Chapter 8
Bond Valuation and Risk
Outline
Bond Valuation Process
Impact of the Discount Rate on Bond Valuation
Impact of the Timing of Payments on Bond Valuation
Valuation of Bonds with Semiannual Payments
Relationships between Coupon Rate, Required Return, and Bond Price
Explaining Bond Price Movements
Factors That Affect the Risk-free Rate
Factors That Affect the Credit (Default) Risk Premium
Summary of Factors Affecting Bond Prices
Implications for Financial Institutions
Sensitivity of Bond Prices to Interest Rate Movements
Bond Price Elasticity
Duration
Bond Investment Strategies Used by Investors
Matching Strategy
Laddered Strategy
Barbell Strategy
Interest Rate Strategy
Valuation and Risk of International Bonds
Influence of Foreign Interest Rate Movements
Influence of Credit Risk
Influence of Exchange Rate Fluctuations
International Bond Diversification
European Debt Crisis
Key Concepts
1. Explain the logic behind how bond prices are affected by interest rates.
2. Use the bond valuation equations to explain how the sensitivity of bond prices to interest rate
movements is a function of bond characteristics (such as maturity and coupon rate).
3. Explain the common strategies that are used to invest in bonds.
POINT/COUNTER-POINT:
Does Governance of Firms Affect the Prices of Their Bonds?
POINT: No. Bond prices are primarily determined by interest rate movements and therefore are not
affected by the governance of the firms that issued bonds.
COUNTER-POINT: Yes. Bond prices reflect the risk of default. Firms that impose more effective
governance may be able to reduce their default risk and therefore increase the price of the bond.
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
ANSWER: A bond’s price is based on the investor’s required rate of return, and investors may accept a
lower return on bonds issued by firms that are subject to a higher degree of governance. Thus, governance
can affect the price of the firm’s bonds.