©2009, the mcgraw-hill companies, all rights reserved 1 5. week financial instruments and valuation

©2009, The McGraw-Hill Companies, All Rights Reserved

1

5. WEEK

FINANCIAL INSTRUMENTS AND VALUATION


2

TYPESOF SECURITIES

Negotiable instruments that represent ownership: Equity instruments such as C.S.

Negotiable instruments that denote indebtness: Debt (fixed income) securities such as bills, notes and bonds.


3

PREFERRED STOCKS

They are issued in international markets representing ownership and carrying some privileges: The right to be paid dividends before the

common stockholders The right to receive a specific amount in the

form of dividends each year.


4

PREFERRED STOCKS cont.

Different from C.S. In a way that their cash dividends are certain (guaranteed) and they do not increase as earnings rise.

The are callable unilaterally: they have a redemption feature.


5

COMMON STOCKS

Holders of the common stock are the actual owners of the issuing corporation.

If you have stocks, you have the right of the companies earnings depending on your proportional share after the interest paid on bonds and dividends paid on preferred stockholders.


6

RIGHTS OF COMMON STOCKHOLDERS

Receiving dividend Voting right Pre-emptive right: subscribing to capital

increases Receiving proportionate share from

dissolution if any Receiving information about the corporation


7

DUITIES AND RESPONSIBILITIES OF STOCKHOLDERS

They must honor their capital subscription payment promises when appealed by the board of directors. If delayed, they become liable for interest and punitive payments.

Their liabilities are confined to their subscriptions only.


8

PRICES OF COMMON STOCKS

Nominal (par) value: face value of the stock Issuance value: it is the value of the common stock

which is calculated by utilizing the discounted cash flows technique by some experts. It can not be lower than its nominal value according to the C.M. Law.

Market value: it is the price at which the stock is traded.


TYPES OF THE STOCKS

Hamiline ve nama yazılı (bearer shares – name shares)

Adi ve imtiyazlı (common and preferred shares)

Bedelli –bedelsiz (scrip issues) Primli-primsiz (shares with premium or not) Kurucu-intifa (preferred stocks)


DERIVATIVES OF THE EQUITY INSTRUMENTS 1. Profit and Loss Sharing Certificates (Kar ve

Zarar Ortaklığı Belgeleri) 2. Participation Dividend Certificates (Katılma

İntifa Senedi) 3. Non-voting Shares (Oydan Yoksun Hisse

Senedi)


1. PROFIT AND LOSS SHARING CERTIFICATES Companies issue them in order to meet their

financial needs. They can be put to sale in or out of Turkey. They have a maturity of 3 months- 7 years.

The longest maturity for them is 15 years. If they are issued by “Participation Banks” the max. Maturity is 2 years.


1. PROFIT AND LOSS SHARING CERTIFICATES cont.

Issued with longer than 2 year maturity, have got to be issued on exchange.

Can not be issued with coupon, no profit guarantee. If there is loss they have to contribute to the loss.



They provide the participation of profit and loss but they are not recognize as common stocks since they have a maturity and no voting rights.

Also they can not be recognized as income bonds since it requires to participate loss if any.



Investors can get principal and dividend at the end of the maturity.

They can be sold either directly by the issuer or through securities dealers.

They must be registered by the CMB.


2. PARTICIPATION DIVIDEND CERTIFICATES

Issued for cash, not represent a specific capital.

Provide Dividend payment, Dispolution payment if any, Pre-emptive right.

Not provide Voting rights (ownership rights), Involment into management .


2. PARTICIPATION DIVIDEND CERTIFICATES

Can be put to sales in or out of Turkey. Overseas sales require approval of the ministry of finance.

Issue limit is max. Net worth of the issuer. Min issue can be one-sixth of net-worth.

They can be issued infinitely in accordance to the decision of the board of company.


3. NON-VOTING SHARES

They are like the ordinary shares, however they do not provide voting rights. Holders of them benefit from dividend payments and dissolution payments if any.

If not authorized by the articles of association, non-voting shares cannot be issued.


3. NON-VOTING SHARES cont.

They have to be in the name, not to the bearer.

In the event of; No dividend distributed for 3 successive years No dividend is distributed for the year while

any permission is given by regulations.

