Chapter 5 - Bond prices and interest rate risk. The purpose of this chapter is to explain how interest rate movements affect the prices of assets and liabilities of investors and financial institutions. We focus on bonds because their behavior in the face of interest rate changes is similar to that of other financial instruments. | Power Point Slides for: Financial Institutions, Markets, and Money, 9th Edition Authors: Kidwell, Blackwell, Whidbee & Peterson Prepared by: Babu G. Baradwaj, Towson University And Lanny R. Martindale, Texas A&M University CHAPTER 5 BOND PRICES AND INTEREST RATE RISK The Time Value of Money: Investing—in financial assets or in real assets—means giving up consumption until later. Positive time preference for consumption must be offset by adequate return. Opportunity cost of deferring consumption determines minimum rate of return required on a risk-free investment— Present sums are theoretically invested at not less than this rate; Future cash flows are discounted by at least this rate. Time value of money has nothing primarily to do with inflation. Inflation expectations affect discount rate, but Deferred consumption has opportunity cost by definition. Future Value or Compound Value The future value (FV) of a sum (PV) is FV = PV (1+i)n where i is the periodic interest rate . | Power Point Slides for: Financial Institutions, Markets, and Money, 9th Edition Authors: Kidwell, Blackwell, Whidbee & Peterson Prepared by: Babu G. Baradwaj, Towson University And Lanny R. Martindale, Texas A&M University CHAPTER 5 BOND PRICES AND INTEREST RATE RISK The Time Value of Money: Investing—in financial assets or in real assets—means giving up consumption until later. Positive time preference for consumption must be offset by adequate return. Opportunity cost of deferring consumption determines minimum rate of return required on a risk-free investment— Present sums are theoretically invested at not less than this rate; Future cash flows are discounted by at least this rate. Time value of money has nothing primarily to do with inflation. Inflation expectations affect discount rate, but Deferred consumption has opportunity cost by definition. Future Value or Compound Value The future value (FV) of a sum (PV) is FV = PV (1+i)n where i is the periodic interest rate and n is the number of compounding periods. Present Value The value now of a sum expected at a future time is given by With risk present, a premium may be added to the risk-free rate. The higher the discount rate, the lower the present value. Bond Pricing: What is a bond? A form of loan—a debt security obligating a borrower to pay a lender principal and interest. Borrower (issuer) promises contractually to make periodic payments to lender (investor or bondholder) over given number of years At maturity, holder receives principal (or face value or par value). Periodically before maturity, holder receives interest (coupon) payments determined by coupon rate, original interest rate promised as percentage of par on face of bond. What is a bond? Example Par value $1,000 Coupon Rate 5% Issued Today Matures 30 years from today Scheduled Payments: $50/year interest for 30 years $1,000 par at end of year 30 Bondholder thus owns right to a stream of cash flows: Ordinary annuity of .
