FIN 310 Chapter 7: Interest Rates and Bond Valuation

Vocabulary practice flashcards covering bond valuation, bond features, credit ratings, government securities, inflation effects, and the determinants of bond yields.

Bond

A legally binding contract between a borrower (debtor/issuer) and a lender (creditor/bondholder) where the borrower borrows money by issuing and selling the debt security.

Coupon

The stated periodic interest payment made on a bond.

Face Value (Par Value)

The principal amount of a bond that is repaid at the end of the term, typically assumed to be $\$1{,}000$ unless otherwise specified.

Coupon Rate

The annual coupon payment divided by the face value of a bond.

Maturity

The specified date on which the principal amount of a bond is repaid to the investor.

Yield to Maturity (YTM)

The interest rate required in the market on a bond, serving as the discount rate used to compute the present value of the bond's remaining cash flows.

Par Value Bond

A bond whose market price is equal to its face value, occurring when the coupon rate equals the yield to maturity ($\text{Coupon Rate} = \text{YTM}$).

Discount Bond

A bond that sells for less than its face value, occurring when market interest rates rise above the coupon rate ($\text{Coupon Rate} < \text{YTM}$).

Premium Bond

A bond that sells for more than its face value, occurring when market interest rates fall below the coupon rate ($\text{Coupon Rate} > \text{YTM}$).

Interest Rate Risk

The risk of fluctuations in a bond's price resulting from changes in market interest rates, which increases with a longer time to maturity and a lower coupon rate.

Bond Ratings

Credit assessments issued by rating agencies (such as Moody's and Standard & Poor's) that evaluate the probability of firm default and the protection creditors possess in such an event.

Treasury Bills

Short-term debt securities issued by the U.S. government with original maturities of $1$ year or less.

Treasury Notes

Medium-term coupon debt securities issued by the U.S. government that mature in $2$ to $10$ years.

Treasury Bonds

Long-term coupon debt securities issued by the U.S. government with maturities ranging from $20$ to $30$ years.

Municipal Bonds (Munis)

Debt obligations issued by state and local governments that carry default risk, are rated like corporate bonds, and provide interest that is exempt from federal income taxes.

Zero Coupon Bond

A bond that pays no periodic interest payments and is issued at a substantial discount from its face value, with yields typically computed using semi-annual periods.

Floating-Rate Bond

A bond where coupon payments adjust periodically according to a predetermined benchmark or interest rate index, such as a U.S. Treasury yield.

Treasury Inflation-Protected Securities (TIPS)

Floating-rate debt securities issued by the U.S. Treasury whose principal value adjusts with inflation and deflation, paying coupons based on the inflation-adjusted principal.

Over-the-Counter (OTC) Market

A decentralized financial market where bond transactions are privately negotiated directly between dealers electronically, characterized by lower transparency than centralized stock exchanges.

Nominal Interest Rate

The percentage change in the actual number of dollars earned or held from an investment, unadjusted for inflation.

Real Interest Rate

The percentage change in purchasing power obtained from an investment after adjusting for the effects of inflation.

Fisher Effect

The formal relationship defining how nominal interest rates ($R$), real interest rates ($r$), and expected inflation ($h$) interact, expressed by $1 + R = (1 + r) \times (1 + h)$ or approximately $R \approx r + h$.

Term Structure of Interest Rates

The relationship between nominal interest rates and time to maturity on default-free, pure discount (zero-coupon) bonds.

Inflation Premium

The portion of a nominal interest rate that compensates investors for expected future inflation that erodes purchasing power over the life of a loan.

Interest Rate Risk Premium

The compensation demanded by investors for holding longer-term bonds that carry greater price volatility from interest rate changes, increasing at a decreasing rate with maturity.

Treasury Yield Curve

A graphical plot displaying the yields of coupon-bearing U.S. Treasury securities relative to their time to maturity.

Default Risk Premium

The additional yield demanded by investors on corporate and non-Treasury bonds to compensate for the possibility that the borrower will fail to make scheduled interest or principal payments.

Taxability Premium

The extra return required by investors on fully taxable bonds relative to tax-exempt bonds (such as municipal bonds) to offset the unfavorable tax treatment.

Liquidity Premium

The extra yield demanded by investors as compensation for holding debt securities that are thinly traded and cannot be quickly converted into cash without a price concession.

Upward-Sloping Term Structure

A pattern in the term structure where long-term interest rates are higher than short-term interest rates, commonly driven by expected increases in inflation and positive interest rate risk premiums.

Downward-Sloping Term Structure

An inverted pattern in the term structure where short-term interest rates exceed long-term rates, typically reflecting anticipated decreases in future inflation sufficient to offset the interest rate risk premium.

Bond Features

Coupon, Face Value, Coupon Rate, Maturity