Essays Solution
Workshop 3
Interest Rates and Bond Valuation
Terminology
• Face value/par value - the original issue price (the amount borrowed).
• Maturity date - date on which loan has to be repaid.
• Coupon interest rate - original interest rate on the bond.
• Coupon payment - the fixed interest payment on the bond.
• YTM=required rate of return.
Bonds pay fixed coupon payments at fixed intervals and the face value at maturity.
there is an inverse relationship between the price of an investment and the rate of return on the investment – if you pay a higher price for an investment your rate of return must be lower (holding all other factors constant))
If the YTM = coupon rate the bond will sell for the face value (i.e. current price = face value).
If the YTM > coupon rate the bond will sell for a discount (yield goes up, price goes down).
If the YTM < coupon rate the bond will sell for a premium (yield goes down, price goes up). Discussion
1. Identify the three most important determinants of the price of a bond. Describe the effect of each?
Answer
The three factors affecting the price of a bond are
- coupon
- yield
- term to maturity. T
=> The relationship between price and coupon is a direct one - the higher the coupon, the higher the price. The relationship between price and yield is an inverse one - the higher the yield the lower the price, all other factors held constant. The relationship between price and maturity is not so clearly evident. Price changes resulting from changes in yields will be more pronounced, the longer the term to maturity.
2. Given a change in the level of interest rates, discuss how two major factors will influence the relative change in price of individual bonds.
Answer
For a given change in the level of interest rates, two factors that will influence the relative change in bond prices are the coupon and maturity of the issues. Bonds with longer maturity and/or lower coupons will have the greatest price
Interest Rates and Bond Valuation
Terminology
• Face value/par value - the original issue price (the amount borrowed).
• Maturity date - date on which loan has to be repaid.
• Coupon interest rate - original interest rate on the bond.
• Coupon payment - the fixed interest payment on the bond.
• YTM=required rate of return.
Bonds pay fixed coupon payments at fixed intervals and the face value at maturity.
there is an inverse relationship between the price of an investment and the rate of return on the investment – if you pay a higher price for an investment your rate of return must be lower (holding all other factors constant))
If the YTM = coupon rate the bond will sell for the face value (i.e. current price = face value).
If the YTM > coupon rate the bond will sell for a discount (yield goes up, price goes down).
If the YTM < coupon rate the bond will sell for a premium (yield goes down, price goes up). Discussion
1. Identify the three most important determinants of the price of a bond. Describe the effect of each?
Answer
The three factors affecting the price of a bond are
- coupon
- yield
- term to maturity. T
=> The relationship between price and coupon is a direct one - the higher the coupon, the higher the price. The relationship between price and yield is an inverse one - the higher the yield the lower the price, all other factors held constant. The relationship between price and maturity is not so clearly evident. Price changes resulting from changes in yields will be more pronounced, the longer the term to maturity.
2. Given a change in the level of interest rates, discuss how two major factors will influence the relative change in price of individual bonds.
Answer
For a given change in the level of interest rates, two factors that will influence the relative change in bond prices are the coupon and maturity of the issues. Bonds with longer maturity and/or lower coupons will have the greatest price