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Fundamentals of Corporate Finance, 2/e

ROBERT PARRINO, PH.D. DAVID S. KIDWELL, PH.D. THOMAS W. BATES, PH.D.

Bond Valuation and the Structure of Interest Rates

Learning Objectives

1. DESCRIBE THE MARKET FOR CORPORATE BONDS AND THREE TYPES OF CORPORATE BONDS. 2. EXPLAIN HOW TO CALCULATE THE VALUE OF A BOND AND WHY BOND PRICES VARY NEGATIVELY WITH INTEREST RATE MOVEMENTS. 3. DISTINGUISH BETWEEN A BOND’S COUPON RATE, YIELD TO MATURITY, AND EFFECTIVE ANNUAL YIELD.

Learning Objectives

4. EXPLAIN WHY INVESTORS IN BONDS ARE SUBJECT TO INTEREST RATE RISK AND WHY IT IS IMPORTANT TO UNDERSTAND THE BOND THEOREMS. 5. DISCUSS THE CONCEPT OF DEFAULT RISK AND KNOW HOW TO COMPUTE A DEFAULT RISK PREMIUM. 6. DESCRIBE THE FACTORS THAT DETERMINE THE LEVEL AND SHAPE OF THE YIELD CURVE.

Corporate Bonds

o MARKET FOR CORPORATE BONDS

• Life insurance companies and pension funds buy most corporate bonds

Transactions tend to be in very large dollar amounts.

• Less than 1% of all corporate bonds are traded on organized exchanges

Most transactions take place through dealers in the over-the-counter (OTC) market.

Corporate Bonds

o MARKET FOR CORPORATE BONDS

• At the end of 2007, the amount of corporate and foreign debt outstanding was \$10.1 trillion, ranking the debt market second behind the market for corporate equity (\$20.8 trillion).

Corporate Bonds

o MARKET FOR CORPORATE BONDS

• Only a small fraction of the bonds outstanding are traded each day.

The market is thin compared to markets for moneymarket securities and stocks. Corporate bonds are less marketable than securities with large daily trading volumes. Prices in the market tend to be more volatile than those of securities with greater trading volumes.

Corporate Bonds

o BOND PRICE INFORMATION

• Corporate bond pricing is not considered transparent.

It is difficult for investors to obtain important information on prices and volume. Many transactions are negotiated directly between buyer and...