CHAPTER 8

Bond Valuation and the Structure of Interest Rates

Learning Objectives
1. Explain what an efficient capital market is and why market efficiency is important to
financial managers.
2. Describe the market for corporate bonds and three types of corporate bonds.
3. Explain how to calculate the price of a bond and why bond prices vary negatively with interest
rate movements.
4. Distinguish between a bonds coupon rate, yield to maturity, and effective annual yield, and be
able to calculate their values.
5. Explain why investors in bonds are subject to interest rate risk and why it is important to
understand the bond theorems.
6. Discuss the concept of default risk and know how to compute a default risk premium.
7. Describe the factors that determine the level and shape of the yield curve.

I.

Chapter Outline

8.1 Capital Market Efficiency

A.

Overview

The supply and demand for securities are better reflected in organized markets.

Any price that balances the overall supply and demand for a security is a market
equilibrium price.

A securitys true value is the price that reflects investors estimates of the value of the
cash flows they expect to receive in the future.

In an efficient capital market, security prices fully reflect the knowledge and
expectations of all investors at a particular point in time.

If markets are efficient, investors and financial managers have no reason to believe
the securities are not priced at or near their true value.

The more efficient a security market, the more likely securities are to be priced at
or near their true value.

The overall efficiency of a capital market depends on its operational efficiency and its
informational efficiency.
Operational efficiency focuses on bringing buyers and sellers together at the
lowest possible cost.
Markets exhibit informational efficiency if market prices reflect all relevant
information about securities at a particular point in time.
In an informationally efficient market, market prices adjust quickly to new
information about a security as it becomes available.
Competition among investors is an important driver of informational efficiency.

A.

Efficient Market Hypotheses

Prices of securities adjust as the buying and selling from investors lead to the price that
truly reflects the markets consensus. This reflects the markets efficiency.

Market efficiency can be explained at three levelsstrong form, semistrong form, and
weak form.

Strong form market efficiency states that the price of a security in the market reflects
all informationpublic as well as private or inside information.

Strong form efficiency implies that it would not be possible to earn abnormally
high returns (returns greater than those justified by the risks) by trading on private
information.

Semistrong market efficiency implies that only public information that is available to
all investors is reflected in a securitys market price.

Investors who have access to inside or private information will be able to earn
abnormal returns.

Public stock markets in developed countries like the United States have a
semistrong form of market efficiency.

New information is immediately reflected in a securitys market price.

In weak-form market efficiency, all information contained in past prices of a security

is reflected in current prices.

Ethics Note
Insider trading is illegal, but the determination of what constitutes insider trading is
difficult. Rule 10B-5 of the Securities Exchange Act of 1934 states: It shall be
unlawful for any person, directly or indirectly, by use of any means or instrumentality
of interstate commerce, or of the mails, or of any facility on a national securities
exchange, (1) to employ any device, scheme, or artifice to defraud, (2) to make any
untrue statement of a material fact or omit to state a material fact necessary in order to
make the statements made, in light of the circumstances under which they were made,
not misleading, (3) to engage in any act, practice, or course of business which
operates or would operate as a fraud or deceit upon any person, in connection with the
purchase or sale of any security.
Additionally, several court cases have sought to more clearly define insider trading.
For insider trading to exist, there must be a fiduciary relationship between the parties.
Actions of the inside trader do not have to meet the legal requirements of fraud; they
merely have to have the appearance of acting as a fraud or deceit. Accidental

discovery does not constitute a fiduciary relationship.

The court decided in Chiarella v. United States that an employee of a printing firm,
who was requested to proofread proxies that contained unannounced tender offers
(and unnamed targets) was not guilty of insider trading because the employee
determined the identity of the target through his own expertise. However, a member
of a companys board of directors, who has knowledge of the companys future
prospects, may not individually trade on this information prior to public disclosure.
The details of the case may be found in SEC v. Texas Gulf Sulfur, 401 F.2d 833 (2d
Cir. 1968).
Despite the passage of increasingly severe penalties for insider trading (see the Insider
Trading Sanctions Act of 1984 and the Insider Trading and Securities Fraud
Enforcement Act of 1988), the evidence suggests that the practice persists in one form
or another. One of the more recent cases deals with Martha Stewart, who recently
completed a five-month prison sentence for obstruction of justice for allegedly lying
to investigators during the investigation into violations of insider trading laws. The
investigation stems from a sale of 4000 shares of Imclone stock a day before it
announced that the FDA rejected the companys application for a proposed cancer
drug. Stewart and Imclones then-CEO, Samuel Waksal were friends and shared the
same stock broker. Waksal pleaded guilty to insider trading, and was sentenced to
seven years in prison and was fined $4.3million.
http://economics.about.com/cs/finance/a/insider_trading.htm

