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July 20 Outline

•TVM Lab, Interest Rates and Bond Valuation

TVM Lab

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Download and complete the spreadsheet template located at:

https://blogs.baylor.edu/fin3310/files/2015/07/Class-Spreadsheet-and-Calculator-Exercise-20-July-1cyg68n.xlsx

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5 years = N14% = Discount rate (YTM)$60 = Payment (PMT)$1,000 = FV

PV = ?

-725.35

1st2nd

TI BA II Plus

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Bond Valuation

Bond Valuation

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Download and complete the spreadsheet template located at:

https://blogs.baylor.edu/fin3310/files/2015/07/Interest_Rate_Sensitivity-1q0zohb.xlsx

Nominal vs Real Interest Rates:

The Fisher Effect

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The Fisher Effect defines the relationship between real rates, nominal rates, and inflation

(1 + R) = (1 + r)(1 + h), whereR = nominal rater = real rateh = expected inflation rate

ApproximationR = r + h

Fisher Effect Example

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If we require a 10% real return and we expect inflation to be 8%, what is the nominal rate?

R = (1.1)(1.08) – 1 = .188 = 18.8%An Approximation: R = 10% + 8% = 18%

Because the real return and expected inflation in this example are relatively high, there is significant difference between the actual Fisher Effect and the approximation.

Term Structure of Interest Rates

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The term structure is the relationship between time to maturity and yields, all else equal; AKA the “yield” curve.

Term Structure of Interest Rates

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“Normal” yield curve – upward-sloping; long-term yields are higher than short-term yields

“Inverted” yield curve – downward-sloping; long-term yields are lower than short-term yields

Upward-Sloping Yield Curve

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Downward-Sloping Yield Curve

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• See http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/Historic-Yield-Data-Visualization.aspx for the current US Treasury Yield Curve.

• See http://www.usinflationcalculator.com/inflation/current-inflation-rates/ for inflation data.

Bond Ratings – Investment Quality

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High Grade– Moody’s Aaa and S&P AAA – capacity to pay is

extremely strong– Moody’s Aa and S&P AA – capacity to pay is very

strongMedium Grade

– Moody’s A and S&P A – capacity to pay is strong, but more susceptible to changes in circumstances

– Moody’s Baa and S&P BBB – capacity to pay is adequate, adverse conditions will have more impact on the firm’s ability to pay

Bond Ratings – Speculative (Junk)

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• Low Grade–Moody’s Ba and B–S&P BB and B–Considered possible that the capacity to pay will degenerate.

• Very Low Grade–Moody’s C (and below) and S&P C (and below)• income bonds with no interest being paid,

or• in default with principal and interest in

arrears