CHAPTER 3: INTEREST RATES AND SECURITY

VALUATION
 VALUATION OF BONDS AND STOCK

 First Principles:
 Value of financial securities = PV of expected future cash flows

 To value bonds and stocks, we need to:

 Estimate future cash flows:
size (how much) and timing (when)
 Discount future cash flows at an appropriate
rate

2
VARIOUS INTEREST RATE MEASURES

 Coupon rate: interest rate on a bond instrument used to calculate the annual cashflow the bond issuer promises to
pay the bond holder.
 Periodic CFs a bond issuer contractually promises to pay a bondholder.

 Required rate of return (r): interest rate an investor should receive on a security given its risk. This is the rate
used to calculate the fair present value on a security (PV).
 Expected rate of return(E(r)): interest rate an investor expects to receive on a security if s/he buys the security
at its current market price (), receives all expected payments, and sells the security at the end of his or her
investment horizon.
 Realized rate of return (): actual interest rate earned on an investment in a financial security. Realized rate of
return is the historical (ex-post) measure of the interest rate.
REQUIRED RATE OF RETURN

 The fair present value (PV) of a security is determined using the required rate of return (r) as the discount rate

 r= Required rate of return

 = Cashflow projected in period t (t=1,…,n)
 n= Number of periods in the investment horizon

 Once PV is calculated, market participants can compare it with the market current price () at which the security id
trading in the financial market.
 If is less than PV, the security is undervalued investors want to buy more of this security at this current price
 If is greater than PV, the security is overvalued investors would not want to buy this security at this current price
 If equals PV, the security is fairly valued/ priced given its risk characteristics
EXAMPLE CALCULATION
 A bond you purchased 2 years ago for $890, is now selling for $925. The
bond paid $100 per year in coupon interest on the last day of each year
 You intend to hold the bond for 4 more years and project. Suppose you
will be able to sell it at the end of year 4 for $960. its required rate of
return (r) over the next 4 years is 11.25%, calculate the bond fair price
Solution:

 Using financial calculator

N = 4 yrs
I/Y = 11.25
PMT = 100
FV = $960
PV = - $935.31
EXPECTED RATE OF RETURN

 The current market price (P) of a security is determined using the expected rate of return (E(r)) as the
discount rate

 E(r) = Expected rate of return

 = Cashflow projected in period t (t=1,…,n)
 n= Number of periods in the investment horizon
 Assuming that any CFs on the investment can be reinvested to earn the same expected rate of return.

 Once E(r) is calculated, market participants can compare it with their required rate of return ()
 If E(r) is less than r, the projected CFs are less than the required to compensate for the risk incurred from investing the
security.
 If E(r) is greater than r, the projected CFs are greater than the required to compensate for the risk incurred from investing the
security.
EXAMPLE CALCULATION
 A bond you purchased 2 years ago for $890, is now selling for $925.
The bond paid $100 per year in coupon interest on the last day of
each year
 Using the current market price of $925, the expected rate of return
on the bond over the next 4 years is
Solution:

 Using financial calculator

N = 4 yrs
PMT = 100
FV = $960
PV = -$925
I/Y = 11.607
 If E(r) r or  BUY THE SECURITY: the expected CFs received on the security are greater than or equal
to those required to compensate for the risk incurred from investing in the security.

 If E(r) r or  DO NOT BUY THE SECURITY: the expected CFs received on the security are less than is
required to compensate for the risk incurred from investing in the security.

 In efficient markets, the current market price of a security tends to equal its fair price present value.
REALIZED RATE OF RETURN

 The realized rate of return () the discount rate that just equates the actual purchase price (P) to the present value
of the realized CFs (RCFs), where t (t=i,…,n)

 = REALIZED Cashflow in period t (t=1,…,n)

 = Realized rate of return on a security
EXAMPLE CALCULATION
 A bond you purchased 2 years ago for $890, is now selling for $925. The
bond paid $100 per year in coupon interest on the last day of each year
 Using the original purchase price of $890, and the current market price on
this bond of 925, the realized rate of return you’ve earned over the last 2
years is
Solution:

 Using financial calculator

N = 2 yrs
PMT = 100
FV = $925
PV = -$890
I/Y = 13.08
BOND VALUATION
What is a bond
debt issued by a corporation or a governmental body.
A bond represents a loan made by investors to the issuer.
In return for his/her money, the investor receives a legal claim on future cash flows of
the borrower.

The issuer promises to:

make regular coupon payments every period until the bond matures, and
pay the face (par) value of the bond when it matures.

Default
an issuer who fails to pay is subject to legal action on behalf of the lenders (bondholders).
 CHARACTERISTICS OF BONDS
 Bonds: debt securities that pay a rate of interest based upon the face amount or par value of the
bond.