Non-voting shares automatically transform to voting shares



They have subscription rights in capital increases.

Rights to bonus shares (scrip issues). Rights to get information. Rights to participate the general meeting of

shareholders with no voting power.



Non-voting shareholders may convene special meeting of shareholders cannot prejudice the rights of non-voting shareholders.

The validity of the ordinary shareholders’ decisions is subject to approval by non-voting shareholders.

First issue of non-voting shares has to be offered to public.


21

BONDS

It is a certificate indicating that a corporation has borrowed a fixed sum of money and promises to repay it at a future date.

They are long-term securities. Bondholders do not have any voice in the

management.


22

BONDS cont.

Corporation agrees to pay at a specified intervals interest at a stated rate. The principle is paid off at the maturity date.

Bonds generally can be traded anywhere in the world. Mostly there are OTC markets for them. Some corporation bonds in USA are listed on an exchange.


23

BONDS cont.

Trading for bonds is usually done by bond dealers. There are bond trading desks of major investment dealers in USA.

The dealers provide liquidity for bond investors. They also buy and sell bonds among themselves.


24

BONDS cont.

Bonds can be issued with or without coupons. No-coupon bonds are issued and sold below

par paid off at maturity in full sums: Treasury bills in Turkey.

Treasury notes and bonds are generally in bearer form.


25

BONDS cont.

Bonds can be issued in Turkey With fixed interest With variable interest

All bonds must be listed on an exchange.


TYPES OF BONDS

Government-corporate Bonds Premium- Par Lottery Bonds Fixed Rate-Variable (Floating Rate) Indexed Bonds (Foreign Exchange or Gold) Guaranteed or Nonguaranteed


DERIVATIVES OF THE BONDS 1. Income Bonds (Kara İştirakli Tahvil) 2. Convertible Bonds (H.S İle Değiştirilebilinir

Tahvil)


1. INCOME BONDS They can be redeemed at maturity only, the

principle payment can not be split over years. There are three types of period income

(returns): Interest+dividend Either interest or dividend Dividend only


1. INCOME BONDS cont. Interest is paid on due dates. Dividend payment is declarated latest two

months from the general meeting of the shareholders when profit for the year is approved.


2. CONVERTIBLE BONDS It is a bond with a call option to buy the C.S.

of an issuer. The holder of it can exchange the security, at

his option for the C.S. of the issuer in accordance of the terms of the bond indepture.


2. CONVERTIBLE BONDS cont. These securities carry a maturity of 2-7 years. Conversion of bonds can be made after 2

years. Conversion is made through the intermediary

of bank branches. Convertible bonds are issued with coupons

which are payable on an annual basis only.


32

Various Interest Rate Measures

Coupon rate periodic cash flow a bond issuer contractually

promises to pay a bond holder Required rate of return (rrr)

rates used by individual market participants to calculate fair present values (PV)

Expected rate of return (Err) rates participants would earn by buying securities at

current market prices (P) Realized rate of return (rr)

rates actually earned on investments

Coupon rate periodic cash flow a bond issuer contractually

promises to pay a bond holder Required rate of return (rrr)

rates used by individual market participants to calculate fair present values (PV)

Expected rate of return (Err) rates participants would earn by buying securities at

current market prices (P) Realized rate of return (rr)

rates actually earned on investments


33

Required Rate of Return

The fair present value (PV) of a security is determined using the required rate of return (rrr) as the discount rate

CF1 = cash flow in period t (t = 1, …, n)~ = indicates the projected cash flow is uncertainn = number of periods in the investment horizon

The fair present value (PV) of a security is determined using the required rate of return (rrr) as the discount rate


n

n

rrr

FC

rrr

FC

rrr

FC

rrr

FCPV

)1(

~...

)1(

~

)1(

~

)1(

~

3

3

2

2

1

1


34

Expected Rate of Return

The current market price (P) of a security is determined using the expected rate of return (Err) as the discount rate


The current market price (P) of a security is determined using the expected rate of return (Err) as the discount rate


n

n

Err

FC

Err

FC

Err

FC

Err

FCP

)1(

~...

