Introduction to Corporate Finance

PArT 2: VALUATION, rISk AND reTUrN

FIGUre 4.2 THE RELATIONSHIP BETWEEN BOND PRICES AND REQUIRED RETURNS FOR BONDS WITH

DIFFERING TIMES TO MATURITY BUT THE SAME 6% COUPON RATE

Bond prices move in the opposite direction of market interest rates. This figure shows that the prices of two-year and 10-

year bonds fall as the required return rises (and vice-versa), but the magnitude of this effect is much greater for the 10-

year bond. Typically, long-term bond prices are much more sensitive to rate changes than are short-term bond prices.

$1,600

$1,400

$1,200

$1,000

$800

$600

$400

$200

$0

2% 6% 8% 10% 12% 14%

Bond price ($)

Required return (%)

2-year bond

10-year bond

4%

FIGUre 4.3 AUSTRALIAN GOVERNMENT BOND YIELDS 1971–2015

This figure shows how volatile interest rates have been over time. The line shows the yield to maturity (YTM) on a 10-year

Treasury bond. Because changes in interest rates cause bond prices to fluctuate, bond investors must be aware of interest-

rate risk.

Jan 1971 Jan 1980 Jan 1989 Jan 1998 Jan 2007

18

16

14

12

10

8

6

4

2

Source: Trading Economics. Used with permission. Trading Economics 2015, http://www.tradingeconomics.com/australia/government-bond-yield