Financial Markets and Institutions (2-downloads)

Solution: Equation

P

⫽ $47.17 ⫹ $44.50 ⫹ $41.98 ⫹ $39.60 ⫹ $792.10 ⫽ $965.35

P

⫽

$100

>2

11 ⫹ .062

⫹

$100

>2

11 ⫹ .062

2

⫹

$100

>2

11 ⫹ .062

3

⫹

$100

>2

11 ⫹ .062

4

⫹

$1,000

11 ⫹ .062

4

E X A M P L E   1 2 . 3 Bond Valuation, Semiannual Payment Bond

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298

Part 5 Financial Markets

Notice that the market price for the bond in Example 3 is below the $1,000 par value

of the bond. When the bond sells for less than the par value, it is selling at a discount.

When the market price exceeds the par value, the bond is selling at a premium.

What determines whether a bond will sell for a premium or a discount? Suppose

that you are asked to invest in an old bond that has a coupon rate of 10% and $1,000

par. You would not be willing to pay $1,000 for this bond if new bonds with similar

risk were available yielding 12%. The seller of the old bond would have to lower the

price on the 10% bond to make it an attractive investment. In fact, the seller would

have to lower the price until the yield earned by a buyer of the old bond exactly

equaled the yield on similar new bonds. This means that as interest rates in the

market rise, the value of bonds with fixed interest rates falls. Similarly, as interest

rates available in the market on new bonds fall, the value of old fixed-interest-rate

bonds rises.

Investing in Bonds

Bonds represent one of the most popular long-term alternatives to investing in stocks

(see Figure 12.6). Bonds are lower risk than stocks because they have a higher pri-

ority of payment. This means that when the firm is having difficulty meeting its oblig-

ations, bondholders get paid before stockholders. Additionally, should the firm have

to liquidate, bondholders must be paid before stockholders.

Even healthy firms with sufficient cash flow to pay both bondholders and stock-

holders frequently have very volatile stock prices. This volatility scares many

investors out of the stock market. Bonds are the most popular alternative. They offer

relative security and dependable cash payments, making them ideal for retired

investors and those who want to live off their investments.

Many investors think that bonds represent a very low risk investment since the

cash flows are relatively certain. It is true that high-grade bonds seldom default; how-

ever, bond investors face fluctuations in price due to market interest-rate movements

in the economy. As interest rates rise and fall, the value of bonds changes in the oppo-

site direction. As discussed in Chapter 3, the possibility of suffering a loss because

of interest-rate changes is called interest-rate risk. The longer the time until the

bond matures, the greater will be the change in price. This does not cause a loss to

those investors who do not sell their bonds; however, many investors do not hold their

bonds until maturity. If they attempt to sell their bonds after interest rates have risen,

they will receive less than they paid. Interest-rate risk is an important considera-

tion when deciding whether to invest in bonds.