Chapter Three

Interest Rates
and Security
Valuation
3-1

2009, The McGraw-Hill Companies, All Rights

Various Interest Rate Measures

Coupon
Couponrate
rate

periodic
periodiccash
cashflow
flowaabond
bondissuer
issuercontractually
contractuallypromises
promises
to
topay
payaabond
bondholder
holder

Required
Requiredrate
rate of
of return
return(rrr)
(rrr)

rates
ratesused
usedby
byindividual
individualmarket
marketparticipants
participantsto
tocalculate
calculate
fair
fairpresent
presentvalues
values(PV)
(PV)

Expected
Expectedrate
rate of
of return
return(Err)
(Err)

rates
ratesparticipants
participantswould
wouldearn
earnby
bybuying
buyingsecurities
securitiesatat
current
currentmarket
marketprices
prices(P)
(P)

Realized
Realizedrate
rate of
of return
return(rr)
(rr)

rates
ratesactually
actuallyearned
earnedon
oninvestments
investments

3-2

2009, The McGraw-Hill Companies, All Rights

Required Rate of Return

The
The fair
fairpresent
present value
value (PV)
(PV) of
of aa security
security isis
determined
determined using
using the
the required
required rate
rate of
of return
return
(rrr)
(rrr) as
as the
the discount
discount rate
rate
~
~
~
~
CF3
CFn
CF1
CF2
PV

...
1
2
3
(1 rrr ) (1 rrr ) (1 rrr )
(1 rrr ) n

CF
CF11==cash
cashflow
flowin
inperiod
periodtt(t(t==1,1,,
,n)
n)
~~==indicates
indicatesthe
theprojected
projectedcash
cashflow
flowisisuncertain
uncertain
nn==number
numberof
ofperiods
periodsin
inthe
theinvestment
investmenthorizon
horizon

3-3

2009, The McGraw-Hill Companies, All Rights

Expected Rate of Return

The
The current
current market
market price
price (P)
(P) of
of aa security
security isis
determined
determined using
using the
the expected
expected rate
rate of
of return
return
(Err)
(Err) as
as the
the discount
discount rate
rate
~
~
~
~
C F3
CFn
CF1
CF2
P

...
1
2
3
(1 Err ) (1 Err ) (1 Err )
(1 Err ) n

CF
CF11==cash
cashflow
flowin
inperiod
periodtt(t(t==1,1,,
,n)
n)
~~==indicates
indicatesthe
theprojected
projectedcash
cashflow
flowisisuncertain
uncertain
nn==number
numberof
ofperiods
periodsin
inthe
theinvestment
investmenthorizon
horizon

3-4

2009, The McGraw-Hill Companies, All Rights

Realized Rate of Return

The
The realized
realized rate
rate of
of return
return (rr)
(rr) isis the
the discount
discount
rate
rate that
that just
just equates
equates the
the actual
actual purchase
purchase price
price ((
)) to
P
to the
the present
present value
value of
of the
the realized
realized cash
cash flows
flows
(RCF
(RCFt)t) tt(t(t==1,1,,
,n)
n)
RCF3
RCFn
RCF1
RCF2
P

...
1
2
3
(1 rr ) (1 rr ) (1 rr )
(1 rr ) n

3-5

2009, The McGraw-Hill Companies, All Rights

Bond Valuation
The
Thepresent
presentvalue
valueof
ofaabond
bond(V
(Vbb))can
canbe
bewritten
writtenas:
as:
t
2T

INT
1
M

Vb

2 t 1 (1 id / 2)
(1 id / 2) 2T
INT

( PVIFAi
2

/ 2 , 2T

) M ( PFIVi

/ 2 , 2T

M
M==the
thepar
parvalue
valueof
ofthe
thebond
bond
INT
INT==the
theannual
annualinterest
interest(or
(orcoupon)
coupon)payment
payment
TT==the
thenumber
numberof
ofyears
yearsuntil
untilthe
thebond
bondmatures
matures
ii==the
theannual
annualinterest
interestrate
rate(often
(oftencalled
calledyield
yieldto
tomaturity
maturity(ytm))
(ytm))

3-6

2009, The McGraw-Hill Companies, All Rights

Bond Valuation
A
Apremium
premium bond
bond has
has aa coupon
coupon rate
rate (INT)
(INT)
greater
greater then
then the
the required
required rate
rate of
of return
return (rrr)
(rrr)
and
and the
the fair
fair present
present value
value of
of the
the bond
bond (V
(Vbb)) isis
greater
greater than
than the
the face
face value
value (M)
(M)
Discount
Discount bond:
bond: ifif INT
INT << rrr,
rrr, then
then VVbb<< M
M
Par
Par bond:
bond: ifif INT
INT == rrr,
rrr,then
then VVbb== M
M

3-7

2009, The McGraw-Hill Companies, All Rights

Equity Valuation
The
The present
present value
value of
of aa stock
stock (P
(Pt)t) assuming
assuming zero
zero
growth
growth in
in dividends
dividends can
can be
bewritten
written as:
as:

Pt D / is
DD==dividend
dividendpaid
paidatatend
endof
ofevery
everyyear
year
PPt t==the
thestocks
stocksprice
priceatatthe
theend
endof
ofyear
yeartt
iiss==the
theinterest
interestrate
rateused
usedto
todiscount
discountfuture
futurecash
cashflows
flows

