Lecture 3

Interest rates & Bonds valuations

Business Finance
Week 3
 Interest Rate

Interest rates: they can be thought of as the cost of borrowing money

For individuals: you will need Companies usually need to

For investors:
to borrow money in order to: borrow money in order to:
Interest rates can provide
Take out student loans want to expand their
insights into future changes in
operations or to replace
Buy a house or a car. the market
equipment,
 Varieties of interest rates
There are a variety of interest rates:
Domestic rates
Foreign rates
Short-term rates
Long-term rates
Commercial loans
Private loans
Mortgages
Credit cards
And many others
 What’s interest rate? (US case)
The Federal Reserve (the Fed) sets the Federal Funds Rate
The Federal Funds Rate is the rate that banks use to borrow between each other to
meet the reserve requirement.
What’s the reserve requirements?
It is the amount of money that a bank holds in reserve to make sure that it is able to
meet liabilities in case of sudden withdrawal, and it is set by the Fed.
The Fed buys and sells US Treasury bonds on the secondary market from US banks :
If the Fed buys US Treasury bonds, it increases the money supply.
If the Fed sells US Treasury bonds, it decreases the money supply.
 The Federal Funds Rate
• The Federal Funds Rate is one of the most important interest rates in the US
economy. Why? It has an impact on the monetary and financial conditions which
will, in their turn, impact the economy as whole such as employment, growth, and
inflation.
• What the Fed should do in case it wants to increase the money supply ? When to
do so?
When the Fed lowers interest rates, it increases the money supply.
It does this during an economic downturn because it wants to stimulate the economy.
• What the Fed should do in case it wants to decrease the money supply ? When to
do so?
When the Fed wants to increase interest rates, it decreases the money supply.
It does this to slow the growth rate of the economy to prevent high inflation.
 What we know so far
New investments requires a lot of money.
Firms can retain & accumulate their earnings
to cover the cost of investment.

They can do so through :

1. Through equity: by selling some shares of common stocks.
2. Or through debts:
2.1. For a short term, firms may borrow from a bank.
2.2. For a long term, firms issue bonds.

What’s a bond?
How it is valued?
 What we have learned so far
We have learned that:
• Business decisions are often related to valuation of assets/CFs
• When valuing a Cash Flows, we need to pay attention to two elements:
1. Time and risk.
2. Value of Cash Flows is determined in financial markets.
From the market, we can learn :
How to value time : time value of money
How to value risk : Risk premium
Today, we will see:
Prices in the bond market gives the time value of money.
 What’s a Bond?
• Fixed-income securities: Are financial claims with promised cash flows of fixed amount paid
at fixed dates.

• What’s a bond?
A long term instrument.
A contract where a borrower agrees to make interest payments & principle payments on specific
dates.
 Types of Bonds
Types of Bonds
Treasury bonds
No risk of default
Corporate bonds
There is a risk that a company could default on its payments.
The more the default risk, the higher the interest they must pay.
Municipal bonds
Bonds issued by state and local governments or Municipalities such as Istanbul
Metropolis municipality.
Foreign bonds
Foreign governments issue bonds to finance their debt
Foreign corporations issue bonds to finance their debt
 Bond Terminology
Bond Terminology
• The primary bond market is where investors buy bonds directly from the company.
• The maturity date is the end date of the bond contract .
• Par value is the face value of the bond or the amount of money a company borrows and promises
to pay back on the maturity date.
• The coupon payment is the dollar value of the regular interest payments that are made
𝐂𝐨𝐮𝐩𝐨𝐧 𝐩𝐚𝐲𝐞𝐦𝐞𝐧𝐭
= Coupon interest rate
𝐏𝐚𝐫 𝐕𝐚𝐥𝐮𝐞
In the US, coupon payments are usually made semi-annually (twice a year). Yet, in Europe, the
payments are made annually .
The yield to maturity (YTM) is the yield promised to investors if they buy a bond at the current price
and hold it until maturity.
A Zero-coupon bond is type of bonds the repay principle at maturity, but makes no coupon payments
along the way.
Some bonds have a call provision, where a company can get back the bond early.
Generally, the company needs to pay a value higher than the par value in the case of the “call
provision”, and this is called the call premium.
However, bonds which do not have a call provision can be traded in the secondary market.
 Bond Terminology
French government bonds, known as OATs, they pay interest and principal in euros
(€).
Let’s suppose that in December 2008 you decide to buy €100 face value of the 8.5%
OAT maturing in December 2012.
Each December until the bond matures you are entitled to an interest payment of 100
× €8.50= .085, This amount is the bond’s coupon.
When the bond matures in 2012, the government pays you the final €8.50 interest,
plus the principal payment of the €100 face value.
Your first coupon payment is in one year’s time, in December 2009. So the cash
payments from the bond are as follows:

