Chapter Three

Interest Rates and

Security Valuation
3-2
Various Interest Rate Measures
Coupon rate
Determines the periodic cash flow received by the bond
investor (and paid by the bond issuer)
Required rate of return (r)
rates used by individual market participants to calculate
present values (PV)
Expected rate of return or E(r)
rates participants would earn by buying securities at current
market prices (P)
The required return and the expected return are the same if
market prices reflect present values
Realized rate of return ( r )
rate actually earned on investments
3-3
Required Rate of Return
The present value (PV) of a security is determined
using the required rate of return (r) as the discount
rate



CF
t
= expected cash flow in period t (t = 1, , n)
n = number of periods in the investment horizon
n
n
r
CF
r
CF
r
CF
r
CF
PV
) 1 (
...
) 1 ( ) 1 ( ) 1 (
3
3
2
2
1
1
+
+ +
+
+
+
+
+
=
3-4
Expected Rate of Return
The current market price (P) of a security is
determined using the expected rate of return or
E(r) as the discount rate



CF
t
= cash flow in period t (t = 1, , n)
n = number of periods in the investment horizon
n
n
r E
CF
r E
CF
r E
CF
r E
CF
P
)) ( 1 (
...
)) ( 1 ( )) ( 1 ( )) ( 1 (
3
3
2
2
1
1
+
+ +
+
+
+
+
+
=
3-5
Realized Rate of Return
The realized rate of return ( r ) is the discount rate
that just equates the actual purchase price ( ) to
the present value of the realized cash flows (RCF
t
) t
(t = 1, , n)
P
n
n
3
3
2
2
1
1
) r 1 (
RCF
...
) r 1 (
RCF
) r 1 (
RCF
) r 1 (
RCF
P
+
+ +
+
+
+
+
+
=
3-6
Bond Valuation
The present value of a semi-annual bond (V
b
) can be written
as:






M = the maturity (or par value or face value) of the bond, usually $1,000
INT = the annual interest (or coupon) payment
T = the number of years until the bond matures
r = the annual interest rate (often called yield to maturity (ytm))
(

+
+
(

+
=
+
+
+
=

=
2T
2T
T 2
1 t
T 2 t
b
r/2) (1
1
M
2 r
) 2 r (1 1 1
2
INT
) 2 / r 1 (
M
) 2 / r 1 (
2
INT
V
3-7
Bond Valuation
A premium (discount) bond has a coupon rate
(INT) greater (less) than the required rate of
return (r) and the price of the bond (V
b
) is
greater (less) than the face or par value
Par bond: if INT = r, then V
b
= Par
Premium bond: if INT > r; then V
b
> Par
Discount bond: if INT < r, then V
b
< Par
3-8
Equity Valuation:
Constant Dividend Model
The present value of a stock (P
t
) assuming zero
growth in dividends can be written as:


D = dividend paid at end of every year
P
t
= the stocks price at the end of year t
r
s
= the interest rate used to discount future cash flows
s t
r / D P =
3-9
Equity Valuation:
Constant Growth Model
The present value of a stock (P
t
) assuming
constant growth in dividends can be written as:




D
0
= current value of dividends
D
t
= value of dividends at time t = 1, 2, ,
g = the constant dividend growth rate
g r
D
g r
) g 1 ( D
P
s
1 t
s
t
0
t

=

+
=
+
3-10
Expected Return on Equity
The return on a stock with zero dividend growth, if
purchased at current price P
0
, can be written as:


The return on a stock with constant dividend growth,
if purchased at price P
0
, can be written as:


g
P
D
g
P
) g 1 ( D
r
0
1
0
0
s
+ = +
+
=
0 s
P / D r =
3-11
Equity Valuation:
Supernormal or Non-Constant Growth Model
Three steps:
1. Find the PV of each dividend during the
supernormal growth period
2. Find the price of the stock at the end of the
supernormal growth period (using the constant
growth model)
3. Discount all the values from steps 1 and 2 and add
them together.

3-12
As Interest Rates Fall, Bond Prices
Increase
Interest
Rate








Bond Value

12%
10%
8%
874.50 1,000 1,152.47
FV 1000 1000 1000
PMT 100/2 100/2 100/2
N 12 x 2 12 x 2 12 x 2
I/Yr 12/2 10/2 8/2
PV 874.50 1000.00 1152.47
3-13
As Time to Maturity Increases, Price
Sensitivity Increases but at a Decreasing
Rate
22.00%
23.00%
24.00%
25.00%
26.00%
27.00%
28.00%
29.00%
12 13 14 15 16
P
e
r
c
e
n
t

c
h
a
n
g
e

i
n

b
o
n
d

p
r
i
c
e

Time to Maturity (years)
Absolute value of change in price of a semi-annual
bond as required return changes from 8% to 12%
(10% coupon, $1000 par value)
3-14
Interest Rate Sensitivity is Lower for
Higher Coupon Rate Bonds
Required return 10% 12%
7.0% $1,240.88 $1,401.46
7.5% $1,195.56 $1,352.01
8.0% $1,152.47 $1,304.94
8.5% $1,111.48 $1,260.12
9.0% $1,072.48 $1,217.43
9.5% $1,035.35 $1,176.76
10.0% $1,000.00 $1,137.99
10.5% $966.33 $1,101.02
11.0% $934.24 $1,065.76
11.5% $903.66 $1,032.11
12.0% $874.50 $1,000.00
12.5% $846.68 $969.34
13.0% $820.14 $940.05
13.5% $794.80 $912.06
14.0% $770.61 $885.31
$ Price 7% to 14% $470.26 $516.15
% Price 7% to 14% -37.9% -36.8%
3-15
Duration
Duration is the weighted-average time to maturity
(in years) on a financial security
Duration measures the sensitivity of a fixed-income
securitys price to small interest rate changes

