Lifecycle of Public Private Partnership (PPP) Projects
In the previous articles, we have undertaken careful consideration of how public-private partnership (PPP) projects work. A lot of details have been provided about the execution stage of PPP projects. However, little is known about how these huge infrastructure projects come into being in the first place. In this article, we will have a closer […]
Dealer Markets vs. Broker Markets
Markets across the world can also be segregated based on the type of intermediary. Prima facie, it may appear that the type of intermediary is not of much consequence. However, over time, market participants have realized that the type of intermediaries has a profound effect on the liquidity, efficiency as well as transaction costs related […]
The Disclosure Statement
The disclosure statement is a legal document which every company undergoing bankruptcy in the United States is expected to create and share with its stakeholders. The disclosure statement is often considered to be a fundamental document. It is often compared to the prospectus, which is issued by companies before they solicit investors during an initial […]
Implied Dividend Growth Rate
We are now aware of the various models that are used for equity valuation like Gordon model, H model, 2 stage model etc. in each of these models, we were assuming that the given inputs are dividend, dividend growth rates and time horizon, The output that we expected from these models was the current stock […]
Pros and Cons of Bank Guarantees
In the previous article, we have already studied what bank guarantees are and how these bank guarantees are provided by a commercial bank as a value-added service to their corporate customers. We are also aware of the various types of bank guarantees as well as their purposes. In this article, we will understand some of […]
Interest rates are one of the most important factors while determining the bond value. All other factors like payments, number of periods etc are standard i.e. the numbers supplied to us are the numbers that have to be used in the formula for calculating present value. However, this is not the case with interest rates. Interest rates are subjective.
The number used in the formula depends upon the intuition and judgment of the investor. Since different investors use different interest rates while making their calculation, they arrive at different fair values for the same bond. Hence, there is difference of opinion. Some people may find the bond undervalued while some may find it overvalued. This is why trade takes place.
However, we need to be aware as to how different assumptions about the interest rates affect the value of the bond. Let’s have a look at the same in this article:
Interest rates have an inverse relation with bonds and all fixed income securities in general. This simply means that an interest rate fall will lead to a price increase in the value of a bond whereas a rise in interest rate will lead to a fall in the market value of the bond. Theoretically the rise and fall happens after the news of the interest rate change has become known to the public at large i.e. it is a fact. However, in reality the market prices in expected changes in the interest rates. So by the time, the interest rates are announced, the value is already priced in and the fall or rise is relatively smaller. The important point is that the market works on opinions or future expectations and not on the basis of facts.
Example:
Let’s consider the example of a bond which has a face value of $1000. It has a coupon rate of 10% per annum and is expected to pay semi-annual coupons for the next 4 years. So we need to see 3 possibilities:
The logic behind the inverse relation is really simple too. In case of fixed income securities we have locked in the nominal value of the money that we will receive. So the coupon payments are going to be the same, no matter what the interest rate is. This is because the coupon payments are fixed anyways.
But it is the real value of money which changes. So when interest rates go up, investors have the opportunity to invest their money in other bonds which currently have a higher yield. Our bond would therefore be overpriced in real terms. The value of the bond will therefore have to fall till it is fairly valued with other bonds in terms of its real value.
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