)1(

~

)1(

~

)1(

~

3

3

2

2

1

1


35

Realized Rate of Return

The realized rate of return (rr) is the discount rate that just equates the actual purchase price ( ) to the present value of the realized cash flows (RCFt) t (t = 1, …, n)

The realized rate of return (rr) is the discount rate that just equates the actual purchase price ( ) to the present value of the realized cash flows (RCFt) t (t = 1, …, n)P

n

n

rr

RCF

rr

RCF

rr

RCF

rr

RCFP

)1(...

)1()1()1( 3

3

2

2

1

1


36

EXAMPLE 3-1

A bond you purchased two years ago for $890 is now selling for $925. The bond paid $100 per year in coupon interest on the last day of each year. You intend to hold the bond for more 4 years and project that you will be able to sell it at the end of year 4 for $960. Given the risk associated with the bond, its required rate of return over the next four years is 11.25%. Find its fair value, Expected rate of return. And realized rate of return.


37

Bond Valuation

The present value of a bond (Vb) can be written as:

M = the par value of the bond

INT = the annual interest (or coupon) payment

T = the number of years until the bond matures

i = the annual interest rate (often called yield to maturity (ytm))

The present value of a bond (Vb) can be written as:

M = the par value of the bond

INT = the annual interest (or coupon) payment

T = the number of years until the bond matures

i = the annual interest rate (often called yield to maturity (ytm))

)()(2

)2/1()2/1(

1

2

2,2/2,2/

2

12

TiTi

T

tT

d

t

db

ddPVIFMPVIFA

INT

i

M

i

INTV


38

EXAMPLE 3-4

You are considering the purchase of a $1000 face value bond that pays 10% coupon interest per year with the coupon paid semiannually. The bond matures in 12 years. If the required rate of return on the bond is 8%. Find the market value of the bond.


39

Bond Valuation

A premium bond has a coupon rate (INT) greater then the required rate of return (rrr) and the fair present value of the bond (Vb) is greater than the face value (M)

Discount bond: if INT < rrr, then Vb < M

Par bond: if INT = rrr, then Vb = M

A premium bond has a coupon rate (INT) greater then the required rate of return (rrr) and the fair present value of the bond (Vb) is greater than the face value (M)

Discount bond: if INT < rrr, then Vb < M

Par bond: if INT = rrr, then Vb = M


40

Yield to Maturity

The return or yield the bondholder will earn on the bond if he buys it at its current market price, receives all coupon and principal payments and hold the bond until maturity.


41

EXAMPLE 3-5

You are considering to purchase of a $1000 face value bond that pays 11% coupon interest per year, paid semiannually. The bond matures in 15 years. If the current market price of the bond is $931.176, what is the yield to maturity?


42

Equity Valuation

PV of the future dividends. Example: Suppose you owned a stock for the

last two years for $25 and just sold it for $35. The stock paid an annual dividend of $1 on the last day of each of the past two years. Calculate the realized rate of return.


43

Equity Valuation

The present value of a stock (Pt) assuming zero growth in dividends can be written as:

D = dividend paid at end of every year

Pt = the stock’s price at the end of year t

is = the interest rate used to discount future cash flows

The present value of a stock (Pt) assuming zero growth in dividends can be written as:

D = dividend paid at end of every year

Pt = the stock’s price at the end of year t

is = the interest rate used to discount future cash flows

st iDP /


44

EXAMPLE 3-8

A stock you are evaluating is expected to pay a constant dividend of $5 per year. The expected rate of return (Err) on the stock is 12%. Calculate the price of the stock.


45

Equity Valuation

The present value of a stock (Pt) assuming constant growth in dividends can be written as:

D0 = current value of dividendsDt = value of dividends at time t = 1, 2, …, ∞g = the constant dividend growth rate

The present value of a stock (Pt) assuming constant growth in dividends can be written as:

D0 = current value of dividendsDt = value of dividends at time t = 1, 2, …, ∞g = the constant dividend growth rate

gi

D

gi

gDP

s

t

s

t

t

10 )1(


46

EXAMPLE 3- 9

A stock you are evaluating paid a dividend at the end of last year of $3.5. Dividend have grown at a constant rate of 2 per year over the last 20 years, and this constant growth rate is expected to continue into the future. The required rate of return (rrr) on the stock is 10%. Calculate the price.


