Cecchetti 6e Chapter 06updated

Chapter 6
Bonds, Bond Prices, and the Determination of

Interest Rates
© 2021 McGraw-Hill. All Rights Reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw-Hill.
Learning Objectives
1. Explain the relationship between bond pricing
and present value.
2. Define the relationship among a bond’s price
and its coupon rate, current yield, yield to
maturity, and holding period return.
3. Explain how bond prices are determined and
why they change.
4. Identify the three major types of bond risk:
default, inflation, and interest rate changes.
© 2021 McGraw-Hill. All Rights Reserved. 6-2
Bond Prices
• A standard bond specifies the fixed amounts
to be paid and the exact dates of the
payments.
How much should you be willing to pay for a

bond?
• That depends on the bond characteristics.

• We will examine four basic types.
Bond Prices
1. Zero-coupon or discount bond
– Promise a single payment on a future date
– Example: Treasury bill
2. Fixed-payment loan
– Sequence of fixed payments
– Example: Mortgage or car loan
3. Coupon bond
– Periodic interest payments + principal repayment at maturity
– Example: U.S. Treasury Bonds and most corporate bonds
4. Consol
– Periodic interest payments forever, principal never repaid

Zero-Coupon Bonds
• U.S. Treasury bills (T-bills) are the most
straightforward type of bond.
– Each T-bill represents a promise by the U.S.
government to pay $100 on a fixed future date.
– No coupon payments - zero-coupon bonds
– Also called pure discount bonds (or discount bonds)
since the price is less than face value - they sell at a
discount.
• Price of $100 face value zero-coupon bond
$100

(1  i) n

Zero-Coupon Bonds
Assume i = 5%
Price of a One-Year Treasury Bill
100
  $95.24
(1  0.05)
Price of a Six-Month Treasury Bill

100
  $97.59
(1  0.05)1/ 2
© 2017 McGraw-Hill Education. All Rights Reserved. 6-6

Zero-Coupon Bonds
• For a zero-coupon bond, the relationship
between the price and the interest rate is the
same as we saw on present value calculations.
• When the price moves, the interest rate
moves with it, in the opposite direction.
• We can compute the interest rate from the
price using the present value formula.
The price of a one-year T-bill is $95.
i = ($100/$95) - 1 = 0.0526 = 5.26%
Fixed-Payment Loans
Conventional home mortgages and car loans are
fixed-payment loans.
– They promise a fixed number of equal payments at
regular intervals.
– Amortized loans - the borrower pays off part of the
principal along with the interest for the life of the
loan.
• Value of a Fixed Payment Loan =
FixedPayment FixedPayment FixedPayment
 2   n
 (1 i) (1 i) (1 i)
• The sum of the present value of the payments.

 © 2021 McGraw-Hill. All Rights Reserved. 6-8
Coupon Bonds
• The issuer of a coupon bond promises to make
a series of periodic interest payments (coupon
payments), plus a principal payment at
maturity.
Price of Coupon Bond =

Consols
• Consols or perpetuities, are like coupon bonds
whose payments last forever.
• The borrower pays only interest, never repaying
the principal.
• The U.S. government sold consols once in 1900,
but the Treasury has bought them all back.
• The price of a consol is the present value of all
future interest payments.
Yearly Coupon Payment
PConsol 
i
• There are two basic types of mortgages:
– Conventional fixed-rate, and
– Adjustable-rate, ARMs.
• Fixed-rate mortgages are easy but ARMs can
be complicated.
– The interest rate changes so payments change.
– Choosing this means one should know about
interest-rate indexes, margins, discounts, caps,
negative amortization, and convertibility.