Cash Payments (€)

2009 2010 2011 2012
€8.50 €8.50 €8.50 €108.50
 Semi annual Coupons & Bonds
The US treasury also raises money by regular auctions of new bond issues.
The treasury issues :
Short term debt called bills which matures in a year or less.
Medium term issues called notes, which are bonds that mature in 10 years.
Long term issues called bonds which do not mature for 20 or 30 years.
And, these are traded in the fixed income market.
What do we do when the payments are made semi- annually?
The coupons on treasury bonds are paid semi annually. So, a coupon payment of a
4.875 coupon rate is 2.4375 (4.875/2= 2.4375%) of the face value every six months.
 How bonds are priced?

There are 3 steps:

1. Estimate the expected CFs (Coupons & FV).
2. Determine the required rate of return or the discount rate this rate
depends on the riskiness of the CF stream.
3. Compute the discounted PV of the future CFs, and the resulted PV us
what the asset is worth at a particular point in time.
 What is the present value of these payments?

1. This depends on the opportunity cost of capital, which in this case equals the rate of return
offered by other government debt issues denominated in euros.
2. In December 2008, other medium-term French government bonds offered a return of about
3.0%.
3. That is what you were giving up when you bought the 8.5% OATs. Therefore, to value the
8.5% OATs, you must discount the cash flows at 3.0%:
8.50 8.50 8.50 108.50
𝑃𝑉 = + 2 + 3 + = € 120.44
1.03 (1,03) (1,03) (1,03)4
Bond prices are usually expressed as a percentage of face value. Thus the price of your 8.5% OAT
was quoted as 120.44%.
PV(Bond) = PV(annuity of coupon payments) + PV(final payments principle)
PV(Bond) =(coupon × 4-year annuity factor) + (final payment ×discount factor)
1 1 100
PV(Bond) = 8.50 [ − 4 ]+ = € 120.44
0.03 0.03 (1:0.03) (1:0.03)
 Bond Value
So, the bond can be valued as a package of an annuity (the coupon payments) and a single, final
payment (the repayment of principal).
Bond Value = PV of coupons + PV of par value.
Bond value = PV of annuity + PV of lump sums.
We want to know what is the present value of the expected cash flows of a bond, discounted at
the appropriate rate of return:
𝑪 𝟏 𝑴
𝑽𝒃 = [𝟏 − ] +
𝒓 (𝟏:𝒓)𝒏 (𝟏:𝒓)

Where, C is the coupon payment , r is the market rate of interest, n is the number of years until
the bond matures M is the par value of the bond.
• When bonds are issued, the coupon rate is usually set to the market rate
The company will continue to pay the coupon rate throughout the life of the bond, but the
market rate may change over time One of the appealing features of bonds is they pay a fixed rate
of return, regardless of what is going on in the market
1. An increase in r will cause the price of a bond to decrease
2. A decrease in r will cause the price of a bond to increase
 Yield to maturity

If the price of the OAT is 120,44%, what’s the interest rate?

8.5 8.5 8.5 8.5
120.44 = 1:𝑦 +(1:𝑦)2 + (1:𝑦)3 +(1:𝑦)4
The rate of the return “𝒚” is called the bond’s yield to maturity.
The present value in this case is known, which is 120.44 at a discount rate of 3 %.
So, the yield to maturity should be 3%. Why?
Because if you hold the bond until maturity, you will earn a return of 3% per year.
Why the yield to maturity is less than 8.5 % coupon payment ?
Because you are paying a €120.44 for a bond with a face value of only € 100. investors
will lose the difference €20.44 if they hold the bond to maturity.
8.50
The immediate current yield of the investment in this case would be : 120.44 = 0.071 or
7.1 %.
The procedure of calculating the yield to maturity is trial and error.
 Yield to maturity
The yield to maturity is the single interest rate that realizes the PV of the cash flows by holding the bond to
maturity equal to the price of the bond.
We just used the 3% interest rate to calculate the present value of the OAT.
Let’s suppose that the price of the OAT is 120.44%, what is the interest rate? What return do investors get if
they buy the bond?

