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Date Created: 11/01/15
111 Chapter 7 Lecture Outline Definition of long term debt and bonds Longterm debt refers to any promissory note that a borrower executes with a lender wherein he or she agrees to repay the borrowed funds and to compensate the lender for the borrowed funds over a period of time greater than one year Bonds are simply long term debt sold by issuing corporations in the capital markets Types of long term bonds Secured or mmtgage bonds Debenture bonds unsecured Senior or junior debt Subordinated debt Features of Long term bonds Coupon rate 0 Zero coupon 0 Original issue discount Maturity Call feature 0 Call price call premium deferred call feature 0 Why do bonds have a call feature Put feature Sinking fund Equity linked debt 0 Conveltible bonds conversion ratio 0 Warrants unit offering Bond ratings measure of default risk Indenture covenants trustee VI Bond valuation I M 0 2 727n 74 21 1kd 1kd in P0 12 M 76 Bond pricing principles First Principle Bond values are inversely related to the required rate of return Second Principle If the required rate of return is greater than the coupon rate then the bond value is less than the par value If the required rate of return is less than the coupon rate then the bond value is greater than the par value Third Principle The sensitivity of bond prices to a given change in the required rate of return increases with the maturity of the bond Fourth Principle The sensitivity of bond prices to a given change in the required rate of return decreases the higher the coupon rate Yield to Maturity The yield to maturity of a bond is the discount rate that equates the present value of all expected interest payments until maturity and the repayment of principal at maturity from a bond to the present bond price The Y TM tells a bond investor what he or she is likely to earn ifa bond is purchased for a given price and held to maturity VII kd rf risk premium Determinants of bond yields maturity risk premium default risk premium 77 marketability risk premium Risk free rate of return The riskfree rate of return rf that we observe is the nominal riskfree rate The nominal riskfree rate depends on the real risk free rate and the expected in ation premium The Fisher effect captures the relation between the nominal riskfree rate and the real riskfree rate and in ation premium 1rf1r f1in 78 rf ryin ryin 79 where r is the real riskfree rate and in is the expected in ation premium The last term on the right hand side is very small so the nominal riskfree rate is usually depicted as simply the sum of the real riskfree rate and the expected in ation premium rf r f in 710 Risk premium 0 Maturity risk premium or term structure of interest rates I Expectations theory I Maturity premium theory I Market segmentation theory 0 Default risk premium 0 Marketability risk premium
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