Chapter 10: Bond Prices and Yields

10.1 BOND CHARACTERISTICS

Bond: a security that obligates the issuer to make specified payments to the
holder over a period of time
Face value, par value: the payment to the bondholder at the maturity
Coupon rate: a bond's annual interest payment per dollar of par value.
Zero-coupon bond: a bond paying no coupon that sells at a discount an provides
only a payment of par value at maturity.
Treasury Bonds and Notes
Accrued interest and quoted bond prices: if a bond is purchased between
coupon payments, the buyer must pay the seller for accrued interest, the prorated share
of the upcoming semiannual coupon.
(Formula for Accrued interest - Page 292)
Corporate Bonds
Call provisions on corporate bonds: Some corporate bonds allowing the issuer to
repurchase the bond at a specified call price before the maturity date. To compensate
investors for the risk, callable bonds are issued with higher coupons and promised
yields to maturity.
Convertible bonds: give bondholders an option to exchange each bond for a
specified number of shares of common stock of the firm. Often, convertible bonds offer
lower coupon rates and yields to maturity than nonconvertible bonds.
Market conversion value: the current value of the shares for which the
bonds may be exchanged.
Conversion premium: the excess of the bond price over its conversion
value.
Puttable bonds: the holder may choose either to exchange for par value at some
date or to extend for a given number of years.
Floating-rate bonds: bonds with coupon rates periodically reset according to a
specified market rate.
Preferred Stock
Although preferred stock is considered to be equity, it often is included in the
fixed-income universe. It promises to pay a specified stream of dividends. However,
unlike bonds, the failure to pay the promised dividend does not result in corporate
bankruptcy, but cumulate, and is paid latter.
International Bond
Innovation in the Bond Market
Inverse floaters: similar to floating-rate bond, but coupon rate has opposite
direction to the market interest rate.
Asset-Backed bonds

Pay-in-kin bond: issuers may choose to pay interest either in cash or in additional
bonds.
Catastrophe bonds: final payment depends on whether there is a catastrophe
Indexed bonds: payments are tied to a general price index or the price of a
particular commodity.
(Nominal return formula: Page 297)
(Real rate of return formula: page 298)
10.2 BOND PRICING
To value a security, we discount its expected cash flows by the appropriate
discount rate.
Bond value = Present value of coupons + Present value of par value

At higher interest rate, the present value of the payments to be received by the
bond-holder is lower. Therefor, the bond price will fall as market interest rate rise.
A general rule in evaluating bond price risk is that, keeping all other factors the
same, the longer the maturity of the bond, the greater of its price to fluctuations in the
interest rate.
Bond Pricing between Coupon Date.
Compute the present value of each remaining payment and sum up.
10.3 BOND YIELDS
Yield to Maturity
The YTM is defined as the discount rate that makes the present value of a bond's
payments equal to its price.
How to calculate: using time value to money formula, better using financial
calculator, and the missing variable is the rate
Yield to Call
Yield to call is used to calculated yield in callable bond.
Callable bond could be retired prior to the maturity date.
If price of bond is higher than call price seller will call that bond and sell them to
the market for profit.
Realized Compound Return versus Yield to Maturity
Compound rate of return on a bond with all coupons reinvested until maturity.

With a reinvestment rate equal to yield to maturity, the realized compound return
equals to yield to maturity.
Reinvestment rate risk: uncertainty surrounding the cumulative future value of
reinvested bond coupon payments.
10.4 BOND PRICES OVER TIME
Relationship between Interest Rate and Bond Price
A long-term negative relationship between interest rates and bond prices, for
bonds with all maturities;
A bond will be sold above its face value when the coupon rate is higher than the
discount rate (market interest rate), at the face value when the coupon rate is equal to
the market interest rate, and below its face value when the coupon rate is lower than the
market interest rate.

When c > k, then price > face value (premium bond);

When c = k, then price = face value (par bond);
When c < k, then price < face value (discount bond).

Yield to Maturity versus Holding-Period Return

When the yield to maturity is unchanged over the period, the rate of return on the
bond will equal that yield.
When the yields fluctuate, a bond s rate of returns will fluctuate
An increase in the bonds yield to maturity acts to reduce its price, which
means that the holding-period return will be less than the initial yield
An decline in the bonds yield to maturity results in the holding-period
return greater than the initial yield
Zero-Coupoon Bonds and Treasury STRIPS
Zero coupon bond carries no coupons and provides all its return in the form of
price appreciation.
When a Treasury fixed-principal note or bond (or a TIPS) is stripped, each
interest payment and the principal payment becomes a separate zero-coupon security.
Each component has its own identifying number and can be held or traded
separately.
For example, a Treasury note with 10 years remaining to maturity consists
of a single principal payment at maturity and 20 interest payments, one
every six months for 10 years. When this note is converted to STRIPS
form, each of the 20 interest payments and the principal payment
becomes a separate security.
STRIPS are also called zero-coupon securities because the only time an
investor receives a payment during the life of a STRIP is when it matures.
10.5 DEFAULT RISK AND BOND PRICING
Junk Bonds
Dterminants of Bond Safety

