CHAPTER 6 Interest Rates and Bond Valuation 273the highest risk premiums and therefore the highest returns result from securities
issued by firms with a high risk of default and from long-term maturities that
have unfavorable contractual provisions.Review Questions
6–1 What is the real rate of interest?Differentiate it from the nominal rate of
interestfor the risk-free asset, a 3-month U.S. Treasury bill.
6–2 What is the term structure of interest rates,and how is it related to the
yield curve?
6–3 For a given class of similar-risk securities, what does each of the following
yield curves reflect about interest rates: (a) downward-sloping; (b) upward-
sloping; and (c) flat? Which form has been historically dominant?
6–4 Briefly describe the following theories of the general shape of the yield
curve: (a) expectations theory; (b) liquidity preference theory; and (c) mar-
ket segmentation theory.
6–5 List and briefly describe the potential issuer- and issue-related risk compo-
nents that are embodied in the risk premium. Which are the purely debt-
specific risks?6.2 Corporate Bonds
A corporate bondis a long-term debt instrument indicating that a corporation
has borrowed a certain amount of money and promises to repay it in the future
under clearly defined terms. Most bonds are issued with maturities of 10 to 30
years and with a par value, or face value, of $1,000. The coupon interest rateon
a bond represents the percentage of the bond’s par value that will be paid annu-
ally, typically in two equal semiannual payments, as interest. The bondholders,
who are the lenders, are promised the semiannual interest payments and, at
maturity, repayment of the principal amount.Legal Aspects of Corporate Bonds
Certain legal arrangements are required to protect purchasers of bonds. Bond-
holders are protected primarily through the indenture and the trustee.Bond Indenture
A bond indentureis a legal document that specifies both the rights of the bond-
holders and the duties of the issuing corporation. Included in the indenture are
descriptions of the amount and timing of all interest and principal payments, var-
ious standard and restrictive provisions, and, frequently, sinking-fund require-
ments and security interest provisions.corporate bond
A long-term debt instrument
indicating that a corporation has
borrowed a certain amount of
money and promises to repay it in
the future under clearly defined
terms.
coupon interest rate
The percentage of a bond’s par
value that will be paid annually,
typically in two equal semian-
nual payments, as interest.
bond indenture
A legal document that specifies
both the rights of the bondhold-
ers and the duties of the issuing
corporation.
LG2 LG3