It would not be possible to earn abnormally high returns by looking for patterns in
security prices, but it would be possible to do so by trading on public or private
information.

8.2 Corporate Bonds

A.

Market for Corporate Bonds

At the end of 2007, the amount of corporate and foreign debt outstanding was $10.1
trillion, making it the second largest portion of the U.S capital market. The largest was
the market for corporate equity, with a value of $20.8 trillion. Lastly, the market for
state and local government debt totaled approximately $2.1 trillion.

The largest investors in corporate bonds are life insurance companies and pension
funds, with trades in this market tending to be in very large blocks of securities.

Less than 1 percent of all corporate bonds are traded on exchanges. Most secondary
market transactions for corporate bonds take place through dealers in the over-thecounter (OTC) market.

Only a small number of the total bonds that exist actually trade on a single day. As a
result, the market for corporate bonds is thin compared to the market for money market
securities or corporate stocks.

Corporate bonds are less marketable than the securities that have higher daily trading
volumes.

Prices in the corporate bond market also tend to be more volatile than securities sold in
markets with greater trading volumes.

The market for corporate bonds is not as efficient as that for stocks sold on the major
stock exchanges or highly marketable money market instruments such as U.S. Treasury
securities.
More on Bond Features

Is it Debt or Equity? - In general, debt securities are characterized by the following

attributes:

Creditors (or lenders or bondholders) generally have no voting rights.

Payment of interest on debt is a tax-deductible business expense.
Unpaid debt is a liability, so default subjects the firm to legal action by its
creditors.

It is sometimes difficult to tell whether a hybrid security is debt or equity. The distinction is
important for many reasons, not the least of which is that (a) the IRS takes a keen interest in the
firms financing expenses in order to be sure that nondeductible expenses are not deducted, and
(b) investors are concerned with the strength of their claims on firm cash flows.
Long-Term Debt: The Basics Promises made by the issuing firm to pay principal
when due and
to make timely interest payments on the unpaid balance (notes, debentures, bonds).

Public issues offered to the general public

Private placement directly placed with a lender or group of lenders

The Indenture - written agreement between issuer and creditors detailing terms of
borrowing. (Also deed of trust.) The indenture includes the following provisions:

Bond terms
o Registered form ownership is recorded, payment made directly to
owner
o Bearer form payment is made to holder (bearer) of bond
The total face amount of bonds issued
A description of any property used as security
o Collateral strictly speaking, pledged securities
o Mortgage securities secured by mortgage on real property
o Debenture an unsecured debt with 10 or more years to maturity
o Note a debenture with 10 years or less maturity
o Seniority order of precedence of claims
o Subordinated debenture of lower priority than senior debt
The repayment arrangements

B.

o Sinking fund an account managed by the bond trustee for early

redemption
Any call provisions
o Call provision allows company to call or repurchase part or all of
issue
o Call premium amount by which the call price exceeds the par value
o Deferred call firm cannot call bonds for a designated period
o Call protected the description of a bond during the period it cant be
called
Any protective covenants
o Protective covenants indenture conditions that limit the actions of
firms
o Negative covenant thou shalt not sell major assets, etc.
o Positive covenant thou shalt keep working capital at or above $X,
etc.

Bond Price Information

The corporate bond market is not considered to be very transparent because it trades
predominantly over the counter and investors do not find it easy to view prices and
trading volume.

In addition, many corporate bond transactions are negotiated between the buyer and
the seller, and there is little centralized reporting of these deals.

C.

Types of Corporate Bonds

Corporate bonds are long-term IOUs that represent claims against a firms assets.

Debt instruments, where the interest income paid to investors is fixed for the life of the
contract, are called fixed-income securities.

