Fall 2013 ADVANCED FINANCIAL INSTRUMENTS AND MARKETS

LectureNo.05 5 DeterminantsofAssetPricesand InterestRates

Hammad HassanMirza AssistantProfessor(Finance) DepartmentofBusinessAdministration UniversityofSargodha

Todays Today sDiscussion

PrinciplesofAssetsPricing InterestRatesandTheoriesofInterest

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PrinciplesofPricingFinancial Assets
Themarketpriceofanassetequals:

CF3 CFN CF1 CF2 P= + + + ... + 1 2 3 (1 + r ) (1 + r ) (1 + r ) (1 + r ) N

where: P = the price of the financial asset CFt = cash flow at end of y year t (t=1,2,,N) ( , , , ) N = maturity of the financial asset r = appropriate discount rate
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AppropriateDiscountRate
Theappropriatediscountrateisequalto: r=RR+IP+DP+MP+LP+EP

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where:RR=therealrateofinterest IP=theinflationpremium DP=thedefaultriskpremium MP=thematurity yp premium LP=theliquiditypremium EP=theexchangerateriskpremium

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PriceandAssetProperties
Thepriceofafinancialassetisinversely relatedtoits discountrate.
Asthediscountraterises,thepricefalls. Asthediscountratefalls,thepricerises.

Reversibilityintheformofcommissionsandtransfer feesreducethepriceoftheasset. asset

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EffectofAssetPropertiesonthe Di Discount tRate R t

Asset Properties Discount Rate Default Risk Liquidity q y Risk Convertibility Currency Risk Positive Positive Negative Positive
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TaxTreatment
Aftertaxdiscountrateequals

Pretaxdiscountratex(1 ( marginal g taxrate) )

Ifthemarginaltaxrateisexpectedtoincrease,the aftertaxdiscountratewilldecrease Ifthemarginaltaxrateisexpectedtodecrease,the aftertaxdiscountratewillincrease
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PriceVolatilityofFinancialAssets
Therequiredrateofreturnorrequiredyield ofan assetisinverselyrelatedtoitsprice. Thesensitivity oftheassetspricetoachangeinthe requiredyieldwillnotbethesameforallassets assets. Changesintherequiredyieldaremeasuredinterms ofbasispoints.

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PriceSensitivityofFinancial Assets
Thepricesensitivityofafinancialassettoagiven changeinyieldisaffectedbytheassets:
Maturity Coupon Yieldlevel

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PriceSensitivityofFinancial Assets
Maturity
Thelongerthematurityofanasset,thegreatertheprice sensitivity ytoachange g intherequired q y yield.

CouponRate
Thelowerthecouponrate,thegreatertheprice sensitivitytoachangeintherequiredyield.

LevelofInterestRates
Thelowertheprevailingyieldlevel,thegreatertheprice sensitivitytoachangeintherequiredyield.
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MeasuringPriceSensitivityto InterestRateChanges
Forasmalldecreaseinrequiredyield,thepercentage changeinpriceis:

P P0 P0
Where: P- = asset price if required yield decreases P0 = initial asset price
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MeasuringPriceSensitivityto InterestRateChanges
Theaveragepercentagechangeinpriceperbasispoint changeinrequiredyieldis:

P P+ 2 P0 (y )100
Wh Where: P- = asset t price i if yield i ld decreases d P+ = asset price if yield increases P0 = initial asset price y = change in required yield
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AssetPropertiesandDuration
For bonds with the same coupon rate and the same yield, the bond with the longer maturity will have the greater duration. g For bonds with the same maturity and the same y yield, , the bond with the lower coupon p rate will have the greater duration. The lower the initial yield, the greater the duration for a given bond.
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RelationshipbetweenDurationand P i S Price Sensitivity iti it

Anestimateofthepercentagechangeinthepriceof afinancialassetis: Durationx(y)x100

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ModifiedDurationandEffective Duration
ModifiedDuration
Assumesfuturecashflowsfromanassetdonotchange withchangesininterestrates.

EffectiveDuration
Assumesfuturecashflowsfromanassetchangewith changesininterestrates.

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InterestRates
Aninterestrate isthepricepaidbyaborrowertoa lenderfortheuseofresourcesthatwillbeused duringsometimeperiodthenreturned.
Realrate Riskfreerate Shorttermrate

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TheoriesofInterestRates

Fishers Fi h Classical Cl i lApproach A h LoanableFundsTheory KeynesLiquidityPreferenceTheory

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Fishers Fisher sClassicalApproach

SupplyofSavings
Marginalrateoftimepreference Income Rewardforsaving

DemandforBorrowedResources
Marginal M i lproductivity d ti it of fcapital it l Rateofinterest

EquilibriumRateofInterest
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Fishers Fisher sLaw

NominalRateofInterest(i) RealRateofInterest(r) PremiumforExpected Inflation(p) p FishersLaw (1+i)=(1+r)(1+p) or i=r+p

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TheLoanableFundsTheory
DemandforandSupplyofFundsbyFirms, Firms Governments,andHouseholds
Changesinthemoneysupply Governmentdeficits Changesinpreferencesbyhouseholds Newinvestmentopportunitiesforfirms

EquilibriumRateofInterest

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TheLiquidityPreferenceTheory
DemandforMoneyBalances
Transactionsdemand Precautionarydemand Speculativedemand

SupplyofMoney Equilibrium ilib i Rateof fInterest

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ChangesintheDemandfor MoneyandInterestRates
LiquidityEffect
Ifincreasing,causestheinterestratetorise.

