CHAPTER 3: INTEREST RATES AND SECURITY VALUATION

Slide 2:
VARIOUS INTEREST RATE MEASURES
● Coupon Rate
○ Interest rate on a bond instrument used to calculate annual (or periodic) cash
flow that the bond issuer contractually promises to pay the bond holder
○ Only one component of the overall return the bond holder earns on a bond
● Required Rate of Return
○ Interest rate an investor should receive on a security given its risk
○ Used to calculate the fair present value on a security on a security
● Expected Rate of Return
○ Interest rate an investor expects to receive on a security if he or she buys the
security at its current market price, receives all expected payments, and sells the
security the end of his or her horizon period
● Realized Rate of Return
○ Actual interest rate earned on an investment in a financial security
○ Realized rate of return is a historical (ex post) measure of the interest rate
Slide 3:
REQUIRED RATE OF RETURN
● Involves the discounting of all projected cash flows (CF)​2​ on the security at an
appropriate interest rate
● Required Rate of Return - interest rate used to find the fair present value of a financial
security
○ Function of the various risks associated with a security
○ This is the interest rate the investor should receive on the security given its risk
● PV is determined by the formula: (given in the slide), where:
○ r = Required Rate of Return
○ CF​t =​ Cash flow projected in period t (t = 1, 2, ..., n)
○ n = Number of periods in the investment horizon
● Once the PV is calculated, market participants then compare this present value with the
current market price at which the security is trading in a financial market
○ Current is less than its fair value (PV) = security is currently undervalued
■ Market participant would want to buy more of this security at its current
price
○ Current is greater than its fair value (PV) = security is overvalued
■ Market participant would not want to buy this security at its current price
○ Current is equal to its fair value (PV) = security is fairly valued
Slide 4:
EXPECTED RATE OF RETURN
● Is the interest rate a market participant expects to earn by buying the security at its
current market price, receiving all the projected cash flow payments, and selling the
security when the security matures at the end of the participant’s investment horizon
○ An ex ante measure of the interest rate on a security
 ● Based on the current market price (P) rather than fair present value
● The current market price is set equal to the present value of projected cash flows
received on the security over the investment horizon
● The expected rate of return [E(r)] is basically the discount rate in the PV equation hat just
makes the PV of projected cash flows equal to its current market price
● Once the expected rate of return is calculated, it is compared to its required rate of return
○ E(r) is greater than r = the projected cash flows are greater than is required to
compensate for the risk incurred
■ The market participant would want to buy more of this security
○ E(r) is less than r = the projected cash flows are less than those required to
compensate for the risk involved
■ The market participant would not want to invest in the security
Slide 5:
REQUIRED VS EXPECTED RATES OF RETURN
● RRR: used to calculate a fair present value of a financial security
● ERR: discount rate used in conjunction with the current market price of a security
● As long as financial markets are efficient, the current market price of a security tends to
equal its fair price present value
● If security is undervalued (current market price is less than fair PV) = demand for
security increases, as does its price
● If security is overvalued (current market price is greater than fair PV) = they will sell the
security, resulting in a price drop
Slide 6:
REALIZED RATE OF RETURN
● The interest rate actually earned on an investment in a financial security
● A historical interest rate of return
● An ex post (after the fact) measure of the interest rate on the security
● To compute for the Realized Rate of Return, all cash flows actually paid or received are
incorporated in time value of money equations to solve for the realized rate of return
● The realized rate of return is the discount rate that just equates the purchase price to the
present value of the realized cash flows (RCF​n​)
● If realized rate of return is greater than required rate of return = the market participant
actually earned more than was needed to compensate for the expected risk
● If realized rate of return is less than the required rate of return = the market participant
actually earned less than the interest rate required to compensate for the risk involved
Slide 7 and 8:
BOND VALUATION FORMULA USED TO CALCULATE FAIR PRESENT VALUES
● Coupon bonds - bonds that pay a stated coupon rate of interest to the holders of the
bonds
○ The interest, or coupon, payments per year are generally constant (or fixed) over
the life of the bond
● Zero-coupon bonds - bonds that do not pay coupon interest rate
○ The interest is zero
 ● Coupon rate is greater than the required rate of return = premium
● Coupon rate is less than required rate of return = discount
Slide 9:
EQUITY VALUATION
● Involves finding the present value of an infinite series of cash flows on the equity
discounted at an appropriate interest rate
● CF from holding equity come from dividends paid out by the firm over the life of the stock
○ Can be viewed as infinite since a firm has no defined maturity life
● Dividends on equity are that portion of a firm’s earnings paid out to the stockholders
● Those earnings retained are normally reinvested to produce future income and future
dividends for the firm and its stockholders
○ The fair price paid for investing in stocks is the present value of its current and
future dividends
● Growth in dividends occurs primarily because of growth in the firm’s earnings
● The realized rate of return is the appropriate interest rate (discount rate) to apply to cash
flows when evaluating the historical performance of an equity
Slide 10:
ZERO GROWTH IN DIVIDENDS
● Zero growth in dividends means that dividends on a stock are expected to remain at a
constant level forever
● Companies that issue preferred stock usually pay investors dividends that exhibit zero
growth through time
Slide 11 and 12:
CONSTANT GROWTH IN DIVIDENDS
● Means that dividends on a stock are expected to grow at a constant rate, g, each year
into the future
EQUITY EVALUATION
● Return on a stock with zero dividend growth (see slide 12)
● Return on a stock with constant dividend growth (see slide 12)
​Slide 13 and 14 (formula):
