CHAPTER 8
Bond Valuation and Risk
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CHAPTER 8 OVERVIEW
This chapter will:
A. Explain how debt securities are priced
B. Identify the factors that affect bond prices
C. Explain how the sensitivity of bond prices to
interest rates is dependent on particular
bond characteristics
D. Explain the benefits of diversifying bonds
internationally
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A. Bond Valuation Process
1. Bond Valuation
Pricing formula:
C
C
C  par
PV 

 ... 
1
2
n
1  k  1  k 
1  k 
where C = coupon payment paid in each period
Par= par value
k = required rate of return
n = number of period to maturity
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A. Bond Valuation Process
2. Impact of the Discount Rate on Bond
Valuation
a. Critical to accurate bond valuation
b. High risk securities have higher discount
rates
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A. Bond Valuation Process
3. Impact of the Timing of Payments on Bond
Valuation
a. Timing affects the market price of a bond
b. Funds received sooner can be reinvested
to earn additional returns
c. Most bonds have semiannual coupons
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B. Factors that Affect Bond Prices
1.
Bonds selling below par
a. If coupon rate is below required rate, present value of the
bond is below par
b. known as a discount bond
2.
Bonds selling at par
a. If coupon rate equals the required rate, the price of the
bond is equal to par value
3.
Bonds selling above par
a. If the coupon rate is above the required rate, the
price of the bond is above the par
b. known as a premium bond
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B. Factors that Affect Bond Prices
4. Factors That Affect the Risk-Free Rate
a. Inflationary Expectations
b. Economic Growth
c. Money Supply Growth
d. Federal Government Budget Deficit
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B. Factors that Affect Bond Prices
5. Factors That Affect the Credit (Default)
Risk Premium
a Changes in the Credit Risk Premium over
Time
b. Changes in Bond Ratings over Time
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C. Sensitivity of Bond Prices to
Interest Rate Movements
1. Bond Price Elasticity
a. Influence of Coupon Rate on Bond Price
Sensitivity
b. Influence of Maturity on Bond Price Sensitivity
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C. Sensitivity of Bond Prices to
Interest Rate Movements
2. Duration
a. Duration of a Portfolio
b. Modified Duration
c. Estimation Errors from Using Modified
Duration
d. Bond Convexity
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C. Sensitivity of Bond Prices to
Interest Rate Movements
3. Bond Investment Strategies Used by
Investors
a. Matching Strategy
b. Laddered Strategy
c. Barbell Strategy
d. Interest Rate Strategy
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D. Return and Risk of International
Bonds
1. Influence of Foreign Interest Rate
Movements
2. Influence of Credit Risk
3. Influence of Exchange Rate Fluctuations
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D. Return and Risk of International
Bonds
4. International Bond Diversification
a. Reduction of Interest Rate Risk
b. Reduction of Credit Risk
c. Reduction of Exchange Rate Risk
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