Three types of corporate bondsvanilla bonds, zero coupon bonds, and convertible
bonds.
1. Vanilla Bonds

These bonds have coupon payments that are fixed for the life of the bond, and
at maturity, the principal is paid and the bonds are retired.

Vanilla bonds have no special provisions, and the provisions they do have are
conventional and common to most bonds, such as a call provision.

Payments are usually made annually or semiannually.

The face value, or par value, for most corporate bonds is $1,000.

The bonds coupon rate is calculated as the annual coupon payment (C)
divided by the bonds face value (F).

2. Zero Coupon Bonds

Corporations sometimes issue bonds that have no coupon payments over its life
and only offer a single payment at maturity.

Zero coupon bonds sell well below their face value (at a deep discount)
because they offer no coupons.

The most frequent and regular issuer of zero coupon securities is the U.S.
Treasury Department.

3. Convertible Bonds

These are bonds that can be converted into shares of common stock at some
predetermined ratio at the discretion of the bondholder.

The convertible feature allows the bondholders to share in the good fortunes of
the firm if the firms stock rises above a certain level.

The conversion ratio is set so that the firms stock price must appreciate 15 to
20 percent before it is profitable to convert bonds into equity.

To secure this advantage, bondholders would be willing to pay a premium.

8.3 Bond Valuation

The value, or price, of any asset is the present value of its future cash flows.

To calculate the price of the bond, we follow the same process as we would to value any
financial asset.

Estimate the expected future cash flowsthese are the coupons that the bond will pay.

Determine the required rate of return, or discount rate. The required rate of return, or
discount rate, for a bond is the market interest rate called the bonds yield to maturity (or
more commonly, yield). This is the return one would earn from bonds that are similar in
maturity and default risk.

Compute the current value, or price, of a bond (PB) by calculating the present value of the
bonds expected cash flows:
PB = PV (Coupon payments) + PV (Principal payments)
o Face value, par value, principal, or maturity value: The principal amount of the bond
that is repaid at maturity. The par value remains constant throughout the life of the
bond. The par value of most bonds is assumed to be $1,000 unless otherwise stated.
o Coupon rate: This is the stated rate of interest the bond pays each period, normally
annually or semi-annually. The coupon rate remains constant throughout the life of the
bond (assuming a fixed-rate bond).
o Coupon or coupon interest payment: The dollar ($) amount of interest the bond pays
each period, which equals the par value x coupon rate. The par value of the bond as
well as the coupon rate on the bond remains constant throughout the bonds life;
therefore, the coupon interest payment also remains constant.

o Maturity date: The date on which the bond ceases to earn interest. On this date, the
last interest payment will be made, and the face value of the bond will be repaid. When
valuing a bond, we are interested in the time to maturity, the length of time between
the date the bond is purchased and its maturity date
o

Yield to maturity, required return, market rate: The percentage rate of return paid on
a bond, note, or other fixed income security if the investor buys and holds it to its
maturity date. The calculation for YTM is based on the coupon rate, length of time to
maturity, and market price. It assumes that coupon interest paid over the life of the
bond will be reinvested at the same rate. The required return on the bond can change at
any time over the life of the bond.

The general equation for the price of a bond can be written as follows in Equation 8.1:
PB

C1
C2
C3
C F

n n
1
2
3
(1 i )
(1 i )
(1 i )
(1 i )

1
1 (1 i ) n
C
i

F
(1 i ) n

where:
PB = the price of the bond, or present value of the stream of cash payments
Ct = the coupon payment in period t, where t = 1, 2, 3, , n
Fn = par value or face value (principal amount) to be paid at maturity
i = market interest rate (discount rate or market yield)
n = number of periods to maturity
Bond value = PV of coupons + PV of face value
Bond value = PV of an annuity + PV of a lump sum

 1 - ( 1 + i )-n

Bond value = C
A.

+ F( 1 + i )-n

Par, Premium, and Discount Bonds

If a bonds coupon rate is equal to the market rate, then the bond will sell at a price
equal to its face value. Such bonds are called par bonds.

If a bonds coupon rate is less than the market rate, then the bond will sell at a price
that is less than its face value. Such bonds are called discount bonds.

