Valuation of Securities

Chapters in this Part

Chapter 6

Interest Rates and Bond Valuation

Chapter 7

Stock Valuation

Integrative Case 3: Encore International

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 6

Interest Rates and Bond Valuation

Instructor’s Resources

Overview

This chapter begins with a thorough discussion of interest rates, yield curves, and their relationship to required returns. Features of the major types of bond issues are presented along with their legal issues, risk characteristics, and indenture convents. The chapter then introduces students to the important concept of valuation and demonstrates the impact of cash flows, timing, and risk on value. It explains models for valuing bonds and the calculation of yield-to-maturity using either an approximate yield formula or calculator. Students learn how interest rates may affect their ability to borrow and expand business operations or assets under personal control.

Suggested Answers to Opener in Review Questions

a. With short-term interest rates near 0 percent in 2010, suppose the Treasury decided to replace maturing notes and bonds by issuing new Treasury bills, thus shortening the average maturity of U.S. debt outstanding. Discuss the pros and cons of this strategy. The U.S. Treasury would face many of the same considerations as those faced by a company that is considering revision of its average debt maturity. Short-term rates are normally lower, reducing total financing costs. However, if the U.S. Treasury relies on short-term rates and short-term rates rise, the cost of financing the federal debt could end up being higher. Even more serious is the risk that the U.S. Treasury may not be able to find buyers of new Treasury bills when old Treasury bills mature. According to market segmentation theory, there is a limited amount of demand for short-term securities. Excessive short-term demand might push up the cost of seasonal business loans higher, hindering business and tax revenues.

Another concern that the U.S. Treasury would have to face is whether the financing adjustment would diminish the high regard with which Treasury bills are held. Currently, Treasury bills are as close as we can get to a risk-free rate in the real world. If the amount of short-term financing becomes excessive, the ability of the federal government to make good on its short-term repayment promises may come into question, no longer make it a “risk-free” surrogate, and increase Treasury bill rates. b. The average maturity of outstanding U.S. Treasury debt is about 5 years. Suppose a newly issued 5-year Treasury note has a coupon rate of 2 percent and sells for par. What happens to the value of this debt if the inflation rate rises 1 percentage point, causing the yield-to-maturity on the 5year note to jump to 3 percent shortly after it is issued?

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 6

Interest Rates and Bond Valuation

103

Debt priced at par provides a coupon payment sufficient to pay the required rate of return. Hence, if the required rate of return is 2%, it must be paying $20 annually. If the discount rate increases, the coupon payment is no longer sufficient. Hence, the price would drop to create a one percent capital gain per year, leading up to $1,000 at maturity. The price would be

N = 5, I = 3%, PMT = $20, FV = 1,000

Solve for PV = 954.20

The price of the Treasury would drop $45.80, or 4.58 percent, to $954.20. c. Assume that the “average” Treasury security outstanding has the features described in part b. If total U.S. debt is $13 trillion and an increase in inflation causes yields on Treasury securities to increase by 1 percentage point, by how much would the market value of outstanding debt fall? What does this suggest about the incentives of government policy makers to pursue policies that could lead to higher inflation?

Based on the information...