Yield to Maturity
• The most useful measure of the return on
holding a bond is called the yield to maturity:
– The yield bondholders receive if they hold the
bond to its maturity when the final principal
payment is made.
• The value of i that solves the equation is the

yield to maturity.
Yield to Maturity
• If Bond Price = $100,
Yield to maturity = the coupon rate
• If Bond Price > $100,

Yield to maturity < the coupon rate
• If Bond Price < $100,

Yield to maturity > the coupon rate
Bond Price   Yield to maturity 

Yield to Maturity
• This relationship should make sense.
• If you pay $95 for a $100 face value bond, you
will receive both the interest payments and
the increase in value from $95 to $100.
• This rise in value is referred to as a capital gain
and is part of the return on your investment.
• When the price of a bond is higher than face
value, the bondholder incurs a capital loss.

Current Yield
• Current yield is the measure of the proceeds
the bondholder receives for making a loan.
Yearly Coupon Payment
Current Yield 
Price Paid
• The current yield measures that part of the

 return from buying the bond that arises solely
from the coupon payments.
• If the price is below par, the current yield will
be below the yield to maturity.
Current Yield
Example:
1 year, 5% coupon bond selling for $99
Current Yield = 5  0.0505 , or 5.05%

99
Yield to maturity for this bond is 6.06

percent found as the solution to:
$5 $100
  $99
(1  i ) (1  i )

Current Yield
• We can see the relationship between the
current yield and the coupon rate.
• Table 6.1 summarizes these relationships.

Holding Period Returns
• The holding period return is the return to
holding a bond and selling it before maturity.
• The holding period return can differ from the
yield to maturity.

• The one-year holding period return is the sum of
the yearly coupon payment divided by the price
paid for the bond and the change in the price
divided by the price paid.

• Whenever the price of a bond changes, there
is a capital gain or loss.
• The greater the price change, the more
important that part of the holding period
return becomes.
• The longer the term of the bond, the greater
those price movements and associated risk
can be.

The Bond Market and the
Determination of Interest Rates
• How are bond prices determined and why do
they change?
• We must look at bond supply, bond demand, and
equilibrium prices.
– First, we will restrict discussion to the quantity of
bonds outstanding - stock of bonds.
– Secondly, we will talk about bond prices rather than
interest rates.
– Finally, we will consider the market for a one-year
zero-coupon bond with a face value of $100.
The Bond Market and the
Determination of Interest Rates
• Assume an investor is planning to purchase a
one-year bond and hold until maturity.
– They have a one-year investment horizon.
– The holding period return equals the bond’s yield
to maturity - both determined directly from price.
• The present value formula shows the
relationship between price and yield as:
$100 $100  P
P or i 
1 i P
Bond Supply, Bond Demand and
Equilibrium in the Bond Market
• Supply and demand determine bond prices
(and bond yields).
• The bond supply curve is the relationship
between the price and the quantity of bonds
people are willing to sell, all else equal.
• The higher the price of a bond, the larger the
quantity supplied.
– The bond supply curve slopes upward.

• The bond demand curve is the relationship
between the price and the quantity of bonds
that investors demand, all else equal.
• The price of bonds is inversely related to the
yield, the demand curve implies that the higher
the demand for bonds, the higher the yield.
• The bond demand curve slopes downward.

Equilibrium is the
point at which
supply equals
demand.
© 2017 McGraw-Hill Education. All Rights Reserved. 6-

• What if bond prices are above equilibrium?
– Quantity supplied > quantity demanded.
– With excess supply, supplier cannot sell bonds
they want at current price.
– Suppliers begin to cut the price.
– Excess supply puts downward pressure on the
price until supply equals demand.

• What if the price is below equilibrium?
– Those who wish to buy bonds cannot get what
they want at that price.
– They start bidding up the price.
– Excess demand puts upward pressure on the
price until supply equals demand.

• To understand bond prices, we really need to
understand what determines supply and
demand.
• Remember the distinction between moving
along a curve (change in quantity supplied or
demanded) versus a shift in the curve (change
in supply or demand).
• A shift in either supply or demand changes the
price of bonds, so it changes yields as well.

