Interest Rates and Bond Valuation · 3 Interest Rates and Bond Valuation BOND VALUES • As time...

1

Financial Management in IB

Interest Rates and Bond Valuation

2


BONDS

• When a corporation or government wishes to borrow money from the

public on a long-term basis, it usually does so by issuing or selling debt

securities that are generally called bonds.

• Borrower usually pays interest every period and nominal value at the

end of the loan.

• Regular interest payments are called coupons.

• Amount to be paid at the end is called face value or par value.

• Coupon payment divided by the face value is called coupon rate.

• Number of years until the face value is paid is called bond’s time to

maturity.

3


BOND VALUES

• As time passes interest rate changes in the market place.

• The cash flows from the bond, however, stay the same.

• Price of bond changes over the time.

• To determine the value of bond at any point we need to know time to

maturity, the face value, the coupon and IR required in the market on

similar bonds – so called YIELD TO MATURITY (YTM)

4


Example

Suppose you are about to issue a bond with 10 years maturity, annual

coupon of $80. Similar bonds have YTM of 8 percent. What should this

bond sell for?

• We simply compute present value of face value in 10 years and add it

to the present value of the coupons (note that coupon payments are in

ordinary annuity form).

5


Example

• The bond should be sold exactly for its face value. That is quite logic

since the market IR is 8 percent and the coupon is $80.

• If interest rates change the price of bond will change as well.

• IF interest rate rises, the value of bond falls and vice versa.

• Bonds sold for less than its face value are called DISCOUNT BONDS

• Bonds sold for more than its face value are called PREMIUM BONDS

6


INTEREST RATE RISK AND BONDS

• Holders of bonds are exposed to interest rate risk.

• The risk depends on the sensitivity of bond value to interest rate

movements.

• Other things being equal:

o The longer the time to maturity, the greater the IR risk

o The lower the coupon rate, the greater the IR risk

• Very often, you know a bond price, coupon rate and maturity date. It is

possible to find implicit YTM, however, by trial and error only.

7


CREDIT RISK AND BONDS

• Holders of the bonds are exposed to credit risk.

•Firms usually pay to have their bonds rated by Moody’s, S&P etc.

•Credit risk refers to changes in bond’s credit rating.

•The lower the credit rating, the higher the risk of default!

•Bonds may be collateralized by other securities, mortgages etc. or by

seniority (priority over other lenders).

8


GOVERNMENT BONDS

• Governments are the biggest borrowers in the world!

• In 2008, total debt of the U.S. government amounted up to $9.4 trillion

(and growing!).

• For long-term financing government sells so called Treasury notes

with the maturity ranging from 2 to 30 years.

• No default risk - (we hope) the Treasury can always come up with the

money to make the payments.

9


ZERO COUPON BONDS

• No coupons paid

• Offered at a price much lower that its face value

• It is easy to compute present value, face value, time to maturity or YTM

if we know all remaining terms:

PV …. Present value

FV …. Face value

YTM …. Yield to maturity

TTM …. Time to maturity

10


ZERO COUPON BONDS

• For tax purposes, the issuer of a zero coupon bond deducts interest

every year and owner must pay taxes on interest even though no

interest is actually paid.

• We use implicit interest = change in bond value for each year.

EXAMPLE

Suppose you issue a $1,000 face value, five-year zero coupon bond. The

initial price is set to be at $500. What are implicit interests in following

five years?

11


FLOATING-RATE BONDS

• Coupon payments are adjustable to an interest rate index such as

Treasury bond rate.

• Adjustments might be based on the simple average of Treasury bond

yield during the previous three months etc.

• Coupon payment usually has a floor (minimum) and collar (maximum).

12


OTHER TYPES OF BONDS

• There are lots of different types of bonds – sometimes even exotic.

• WARRANT gives the holder of the bond the right to purchase the

stocks in the company for the fixed price.

• INCOME BONDS have coupon payments depending on the company

income.

• CONVERTIBLE BONDS can be swapped for a fixed number of shares.

• PUT BONDS allow the holder to force the issuer to buy back the bond

at a stated price (if for example the rating of issuing company

significantly decreases etc.)

13


TRADING THE BONDS

• Bonds are traded on OTC markets (electronically)

• There are market makers who quote bid and ask prices

•Bond market is the largest security market in the world (U. S. Treasury

market)

•If we buy bond between coupon payments, we should distinguish

between clean and dirty price:

o Clean price – the price of bond net of accrued interest (typically

quoted)

o Dirty price – the price of bond including accrued interest (full,

invoice price)

o Accrued interest – interest which is paid by the bond buyer to the

bond seller for the period from last coupon payment.

14


Example

Suppose you buy a bond with 12 percent annual coupon, payable

semiannually. How much do you pay (dirty price) if the quoted price is

$1,060 and on the day you buy it the next coupon is due in 4 months?

