The “WeWork” Business Model
The name WeWork is now a known brand name for millennials around the world. This is a remarkable feat given that the company is relatively nascent. WeWork has become so popular that it is the fourth highest valued start-up in the world, just behind companies like Uber. This valuation is largely the result of huge […]
Financial Modelling For Leveraged Buyouts (LBOs)
Just like mergers and acquisitions, modeling for leveraged buyouts (LBOs) also requires special skill and knowledge. In this article, we will have a closer look at how leveraged buyouts work as well as how financial modeling techniques need to be adopted to meet the needs of investors indulging in LBO’s. What is a Leveraged Buyout? […]
Technology Risks In Commercial Banking: KfW Bank Case Study
The speed at which commercial banking is being automated is astounding. The automation process is about two decades old. However, over time, many difficult processes have been automated. However, commercial banks have realized that automation can be a double-edged sword and can sometimes lead to spectacular blunders which can impact the reputation of the bank. […]
Essential Vs Non-Essential Retail
The retail sector is often considered to be a part of a single industry that has similar characteristics. However, this is not necessarily the case. It needs to be understood that the retail sector is very diverse. There are many different types of businesses which operate in this sector. These businesses have considerably different characteristics. […]
Calculating Free Cash Flow to Firm: Method #1 (Contd): Treatment of Fixed Capital Expenditure
In the previous article we learned that free cash flow to the firm is closely related to the concept of cash flow from operations. The major difference was in the way free cash flow to the firm (FCFF) treats long term capital expenditures versus how they get treated in the regular cash flow statement. The […]
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.
Your email address will not be published. Required fields are marked *