Factors That Shift Bond Supply
1. Changes in Government Borrowing
– Any increase in the government’s borrowing needs
increases the quantity of bonds outstanding,
shifting the bond supply curve to the right.
2. Change in General Business Conditions
– As business conditions improve, the bond supply
curve shifts to the right.
3. Changes in Expected Inflation
– When expected inflation rises, the cost of
borrowing falls, shifting the bond supply curve to
the right.
Factors That Shift Bond Supply
When borrowers’
desire for funds
increases, the
supply curve shifts
to the right.
This lowers bond

prices, thereby
raising interest
rates.

Factors That Shift Bond Demand
1. Wealth
– Increases in wealth shift the demand for bonds to the
right.
2. Expected Inflation
– Declining inflation means promised payments have
higher value - bond demand shifts right.
3. Expected Returns and Expected Interest Rates
– If the expected return on bonds rises relative to the
return on alternative investments, bond demand will
shift right.
– When interest rates are expected to fall, price prices
are expected to rise shifting bond demand to the right.
4. Risk Relative to Alternatives
– If bonds become less risky relative to alternative
investments, demand for bonds shifts right.
5. Liquidity Relative to Alternatives
– Investors like liquidity: the more liquid the bond,
the higher the demand.
– If bonds become less risky relative to alternative
investments, demand for bonds shifts right.

When bonds
become more
attractive for
investors, the
demand curve
shifts to the right.
This raises bond

prices, lowering
interest rates.

© 2021 McGraw-Hill. All Rights Reserved. 36
Understanding Changes in
Equilibrium Bond Prices and Interest
Rates
• Increasing expected inflation
– Reduces the real cost of borrowing shifting bond
supply to the right.
– But, lowers real return on lending, shifting bond
demand to the left.

Rates
S0 1) Shift S right
S1 2) Shift D right
E0
These two effects
Price per Bond
reinforce each other.

•Lower bond prices
•Raise interest rates
E1 However, graphically
unknown effect on
D0
quantity of bonds.
D1
Quantity of Bonds
© 2021 McGraw-Hill. All Rights Reserved.

6-38
Rates
• A business cycle downturn:
– Reduces business investment opportunities
shifting bond supply to the left.
– Reduces wealth, shifting bond demand to the left
also.
• Although both shifts could give an ambiguous
answer in terms of bond price, theory is not
ambiguous.
– In recessions, interest rates tend to fall meaning
that bond prices should rise.
Rates
S1
1) Shift S left
2) Shift D left
S0
E1
We know price
Price per Bond
increases so
E0 supply shifts
more than
demand.
D0
D1
Quantity of Bonds

Why Bonds Are Risky
Bonds are a promise to pay a certain amount in
the future. How can that be risky?

• Investors’ concerns about
risk affect their demand for
U.S. Treasuries.
• 1998, Russia defaulted and
people lost confidence in
emerging market countries.
• Safest assets are U.S.
Treasuries.
• Demand increased, price
increased, and yields
declined.
© 2017 McGraw-Hill Education. All Rights Reserved. 6-42

Default Risk
• Although there is little to no default risk with
U.S. Treasury bonds, there is with other
government and corporate bonds.
• In determining what happens to bond prices
when we consider default risk, we can look at
an example of a corporate bond.
• Assume the one-year risk-free interest rate is
5 percent.
• A company has issued a 5 percent coupon
bond with a face value of $100.
Default Risk
• If this bond was risk-free, the price of the bond
would be the present value of the $105
payment.
Price of risk free bond = ($100 + $5)/$1.05 = $100
• Suppose, however, there is a 10% probability
that the company will go bankrupt before
paying back the loan.
– Assume the outcome is either $105 or $0.
– Expected value equals $94.50
Price of bond = $94.50/1.05 = $90
Default Risk
• If the price of the bond is $90, what yield to
maturity does this price imply?
Promised yield on bond = $105/$90 - 1 = 0.1667
• Since the default risk premium is the promised
yield to maturity minus the risk-free rate:
= 16.67 percent - 5 percent = 11.67 percent.
• Any risk premium will drive the price below
$90 and push the yield to maturity above
16.67 percent.
• The higher the default risk, the higher the
yield.
• Securitization is the process by which
financial institutions pool various assets that
generate a stream of payments and
transform them into a bond that gives the
bondholder a claim to those payments.
• Securitization has grown over the last 35
years, mortgage-backed securities account
for the largest share of securitized debt (90%)