If a bonds coupon rate is greater than the market rate, then the bond will sell at a price
that is more than its face value. Such bonds are called premium bonds.

Example:

Find the value of the bond assuming a yield to maturity (market rate) of 8%:
1 - ( 1 + .08 )-10

.08

Bond value = $80

Bond value = $80(
Bond value = $

) + $1,000(

+ $1,000( 1 + .08 )-10

)

The bond is selling at par. This will occur any time the market rate equals the
bonds coupon rate.
n
N
10

i
I/YR
8

PB
PV

C
PMT
80

F
FV
1,000

Find the value of the bond assuming a yield to maturity (market rate) of 9.5%:
1 - ( 1 + .095 )-10

.095

Bond value = $80

Bond value = $80(
Bond value = $

) + $1,000(

+ $1,000( 1 + .095 )-10

The bond is selling at a discount. This will occur any time the market rate exceeds
the bonds coupon rate.
n
N
10

i
I/YR
9.5

PB
PV

C
PMT
80

F
FV
1,000

Find the value of the bond assuming a yield to maturity (market rate) of 6%:
1 - ( 1 + .06 )-10

.06

Bond value = $80

Bond value = $80(
Bond value = $

) + $1,000(

+ $1,000( 1 + .06 )-10

)

The bond is selling at a premium. This will occur any time the market rate is
below the bonds coupon rate.
n
N
10

i
I/YR
6

PB
PV

C
PMT
80

F
FV
1,000

Note: Bond prices and interest rates move in opposite directions, i.e., they are
inversely related. This is intuitive given that the price of a bond is simply the present
value of its cash flows, and present values move opposite to changes in the discount
rate.

B.

Semiannual Compounding

While bonds in Europe pay annual coupons, bonds in the United States pay coupons
semiannually.

In calculating the current price of a bond paying semiannual coupons, one needs to
modify Equation 8.1.

Each coupon payment is half of an annual coupon.

The number of payments is twice the number of years to maturity.

The discount rate used is then half of the annual rate.

PB

C m Fmn
C3 m
C1 m
C2 m

....... mn
2
3
(1 i m) (1 i m)
(1 i m)
(1 i m) mn

(8.2)

Find the value of the bond assuming the coupon is paid semi-annually and the market rate (yield
to maturity) is 6%:
1 - ( 1 + i/m )-(m x n)
-(m x n)
+ F( 1 + i/m )
i/m

Bond value = C

1 - ( 1 + .06/2 )-(2)(10)

.06/2

Bond value = $40

+ $1,000( 1 + .06/2 )-(2)(10)

1 - ( 1.03 )-20
-20
+ $1,000( 1.03 )
.03

Bond value = $40

Bond value = $40(

) + $1,000(

Bond value = $ + $ = $
mxn
N
20

i/m
I/YR
3

PB
PV

C
PMT
40

F
FV
1,000

Brittany Co. issued 15-year bonds one year ago at a coupon rate of 8.50 percent. The bonds make
semiannual payments. If the YTM on these bonds is 7.90 percent, what is the current bond price?
To find the price of this bond, we need to realize that the maturity of the bond is 14 years. The bond was
issued one year ago, with 15 years to maturity, so there are 14 years left on the bond. Also, the coupons
are semiannual, so we need to use the semiannual interest rate and the number of semiannual periods. The
price of the bond is:
Price = $42.50(PVIFA3.95%,28) + $1,000(PVIF3.95%,28) = $1,050.28
mxn
N
28

C.

i/m
I/YR
3.95

PB
PV

C
PMT
42.50

F
FV
1,000

Zero Coupon Bonds

Zero coupon bonds have no coupon payments but promise a single payment at
maturity.

The price (or yield) of a zero coupon bond is simply a special case of Equation 8.2, in
that all the coupon payments are equal to zero.

Hence, the pricing equation is:

PB = Fmn/(1 + i/m)mn

(8.3)

Example: You are offered a bond that will pay no interest but will return the par value of $1,000 twenty
years from now. If your required return for this bond is 7.35%, what are you willing to pay?
Zero-coupon bond price = F( 1 + i )-n = $1,000( 1 + .0735 )-20 = $1,000(.2420800635) = $242.08

Zero coupon bonds, for which all the cash payments are made at maturity, must sell for
less than similar bonds that make periodic coupon payments.