IncomeEffect
Ifincreasing,causestheinterestratetorise.

PriceExpectationsEffect
Ifincreasing,causestheinterestratetorise.

NetEffect:
Th Theinterest i t trate t mayrise, i f fall, ll orremain i unchanged depending on theneteffectofchanges PropertyofDepartment ofBusinessAdministraiton, Universityof 22 Sargodha indesiredliquidity,income,andpriceexpectations.

FeaturesofaBond

TimetoMaturity PrincipalorParValue Coupon p Interest YieldtoMaturity(YTM) IfYTM=couponrate,marketprice=parvalue IfYTM>couponrate,marketprice<parvalue IfYTM<couponrate,marketprice>parvalue

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DeterminantsoftheStructureof InterestRates
TheBaseInterestRate RiskPremiumsAreDeterminedBy:
IssuerType Creditrisk Termtomaturity Embeddedoptions p Taxabilityofinterest Liquidity

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TypesofIssuers
TreasuryMarketSector CorporateMarketSector
Utilities Industrials Finance B k Banks

IntermarketandintramarketSector
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TermtoMaturity
Thevolatilityofabond bonds spriceisinfluencedbyits maturity. Thelongerthematurityofabond,thegreaterits pricesensitivitytoachangeinmarketyields. Maturityspreadoryieldcurvespread

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TheYieldCurve
Relationshipbetweenyieldandmaturityforbondsof thesamecreditqualitybutdifferentmaturities. Yieldcurveshapes
N l Normal Inverted Flat Humped

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UsingtheYieldCurvetoPricea Bond
Anyfinancial f assetcanbeviewedasapackageof fzero couponinstruments.
Maturityofaninstrumentisthecouponpaymentdateor maturitydate. Valueoftheassetequalsthetotalvalueofthecomponent zerocouponinstruments. instruments

SpotRate
Rateonzerocoupon p bond
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TheoreticalSpotRateCurve
Theprocessofcreatingayieldcurvebasedon theoreticalspotratesiscalledbootstrapping. Thetheoreticalvalueofabondisequaltothepresent valueofitsperiodiccashflowsdiscountedatthe correspondingtheoreticalspotrateforeachperiod.

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ForwardRates
Markets Market sConsensusPredictionofFutureInterest Rates
Theimpliedforwardrateiscalculatedfromeitherthe spotratesoryieldcurve. Theyieldcurvecanbeusedtocalculatetheimplied forwardrateforany yinvestmenthorizonorany ysub periodwithinthathorizon.

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RelationshipBetweenSpotRatesandShort TermForwardRates
Therelationshipbetweenthespotrateonan instrumentmaturinginsixmonths(thecurrentsix month thspot trate), t ) and dthe th implied i li dmonthly thl forward f d ratesforthenextsixmonthsis:

zt = [(1 + z1 )(1 + f1 )(1 + f 2 )(1 + f 3 )...(1 + f t 1 )] 1

1/ t

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ForwardRateasaHedgeable Rate
Forwardratesdonot predictfutureinterestrates. rates Forwardratesdoindicatehow aninvestors expectationsmustdifferfromthemarketconsensus inordertomakethecorrectdecision.

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DeterminantsoftheShapeofthe TermStructure
(Pure)ExpectationsTheory LiquidityTheory PreferredHabitatTheory MarketSegmentationTheory

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PureExpectationsTheory
Yieldsonbondswithdifferentmaturitiesarebased onlyonexpectationsoffutureshorttermrates. Termstructuremightbenormal,inverted,humped, orflat flat. Ignorespriceriskandreinvestmentrisk. p includebroad,localandreturnto Interpretations maturity.

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LiquidityTheory
Yieldsonbondswithdifferentmaturitiesare basedonlyonexpectedfutureratesplusa li idi premium liquidity i that h increases i with i h maturity. Termstructuremightbenormalorflat flat. Presupposesthatalllenderswanttolend shorttermandallborrowerswanttoborrow longterm. Inreality,therearelendersforshortandlong termsand dborrowers b for f short h and dlong l terms.
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PreferredHabitatTheory
Yieldsonbondswithdifferentmaturitiesare basedonlyondemandandsupplyateach maturity. i Termstructuremightbenormal,inverted, humped humped,orflat flat. Issuersandbuyersofbondshavematurity preferencesbutwillshifttoothermaturitiesif p thepricesoryieldsareattractiveenough. Yieldsarecompletelyunrelatedto expectations i of ff futurerates.
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MarketSegmentationTheory
Yieldsonbondswithdifferentmaturitiesare basedonlyondemandandsupplyateach maturity. maturity Termstructuremightbenormal,inverted, humped,orflat. Issuersandbuyersofbondshavematurity preferencesandwillnotshifttoanother maturitybecauseeachmaturityisaseparate market. Yieldsarecompletelyunrelatedto expectationsoffuturerates.
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ThankYou!
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