• Securitization uses the efficiency of markets
to lower the cost of borrowing by:
1. Facilitating diversification of risks
2. Making assets liquid
3. Allowing greater specialization in the business of
finance,
4. Broadening markets
5. Promoting innovations

• Inflation-indexed bonds are structured so
that the government promises to pay you a
fixed interest rate plus the change in the
consumer price index (CPI).
• The U.S. Treasury sells two types of bonds
that are adjusted for inflation.
1. Series I savings bonds
2. Treasury Inflation Protected Securities (TIPS)

Inflation Risk
• With few exceptions, bonds promise to make
fixed-dollar payments.
• Remember that we care about the
purchasing power of our money, not the
number of dollars.
– This means bondholders care about the real
interest rate.
• How does inflation risk affect the interest
rate?
Inflation Risk
• Think of the interest rate having three
components:
1. The real interest rate
2. Expected inflation, and
3. Compensation for inflation risk.
• Example:
– Real interest rate is 3 percent.
– Inflation could be either 1 percent or 3 percent.
– Expected inflation is 2 percent, with a standard
deviation of 1.0 percent.
Inflation Risk
• Nominal interest rate should equal
– 3 percent real interest rate +
– 2 percent expected inflation +
– Compensation for inflation risk
• The greater the inflation risk, the larger the
compensation for it.

Interest-Rate Risk
• Interest-rate risk arises from the fact that investors
don’t know the holding period return of a long-
term bond.
– The longer the term of the bond, the larger the price
change for a given change in the interest rate.
• For investors with holding periods shorter than the
maturity of the bond, the potential for a change in
interest rates creates risk.
– The more likely the interest rates are to change during
the bondholder’s investment horizon, the larger the
risk of holding a bond.
• Corporate bonds were highly illiquid before
the crisis as well as after it
– Turnover extremely low
– Consist of a large number of small issues that are
traded rarely because it is very costly
• Loss of liquidity in U.S. Treasury debt markets
– Principle trading firms (PTFs)
• The resilience of intermediaries and the
resilience of markets are mutually reinforcing

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Chapter 6

Bonds, Bond Prices, and the Determination of

How much should you be willing to pay for a

• That depends on the bond characteristics.

© 2021 McGraw-Hill. All Rights Reserved. 6-4

© 2021 McGraw-Hill. All Rights Reserved. 6-5

Price of a Six-Month Treasury Bill

© 2017 McGraw-Hill Education. All Rights Reserved. 6-6

• The sum of the present value of the payments.

© 2021 McGraw-Hill. All Rights Reserved. 6-9

© 2021 McGraw-Hill. All Rights Reserved. 6-11

• The value of i that solves the equation is the

• If Bond Price > $100,

• If Bond Price < $100,

Bond Price   Yield to maturity 

© 2021 McGraw-Hill. All Rights Reserved. 6-13

© 2021 McGraw-Hill. All Rights Reserved. 6-14

• The current yield measures that part of the

Current Yield = 5  0.0505 , or 5.05%

Yield to maturity for this bond is 6.06

© 2021 McGraw-Hill. All Rights Reserved. 6-16

© 2021 McGraw-Hill. All Rights Reserved. 6-17

© 2021 McGraw-Hill. All Rights Reserved. 6-18

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© 2017 McGraw-Hill Education. All Rights Reserved. 6-

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© 2021 McGraw-Hill. All Rights Reserved. 6-28

This lowers bond

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This raises bond

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© 2021 McGraw-Hill. All Rights Reserved. 6-37

reinforce each other.

© 2021 McGraw-Hill. All Rights Reserved.

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© 2017 McGraw-Hill Education. All Rights Reserved. 6-42

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