A popular financial innovation of the last decade are Treasury strips. Treasury strips are created when a
coupon-bearing Treasury issue is purchased, placed in escrow, and the coupon payments are stripped
away from the principal portion. Each component is then sold separately to investors with different
objectives: the coupon portion is purchased by those desirous of safe current income, while the principal

portion is purchased by those with cash needs in the future. (The latter portion is, in essence, a
synthetically created zero-coupon bond.) Merrill Lynch was the first to offer these instruments, calling
them TIGRs (Treasury Investment Growth Receipts), soon to be followed Salomon Brothers CATs
(Certificates of Accrual of Treasury securities).
8.4 Bond Yields
A.

Yield to Maturity

The yield to maturity of a bond is the discount rate that makes the present value of
the coupon and principal payments equal to the price of the bond.

It is the yield that the investor earns if the bond is held to maturity and all the coupon
and principal payments are made as promised.

A bonds yield to maturity changes daily as interest rates increase or decrease.

We can compute a bonds yield to maturity using a trial-and-error approach.

Finding the Yield to Maturity: More Trial and Error - The yield to maturity (YTM) of a bond
is the compound average annual expected rate of return if the bond is purchased at its current
market price and held to maturity. The YTM also assumes that the interest payments are
reinvested for the life of the bond at the same yield. The YTM is the internal rate of return
(IRR) of the bond.

A corporate bond is currently selling for $863.07, has 20 years left to maturity, and a
coupon rate of 7.5%. If you purchase the bond today at the listed price and hold until
maturity, what is your yield to maturity?
Trial and error - Set up the bond pricing equation with the given values and solve for
the YTM (r):
1 - ( 1 + i )-n

Bond value = C

1 - ( 1 + i )-20

$863.07 = $75

+ F( 1 + i )-n

+ $1,000( 1 + i )-20

$863.07 = $75(PVIFA i,20) + $1,000(PVIF i,20)

At this point, you can look up (using the interest tables) or compute the PVIFA and
PVIF factors for your estimate of i and plug them into the equation above. You have
found the yield to maturity when your estimate causes the right-hand side of the
equation to equal the left-hand side.
Alternatively, the approximation formula given below will give you a fairly close
estimate unless the bond is selling at a steep discount or premium:

(Par Value - Bond Price)

Years to Maturity

Par Value 2(Bond Price)

Coupon

Estimated YTM

($1,000 - $863.07)
$75

20
Estimated YTM
$1,000 2($863.07)

$81.8465
.090068 9.01%
$908.713333

Estimated YTM

Of course, the best alternative is to use a spreadsheet or a financial calculator to solve:

n
N
20

YTM (i)
I/YR

PB
PV
-863.07

C
PMT
75

F
FV
1,000

Current yield - The current yield is simply the annual interest payment divided by the
current market price of the bond ( $C / $Bond price ).
For the bond shown above, the current yield = $75 / $863.07 = .086899 = 8.69%
The total rate of return on the bond (YTM) = Current yield + Capital gains (loss) yield
.09 = .0869 + Capital gains yield
Capital gains yield = .09 - .0869 = .0031 = .31%

Yield to maturity on a zero-coupon bond: YTMzero =

F
PB

1
n

Example: You purchased a zero-coupon bond that matures in 25 years for $165.00. What YTM do
you expect to earn on this bond assuming you hold it until maturity?
YTMzero =

B.

F
PB

1
n

$1,000
$165

1
25

= (6.060606061).04 1 = .074733 = 7.47%

Effective Annual Yield

As pointed out in Chapter 7, the correct way to annualize an interest rate (yields) is to
compute the effective annual interest rate (EAR).

On Wall Street, the EAR is called the effective annual yield (EAY) and EAR = EAY.

The correct way to annualize the yield on a bond is as follows:

EAY = (1 + Quoted rate/m)m 1

The simple annual yield is the yield per period multiplied by the number of
compounding periods. For bonds with annual compounding, the simple annual yield =
semiannual yield 2.

C.

Realized Yield

The realized yield is the return earned on a bond given the cash flows actually
received by the investor.