47

EXAMPLE 3-11

A stock you are evaluating is expected to experience supernormal growth in dividends of 10%, over the next 5 years. Following to this period dividends are expected to grow at a constant rate of 4%. The stock paid a dividend of $4 last year, and the rrr on the stock is 15%. Find the fair PV of the stock.


48

Equity Valuation

The return on a stock with zero dividend growth, if purchased at price P0, can be written as:

The return on a stock with constant dividend growth, if purchased at price P0, can be written as:

The return on a stock with zero dividend growth, if purchased at price P0, can be written as:

The return on a stock with constant dividend growth, if purchased at price P0, can be written as:

gP

Dg

P

gDis

0

1

0

0 )1(

0/ PDis


49

Relation between InterestRates and Bond Values

Interest Rate

Bond Value

Interest Rate

Bond Value

12%

10%

8%

874.50 1,000 1,152.47


50

Impact of Maturity onInterest Rate Sensitivity

Absolute Value of Percent Change in aBond’s Price for aGiven Change inInterest Rates

Absolute Value of Percent Change in aBond’s Price for aGiven Change inInterest Rates

Time to Maturity


51

Impact of Coupon Rates onInterest Rate Sensitivity

Bond Value

Bond Value

Interest Rate

Low-Coupon Bond

High-Coupon Bond


52

Duration

Duration is the weighted-average time to maturity (measured in years) on a financial security

Duration measures the sensitivity (or elasticity) of a fixed-income security’s price to small interest rate changes

Duration is the weighted-average time to maturity (measured in years) on a financial security

Duration measures the sensitivity (or elasticity) of a fixed-income security’s price to small interest rate changes


53

Duration

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

t = 1 to T, the period in which a cash flow is receivedT = the number of years to maturity

CFt = cash flow received at end of period tR = yield to maturity or required rate of return

PVt = present value of cash flow received at end of period t

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

t = 1 to T, the period in which a cash flow is receivedT = the number of years to maturity

CFt = cash flow received at end of period tR = yield to maturity or required rate of return

PVt = present value of cash flow received at end of period t

T

tt

T

tt

T

tt

t

T

tt

t

PV

tPV

RCFRtCF

D

1

1

1

1

)1(

)1(


54

Duration

Duration (D) (measured in years) for a fixed-income security in general can be written as:

m = the number of times per year interest is paid

Duration (D) (measured in years) for a fixed-income security in general can be written as:

m = the number of times per year interest is paid

T

mtmt

t

T

mtmt

t

mRCFmRtCF

D

/1

/1

)/1(

)/1(


55

EXAMPLE

Consider a bond with one year remaining to maturity, a $1000 face value, an 8% coupon rate and an interest rate of 10%. Coupons are paid semiannually. Find duration for this bond.


56

EXAMPLE 3-12

Suppose you have a bond that offers a coupon rate of 10% paid semiannually. The face value of the bond is $1000, it matures in 4 years, its current yield to maturity is 8%, and its current market price is $1067.34. Calculate the duration.


57

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 at a decreasing rate

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 at a decreasing rate


58

Duration and Modified Duration

Given an interest rate change, the estimated percentage change in a (annual coupon paying) bond’s price is found by rearranging the duration formula:

MD = modified duration = D/(1 + R)

Given an interest rate change, the estimated percentage change in a (annual coupon paying) bond’s price is found by rearranging the duration formula:

MD = modified duration = D/(1 + R)

RMDR

RD

P

P

1


59

EXAMPLE 3-12 cont

Suppose that yield to maturity increases by 10 basis points (1/10 of 1%) from 8% to 8.1%. Find the percentage change on bond price.

What will be the price if the coupon rate is 6%


60

DURATION cont.

The higher the coupon rate, the shorter the duration and the smaller the percentage decrease in bond price.

Duration model predicts symmetric effects for rate increases and decreases.

Capital loss effect of large rate increases tends to be smaller than capital gain effect of large rate decreases.


61

Figure 3-7


62

Convexity

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:

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:

22 )(2

1)(

2

1

1RCXRMDRCX

R

RD

P

P

©2009, the mcgraw-hill companies, all rights reserved 1 5. week financial instruments and valuation

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