 Price changes as market interest changes

 Interest payments are commonly semiannual

 Bond investors receive full face amount when bonds mature

 Zero coupon bonds – no periodic payment (no interest reinvestment rate)

 Originally sold at a discount
 Present of the Bond = Present value of interest payments + Present Value of Principal
BOND PRICING
PV of Annuity (pmt, I, N) + PV (FV, I, N)

Where N = time to maturity; number of periods

r = market interest rate
PMT = coupon payments
FV = face value
EXAMPLE CALCULATION
 The bond pays $25 semiannual coupon payment
 Maturity: three years and one month
 Market interest rate: 6% (APR)
Solution:

 Using financial calculator

N = 2 x 3 +1/6 = 6.167 yrs

I/Y = 6% /2 = 3%
PMT = 25
FV = $1,000
PV = $972.23
BOND VALUATION

 A premium bond has a coupon rate (C) greater than the required rate of return (r) and the present
value of the bond () is greater than the face or par value.
 Premium Bond: if
 Discount Bond: if
 Premium Bond: if
EXAMPLE CALCULATION
 Par = $1000
 The bond pays 10% coupon interest rate per year, compounded semiannually
 Maturity: 12 years
 Required rate of return (r) : 8% (APR)
 Calculate the market value of the bond

Solution:
 Using financial calculator

N = 12 x 2 = 24
I/Y = 8% /2 = 4%
PMT = 1000 x (0.1/2)= $50
FV = $1,000
PV = -$1152.47
EXAMPLE CALCULATION
 Par = $1000
 The bond pays 10% coupon interest rate per year, compounded semiannually
 Maturity: 12 years
 Required rate of return (r) : 10% (APR)
 Calculate the market value of the bond

Solution:
 Using financial calculator

N=
I/Y =
PMT =
FV =
PV = ???
EXAMPLE CALCULATION
 Par = $1000
 The bond pays 10% coupon interest rate per year, compounded semiannually
 Maturity: 12 years
 Required rate of return (r) : 12% (APR)
 Calculate the market value of the bond

Solution:
 Using financial calculator

N=
I/Y =
PMT =
FV =
PV = ???
YIELD TO MATURITY (YTM)CALCULATION
 The return or yield the bondholder will earn on the bond if s/he buys it at the
current market price, receives all coupon and principal payments as promised, and
holds the bond until maturity.

𝑛
𝑃𝑀𝑇 𝐹𝑉
𝑉 𝐵 =∑ 𝑡
+
𝑡 =1 (1+YTM ) (1+𝑌𝑇𝑀 )𝑛

 Example: consider the purchase of $1000 face value bond that pays 11% coupon
interest rate per year, paid semiannually. The bond matures in 15 years. If the
current market price is $931.176, the yield-to-maturity (YTM) is?
EQUITY VALUATION
 The present value of a stock () assuming zero growth in dividends can be written as:

 Div: constant dividend paid at end of every year (= = =…= = )

 : required rate of return on the stock.
 WHAT WOULD THE EXPECTED PRICE TODAY BE,
IF G = 0?

The dividend stream would be a perpetuity.

0 rs = 13% 1 2 3

2.00 2.00 2.00

PMT $2.00
P̂0    $15.38
r 0.13
EXAMPLE
 A preferred stock you are evaluating is expected to pay a constant dividend of $5 per year each year into the
future
 The required return on the stock is 12%.
 Constant Growth Model: A stock whose dividends are expected to grow forever at a constant rate, g.

 The present value of a stock () assuming constant growth in dividends can be written as:

 : current dividend per share

 : dividend per share at time t=1, 2, …,
 g : constant dividend growth rate
 : required rate of return on the stock.
WHAT HAPPENS IF G > RS?

 If g > rs, the constant growth formula leads to a negative stock price,
which does not make sense.
 The constant growth model can only be used if:
 rs > g.
 g is expected to be constant forever.
 FIND THE EXPECTED DIVIDEND STREAM FOR THE
NEXT 3 YEARS AND THEIR PVS

D0 = $2 and g is a constant 6%.

0 g = 6%
1 2 3

2.12 2.247 2.382

1.8761
rs = 13%
1.7599
1.6509
WHAT IS THE STOCK’S INTRINSIC VALUE?

Using the constant growth model:

D1 $2.12
P̂0  
rs  g 0.13  0.06
$2.12

0.07
 $30.29

9-28
WHAT IS THE STOCK’S EXPECTED VALUE,
ONE YEAR FROM NOW?

