Interest Rate and Bond Valuation

Interest Rate

The compensation paid by the borrower of funds to the lender.

Required return

The cost of funds obtained by selling an ownership interest.

Liquidity preference

The general tendency for investors to prefer short-term and more liquid securities.

Real rate of interest

The rate that creates equilibrium between the supply of savings and the demand for investment funds.

Nominal rate of interest

The actual rate of interest charged by the supplier of funds and paid by the demander.

Yield curve

A graphic depiction of the term structure of interest rates.

Expectations Theory

The theory that suggests that the yield curve reflects investor expectations about future interest rates.

Liquidity Preference Theory

The theory that states that long-term rates are generally higher than short-term rates due to the perception of short-term investments being more liquid and less risky.

Market Segmentation Theory

The theory that states that the market for loans is segmented based on maturity, and the supply and demand for loans within each segment determine prevailing interest rates.

Risk premium

The additional return demanded by investors for taking on specific issuer and issue-related risks.

Bond indenture

A legal document that specifies the rights of bondholders and the duties of the issuing corporation.

Restrictive covenants

Provisions in a bond indenture that place operating and financial constraints on the borrower.

Sinking-fund requirements

A provision for the systematic retirement of bonds prior to their maturity.

Yield to maturity (YTM)

The compound annual rate of return earned on the bond if held to maturity.

Current yield

A measure of a bond's cash return for the year, calculated by dividing the bond's annual interest payment by its current price.

Bond ratings

Assessments of the riskiness of publicly traded bond issues by independent agencies.

Debentures

Unsecured bonds that only creditworthy firms can issue.

Income Bonds

Bonds where the payment of interest is required only when earnings are available.

Mortgage Bonds

Bonds secured by real estate or buildings.

Floating-rate bonds

Bonds with interest rates that fluctuate based on changes in a specified benchmark interest rate.

Debt rating

A rating given by credit rating agencies such as Moody's and Standard & Poor's to indicate the creditworthiness of a debt instrument.

Junk bonds

High-risk bonds with low credit ratings, typically rated Ba or lower by Moody's or BB or lower by Standard & Poor's.

Growth capital

Capital obtained by rapidly growing firms to finance their expansion and growth.

Mergers and takeovers

The use of debt to finance the acquisition of another company or to facilitate a merger between two companies.

High yield

The interest rate or return on investment offered by junk bonds, which is higher than that of high-quality corporate debt.

Zero-coupon bonds

Bonds that are issued with no or very low coupon rates and are sold at a significant discount from their par value.

Callable bonds

Bonds that can be redeemed by the issuer at par value before their maturity date.

Adjustable-rate bonds

Bonds with a stated interest rate that is adjusted periodically within certain limits, often used when future inflation and interest rates are uncertain.

Putable bonds

Bonds that provide the bondholder with the option to redeem the bond at specific dates or when certain actions are taken by the issuer.

Extendible notes

Short-term bonds with maturities typically ranging from 1 to 5 years, which can be renewed for a similar period at the option of the bondholders.

Foreign bond

A bond issued by a foreign corporation or government, denominated in the investor's home currency and sold in the investor's home market.

Eurobond

A bond issued by an international borrower and sold to investors in countries with currencies other than the bond's denomination.

Valuation

The process of determining the worth or value of an asset by linking risk and return.

Cash flows

The returns or cash payments expected to be received from an asset over its ownership period.

Timing

The consideration of when the cash flows from an asset will be received, which can impact its value.

Discount rate

The rate used to discount future cash flows to their present value in the valuation process, reflecting the measure of risk associated with the asset.

Present value

The current value of future cash flows, obtained by discounting them using the appropriate discount rate.

Bond valuation

The process of determining the value of a bond by calculating the present value of the payments the issuer is obligated to make until it matures.

Coupon interest rate

The annual interest rate paid by a bond, expressed as a percentage of its par value.

Yield to maturity (YTM)

The compound annual rate of return earned on a bond held until its maturity date.

Semiannual interest

The interest payments made twice a year by bonds that pay interest semiannually.

Premium

The situation where the value of a bond is higher than its par value, typically due to economic forces or the passage of time.

Discount

The situation where the value of a bond is lower than its par value, typically due to economic forces or the passage of time.

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