(3)The yield to maturity on a bond:
a)is fixed in the indenture
b)is lower for higher risks bonds
c)is the required return on the bond
d)is generally equal to the coupon interest rate

If current market interest rates rise, what will happen to the value
of outstanding bonds?
a) they will rise
b) they will fall
c) they will remain unchanged
d) there is no connection between current market interest rates and
the value of outstanding bonds.

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Request for Question Clarification by nauster-ga on 11 Feb 2003 16:03 PST

I can provide you with enough information and explanation that you
will be able to answer these questions on your own. Do you consider
that to be a satisfactory form of answer?

---

Clarification of Question by k9queen-ga on 11 Feb 2003 16:13 PST

No

Hi again k9queen!!

The yield to maturity on a bond:
c) Yield to maturity is a special name in the bond context for the
return that investors are currently requiring.

See a good definition at "Corporate Finance Live" website:
"The yield to maturity on a bond is the rate of return that an
investor would earn if he bought the bond at its current market price
and held it until maturity. It represents the discount rate which
equates the discounted value of a bond's future cash flows to its
current market price."
http://www.prenhall.com/divisions/bp/app/cfldemo/BV/YTM.html


If current market interest rates rises, what will happen to the value
of outstanding bonds?
b) they will fall.

The interest rate is the cost of the money, such is the minimum price
that the market is willing to receive for lending money. Bonds, as
debt instruments, must offer the rate that the market require. But
nobody can fix the interest rate to avoid its fluctuation. When the
interest rate rises, the bonds, that start to pay at a smaller rate
than the market rate, will be less attractive. In this situation the
bonds owners will try to to get rid of they, wich generates an
increase of the offer and consequently a depreciation of the bonds
value.

Additional information can be found here:
"Bonds offer many rewards, but be sure to weigh risks" By Libby
Mihalka for ContraCostaTimes.com:
http://www.bayarea.com/mld/cctimes/business/personal_finance/4858092.htm


And also the paragraph "INVERSE RELATIONSHIP OF BOND PRICES AND
INTEREST RATES" of the following page at Loyola College in Maryland
website:
http://webdev.loyola.edu/aeddy/net320/bond2.htm


I hope this helps you, please feel free to request for a clarification
if it is needed.

Regards.
livioflores-ga

---

Clarification of Answer by livioflores-ga on 12 Feb 2003 12:13 PST

Hello!!

I just read the comment of elwtee-ga and I must say that his critic
about "change in value has nothing to do with market forces or supply
and demand" is almost true.

So to clarify this point I suggest you to read the following
paragraph:
"Interest rate risk" from the article "Bonds offer many rewards, but
be sure to weigh risks" By Libby Mihalka for ContraCostaTimes.com:
http://www.bayarea.com/mld/cctimes/business/personal_finance/4858092.htm


This article was included as a recommended reading in the original
answer.

But remember that sometimes, in special situations, the big rise of
interest rates and/or risk rates generates panic in the bonds holders,
and motivate very big offer with the consecuence of an additional fall
of the prices of the bonds.
One of this scenarios could be a sustained inflation situation.

Regards.
livioflores-ga

Awesome answer again!

the first question is so poor that the author should be barred from
writing questions on this subject. technically none of the answers are
correct. we will make a case for a couple.

a bond indenture, includes the coupon rate of the bond, the original
offering price and the maturity date and value, among other things.
the indenture does not in fact address the yield to maturity of the
bond. although you could argue that the terms of the offering defacto
define a yield to maturity to a buyer. so a case for "a" could be
made.

a bond has no required rate of return. the market of investors may
collectively and individually have such requirements but the bond
itself offers a cash flow and a promise of repayment. rate of return
is a function of the price an investor pays for the paper. but a
semantic argument over the meaning of "required" could be made if we
take required to mean the price investors are willing to pay to obtain
the bond and its attendant cash flow and redemption value. that view,
through the looking glass, could support a "c" response.

the coupon rate of a bond would equal the yield to maturity any time
the bond is aquired at par assuming that as the redemption value. so
yet another weak case can be made for answer "d". the questioner
should learn to be more precise in the construction the questions and
multiple choice responses if clarity is an objective

also, while it is clear that bond prices will fall during periods of
rising interest rates that change in value has nothing to do with
market forces or supply and demand. market prices, the actual price
bonds are trading at might be less than calculated valuations during
periods that include excessive liquidations but those liquidations are
not part of the mathmatical valuation of the paper.

bond valuations change based on yields. if you own paper that is
paying $80 per thousand per year or 8% and the market shifts so that
bond buyers now seek 100 dollars per thousand per year to justify the
risk of investment it stands to reason that your bond at 80 dollars
per year is now less valuable. how much less? generally speaking the
price of your 80 dollar cash flow bond will drop until the ytm of your
bond is equal to the ytm of the 100 cash flow bond. assuming a 20 year
maturity your bond is now worth about 828.40. your bond is worth the
lesser amount whether any bonds are being bought and sold or not. for
example, if you collateralized a loan with your bonds and no one
anywhere buys or sells your bond, you still may have to put up more
collateral. your bonds are worth less.