Bond Indentrues
Sinking funds
Subordination of further debt
Dividend restriction
Collateral
Yield to Maturity and Default Risk
10.6 THE YIELDS CURE
Term structure of interest rate: Relationship between yields to maturity and the
term to maturity
Yield curve: a graph of the yields on bonds relative to the number of years to
maturity
Have to be similar risk or other factors would be influencing yields
Expectations
Long term rates are a function of expected future short term rates
Upward slope means that the market is expecting higher future short term
rates
Downward slope means that the market is expecting lower future short
term rates
(1+yn)n = (1+yn-1)n-1(1+fn)
Liquidity Preference
The expectation theory does not take into account risk.
Risk of long-term > Risk of short-term
Liquidity preference theory: investors demand a risk premium on long-term
bonds.
Liquidity premium: the extra expected return demanded by investors as
compensation for the greater risk form longer term bonds
fn = E(rn) + Liquidity premium
Predict upward sloping yield curve even in the case of expected shortterm rates are unchanged.

Chapter 11: Managing Bond Portfolios

11.1 INTEREST RATE RISK
Interest Rate Sensitivity
1. Inverse relationship between price and yield. As yields increase, bonds prices
fall; as yields fallbonds prices rise
2. An increase in a bonds yield to maturity results in a smaller price decline than
the gain associated with a decrease in yield.
3. Long-term bonds tend to be more price sensitive than short-term bonds. (
Compare bond A and bond B)
4. As maturity increases, price sensitivity increases at a decreasing rate. ( Compare
bond A and B)

5. Price sensitivity is inversely related to a bonds coupon rate. ( Bond B and bond
C)
6. Price sensitivity is inversely related to the yield to maturity at which the bond is
selling. (Bond C and bond D)
Duration
A measure of the effective maturity of a bond.
The weighted average of the times until each payment is received, with the
weights proportional to the present value of the payment.
Duration is equal to maturity for zero coupon bonds.
Duration is shorter than maturity for all bonds except zero coupon bonds.
How to calculate duration:

wt CF t (1 y ) Price
t

D t wt
t 1

Price change is proportional to duration and not to maturity.

P/P = -D x [(1+y) / (1+y)
D* = modified duration
D* = D / (1+y)
P/P = - D* x y
Modified duration measures interest rate sensitivity of bond
What Determines Duration
Rule 1 The duration of a zero-coupon bond equals its time to maturity.
Rule 2 With time to maturity and YTM held constant, a bonds duration and
interest rate sensitivity are higher when the coupon rate is lower.
Rule 3 With the coupon rate held constant, a bonds duration and interest rate
sensitivity generally increases with time to maturity.
Rule 4 Holding other factors constant, the duration and interest rate sensitivity of
a coupon bond are higher when the bonds YTM is lower.
11.2 PASSIVE BOND MANAGEMENT
Immunization
A strategy to shield net worth from interest rate movement
A form of passive management. There are 2 versions:
Net worth immunization: Make net worth today unchanged in response
to interest rate movements. Accomplish by matching duration of the bond
to the investment horizon
Target date immunization: Make funds available at a target future date
unchanged in response to interest rate movements. Accomplish by
matching duration of asset to duration of liabilities.
Problems with immunization
May be a suboptimal strategy
Does not work as well for complex portfolios with option components nor
for large interest rate changes

Requires rebalancing of the portfolio periodically, which then incurs

transaction costs
- Rebalancing is required when interest rates move
- Rebalancing is required over time

Cash Flow Matching and Dedication

Cash flow from the bond and the obligation exactly offset each other.
Automatically immunizes a portfolio from interest rate movements
Not widely pursed, too limiting in terms of choice of bonds
May not be feasible due to lack of availability of investments needed.
11.3 CONVEXITY
Duration and Convexity
Duration calculation is valid for small changes in bond yield. It is less accurate
for large changes in bond yield.
The duration approximation a straight line relating change in bond price to
change in YTM always understates the price of the bond
This effect is due to the convex nature of the relationship between prices and
yields. The curvature of the price-yield relationship for bonds is called the
convexity of the bond.
We can quantify the convexity.
Formula given below. Basically it corrects for the second derivative
Correction for Convexity
n
CFt

1
2
Convexity
(
t

t
)

P (1 y) 2 t 1 (1 y)t

P
D y 1 [Convexity (y) 2 ]
2
P
Why Do Investors Like Convexity?
Investors generally like convexity. Bonds with more convexity gain more in price
when yields fall than they lose when yields rise. See following graph. Bond A is
more convex; It enjoys greater price increases for falling yields and small price
decreases for rising yields than Bond B.
Of course, if convexity is valuable it is not free. Investors pay for it with a lower
yield on bonds with greater convexity.
11.4 ACTIVE BOND MANAGEMENT
Finding mispriced securities, especially underpriced ones
Forecasting interest rates
If the decline in interest rates are anticipated the managers will increase
the duration of their asset portfolios.

 Homer and Liebowitz (1972) characterize portfolio rebalancing activities.