The interest rate at which the present value of the actual cash flows generated by the
investment equals the bonds price is the realized yield on an investment.

The realized yield is an important bond calculation because it allows investors to see
the return they actually earned on their investment.

8.5 Interest Rate Risk

The prices of bonds fluctuate with changes in interest rates, giving rise to interest rate
risk.

A.

Bond Theorems
1. Bond prices are negatively related to interest rate movements.

As interest rates decline, the prices of bonds rise; and as interest rates rise, the prices of
bonds decline.

2. For a given change in interest rates, the prices of long-term bonds will change more
than the prices of short-term bonds.

Long-term bonds have greater price volatility than short-term bonds.

All other things being equal, long-term bonds are more risky than short-term bonds.

Interest rate risk increases as maturity increases, but at a decreasing rate.

3. For a given change in interest rates, the prices of lower-coupon bonds change more
than the prices of higher-coupon bonds.

The lower a bonds coupon rate, the greater its price volatility, and hence, lower
coupon bonds have greater interest rate risk.

The lower the bonds coupon rate, the greater the proportion of the bonds cash flow
investors will receive at maturity.

All other things being equal, a given change in the interest rates will have a greater
impact on the price of a low-coupon bond than a higher-coupon bond with the same
maturity.

Interest Rate Price 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.

Interest Rate Reinvestment Risk - The YTM calculation assumes that the investor reinvests all coupons
received from a bond at a rate equal to the computed YTM on that bond, thereby earning interest on
interest over the life of the bond at the computed YTM. In effect, this calculation assumes that the
reinvestment rate is the yield to maturity. If the investor spends the coupons, or reinvests them at a rate
different from the assumed reinvestment rate, the realized yield that will actually be earned at the
termination of the investment in the bond will differ from the promised YTM. And, in fact, coupons
almost always will be reinvested at rates higher or lower than the computed YTM, resulting in a realized
yield that differs from the promised yield. This gives rise to reinvestment rate risk.

B.

Bond Theorem Applications

If rates are expected to increase, a portfolio manager should avoid investing in longterm securities. The portfolio could see a significant decline in value.

If you are an investor and you expect interest rates to decline, you may well want to
invest in long-term zero coupon bonds. As interest rates decline, the price of long-term
zero coupon bonds will increase more than that of any other type of bond.

8.6

The Structure of Interest Rates

Market analysts have identified four risk characteristics of debt instruments that are
responsible for most of the differences in corporate borrowing costs: the securitys
marketability, call feature, default risk, and term to maturity.

A.

Marketability

Marketability refers to the ability of an investor to sell a security quickly, at a low

transaction cost, and at its fair market value.

The lower these costs are, the greater a securitys marketability.

The interest rate, or yield, on a security varies inversely with its degree of
marketability.

The difference in interest rates or yields between a marketable security (imarkt) and a
less marketable security (iless) is known as the marketability risk premium (MRP).
MRP = ilow mkt ihigh mkt > 0

U.S. Treasury bills have the largest and most active secondary market and are
considered to be the most marketable of all securities.

B.

Call Provision

A call provision gives the firm issuing the bonds the option to purchase the bond from
an investor at a predetermined price (the call price); the investor must sell the bond at
that price.

When bonds are called, investors suffer a financial loss because they are forced to
surrender their high-yielding bonds and reinvest their funds at the lower prevailing
market rate of interest.

Bonds with a call provision sell at higher market yields than comparable noncallable
bonds.

The difference in interest rates between a callable bond and a comparable noncallable
bond is called the call interest premium (CIP) and can be defined as follows:
CIP = icall - incall > 0

Bonds issued during periods when interest is high are likely to be called when interest
rates decline, and as a result, these bonds have a high CIP.

C.

Default Risk

The risk that the lender may not receive payments as promised is called default risk.

Investors must be paid a premium to purchase a security that exposes them to default
risk.

The default risk premium (DRP) can thus be defined as follows:

DRP = idr - irf

U.S. Treasury securities do not have any default risk and are the best proxy measure for
the risk-free rate.

D.

Bond Ratings

Individuals and small business have to rely on outside agencies to provide them
information on the default potential of bonds.