• D1 will have been paid out already. So,

expected P1 is the present value (as of Year 1)
of D2, D3, D4, etc.
D2 $2.247
P̂1  
rs  g 0.13  0.06
 $32.10

• Could also find expected P1 as:

P̂1  P0 (1.06)  $32.10
EXAMPLE
 A stock paid a dividend at the end of the last year of $3.50.
 Dividends have grown at a constant rate of 2% per year over the last 20 years, and expected to do so into
the future
 The required return on the stock is 10%.
 Calculate the fair present value of the stock
 The return on a stock with zero dividend growth, if purchased at current price () is:

The return on a stock with constant dividend growth, if purchased at current price () is:
 Supernormal (or non constant) growth in dividends
 Firms often experience periods of supernormal or nonconstant dividends growth, after which
dividends growth settles at some constant rate, or sometimes zero growth.
 Step 1: find the PV of the dividends during the supernormal periods.
 Step 2: find the price of the stock at the end of the super normal growth period, using the
constant growth model. Then discount this price to a present value.
 Step 3: add the two components of the stock price together
SUPERNORMAL GROWTH: WHAT IF G = 30% FOR 3 YEARS BEFORE
ACHIEVING LONG-RUN GROWTH OF 6%?

 Can no longer use just the constant growth model to find

stock value.
 However, the growth does become constant after 3 years.
VALUING COMMON STOCK WITH NONCONSTANT
GROWTH

D0 = $2.00.
0 rs = 13% 1 2 3 4

g = 30% g = 30% g = 30% g = 6%

2.600 3.380 4.394 4.658
2.301
2.647
3.045
4.658
46.114 P̂3   $66.54
0.13  0.06
54.107 = P̂0
FACTORS AFFECTING SECURITY PRICES AND PRICE VOLATILITY

 Interest rate:
 There is a negative relation between interest rate
changes and present value changes on financial
security.
 As interest rates increases, security prices decrease at
a decreasing rate.
IMPACT OF R ON PRICE VOLATILITY

 Price sensitivity
 The percentage change in a bond’s present value for
a given change in interest rates.
FACTORS AFFECTING SECURITY PRICES AND PRICE VOLATILITY

 Coupon rate
 The higher a bond’s coupon rate, the smaller the
price change on the bond for a given change in
interest rates.
FACTORS AFFECTING SECURITY PRICES AND PRICE VOLATILITY

 Time remaining to maturity:

 The shorter the time to maturity for a security, the
closer the price is to the face value of the security.
 The longer the time to maturity for a security, the
larger the price change of the security for a given
interest rate change.
 Increases at a decreasing rate.
PRICE SENSITIVITY AND MATURITY

 In general, the longer the term to maturity, the greater the sensitivity to interest rate changes
 The longer maturity bond has the greater drop in price because the payment is discounted a greater number of
times
DURATION

 Duration
 Weighted average time to maturity using the relative present values of the cash flows as weights
 Measures the sensitivity (or elasticity) of a fixed-income security’s price to small interest rate changes.
 More complete measure of interest rate sensitivity than is maturity
 The units of duration are years
MACAULAY’S DURATION

where
D = Duration measured in years
CFt = Cash flow received at end of period t
N= Last period in which cash flow is received
DFt = Discount factor = 1/(1+R)t
DURATION

 Since the price (P) of the bond equals the sum of the present values of all its
cash flows, we can state the duration formula another way:

 Notice the weights correspond to the relative present values of the cash flows
EXAMPLE
Bond with 10% coupon, face value of $1000, 4 years maturity,
current YTM of 8%, and current price of $1066.24
SEMIANNUAL CASH FLOWS

 For semiannual cash flows, Macaulay’s duration, D, is equal to:

DURATION OF ZERO-COUPON BOND

 Zero-coupon bonds: sell at a discount from face value on issue, pay

the face value upon maturity, and have no intervening cash flows
between issue and maturity
 Duration equals the bond’s maturity since there are no intervening cash
flows between issue and maturity
 For all other bonds, duration < maturity because here are
intervening cash flows between issue and maturity
FEATURES OF DURATION

 Duration and maturity

 Duration increases with maturity of a fixed-income asset/liability, but at a decreasing rate

 Duration and yield

 Duration decreases as yield increases

 Duration and coupon interest

 Duration decreases as coupon increases
ECONOMIC INTERPRETATION

 Duration is a direct measure of interest rate sensitivity, or elasticity, of an asset or liability:

 Or equivalently,

where MD is modified duration

ECONOMIC INTERPRETATION CONTINUED

 To estimate the change in price, we can rewrite this as:

SEMI-ANNUAL COUPON BONDS

 With semi-annual coupon payments, the percentage change in price is calculated as:
CONVEXITY (CX)

 Convexity measures the sensitivity of (modified) duration to changes in interest rate (the rate of
“acceleration” in bond price changes)
 Is the degree of curvature of the price-interest rate curve around some interest rate level.
 The degree of bend in the price–yield curve

 Convexity is desirable
 The greater the convexity of a security or portfolio, the more insurance or interest rate protection an investor or FI
manager has against rate increases and the greater the potential gains after interest rate falls.
 Convexity diminishes the error in duration as an investment criterion.
 All fixed-income securities are convex.
 As interest rates change, bond prices change at a nonconstant rate.