Explain the four important relationships on bond valuation.
May 29th, 2022
The price of a bond is inversely related to its yield-to-maturiy (YTM). Since YTM depends positively on the market interest rate, we can infer that as market interest rate increases (decreases), bond value decreases (increases). The change in value caused by changing interest rates is called interest rate risk.
- If the bondholder’s YTM equals the coupon interest rate, the bond will sell at par, or maturity value.
- If the YTM exceeds the bond’s coupon rate, the bond will sell below par value or at a “discount.” This is called a discount bond.
- If the YTM is less than the bond’s coupon rate, the bond will sell above par value or at a “premium.” This is called a premium bond.
Longer-term bonds are exposed to greater interest rate risk than shorter-term bonds.
Lower-coupon bonds are exposed to greater interest rate risk than higher-coupon bonds.