8.50 8.50 8.50 108.50

€ 120.44 = + + +
1:𝑦 (1:𝑦)2 (1:𝑦)3 (1:𝑦)4
• The rate of return “y “is called the bond’s yield to maturity.
In this case, we already know that the present value of the bond is €120.44 at a 3% discount rate, so the yield
to maturity must be 3.0%. If you buy the bond at 120.44% and hold it to maturity, you will earn a return of 3.0%
per year.
Why is the yield to maturity less than the 8.5% coupon payment?
1. Because you are paying €120.44 for a bond with a face value of only €100. You lose the difference of
€20.44 if you hold the bond to maturity.
2. On the other hand, you get four annual cash payments of €8.50. (The immediate, current yield on your
investment is 8.50/120.44 = .071, or 7.1%.)
3. The yield to maturity blends the return from the coupon payments with the declining value of the bond
over its remaining life.
• The only general procedure for calculating the yield to maturity is trial and error. You guess at an interest
rate and calculate the present value of the bond’s payments. If the present value is greater than the actual
price, your discount rate must have been too low, and you need to try a higher rate
 Example
Example 1: Compute the value for a $1000 par value bond with a 6,375 % coupon rate that will
mature in 5 years given that your require a 8 % return on your investment.
Now let’s assume that the required return is 10% what would happen? And what would happen if
the required return becomes 7 %?

What’s the relationship between interest rate and bond prices?

Example 2: Suppose a bond has a par value of $1000 with a coupon rate of 9%. The current
market rate is 4% and the bond will mature in 14 years. What is the value of the bond?
 Relation between Coupon rate and interest rate

When the Coupon rate (% 8)= the YTM (8% ) (The ongoing rate in the market for
bonds for similar risks) <= the price of bond = Par Value. And this is happens when
the bond is issued. However, the ongoing rate in the market will change over time.
Which will lead to the change of the price of the bond.

Whenever r > Coupon Rate, then the value of a bond will fall below its par value
When this is the case, this is called a discount bond.

Whenever r < Coupon Rate, then the value of a bond will increase above its par value
When this is the case, this is called a premium bond.
 Understanding Premium and Discount Bonds

Example 2: Suppose a bond has a par value of $1000 with a coupon rate of 9%. The
current market rate is 4% and the bond will mature in 14 years. What is the value of
the bond?
This bond is sold at a premium, Why?
Because the current market rate is 4%.
Whenever r > Coupon Rate, then the value of a bond will fall below its par value
When this is the case, this is called a discount bond.

Whenever r < Coupon Rate, then the value of a bond will increase above its par value
When this is the case, this is called a premium bond.
 Bonds yields

Example:
Suppose a bond has a par value of $1000 with a coupon rate of 9%. The current market rate is 4%
and the bond will mature in 14 years. What is the value of the bond?
Coupon Payment(C) = $1, 000(.09) = $90
90 1 1000
𝑣𝑏 = 1 − (1.04)14 +(1.04)14 = $1, 528.16
0.04
Because the value of this bond is greater than its par value, this bond could be sold at a premium.
Understanding Premium and Discount Bonds
This bond is sold at a premium because the current market rate is 4%.
This means that any company issuing a bond today would do so at 4%, and if the par value is
$1,000, then the coupon payment would be $40.
Since this bond pays a coupon payment of $90, it makes this bond more valuable.
The opposite is true of the market rate were higher than 9%, then new bonds would have higher
coupon payments than $90, so that would decrease the value of this bond.
 How bond prices vary with interest rate

This is a yield to maturity on 10-year US treasury bonds from 1900 to 2018.

The rate fluctuates a lot. What happened in 1979? And 2008?
So, by the end of that year term treasury bonds offered a 2,2 % rate of interest. So, bond prices change as interest
rates change.
 How bond prices vary with interest rate

Interest rates and bond prices must move in opposite directions.