The two most prominent credit rating agencies are Moodys Investors Service
(Moodys) and Standard and Poors (S&P). Both credit rating services rank bonds in
order of their expected probability of default and publish the ratings as letter grades.

The rating schemes used are shown in Exhibit 8.4.

The highest-grade bonds, those with the lowest default risk, are rated Aaa (or AAA).

Bonds in the top four rating categories are called investment-grade bondsAAA to
Baa.

State and federal laws typically require commercial banks, insurance companies,
pension funds, other financial institutions, and government agencies to purchase
securities rated only as investment grade.

E.

The Term Structure of Interest Rates

The relationship between yield and term to maturity is known as the term structure of
interest rates.

Yield curves show graphically how market yields vary as term to maturity changes.

The shape of the yield curve is not constant over time.

As the general level of interest rises and falls over time, the yield curve shifts up and
down and has different slopes.

There are three basic shapes (slopes) of yield curves in the marketplace.

Ascending or normal yield curves are upward-sloping yield curves that occur
when an economy is growing.

Descending or inverted yield curves are downward-sloping yield curves that occur
when an economy is declining or heading into a recession.

F.

Flat yield curves imply that interest rates are unlikely to change in the near future.

The Shape of the Yield Curve

Three economic factors determine the shape of the yield curve: (1) the real rate of
interest, (2) the expected rate of inflation, and (3) interest rate risk.
1. The Real Rate of Interest

The real rate of interest varies with the business cycle, with the highest rates
seen at the end of a period of business expansion and the lowest at the bottom
of a recession.

Changes in the expected future real rate of interest can affect the slope of the
yield curve.

2. The Expected Rate of Inflation

If investors believe that inflation will be increasing in the future, the yield
curve will be upward sloping because long-term interest rates will contain a
larger inflation premium than short-term interest rates.

If investors believe inflation will be subsiding in the future, the prevailing yield
curve will be downward sloping.

3. Interest Rate Risk

The longer the maturity of a security, the greater its interest rate risk, and the
higher the interest rate.

The interest risk premium always adds an upward bias to the slope of the yield
curve.

G.

The Cumulative Effect

Exhibit 8.6 shows the cumulative effect of the three economic factors that influence
the shape of the yield curve: the real rate of interest, the inflation premium, and the
interest rate risk premium.

In a period of economic expansion, both the real rate of interest and the inflation
premium tend to increase monotonically over time.

In a period of contraction, both the real rate of interest and the inflation premium
decrease monotonically over time.

Living yield curve

The Term Structure of Interest Rates - The relationship between short- and long-term interest
rates is known as the term structure of interest rates. The relationship between nominal interest
rates on default-free, pure discount securities and time to maturity; that is, the pure time value of
money.

What determines the shape of the term structure? There are three basic
components. The first two are 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. The real rate of interest is the basic component
underlying every interest rate, regardless of the time to maturity. When the real rate
is high, all interest rates will tend to be higher, and vice versa. Thus, the real rate
doesn't really determine the shape of the term structure; instead, it mostly
influences the overall level of interest rates.

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.

The third, and last, component of the term structure has to do with interest rate
risk. 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. The longer the term to
maturity, the greater is the interest rate risk, so the interest rate risk premium
increases with maturity.

Chapter 8 Sample Questions

Multiple Choice
Identify the choice that best completes the statement or answers the question.
1. Bond price: Briar Corp is issuing a 10-year bond with a coupon rate of 7 percent. The interest rate for
similar bonds is currently 9 percent. Assuming annual payments, what is the present value of the bond?
(Round to the nearest dollar.)
a. $872
b. $1,066
c. $990
d. $945
2. Bond price: Kevin Rogers is interested in buying a five-year bond that pays a coupon of 10 percent
on a semiannual basis. The current market rate for similar bonds is 8.8 percent. What should be the
current price of this bond? (Round to the nearest dollar.)
a. $1,048
b. $965
c. $1,099
d. $982
3. Zero coupon bonds: Shana Norris wants to buy five-year zero coupon bonds with a face value if
$1,000. Her opportunity cost is 8.5 percent. Assuming annual compounding, what would be the current
market price of these bonds? (Round to the nearest dollar.)
a. $1,023
b. $665
c. $890
d. $1,113
4. Zero coupon bonds: Robertsons, Inc., is planning to expand its specialty stores into five other states
and finance the expansion by issuing 15-year zero coupon bonds with a face value of $1,000. If your
opportunity cost is 8 percent and similar coupon-bearing bonds will pay semiannually, what will be the
price at which you will be willing to purchase these bonds? (Round to the nearest dollar.)
a. $308
b. $383
c. $803
d. $866

