Valuation of Fixed-Income Securities


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SUMMARY

An understanding of the key characteristics of debt financing is essential for managers and investors because:

  • in the markets today a wide variety of debt instruments are traded;
  • lenders demand different interest rates on loans of different lenghts of time to maturity;
  • the decision to raise equity or debt finance is neither simple nor straightforward.

The market value of a debt instrument is determined by discounting each of its future interest and principal payments at a required rate of return that is approriate for its term to maturity and risk. The key component in valuing bonds is the interest rate, which represesents the cost of money to the borrower and the return to the lender. However, once issued, any change in market rates can make bonds more or less attractive to investors. If the bond pays more interest than is available elsewhere for comparable risk, investors willingly pay more to own the fixed income security. However, if the bond pays less interest than can be earned for comparable risk, investors pay less for the bond.

LEARNING OUTCOMES

Participants who have completed this chapter should understand:

  • the valuation of a pure-discount bond;
  • the valuation of a coupon bond;
  • several different return measures associated with bonds;
  • the interpretation of yield curves;
  • the behavior of prices of bonds to changing interest rates and maturities.

 



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