So, the yield to maturity is the discount rate that explains the bond price.
𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑙𝑒
Pric𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑 = + + +
1:𝑦 (1:𝑦)2 (1:𝑦)3 (1:𝑦)4
When the yield to maturity falls, the bond price increases.
- When the annual yield is equal to the bonds annual coupon rate (4.875%), the bond is sold for exactly its face value.
- When the yield is higher than 4.875%, the bond sells at a discount to face value.
- When the yield is lower than 4.875%, the bond sells at a premium to face value.
We can see also that a change in interest rates has only modest impact on near-term CF but a much higher impact on the
value of the distant CF.
 Term structure of interest rate

The relationship between long-term & short-term interest rates is called the term structure of
interest rates. Short- and long-term interest rates do not always move in parallel.
The figure shows the term structure in two different years.
In April 2000: the slope was downward, the long term interest rates were lower than the short
term ones.
In September 1992: the slope was upward, the long term bonds provided a much higher interest
rate than short-term bonds.
 Term Structure of interest rates
Consider a simple loan that pays $1 at the end of one year. To find the PC of the loan
you need to discount the CF by the one-year rate of interest rate, 𝑟1 :
1
𝑃𝑉 =
1 + 𝑟1
This rate, 𝑟1 is the one-year spot rate. The first year CS is discounted at today’s one-
year spot rate.
To find, for example, the PV of a loan that pays $1 at the end of the two years, you
need to discount by the two-year spot rate, 𝑟2 :
1
𝑃𝑉 =
(1 + 𝑟2 )2
This rate, 𝑟2 is the two-year spot rate. The second year’s CS is discounted at today’s
two-year spot rate.
 Term Structure of interest rates
Example: Now suppose you have to value $1 paid at the end of years 1 and 2. If the
spot rates are different, say 𝑟1 =3% and 𝑟2 = 4%, then we need two discount rates to
calculate present value.
1 1
𝑃𝑉 = +(1:0,04)2 =1.895
1:0,03
Once we get the PV=1.895, we can go on to calculate a single discount rate that would
give the right answer:

1 1
𝑃𝑉 = 1.895 = +
1 + 𝑦 (1 + 𝑦)2
This gives a yield to maturity of 3.66%. So, we use it to value other two-year
annuities.
Spot rates come first, Yields to maturity come later, after bond prices are set.
 Term Structure of interest rates
We call the graphical representation of term structure: YIELD CURVE, where the term
structure represents the relationship between time to maturity to yields, everything
else equal.
The term structure of interest rates :
The longer until maturity (the term), the higher the interest rate will be.
This can visually be captured using the yield curve :
When interest rates increase as the term gets longer, we have a normal yield curve.
When interest rates decrease as the term gets longer, we have an inverted yield curve.
The yield curve inverts due to the expectation of a decline in interest rates by the
investors and as a result they try to lock in a fixed interest rate with longer-term
investments.
While every recession has been preceded by an inverted yield curve, it is important to
note that not every inverted yield curve results in a recession.
 Capital gain & Capital loss

Example: As a bond gets closer to maturity, the value will approach its par
value if the market rate remains unchanged
Lets look at our previous example: Suppose a bond has a par value of $1000
with a coupon rate of 9%. The current market rate is 4% and the bond will
mature in 14 years. What is the value of the bond?
90 1 1000
Coupon Payment(C) = $1, 000(.09) = $90/ 𝑣𝑏 = 1− + = $1, 528.16
0.04 (1.04)14 (1.04)14

Then now, what would this bond be worth if we held it for 1 year and the
market rate, r, did not change. This means n = 13 now.
90 1 1000
𝑣𝑏 = 1− + =$1499.28
0.04 (1.04)13 (1.04)13
The value of this bond declined by $28.88.
So, if I purchased this bond today at $1,528.16 and sold it next year at
$1,499.28, I would lose $28.88.This is called a capital loss.
 Capital gain & Capital loss
Yet, because I held the bond for 1 year, I would collect the coupon payment of $90.
Despite the fact that I had a capital loss, my dollar return is not actually negative because of the
$90 that I got as a coupon payment.
Total Dollar Return = $90 − $28.00 = $61.12

