Interest Rates and

Security Valuation

Bañez and Bersabe

Various Interest Rate Measures
Coupon rate
•Interest rate specific to debt instruments
•Annual or periodic cash flow that a bond issuer
contractually promises to pay the bondholder
•One component of overall return
Various Interest Rate Measures
Required Rate of Return
• Used to calculate for the present value of a security
• Rate an investor should receive on a security given its risk
• Function of the various risks associated with the security
Various Interest Rate Measures
Expected Rate of Return
● Rate a market participant expects to earn by buying the security
at its current market price, receiving all the projected cash flow
payments on the security and selling the security when the
security matures at the end of the participant’s investment
horizon
•Based on the current market price rather than fair present value
Various Interest Rate Measures
Realized Rate of return
•Interest rate actually earned on an investment in a financial security
•Historical interest rate of return
•Discount rate the just equates the purchase price to the present
value of the realized cash flows
•If the realized rate of return is greater(less) than the required rate of
return, the market participant actually earned more(less) than was
needed to compensate for the expected risk
•
Bond Valuation
● Employs time value of money concepts
● Fair value of a bond reflects the present value of all cash
flows promised or projected to be received on that bond
discounted at the required rate of return
● Expected rate of return - interest rate that equates
current market price with PV of all promised cash flows
received over the bond’s life
● Realized rate of return - actual return earned on a bond
investment
● Cash flows come from:
○ Interest
○ Lump sum payment upon maturity
Bond Valuation
● Coupon bonds
○ Bonds that pay a stated coupon rate of interest to bondholders
○ Interest payments are constant over the life of a bond
■ Annuity paid usually semi-annually
● Zero coupon bonds
○ No interest
○ Face/par value is a lump-sum payment received upon the maturity
of the bond
○ Face value is set at $1000 in the US
Bond Valuation
● Formula used to calculate present values
Bond Valuation
● Bond sold at a premium
○ Coupon rate on the bond is greater that the required rate of return on the bond
○ Bondholder experiences a loss on the difference between the purchase price of the
bond and the face value at maturity
● Bond sold at a discount
○ Coupon rate on the bond is less that the required rate of return on the bond
○ Bondholder experiences a gain on the difference between the purchase price of the
bond and face value at maturity
Bond Valuation
● Yield to maturity
○ Return the bondholder will earn on the bond if the bond is bought at its current
market price and receives all coupon and principle payments as promised and holds
the bond until maturity
○ Calculation assumes that coupon payments received can be invested at the same
rate
Equity Valuation
● Involves finding the present value of an infinite series of cash flows on the
equity discounted at the appropriate interest rate
● Cash flows come from dividends
○ Fair price paid for investing in stocks is the present value of its current and future dividends
○ Dividends are a function of firm’s earnings, profitability of the firm’s investments
○ Earnings growth, dividend growth and stock value are highly correlated
● Expected Rate of Return - used for analyzing expected future return on
stocks
● Required Rate of Return - used for analyzing the FV of a stock investment
over its whole lifetime
Equity Valuation
● The price or value of a stock is equal to the present value of its future
dividends
● Assumptions on the expected pattern of the uncertain flow of dividends:
○ Zero growth in dividends over the infinite life of the stock
○ Constant growth rate in dividends
○ Nonconstant growth in dividends
Equity Valuation
● Zero growth in Dividends
○ Dividends are expected to remain in a constant level forever
Equity Valuation
● Zero growth in Dividends
○ If Fair Market price is applied, we can get the required
rate of return
○ If Current market price, we get expected return
Equity Valuation
● Constant Growth in Dividends
○ Dividends on a stock are expected to grow at a
constant rate,g, each year into the future
Equity Valuation
● Constant Growth in Dividends
○ Required rate of return <-> fair market price
○ Expected return <-> current market price
Equity Valuation
● Supernormal/Nonconstant Growth in Dividends
○ Non constant growth followed by settling into a
constant rate of growth
○ Stock value = PV of the firm’s expected future
dividends
Equity Valuation
● Supernormal/Nonconstant Growth in Dividends
○ 3 step process
■ Find PV of dividends during period of nonconstant
growth
■ Find stock price at the end of nonconstant growth
using the constant growth dividends model. Get
PV
■ Add
Impact of Interest Rate Changes on Security
Values
Interest rate—there is a negative relation between interest rate changes and
present value (or price) changes on financial securities As interest rates
increase, security prices decrease at a decreasing rate.