Substitution swap
It is an exchange of one bond for another with equal coupon, maturity,
quality, call features,
sinking fund provisions, and so on.
Motivated by a belief that the market has temporarily mispriced two bonds.
Intermarket spread swap
It is an exchange of bonds when an investor believes that the yield spread
between two sectors of the bond market is temporarily out of line.
Rate anticipated swap
The investors swap shorter duration bonds with the longer duration ones
since they believe that interest rates will decrease.
Pure yield pickup swap
The investors swap longer-term bonds with the shorter-term bond when
yield curve is upward sloping.
Horizon Analysis
Form of interest rate forecasting
The analyst selects a particular holding period and predicts the yield curve at end
of period
Given a bonds time to maturity at the end of the holding period its yield can be
read from the predicted yield curve and the end-of-period price can be calculated.
The total return over the period is computed by adding the capital gain and
coupon income for the holding period
Contingent Immunization
Mixed passive and active strategy.
You have to calculate the funds required to lock in via immunization.
This value is trigger point.
If and when the actual portfolio value dips to the trigger point, active
management will cease.

Chapter 13: Equity Valuation

13.1 VALUATION BY COMPARABLES
Valuation models using comparable looks at the relationship between price and
various determinants of value for similar firms
Basic Types of Models
Balance Sheet Models
Dividend Discount Models
Price/Earnings Ratios
Free Cash Flow Models
Limitations of Book Value
Value of common equity on the balance sheet

Based on historical values of assets and liabilities, which may not reflect current
values
Some assets such as brand name or specialized skills are not on a balance
sheet
13.2 INTRINSIC VALUE VERSUS MARKET PRICE
The expected holding-period return: the return on a stock investment
comprises 2 components: Cash dividends and Capital gains or losses

Expected HPR = E(r) = {E(D1) + [E(P1) -- P0]}/ P0

Required return: CAPM gave us required return or market capitalization rate,
denoted as k. If the stock is priced correctly
k = E(r)

k rf E (rM ) rf
Intrinsic value: the present value of a firm's expected futrue net cash flows
discounted by the required rate of return.

E ( D1 ) E ( P1 )
V0
1 k
In equilibrium the current market price will equal intrinsic value
Trading Signals
If V0 > P0 => Sell
If V0 < P0 => Buy
If V0 = P0 => Hold

13.3 DIVIDEND DISCOUNT MODELS

Intrinsic value of a stock as a present value of dividends over H years and sale price PH

+
=
+
++
+ ( + )
( + )

In general, we have the formula of DDM of stock price:

=
+
+=

+ ( + )
( + )
=

This equation is not useful because it requires dividend forecasts for every year into
the infinite future
To make the model more practical we need some simplifying assumptions about the
dividends
Constant growth DDM
Assume that dividends are trending upward at a stable growth g, we have
simplified equation:

( + )

=
=

The constant growth DDM is valid only when g is less than k.

The constant growth rate DDm implies that a stocks value will be greater:
The larger its expected dividend per share
The lower the market capitalixation rate, k.
The higher the expected growth rate of dividends.
Stock price and Investment Opportunities
g = growth rate in dividends is a function of two variables:
ROE = Return on Equity for the firm
b = plowback or retention percentage rate
(1- dividend payout percentage rate)
g increases if a firm increases its retention ratio and/or its ROE
Present Value of Growth Opportunities
PVGO = Price No-growth value per share

PVGO =

Life Cycles and Multistage Growth Models

As firms progress through their industry life cycle, earnings and dividend growth
rates (ROE) are likely to change.
A two stage growth model:
T

(1 g1 ) t
DT (1 g 2 )
V0 D0

t
T
t 1 (1 k) (k g 2 )(1 k)

g1 = first growth rate

g2 = second growth rate
T = number of periods of growth at g1

13.4 PRICE-EARNINGS RATIOS

P/E and Growth Opportunities
P/E Ratio is a function of two factors
Market Capitalization Rate (k)
Expected Growth in Dividends (g)
One common use is to estimate the value of stock
Recall: DDM Formula

= ( )
Hence, P/E ratio equals:

When g=0 then

P/E Ratio and Stock Risk

From P/E ratio:

P0
1b
=
E1
kg

P0 1
=
E1 k

Riskier firms will have higher required rates of return (higher values of k)
Holding all else equal, riskier stocks will have lower P/E multiples

Pitfalls in P/E Analysis

P/E ratio tends to be influenced by inflation, as inflation impacts the calculation of
earnings

Lack of standards in earnings management gives way to much flexibility to

calculate earnings
In equation, earnings rise at a constant rate. However, reported earnings can
fluctuate dramatically around a trend line over the course of business cycle
In using P/E analysis, it is necessary to refer to the companys long run growth
prospects and EPS relative to the long run trend line

13.5 FREE CASH FLOW VALUATION APPROACHES

Advantages:
Useful for firms that dont pay dividends,
Practical for firms that the dividend discount model would be difficult to
implement,
Valid for any firm,
Provide helpful insights about firm value beyond the DDM,
Firm value = Market value of equity + Market value of debt
13.6 THE AGGREGATE STOCK MARKET