Note: When you sold a bond and made money, this would be called a capital gain.
 Other Determinants of Interest Rates
What’s inflation?
Inflation is the average change in prices from one year to the next.
1. Inflation Premium
Inflation can have a huge impact on interest rates because it destroys the purchasing
power of the dollar, thus reducing the “real” rate of return.
The “real” rate is the rate of return adjusted for inflation
Example
Suppose you invest $3,000 in a default free zero-coupon bond that matured in 1 year
and pays a 5% interest rate. At the end of the year you will get $3,150.
The interest premium is the average expected inflation over the length of the loan and
investors account for this into the interest rate when they lend money.
 Other Determinants of Interest Rates
2. Default Risk Premium
US Treasury bonds are the closest thing to a risk-free interest rate, and this is due to
the fact that that the US government is unlikely to default.
• For any other investment, there is a risk of default that is associated with it.
• The Default Risk Premium is the amount investors must be compensated for the
risk of default.
 Corporate Bonds & Default Risk
The corporations also do borrow by selling bonds.
National governments do not go bankrupt because they just print money. Yet, they cannot print
money of other countries.
Corporations maybe forced to default on their bonds .
The quoted rate of interest has a default risk premium built in
• The more likely a company is to default on a payment, the higher the interest rate.
• Risk of default is assessed using Bond Ratings.
The safety of most corporate bonds can be provided by Moody’s & Standard & Poor’s (S&P), and
Fitch in terms of bond ratings.
Corporate Bonds & Default Risk
 Bond Yields and Default Risk
The yields on corporate bonds vary with the bond rating?
The credit spread is the difference between a bonds yield and the yield on a US
treasury bond of the same maturity:
Default Risk Premium (DRP ) = Yield on Corporate Bond − Yield on US Treasury Bond
 Short term interest rates

Short-term interest rates can be approximated using the Fisher Equation:

i = 𝑟 ∗ + πe + 𝐷𝑅𝑃
Where,
i: is the interest rate.
𝒓∗ :is the risk-free interest rate (the rate on a 3-month US Treasury Bill).
πe : is the average expected inflation until maturity
𝐷𝑅𝑃 : is the default risk premium.
The longer until maturity, investors must be compensated for not being able to spend
that money today.
 Real and Nominal Rates of Interests
𝐍𝐨𝐦𝐢𝐧𝐚𝐥 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐚𝐭 𝐝𝐚𝐭𝐞 𝐭
𝐑𝐞𝐚𝐥 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐚𝐭 𝐝𝐚𝐭𝐞 𝐭 =
(𝟏 + 𝐢𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐫𝐚𝐭𝐞)𝐭

Example: suppose you invest in a 20-year Treasury Zero-coupon bond, but inflation over 20 years
averages 6% per year. The Zero-coupon bond pays $1000 in year 20. What’s the real value of the
payoff.
Let’s see how we get from nominal to real cash flows:
1000
= $ 311.80
1.0620
The real rate of return:
𝟏 + 𝐫𝐫𝐞𝐚𝐥 = (𝟏 + 𝐫𝐧𝐨𝐦𝐢𝐧𝐚𝐥 ) (𝟏 + 𝐢𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧)
Example: if a bond offers a 10% nominal rate of return. What’s the expected real rate of return
with an expected inflation rate of 6%?
𝟏 + 𝐫𝐫𝐞𝐚𝐥 = (𝟏.10) (𝟏. 𝟎𝟔) = 1.03774
𝐫𝐫𝐞𝐚𝐥 = 0.03774
 What determines the Real Rate of Interest?

The real interest rate depends on The supply of capital, and the opportunities for
productive investment by governments and business which is the demand for capital.
The real rate of interest rate depends on the balance of saving & investment in the
overall economy.
 Reference
Introduction to Business Finance: Techniques & Tools. Jeffrey S. Smith, Ph.D. Department of
Economics and Business Virginia Military Institute
Brealey, Stewart C. Myers, and Franklin Allen, Principles of Corporate Finance, 13th edition
(McGraw‐Hill Irwin, 2020).
Lecture Notes of: https://timmurrayecon.com/wp-content/uploads/2022/07/Business-Finance-
Lecture-Notes-June-2022.pdf