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. The maturity effect described above increases at a
decreasing rate.

Coupon rate—the higher a security’s coupon rate, the smaller the price change
on the security or a given change in interest rates.
Impact of Interest Rate Changes on Security
Values

As yields on bonds increase, current market prices of bonds decrease

Impact of Interest Rate Changes on Security
Values
When required rates of return rise(fall) on securities, the fair present values of
the assets and liability portfolios decrease (increase) and affects the FPV of
equity.

The inverse relationship between bond prices and interest rates is not linear.
Rather, the percentage change in the present value of a bond to a given change in
interest rates is smaller when interest rates are higher
Impact of Maturity on Security Values

Price Sensitivity - measured by the percentage change in its present value for a
given change in interest rates. The larger the percentage change in bond value,
the larger the bond’s price sensitivity.

As the time remaining to maturity on a bond increases, price sensitivity increases

but at a decreasing rate.
Impact of Maturity on Security Values
Impact of Maturity on Security Values
Impact of Maturity on Security Values
Impact of Coupon Rates on Security Values

The higher the bond’s coupon rate, the smaller the price changes on the bond for
a given change in interest rates.
Impact of Coupon Rates on Security Values
Duration

The weighted-average time to maturity on a financial security using the relative

present values of the cash flows as weights. The larger the numerical value of
duration (D), the more sensitive the price of that bond to (small) changes or
shocks in interest rates.

Elasticity - The percentage change in the price of a bond for a given change in
interest rates.
Duration
Duration
Duration
Duration

Features of Duration:

● Duration and coupon interest - the higher the coupon payment, the lower
the bond’s duration.
● Duration and yield to maturity - the higher the yield to maturity, the lower
the bond’s duration.
● Duration and maturity - duration increases with maturity but at a decreasing
rate.
Duration

Features of Duration:

● Duration and coupon interest - the higher the coupon payment, the lower
the bond’s duration.
● Duration and yield to maturity - the higher the yield to maturity, the lower
the bond’s duration.
● Duration and maturity - duration increases with maturity but at a decreasing
rate.
Modified Duration

Given an interest rate change, the estimated percentage change in a (annual

coupon paying/semi-annual coupon) bond’s price given by:
Modified Duration

Modified duration (MD) can be used to predict price changes for non-annual
payment loans or securities:
Convexity

The degree of curvature of the price–interest rate curve around some interest
rate level.
Convexity

The degree of curvature of the price–interest rate curve around some interest
rate level.
Convexity

Characteristics of Convexity:

● All fixed-income securities are convex.

● Convexity diminishes the error in duration as an investment criterion.
● Convexity is desirable.
Questions
True or False

1. The required rate of return is the appropriate interest rate when analysing the
fair value of a stock investment over its whole lifetime

2. Zero growth in dividends pertains to dividends that are expected to grow at a

constant rate g each year into the future

3. Interest rate changes and present value changes on financial securities have a
directly proportional relationship

4. Realised rate of return is the rate actually earned on an investment in a

financial security

5. Discount bonds have a coupon rate greater that the required rate of return on
the bond
Questions
True or False

6. It is useful to use the duration formula in predicting price changes for

non-annual payment loans or securities

7. As the time remaining to maturity on a bond increases, price sensitivity

increases but at an increasing rate

8. The description “duration increases with maturity but at a decreasing rate”

best describes the feature, duration and yield to maturity

9. Some fixed-income securities are convex

10. The higher the bond’s coupon rate, the smaller the price changes on the bond
for a given change in interest rates
Questions
True or False

1. The required rate of return is the appropriate interest rate when analysing the
fair value of a stock investment over its whole lifetime (T)

2. Zero growth in dividends pertains to dividends that are expected to grow at a

constant rate g each year into the future (F)

3. Interest rate changes and present value changes on financial securities have a
directly proportional relationship (F)

4. Realised rate of return is the rate actually earned on an investment in a

financial security (T)

5. Discount bonds have a coupon rate greater that the required rate of return on
the bond (F)
Questions
True or False

6. It is useful to use the duration formula in predicting price changes for

non-annual payment loans or securities (F)

7. As the time remaining to maturity on a bond increases, price sensitivity

increases but at an increasing rate (F)

8. The description “duration increases with maturity but at a decreasing rate”

best describes the feature, duration and yield to maturity (F)

9. Some fixed-income securities are convex (F)

10. The higher the bond’s coupon rate, the smaller the price changes on the bond
for a given change in interest rates (T)