3-16
Duration
Duration (Dur) for a fixed-income security that pays interest
annually can be written as:




P
0
= Current price of the security
t = 1 to T, the period in which a cash flow is received
N = the number of years to maturity
CF
t
= cash flow received at end of period t
r = yield to maturity or required rate of return
PV
t
= present value of cash flow received at end of period t
0
N
1 t
t
0
N
1 t
t
t
P
t PV
P
) r 1 (
t CF
Dur

= =

=
+

=
3-17
9% Coupon, 4 year maturity annual payment bond with a 8% YTM
Calculating Duration
Duration = 3.54 years
0
N
1 t
t
t
P
r) (1
t CF
Dur

=
+

=
Year (t)
Cash Flow
(CF
t
)
PV @ 8%
CF
t
/(1.08)
t

% of Total PV
[CF
t
/(1.08)
t
]/P
0

Duration
[CF
t
/(1.08)
t
]/P
0
x t
1 $ 90 $ 83.33 8.06% 0.0806
2 90 77.16 7.47% 0.1494
3 90 71.45 6.92% 0.2076
4 $1,090 $ 801.18 77.55% 3.1020
Totals P
0
= $1,033.12 100.00% 3.5396

3-18
9% Coupon, 4 year maturity semi-annual payment bond with a 8%
YTM
Calculating Duration
Duration = 3.46 years
0
N
1 t
t
t
P
r) (1
t CF
Dur

=
+

=
Year (t)
Cash Flow
(CF
t
)
PV =
CF
t
/(1.04)
2t

% of Total PV
[CF
t
/(1.08)
2t
]/P
0

Duration
[CF
t
/(1.08)
2t
]/P
0
x t
.5 $ 45 $ 43.27 4.19% 0.0209
1 45 41.61 4.03% 0.0403
1.5 45 40.00 3.87% 0.0581
2 45 38.47 3.72% 0.0744
2.5 45 36.99 3.58% 0.0895
3 45 35.56 3.44% 0.1032
3.5 45 34.20 3.31% 0.1158
4 1,045 763.57 73.87% 2.9548
Totals P
0
= $1,033.66 100.00% 3.4569

3-19
Duration
Duration and coupon interest
the higher the coupon payment, the lower the bonds
duration
Duration and yield to maturity
the higher the yield to maturity, the lower the bonds
duration
Duration and maturity
duration increases with maturity but at a decreasing rate
3-20
Economic Meaning of Duration
Given a small change in interest rates, the
estimated percentage change in a semi-annual
coupon bonds price is approximately:



(
(
(

+
=
2
r
1
r
Dur
P
P A A
3-21
Duration Based Prediction Errors
3-22
Convexity
Convexity is good because it provides partial
insurance against interest rate movements
Convexity (CX) measures the change in slope of
the price-yield curve around interest rate level r
Convexity incorporates the curvature of the price-
yield curve into the estimated percentage price
change of a bond given an interest rate change:




2
) r ( CX
2
1
r 1
r
Dur
P
P
A
A A
+
(

+
=
3-23
Convexity
Example: Consider an 8% semi-annual coupon
bond with 6 years to maturity and an 8% rate of
return. What is the change in price if rates rise by
2%?
1. The current price is $1000 because the coupon
rate equals the rate of return. Calculate what
the price will be if the rate of return is 0.01%
higher and 0.01% lower?
PMT = 80, N = 6, FV =1000
If I/Yr = 8.01 then PV = 999.53785
If I/Yr = 7.99 then PV = 1000.46243



3-24
Convexity
Example: Consider an 8% semi-annual coupon
bond with 6 years to maturity and an 8% rate of
return. What is the change in price if rates rise by
2%?
2. Calculate the convexity




(

+
+

=
P
P
P
P
10 CX
8
A A
28 1
1000
46243 . 1000
1
1000
53785 . 999
10 CX
8
=
(

|
.
|

\
|
+
|
.
|

\
|
=
3-25
Convexity
Example: Consider an 8% semi-annual coupon
bond with 6 years to maturity and an 8% rate of
return. What is the change in price if rates rise by
2%?
3. Calculate the change in price




2
) r ( CX
2
1
r 1
r
Dur
P
P
A
A A
+
(

+
=
% 69 . 8 0056 . 09246 . ) 02 (. 28
2
1
08 . 1
02 .
993 . 4
P
P
2
= + = +
(

=
A
3-26
Immunization
In order to eliminate risk of an obligation due in N
years:
1. Buy a zero coupon bond that matures in N years
2. Buy a coupon bond with a duration of N years

Example: Horizon is 5 years but you buy a 6 year
bond with a duration of 5 years.
Bond pays 8% annual coupon or $80 a year for 5
years.
What happens if rates are 8%? 7%? 9%?