Asymmetric Information Problems:
financial managers have a number of
tools available to assist in reducing or eliminating
the asymmetric
information problem:
 Cont’d

1. Screening: collecting reliable information about

prospective borrowers. This has also lead some
institutions to specialize in regions or industries,
gaining expertise in evaluating particular firms or
individuals.
2. Monitoring: requiring certain actions, or prohibiting
others, and then periodically verifying that the
borrower is complying with the terms of the loan
contact.
 Cont’d

3. Long-term Customer Relationships: past

information contained in checking accounts, savings
accounts, and previous loans provides valuable
information to more easily determine credit worthiness.
4. Loan Commitments: arrangements where the bank
agrees to provide a loan up to a fixed amount, whenever
the firm requests the loan.
5. Collateral: a pledge of property or other assets that
must be surrendered if the terms of the loan are not met
( the loans are called secured loans).
 Cont’d

6. Compensating Balances: reserves that a borrower

must maintain in an account that act as collateral should
the borrower default.
7. Credit rationing: (1) lenders will refuse to lend to
some borrowers, regardless of how much interest they
are willing to pay, or (2) lenders will only finance part
of a project, requiring that the remaining part come
from equity financing.
 Cont’d
B. Interest Rate Risk
• The risk that arises for bond owners from fluctuating
interest rates is called interest rate risk.
• How much interest rate risk a bond has depends on
how sensitive its price is to interest rate changes.
• This sensitivity directly depends on two things: the
time to maturity and the coupon rate, i.e:
1. All other things being equal, the longer the time to
maturity, the greater the interest rate risk.
2. All other things being equal, the lower the coupon rate,
the greater the interest rate risk.
 Bond features and prices

• A bond is normally an interest-only loan, meaning

that the borrower will pay the interest every period,
but none of the principal will be repaid until the end
of the loan.
Coupon
• It is the stated interest payment made on a bond.
Face value
• The principal amount of a bond that is repaid at the
end of the term. Also, called par value.
 Cont’d

Coupon rate
• The annual coupon divided by the face value of a
bond.
Maturity
• Specified date on which the principal amount of a
bond is paid.
 Bond Values and Yields

• To determine the value of a bond at a particular point in

time, we need to know the number of periods remaining
until maturity, the face value, the coupon, and the market
interest rate for bonds with similar features.
• This interest rate required in the market on a bond is
called the bond’s yield to maturity (YTM). This rate is
sometimes called the bond’s yield for short.
• Given all this information, we can calculate the present
value of the cash flows as an estimate of the bond’s
current market value.
 Cont’d

• Bond value = C* [1- 1/(1 + r)t]/r + F/(1 + r)t

Bond value Present value of the coupons + Present value of
the face amount.
where
C = Coupon paid each period
r = Rate per period
t =Number of periods
F = Bond’s face value
• Interest rates and bond prices have an "inverse relationship"
– meaning, when one goes up, the other goes down.
 Finding the Yield to Maturity

• The yield to maturity (“YTM”) is the rate that makes

the market price of the bond equal to the present
value of its future cash flows. It is the unknown r.
• Given a bond value, coupon, time to maturity, and face
value, it is possible to find the implicit discount rate, or
yield to maturity, by trial and error only.
• To do this, try different discount rates until the
calculated bond value equals the given value.
• Remember that increasing the rate decreases the bond
value.
 Cont’d
• For example, suppose we are interested in a six-year,
8 percent coupon bond. A broker quotes a price of
$955.14. What is the yield on this bond? We’ve seen
that the price of a bond can be written as the sum of
its annuity and lump-sum components. Knowing that
there is an $80 coupon for six years and a $1,000 face
value, we can say that the price is:
$955.14 =$80 *[1 - 1/(1 + r)6]/r + 1,000/(1 + r)6
 Cont’d
• where r is the unknown discount rate, or yield to
maturity. We have one equation here and one
unknown, but we cannot solve it for r explicitly. The
only way to find the answer is to use trial and error.
• We can speed up the trial-and-error process by using
what we know about bond prices and yields. In this
case, the bond has an $80 coupon and is selling at a
discount. We thus know that the yield is greater than
8 percent. If we compute the price at 10 percent:
 Cont’d
• Bond value = $80 * (1 - 1/1.106)/.10 +
1,000/1.106=$80*4.3553+1,000/1.7716=$912.89
• At 10 percent, the value we calculate is lower than the
actual price, so 10 percent is too high. The true yield
must be somewhere between 8 and 10 percent. You
would probably want to try 9 percent next. If you did,
you would see that this is in fact the bond’s yield to
maturity
 Different types of bonds
1. Corporate bonds
2. Government bonds / municipal bonds
3. Zero coupon
4. Income bonds
5. Convertible bonds
6. Put bonds
7. Floating rate bonds
 Cont’d
• A particularly interesting type of floating-rate bond is
an inflation-linked bond. Such bonds have coupons
that are adjusted according to the rate of inflation (the
principal amount may be adjusted as well).
 Inflation and Interest Rates

