1. Valuation Bonds & Stocks

2. Bonds and Interest rates Bond taxonomy –Definition –Grading –Quotes Bond valuation –Discounted cash flow –Bond Properties and risks Yields –Calculation and assumption –Interest rates components –Interest rates term structure

3. Bond taxonomy Bond = Long Term Debt from state, government or corporation-Contractual agreement (Default = bankruptcy) Face value or maturity value Market value or proceed Coupon or payment Maturity Yield or discount rate

4. Indenture Term and amount of issue Date of issue and maturity Face value and Ask price Coupon and payment date Collateral and seniority Sinking fund Call provision and call premium Covenants on dividends, asset restriction and financing restrictions

5. Rating

6. Quotation

7. Bond Valuation PV=Present of future payments + Present value of maturity value Then, intuitively PV=PMT x PVIFA(n x m, i/m) + FV/FVIF(n x m, i/m) Calculator: FV I n PMT CPT PV

8. Example A bond has 5 years to maturity and a coupon rate of 10%. Interest rates are compounded semi-annually Joe thinks that such bond is expected (as of now) to return 12%, Cindy thinks it should yield 8%, and for Charles it must return 10%. What is the bond value for each individuals?

9. Solution Variables: FV=1000; m=2; n=5 PMT=%C x FV/m=10% x 1000/2=$50 For Joe: PV=50 PVIFA(10,6%)+1000/FVIF(10,6%)=926.7 For Cindy: PV=50 PVIFA(10,4%)+1000/FVIF(10,4%)=1081.2 For Charles: PV=50 PVIFA(10,5%)+1000/FVIF(10,5%)=1000

10. Yields Reinvestment rate=Yield Calculating yield: calculator (PV is “-”) Approximation: “Nominal” Rate=Risk-free rate + Risk Premium Real rate + Inflation + Risk Premium

13. Bond Properties Par, Premium and Discount Bond prices and yield are inversely related As Coupon is greater, Price sensitivity to yield decreases As Maturity gets greater, Price sensitivity to yield increases Price risk and reinvestment risk Q: with an expected change interest rates, which bond would you pick?

15. Term-structure Cross-section of short versus long-term rates Relationship with capital markets 3 possible shapes –Normal –Flat –Inverted Remember: k = k* + IP + risk premium What conclusion(s) can you draw from a yield curve?

17. STOCKS Taxonomy Valuation Growth revisited

19. Stocks’ features Features –C/S: Voting rights; classes (control of the firm); dividends; prospectus –P/S: Dividends right; fixed income; rating; convertibility –Q: How do P/S differ or resemble bonds? Markets – Spread for Dealers; transaction costs for Brokers –NYSE and other auction markets: Floor Brokers, Commission Brokers, floor traders and Specialists; S- DOT –Dealers’ market: Bid-ask quotations at Levels 1, 2, and 3

21. EQUITY MARKET OWNERSHIP Source: Federal Reserve Board Data as of 9/30/98 $5.3 tril $800 mil $1.7 tril $1.3 tril $2.0 tril $900 mil $800 mil Total Equity Market Value $12.8 trillion

22. Valuation Same stuff as before: today’s price is the present value of all expected future cash flows: PV= PV(future dividends for ever and ever…) Mathematically,

23. Growth factor... Technically, we cannot really “simplify” nor use the previous equation. Then, we use a trick: DIVIDENDS GROW! That is, Next years dividend is proportional to this year’s dividends: PMT 1 =PMT 0 x (1+g) PMT 2 =PMT 1 x (1+g)=PMT 0 x (1+g) 2 PMT 3 =PMT 2 x (1+g)=PMT 0 x (1+g) 3 Q: What is growth?

24. Three models... Zero growth: same dividend amount for ever… Constant growth: same growth for ever… Non-constant growth: growth changes…

25. Example Calculate the market value of the following companies: –ABC corp. will pay the same dividends of $1/share in the future. Such company has been returning 10% per year on average. –DEF corp. has paid $1/share in dividends this year. This amount will grow at 6% per annum. Such company is required to return 10% per annum. –GHI corp. has paid $1/share in dividends this year. This amount will grow at 12% per annum for the next three years and remain at 6% after. Such company is expected to return 10% per annum.

26. Solution ABC: zero growth; PV=1/10%=$10 DEF:constant growth; PV=1 x (1+6%)/(10%-6%)=$26.5 GHI: non-constant growth –Dividend 1=PMT 1 =1 x (1+12%)=1.12 –Dividend 2= PMT 2 = 1.12 x (1+12%)=1.2544 –Dividend 3= PMT 3 = 1.2544 x (1+12%)=1.4049 –Then, Price at year 3=PV 3 = PMT 3 x (1+g 1 )/(R-g 2 )=$37.23 Finally, PV(today)=1.12/(1.1)+1.25/(1.1) 2 + 1.41/(1.1) 3 + 37.23/(1.1) 3 =$31.09

27. Growth and Return... Growth is the growth in dividends; it is also assumed as the growth in earnings. Why? Growth, if constant, can be estimated by “b x ROE”. Why? What is i? What is a ”required rate of return”; it is a discount factor that includes inflation and risk. What does it mean?

30. Think further… R=PMT 1 /PV +g R= dividend yield + growth in earnings R= dividend gain + capital gain R= additional + perception of dividend growth in ROE What is the effect of risk and inflation on stock prices?

31. U.S. Yield Curve Inverts Before Last Five Recessions (5-year Treasury bond - 3-month Treasury bill) % GDP Growth/ Yield Curve % Real annual GDP growth Yield curve ? Recession Correct 2 Recessions Correct Recession Correct Recession Correct Recession Correct Data though 12/20/00