3-8

2009, The McGraw-Hill Companies, All Rights

Equity Valuation
The
The present
present value
value of
of aa stock
stock (P
(Pt)t) assuming
assuming
constant
constant growth
growth in
in dividends
dividends can
can be
be written
written as:
as:
D0 (1 g ) t
Dt 1
Pt

is g
is g
DD00==current
currentvalue
valueof
ofdividends
dividends
DDt t==value
valueof
ofdividends
dividendsatattime
timett==1,1,2,2,,
,
gg==the
theconstant
constantdividend
dividendgrowth
growthrate
rate
3-9

2009, The McGraw-Hill Companies, All Rights

Equity Valuation
The
The return
return on
on aa stock
stock with
with zero
zero dividend
dividend growth,
growth,
ifif purchased
purchased at
at price
price PP00,, can
can be
be written
written as:
as:

is D / P0
The
The return
return on
on aa stock
stock with
with constant
constant dividend
dividend
growth,
growth, ififpurchased
purchased at
at price
price PP00,, can
can be
be written
written as:
as:
D0 (1 g )
D1
is
g
g
P0
P0

3-10

2009, The McGraw-Hill Companies, All Rights

Relation between Interest

Rates and Bond Values
Interest
Interest
Rate
Rate
12%
10%
8%

874.50

1,000

3-11

1,152.47

Bond
BondValue
Value

2009, The McGraw-Hill Companies, All Rights

Impact of Maturity on
Interest Rate Sensitivity
Absolute
AbsoluteValue
Valueof
of
Percent
PercentChange
Changein
inaa
Bonds
BondsPrice
Pricefor
foraa
Given
GivenChange
Changein
in
Interest
InterestRates
Rates

Time to Maturity

3-12

2009, The McGraw-Hill Companies, All Rights

Impact of Coupon Rates on

Interest Rate Sensitivity
Bond
Bond
Value
Value
High-Coupon Bond

Low-Coupon Bond

Interest Rate
3-13

2009, The McGraw-Hill Companies, All Rights

Duration
Duration
Duration isis the
the weighted-average
weighted-average time
time to
to
maturity
maturity (measured
(measured in
in years)
years) on
on aa financial
financial
security
security
Duration
Duration measures
measures the
the sensitivity
sensitivity (or
(or
elasticity)
elasticity) of
of aa fixed-income
fixed-income securitys
securitys price
price
to
to small
small interest
interest rate
rate changes
changes

3-14

2009, The McGraw-Hill Companies, All Rights

Duration
Duration
Duration(D)
(D)for
foraafixed-income
fixed-incomesecurity
securitythat
thatpays
paysinterest
interest
annually
annuallycan
canbe
bewritten
writtenas:
as:
CF t t

t
t 1 (1 R )
D T

CF t

t
t 1 (1 R )
T

PV t
t 1
T

PV
t 1

tt==11totoT,
T,the
theperiod
periodininwhich
whichaacash
cashflow
flowisisreceived
received
TT==the
thenumber
numberof
ofyears
yearstotomaturity
maturity
CF
CFt t==cash
cashflow
flowreceived
receivedatatend
endof
ofperiod
periodtt
RR==yield
yieldtotomaturity
maturityor
orrequired
requiredrate
rateof
ofreturn
return
PV
PVt t==present
presentvalue
valueof
ofcash
cashflow
flowreceived
receivedatatend
endof
ofperiod
periodtt

3-15

2009, The McGraw-Hill Companies, All Rights

Duration
Duration
Duration (D)
(D) (measured
(measured in
in years)
years) for
for aa fixedfixedincome
income security
security in
in general
general can
can be
be written
written as:
as:
CF t t

mt
(
1

R
/
m
)
D t 1T/ m
CF t

mt
(
1

R
/
m
)
t 1 / m
T

m
m==the
thenumber
numberof
oftimes
timesper
peryear
yearinterest
interestisispaid
paid
3-16

2009, The McGraw-Hill Companies, All Rights

Duration
Duration
Duration and
and coupon
coupon interest
interest
the
thehigher
higherthe
thecoupon
couponpayment,
payment,the
thelower
lowerthe
thebonds
bonds
duration
duration

Duration
Duration and
and yield
yieldto
to maturity
maturity
the
thehigher
higherthe
theyield
yieldto
tomaturity,
maturity,the
thelower
lowerthe
thebonds
bonds
duration
duration

Duration
Duration and
and maturity
maturity
duration
durationincreases
increaseswith
withmaturity
maturityatataadecreasing
decreasingrate
rate

3-17

2009, The McGraw-Hill Companies, All Rights

Duration and Modified Duration

Given
Given an
an interest
interest rate
rate change,
change, the
the estimated
estimated
percentage
percentage change
change in
in aa (annual
(annual coupon
coupon paying)
paying)
bonds
bondsprice
price isis found
found by
by rearranging
rearranging the
the duration
duration
formula:
formula:
P
R
D
MD R

P
1 R
MD
MD==modified
modifiedduration
duration==D/(1
D/(1++R)
R)
3-18

2009, The McGraw-Hill Companies, All Rights

Figure 3-7

3-19

2009, The McGraw-Hill Companies, All Rights

Convexity
Convexity
Convexity (CX)
(CX) measures
measures the
the change
change in
in slope
slope of
of
the
the price-yield
price-yield curve
curvearound
around interest
interest rate
rate level
level RR
Convexity
Convexity incorporates
incorporates the
the curvature
curvature of
of the
the pricepriceyield
yield curve
curve into
into the
the estimated
estimated percentage
percentageprice
price
change
change of
of aa bond
bond given
given an
an interest
interest rate
rate change:
change:
P
1
R 1
2
2
D

CX
(

R
)

MD

CX
(

R
)
P
2
1 R 2

3-20

2009, The McGraw-Hill Companies, All Rights