1. Real Versus Nominal Rates

A. Nominal rates -Interest rates or rates of return that
have not been adjusted for inflation
B. Real rates- Interest rates or rates of return that have
been adjusted for inflation
2. The Fisher Effect-our discussion of real and nominal
returns illustrates a relationship often called the Fisher
effect (after the great economist Irving Fisher). Because
investors are ultimately concerned with what they can buy
with their money, they require compensation for inflation.
 Cont’d
• Therefore, the Fisher effect indicates the relationship
between nominal returns, real returns, and inflation.
• Let R stand for the nominal rate and r stand for the real rate.
The Fisher effect tells us that the relationship between
nominal rates, real rates, and inflation can be written as:
1 + R = (1 + r) * (1 + h)
where h is the inflation rate.
 The nominal rate is approximately equal to the real rate plus
the inflation rate:
R≈r+h
 Example
• If investors require a 10 percent real rate of return, and
the inflation rate is 8 percent, what must be the
approximate nominal rate? The exact nominal rate?
• First of all, the nominal rate is approximately equal to
the sum of the real rate and the inflation rate: 10% +
8% = 18%. From the Fisher effect, we have:
1 + R = (1 + r) * (1 + h) = 1.10 * 1.08 = 1.1880
R=1.1880-1=18.8%
Therefore, the nominal rate will actually be closer to 19
percent.
 Determinants of Bond Yields
1. The Term Structure of Interest Rates
• The term structure of interest rates is the relationship
between nominal interest rates on default-free, pure
discount securities and time to maturity.
• To be a little more precise, the term structure of
interest rates tells us what nominal interest rates are
on default-free, pure discount bonds of all maturities.
 Cont’d
• These rates are, in essence, “pure” interest rates
because they involve no risk of default and a single,
lump-sum future payment.
• In other words, the term structure tells us the pure
time value of money for different lengths of time.
• When long-term rates are higher than short-term
rates, we say that the term structure is upward
sloping, and, when short-term rates are higher, we say
it is downward sloping.
Cont’d
Cont’d
 Cont’d
• The term structure can also be “humped.” When this
occurs, it is usually because rates increase at first, but
then begin to decline as we look at longer- and longer
term rates.
• The most common shape of the term structure,
particularly in modern times, is upward sloping, but
the degree of steepness has varied quite a bit.
 Cont’d
• What determines the shape of the term structure?
There are three basic components. The first two are
the ones we discussed in our previous section, the real
rate of interest and the rate of inflation.
• The real rate of interest is the compensation investors
demand for forgoing the use of their money. You can
think of it as the pure time value of money after
adjusting for the effects of inflation.
• When the real rate is high, all interest rates will tend
to be higher, and vice versa
 Cont’d
• In contrast, the prospect of future inflation very
strongly influences the shape of the term structure.
• Investors thinking about loaning money for various
lengths of time recognize that future inflation erodes
the value of the dollars that will be returned. As a
result, investors demand compensation for this loss in
the form of higher nominal rates. This extra
compensation is called the inflation premium.
• Therefore, inflation premium is defined as the
portion of a nominal interest rate that represents
compensation for expected future inflation.
 Cont’d
• If investors believe that the rate of inflation will be
higher in future, then long-term nominal interest rates
will tend to be higher than short-term rates. Thus, an
upward sloping term structure may be a reflection of
anticipated increases in inflation. Similarly, a
downward-sloping term structure probably reflects
the belief that inflation will be falling in the future.
 Cont’d
• The third, and last, component of the term structure
has to do with interest rate risk. As we discussed
earlier in the chapter, longer-term bonds have much
greater risk of loss resulting from changes in interest
rates than do shorter-term bonds. Investors recognize
this risk, and they demand extra compensation in the
form of higher rates for bearing it. This extra
compensation is called the interest rate risk
premium. Therefore, interest rate risk premium is
defined as The compensation investors demand for
bearing interest rate risk.
 Cont’d
• The longer is the term to maturity, the greater is the
interest rate risk, so the interest rate risk premium
increases with maturity.
• Putting the pieces together, we see that the term
structure reflects the combined effect of the real rate
of interest, the inflation premium, and the interest rate
risk premium.
 Bond Yields and the Yield Curve
• The shape of the yield curve is a reflection of the
term structure of interest rates.
• In fact, the Treasury yield curve (which refers to a
plot of the yields on Treasury notes and bonds
relative to maturity) and the term structure of interest
rates are almost the same thing. The only difference is
that the term structure is based on pure discount
bonds, whereas the yield curve is based on coupon
bond yields
 Cont’d
• As a result, Treasury yields depend on the three
components that underlie the term structure—the real
rate, expected future inflation, and the interest rate
risk premium.
• Treasury notes and bonds have three important
features that we need to remind you of: they are
default-free, they are taxable, and they are highly
liquid.
• This is not true of bonds in general, so we need to
examine what additional factors come into play when
we look at bonds issued by corporations or
municipalities.
 Cont’d
• The first thing to consider is credit risk, that is, the
possibility of default. Investors recognize that issuers
other than the Treasury may or may not make all the
promised payments on a bond, so they demand a higher
yield as compensation for this risk. This extra
compensation is called the default risk premium.
• The second thing to consider is tax, that is, investors
demand the extra yield on a taxable bond as
compensation for the unfavorable tax treatment. This
extra compensation is the taxability premium or it is
the portion of a nominal interest rate or bond yield that
represents compensation for unfavorable tax status.
 Cont’d
• Finally, bonds have varying degrees of liquidity. As a
result, if you wanted to sell quickly, you would
probably not get as good a price as you could
otherwise. Investors prefer liquid assets to illiquid
ones, so they demand a liquidity premium on top of
all the other premiums we have discussed. liquidity
premium is the portion of a nominal interest rate or
bond yield that represents compensation for lack of
liquidity. As a result, all else being the same, less
liquid bonds will have higher yields than more liquid
bonds.
 Conclusion

• If we combine all of the things we have discussed

regarding bond yields, we find that bond yields
represent the combined effect of no fewer than six
things. The first is the real rate of interest. On top of
the real rate are five premiums representing
compensation for (1) expected future inflation, (2)
interest rate risk, (3) default risk, (4) taxability, and
(5) lack of liquidity. As a result, determining the
appropriate yield on a bond requires careful analysis
of each of these effects.
End of chapter five!
 Chapter Six

Financial Markets and Institutions in

Ethiopia-Group Assignment

Prepare your own term paper on the current

status of financial sector and financial market in
Ethiopia