Intermediate Financial Management (with Thomson One)

See IFM9 Ch04 Tool Kit.xls
for details.
132 • Part 1 Fundamental Concepts
Figure 4-3
Bond Value
($)
2,000
1,500
1,000
500
0
Value of Long- and Short-Term 10% Annual Coupon Bonds
at Different Market Interest Rates
1-Year Bond
14-Year Bond
5 10 15 20 25
Interest Rate, rd (%)
VALUE OF
Current Market
Interest Rate, rd 1-Year Bond 14-Year Bond
5% $1,047.62 $1,494.93
10 1,000.00 1,000.00
15 956.52 713.78
20 916.67 538.94
25 880.00 426.39
Note: Bond values were calculated using a financial calculator assuming
annual, or once-a-year, compounding.
risk, long-term bonds must have a higher expected rate of return than short-term
bonds. This additional return is the maturity risk premium (MRP). Therefore, one
might expect to see higher yields on long-term than on short-term bonds. Does this
actually happen? Generally, the answer is yes. Recall that the yield curve usually is
upward sloping, which is consistent with the idea that longer maturity bonds must
have higher expected rates of return to compensate for their higher risk. Indeed, the
interest rate on a bond depends on the underlying level of interest rates in the economy,
r*, and several types of risk. These sources of risk are expected inflation
(IP), default risk (DRP), liquidity (LP), and maturity (MRP): r d r* IP DRP
LP MRP.