supply and demand may have an impact. in this case. assume the
conditions as previously described, further assume that for whatever
reason all holders of this paper want to sell. it is likely that given
the oversupply relative to current demand may have bonds being traded
at, say for example, $750 per bond. that situation will eventually
abate and correct itself. that of course is the opportunity of the
market. he who recognizes the deparity between value and market price
and is willing to commit funds can buy at 750 and wait to sell at 828.
the point being that while market action will effect market price the
bond, in our simple example does not devalue because of supply and
demand. the devaluation is a function of changes in yield on competing
investments and is seperate and distinct from supply and demand.

in fact a change in the interest rate environment by itself rarely
causes mass bond sales the reason is obvious if you think about it for
a minute. you own a cash flow per thousand of 80. competing
investments are offering 100. you would like to upgrade but you can
only recover about 82 cents on your invested dollar. reinvesting those
82 cents in a new bond paying 100 dollars per thousand will leave you
on a cash flow basis in about the exact same place and have cost you
two transaction fees. that's not to say there are conditions and times
that such movement of money doesn't happen, just to say given the
confines of this problem it is highly unlikely.

elwtee-ga your comment is excelent, and I almost agree with you about
the "market forces influence on the bonds value" topic. I introduce it
at the answer in order to give to the asker a basic introduction of
the consecuences of the rising rates.
The fact is that because the rise ot the interest rates, the bonds
must be repriced.
See the paragraph "Interest rate risk" at the following page:
http://www.bayarea.com/mld/cctimes/business/personal_finance/4858092.htm

livioflores-ga

i have just read the critique of my comment by livioflores and feel
compelled to indicate that said critique is no more correct this time
than it was the first time it was posted. what i said isn't 'almost
true", it is a real world fact.

my comment was originally inspired by livio's statement in explaining
bond price fluctuation relative to interest rate changes. the
statement was, "In this situation the bonds owners will try to to get
rid of they, wich generates an increase of the offer and consequently
a depreciation of the bonds
value." (sic). this statement was a mischaracterization of bond
dynamics relative to the question at hand the first time it was
posted. it continues to be such.

livio seems to be unable to differentiate between valuation and market
price. they are not the same. market price is a function of valuation
which includes a component of supply and demand. what is the
theoritical valuation of an 8% coupon in a 10% market is a different
question than at what price is the 8% paper trading. it is the
relative equality or difference in valuation and market price that
makes one bond more or less attractive as an investment over another
bond of otherwise equal characteristics. this is the basis of the
concept of overvalued and undervalued.

for example, if 8% paper is valued in the market at 9% ytm and we have
two different issues that we can add to a portfolio, all other things
being equal and beyond the scope of this lesson, if one choice is
available at a 9.20% ytm and the other at an 8.65% ytm, we would
likely invest in the higher yielding instrument. all other things
being equal in this simplistic example. in this example, 9% is our
benchmark valuation for 8% paper and the 9.20 and 8.65 yields
represent market forces, which we are limiting to supply and demand at
this time. 9.20 is undervalued. 8.65 is overvalued. we buy the 9.20
over the 8.65 because given the 9% benchmark for this type and quality
paper we are getting more than we bargained for. our portfolio will
benefit from the increased yield and if we are correct eventually from
the appreciation in price that the 9.20 bond will see to bring the
yield back to valuation pricing. if the market never corrects the
price relative to valuation we still get the benefit of the
undervalued purchase at maturity.

the article now referenced twice, is a very nice little piece. it
however says exactly what i have now said twice. in fact the example
in the article, except for the numbers is a carbon copy of the
valuation example i gave in my comment. the article however does not
address supply and demand or any other market forces. this article
speaks to the issue of valuation and how that valuation is changed by
changing interest rates. i clearly differentiated valuation and market
price and demonstrated that supply and demand is a secondary
characteristic in price changes in the discussion of the changing
value of paper in a situation where there is no market activity in the
bond. it is not the supply and demand that changes the value as livio
seems to misunderstand and wants to prove. change in value is
contemporaneous with change in interest rates. change in market price
reflects supply and demand and a bunch of other things but let's not
go there right now.

livio's quoted statement is also incorrect, generally, as to a change
in interest rates creating a swelling of sales for lower coupon bonds
in favor of higher coupon bonds. i addressed this typically erroneous
statement in the last paragraph of my prior comment. the reason this
does not happen on a wholesale basis is because, as i showed, it
doesn't work. there are situation where this movement of funds is
warranted, practical and executed. however for the most part,
individuals selling depreciated paper to buy higher coupon paper will
not net an increased cash flow all things being equal. the spread on
the bonds and the transaction costs will also often make this swap
difficult to execute. now if your depreciated paper is trading in an
overvalued condition and the paper you seek is undervalued, well now
we've got something to think about.

Hey you 2, I did not mean to start a war!  All I wanted was the
correct answer-the rest is Chinese to me.  Stay tuned, I will be
posting more pain in the butt questions next week!!!!!!!!!!!!!!
K9 Queen

Don´t worry k9queen, I only recognized the excelent elwtee´s comment,
but my mistake was that I used the word critic instead the word
critique in the clarification for you, it was a typo that may be
caused a misunderstanding.
Excuse us for this situation.

PD: I am waiting for more questions!!!

Best Regards
livioflores-ga