15


INFLATION AND INTEREST RATES

• In examining interest rates or any other market rates we have to

distinguish between real rates and nominal rates.

• Nominal rate on an investment is the percentage change in money you

have at the end.

•Real rate on an investment is the percentage change in your buying

power (how much you can buy).

16


INFLATION AND INTEREST RATES

• Nominal rate has 3 components – real interest rate, compensation for

the decrease in the value of money originally invested because of

inflation and compensation for the fact that the money earned on the

investment is also worth less because of inflation:

IRN …. Nominal interest rate

IRR …. Real interest rate

p …. Inflation rate

17


TERM STRUCTURE OF INTEREST RATES

• We can find different interest rates for different maturities.

•The relation between short-term and long-term interest rates is known

as the term structure of interest rates.

•When long-term interest rates are higher than short-term interest rates,

term structure is upward sloping .

•When long-term interest rates are lower than short-term interest rates,

term structure is downward sloping.

18


TERM STRUCTURE OF INTEREST RATES

• Term structure depends on real interest rate, inflation premium,

interest risk premium, default risk premium and liquidity premium.

o Real interest rates influence the overall level of yield curve

o Anticipated high inflation in the future erodes the value of long-

term investments – investors would demand compensation for this

loss

o Longer-term bonds have much greater risk of loss resulting from

interest rate movements.

o Default risk premium depends on the credibility of the issuer –

lower rated bonds have higher yields.

o Less liquid bonds will have higher yields than more liquid bonds.

19

International Financial Strategies

Stock Valuation

20

Stock Valuation

STOCKS

• Stocks are more difficult to value than bonds:

o cash flows are not known in advance

o stocks have no maturity

o it is difficult to find the required rate of return

21

Stock Valuation

FUNDAMENTAL ANALYSIS

• Fundamental analysis is used to find the value of an stock

• Based on stockmarkets’ indicators and reacts to expectations.

• Uses available, clear, reliable, understandable information

• Uses economic and financial data on the sector and on the firm:

o Economy and geopolitics

o Market (segment,maturity…), competitive position of the firm

o Results’ analysis :

• internal : EBIT, consolidated profit

• external : PER, return on stock

22

Stock Valuation

DIVIDEND DISCOUNT MODELS

• Fundamental analysis will only be outlined through valuation model by the dividends’ present value

• We may distinguish 3 special cases:

o zero growth

o constant growth

o non-constant growth

23

Stock Valuation

ZERO GROWTH

• A share of common stock in a company with a constant dividends is much like a share of preferred stock. • Stock with promised constant dividends that occur forever.

• It can be viewed as an ordinary perpetuity.

P0 …. Current stock value

D …. Constant dividends

R …. Required rate of return

24

Stock Valuation

CONSTANT GROWTH

• For many companies a steady growth in dividends is an explicit goal. • It can be viewed as growing perpetuity.

Pt …. Stock value in time t

Dt …. Dividends in time t


GR …. Dividends growth rate

25

Stock Valuation

NON-CONSTANT GROWTH

• The dividends growth rate may change over time. • There are companies which pay no dividends at the beginning whereas some companies have supernormal dividends at an early stage.

26

Stock Valuation

NON-CONSTANT GROWTH

• For two-stage growth we can write:

Pt …. Stock value in time t

Dt …. Dividends in time t


GR1 …. Dividends growth rate for t years

GR2 …. Dividends growth rate after t years forever

27


Exercises

28


A Microgates Industries bond has a 10 percent coupon rate and a $1,000 face value. The bond has 20 years to maturity. If investors require a 12 percent yield, what is the bond’s value.

29


Suppose the Company issues a $1,000 face value, five-year zero coupon bond. The initial price is set at $600. What are the implicit interest expenses for tax purposes?

30


Suppose you buy a bond with 8 percent annual coupon, payable semiannually. How much do you pay (dirty price) if the quoted price is $1,030 and on the day you buy it the next coupon is due in 3 months?

31


A Bike Corp. bond carries an 8 percent coupon, paid semiannually. The par value is $1,000, and the bond matures in six years. If the bond currently sells for $911,37, what is its yield to maturity?

32

Stock Valuation

Exercises

33

Stock Valuation

The BP Co. has just paid a cash dividend of $2 per share. Investors require a 16 percent return from investments such as this. If the dividend is expected to grow at a steady 8 percent per year, what is the current value of stock? What will the stock be worth in five years?

34

Stock Valuation

The LM Co. has just paid a cash dividend of $4 per share. Investors require a 10 percent return from investments such as this. What is the current value of stock, if the dividend is expected to grow at 20 percent per year for the next three years and then settle down to 8 percent per year, indefinitely.

Interest Rates and Bond Valuation · 3 Interest Rates and Bond Valuation BOND VALUES • As time...

Documents

Transcript of Interest Rates and Bond Valuation · 3 Interest Rates and Bond Valuation BOND VALUES • As time...