5. Yield to maturity: Jenny LePlaz is looking to invest in some five-year bonds that pay annual coupons
of 6.25 percent and are currently selling at $912.34. What is the current market yield on such bonds?
(Round to the closest Answer.)

a.
b.
c.
d.

9.5%
8.5%
6.5%
7.5%

6. Yield to maturity: Shawna Carter wants to invest her recent bonus in a four-year bond that pays a
coupon of 11 percent semiannually. The bonds are selling at $962.13 today. If she buys this bond and
holds it to maturity, what would be her yield? (Round to the closest Answer.)
a. 11.5%
b. 11.8%
c. 12.5%
d. 12.2%
7. Effective annual yield: Stanley Hart invested in a municipal bond that promised an annual yield of
6.7 percent. The bond pays coupons twice a year. What is the effective annual yield (EAY) on this
investment?
a. 13.4%
b. 6.81%
c. 6.70%
d. None of the above

Chapter 8 Sample Questions - Answer Section

MULTIPLE CHOICE
1.

ANS: A

Learning Objective: LO 3
Level of Difficulty: Medium
Feedback: Years to maturity = n = 10
Coupon rate = C = 7%
Annual coupon = $1,000 x 0.07 = $70
Current market rate = i = 9%
Present value of bond = PB

PTS:

2.

ANS: A

Learning Objective: LO 3
Level of Difficulty: Hard
Feedback: Years to maturity = n = 5
Coupon rate = C = 10%
Frequency of payment = m = 2
Semiannual coupon = $1,000 x (0.10/2) = $50.00
Current market rate = i = 8.8%
Present value of bond = PB

Prepared by Jim Keys

29

PTS:

3.

ANS: B

Learning Objective: LO 3
Level of Difficulty: Medium
Feedback: Years to maturity = n = 5
Coupon rate = C = 0%
Current market rate = i = 8.5%

PTS:

4.

ANS: A

Learning Objective: LO 3
Level of Difficulty: Medium
Feedback:

Prepared by Jim Keys

30

PTS:

5.

ANS: B

Learning Objective: LO 4
Level of Difficulty: Medium
Feedback: Years to maturity = n = 5
Coupon rate = C = 6.25%
Annual coupon = $1,000 x (0.0625) = $62.50
Yield to maturity = i
Present value of bond = PB = $912.34
Use the trial-and-error approach to solve for YTM. Since the bond is selling at a discount, we know that the yield to
maturity is higher than the coupon rate. Try YTM = 8%:

Try a higher rate, say YTM = 8.5%:

The YTM is approximately 8.5 percent. Using a financial calculator provided an exact YTM of 8.47 percent.
Enter

5
N

i%

$62.50
PMT

-$912.34
PV

Prepared by Jim Keys

$1,000
FV

31

PTS:

6.

ANS: D

Learning Objective: LO 4
Level of Difficulty: Medium
Feedback: Years to maturity = n = 4
Coupon rate = C = 11%
Semiannual coupon = $1,000 x (0.011/2) = $55
Yield to maturity = i
Present value of bond = PB = $962.13
Use the trial-and-error approach to solve for YTM. Since the bond is selling at a discount, we know that the yield to
maturity is higher than the coupon rate. Try YTM = 12%:

Try a higher rate, say YTM = 12.2%:

The YTM is approximately 12.2 percent. Using a financial calculator provided an exact YTM of 12.22 percent (2 x
6.11%).
Enter

8
N

PTS:

7.

ANS: B

$55
i%

- $962.13
$1,000
PMT
PV

FV

Learning Objective: LO 4
Level of Difficulty: Hard
Feedback: Annual yield = 6.7%
The effective annual yield can be computed as:

PTS:

1
Prepared by Jim Keys

32