BOND_PRICES.docVIP

BOND PRICES INTEREST Bond - borrower promises to pay interest repay principal at maturity Coupon - contractual rate of interest - borrower must pay this every year until bond matures --- does not change if general interest rates change Bond Prices - once a bond is sold, the price of the bond will change as interest rates change -bond prices change so that the bond sold at that price will provide a return equal to current market yields eg. - bond originally sold for $100 with 7% coupon - market yields for same type of bond are now 9% - this bond is less valuable because it pays a lower rate - therefore its price falls Yield - rate of return earned if buy bond at current price If interest rates ( bond prices ( If interest rates ( bond prices ( Bond prices always expressed in terms of $100 Sample Bond Quotations Issuer Coupon Maturity Date Bid Ask Yield ABC Company 8.00% Jan 2/04 104.50 105.00 7.25% XYZ Inc 6.50% Mar 15/04 97.75 98.15 7.10% Acme Ltd 7.55% May 10/04 101.50 101.95 7.22% Determinants of Bond Yields interest rates are determined in the capital markets by the supply/demand for capital a bond investor wants to be compensated for - inflation risk earn a return - the yield for a specific bond = real interest rate + inflation premium + default risk premium + maturity risk premium real interest rate inflation premium ( 90 day Tbill rate default risk premium = (yield on this bond - yield on fed bond of same maturity) maturity risk premium = (yield on this bond - yield on bond of same issuer but diff maturity) Bonds - 2 Plot the yield curves for the bonds listed below Yield 10% 0% 1 2 5 10 15