SUPERNORMAL (NON CONSTANT) GROWTH IN DIVIDENDS
● Dividends during the period of supernormal (nonconstant) growth must be evaluated
individually
● The constant growth in dividends model can then be adapted to find the present value of
dividends following the supernormal growth period
● Three-step process:
○ STEP 1: Find the present value of the dividends during the period of supernormal
(nonconstant) growth
○ STEP 2: Find the price of the stock at the end of the supernormal (nonconstant)
growth period (when the constant growth in dividends begins) using the constant
growth in dividends model. Then discount this price to a present value
○ STEP 3: Add the two components of the stock price together
Slide 15:
IMPACT OF INTEREST RATE CHANGES ON SECURITY VALUES
● The variability of financial security depends on interest rates and the characteristics of
the security
● The factors that affect financial security include interest rate changes, the time remaining
to maturity, and the coupon rate
○ Interest rate = there is a negative relation between interest rate changes and PV
changes
○ Time remaining to maturity = the shorter the time to maturity a security, the closer
the price is to the face value of the security
○ Coupon rate = the higher a security’s coupon rate, the smaller the price change
on the security for a given change in interest rates
Slide 16:
IMPACT OF INTEREST RATE CHANGES ON PRICE VOLATILITY
● Price volatility is inversely related to the level of the initial interest rate
○ Higher interest rate, lower slope
Slide 17 and 18:
IMPACT OF TIME REMAINING TO MATURITY CHANGES ON SECURITY VALUES
● Price sensitivity
○ Measured by the percentage change in its present value for a given change in
interest rates
○ Larger percentage change, larger bond sensitivity
● The further a bond is from maturity, the more sensitive the price (fair or current) of the
bond as interest rate changes
Slide 19:
IMPACT OF COUPON RATES ON SECURITY VALUES
● The higher the bond’s coupon rate, the higher its present value at any given interest rate
● The higher the bond’s coupon rate, the smaller the price changes on the bond for a
given change in interest rates
Slide 20:
DURATION
● The weighted average time to maturity on a financial security using the relative present
values of the cash flows as weights
● Duration also has economic meaning as the sensitivity, or elasticity, of the asset or
liability’s value to small interest rate changes
● Provides a simple measure that allows for a straightforward calculation of a bond’s
interest rate sensitivity
● Duration produces an accurate measure of price sensitivity of a bond interest rate
changes for relatively small changes in interest rates
● Larger changes in interest rate, the less accurate the measure of price sensitivity
● Captures the coupon and maturity effects on volatility
Slide 22 and 23:
GENERAL FORMULA FOR DURATION
● The denominator of the equation is the present value of the cash flows on the security
 ○ In an efficient market is equal to the current market price
● The numerator is the present value of each cash flow received on the security multiplied
or weighted by the length of time required to receive the cash flow
Slide 24:
DURATION OF A ZERO-COUPON BOND
● These bonds have no intervening cash flow, such as coupon payments, between issue
and maturity
● The current price that an investor is willing to pay for such a bond is equal to the present
value of the single, fixed (face value) payment on the bond that is received on maturity
date
● Duration of a zero coupon bond equals maturity
○ For any bond that pays some cash flows prior to maturity, duration will always be
less than maturity
Slide 25:
FEATURES OF DURATION
● Duration and coupon interest
○ The higher the coupon or promised interest payment on the bond, the shorter its
duration
○ The larger the coupon or promised interest payment, the more quickly investors
receive cash flows on a bond and the higher are the present value weights of
those cash flows
○ The investor recoups his or her initial investment faster when coupon payments
are higher
● Duration and rate of return
○ Duration decreases as rate of return increases
○ The higher the rate of return on the bond, the lower the present value cost of
waiting to receive the later cash flows on the bond
○ Higher rates of return discount later cash flows more heavily
■ The relative weights of those later cash flows decline when compared to
cash flows received earlier
● Duration and maturity
○ Duration increases with the maturity of the bond, but at a decreasing rate
○ For a coupon bond, the longer the maturity on the bond the larger the
discrepancy between maturity and duration
Slide 26, 27 and 28:
ECONOMIC MEANING OF DURATION
● Duration is also a direct measure of its related interest rate sensitivity, or elasticity
● The larger the numerical value of duration, the more sensitive the price of that bond to
small changes or shocks in interest rate
● The negative sign in front of D indicates the inverse relationship between interest rate
changes and price changes (-D)
Slide 29:
DURATION BASED PREDICTION ERRORS
 ● Duration predicts that the relationship between an interest rate change and a security’s
price change will be proportional to the security’s D (duration)
● For larger interest rate increases, duration overpredicts the fall in the security’s price
● For large interest rate decreases, it underpredicts the increase in the security’s price
● As seen in the table, the capital loss effect of large rate increases tends to be smaller
than the capital gain effect of large rate increases
Slide 30:
CONVEXITY
● The degree of curvature of the price-interest rate curve around some interest rate level
● Measures the changes in slope of the price-yield curve around interest rate level R
● Incorporates the curvature of the price-yield curve into the estimated percentage price
change of a bond given an interest rate change
● The higher the level of interest rate, the smaller a bond’s price sensitivity to interest rate
changes
● Three characteristics of convexity
○ Convexity is desirable
■ The greater the convexity of a security or portfolio of securities, the more
insurance or interest rate protection an investor or FI manager has
against interest rate
○ Convexity diminishes the error in duration as an investment criterion
■ The larger the interest rate changes and the more convex a fixed income
security or portfolio, the greater the error the investor or FI manager faces
in using just duration to immunize exposure to interest rate shocks
○ All fixed-income securities are convex
■ As interest rates change, bond prices change at a non-constant rate zero