1. 6-1 July 20 Outline TVM Lab, Interest Rates and Bond Valuation

2. TVM Lab 2 Download and complete the spreadsheet template located at: https://blogs.baylor.edu/fin3310/files/201 5/07/Class-Spreadsheet-and-Calculator- Exercise-20-July-1cyg68n.xlsx

3. 3 5 years = N 14% = Discount rate (YTM) $60 = Payment (PMT) $1,000 = FV PV = ? -725.35 1st 2nd TI BA II Plus

4. 4 Bond Valuation

5. 5 Download and complete the spreadsheet template located at: https://blogs.baylor.edu/fin3310/files/201 5/07/Interest_Rate_Sensitivity- 1q0zohb.xlsx

6. Nominal vs Real Interest Rates: The Fisher Effect 6 The Fisher Effect defines the relationship between real rates, nominal rates, and inflation (1 + R) = (1 + r)(1 + h), where R = nominal rate r = real rate h = expected inflation rate Approximation R = r + h

7. Fisher Effect Example 7 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.

8. Term Structure of Interest Rates 8 The term structure is the relationship between time to maturity and yields, all else equal; AKA the “yield” curve.

9. Term Structure of Interest Rates 9 “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

10. Upward-Sloping Yield Curve 10

11. Downward-Sloping Yield Curve 11

12. 12 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.http://www.treasury.gov/resource-center/data-chart-center/interest- rates/Pages/Historic-Yield-Data-Visualization.aspx See http://www.usinflationcalculator.com/inflation/current-inflation-rates/ for inflation data.http://www.usinflationcalculator.com/inflation/current-inflation-rates/

13. Bond Ratings – Investment Quality 13 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 strong Medium 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

14. Bond Ratings – Speculative (Junk) 14 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