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Bond Prices Zero-coupon bonds: promise a single future payment, e.g., a U.S. Treasury Bill. Fixed payment loans, e.g., conventional mortgages. Coupon Bonds: make periodic interest payments and repay the principal at maturity, e.g., U.S. Treasury Bonds and most corporate bonds. Consols: make periodic interest payments forever, never repaying the principal that was borrowed, e.g., British consols.

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Bond Prices Zero-Coupon Bonds or Discount Bonds Price of a $100 face value zero-coupon bond Where i = interest rate n = time until the payment is made

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Bond Prices Zero-Coupon Bonds or Discount Bonds Examples. Assume i=4% Price of a One-Year Treasury Bill. Price of a Six-Month Treasury Bill

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Bond Prices Fixed Payment Loans Value of a Fixed Payment Loan =

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Bond Prices Coupon Bond

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Bond Prices Consols

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Bond Yields Yield to Maturity Price of One-Year 5 percent Coupon Bond = The value of i that solves this equation is the yield to maturity

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Bond Yields Yield To Maturity If the price of the bond is $100, then the yield to maturity equals the coupon rate. Since the price rises as the yield falls, when the price is above $100, the yield to maturity must be below the coupon rate. –If you pay more than the face value for a bond, you are earning less than the coupon rate.

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Bond Yields

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Bond Yields Relationship Between a Bond’s Price and Its Coupon Rate, Current Yield and Yield to Maturity Bond Price < Face Value Coupon Rate < Current Yield < Yield to Maturity Bond Price = Face Value Coupon Rate = Current Yield = Yield to Maturity Bond Price > Face Value Coupon Rate > Current Yield > Yield to Maturity

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Bond Yields Holding Period Return: the return to holding a bond and selling it before maturity. The holding period return can differ from the yield to maturity when you do not hold the bond to maturity.

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Bond Yields Example: 10 year bond (Face value=$100) and a 6% coupon rate. Sold one year later. If the interest rate in one year is 5%, one year holding period return =

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Bond Yields If the interest rate in one year is 7% One year holding Period return = or -.52%

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Bond Market and Interest Rates One Year Zero-coupon (discount) Bond.

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Bond Market and Interest Rates

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Factors that shift Bond Supply An increase in the government’s borrowing increases the quantity of bonds outstanding, shifting the bond supply curve to the right. As business conditions improve, the bond supply curve shifts to the right. An increase in expected inflation shifts the bond supply curve to the right.

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Bond Market and Interest Rates

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Factors that Shift Bond Demand to Right An increases in wealth. A fall in expected inflation. If the return on bonds rises relative to the return on alternative investments, the demand for bonds increases. If a bond becomes less risky relative to alternative investments, the demand for the bond increases. When a bond becomes more liquid relative to alternatives, the demand for the bond increases.

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Bond Market and Interest Rates

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Bonds and Risk Sources of Bond Risk Default Risk Inflation Risk Interest-Rate Risk

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McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Money and Banking Lecture 14.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Money and Banking Lecture 14.

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