8.properties and pricing of fin. assets

7/24/2019 8.Properties and Pricing of Fin. Assets

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Chapter 08: Properties andPricing of Financial Assets

Properties of nancial assets:

1. Moneyness: some fnancial assets are used

as medium o exchange or in settlements otransactions.

2. Divisibility and Denomination: Divisibility

relates to the minimum size in which a fnancialasset can be liquidated and exchanged ormoney. The smaller the size, the more thefnancial asset is divisible. Denomination is the

value o each divided smaller unit.


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3. Reversibility: It reers to the costs oinvesting in a fnancial asset and then

getting out o it and bac into cashagain.

4. Cash fow: It reers to the cash

benefts to be received in uture asdividend!interest and ca"italgain!loss rom the fnancial asset.


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5. Term to maturity: It is the length o "erioduntil the date at which the instrument is

scheduled to mae its fnal "ayment or theowner is entitled to demand liquidation.

. Convertibility: #ome o the fnancial assetcontains the eature o conversion rom one

nature to another nature. $or exam"le, bondsand "reerred stocs may be converted intocommon stoc i terms included.


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!. Curren"y: %enerally a fnancial asset isissued in a certain currency in which all

relevant cash &ows will be incurred.#. $i%uidity: It relates to the conversion o

fnancial asset into cash or cash equivalenteasily and quicly when required.

&. Ta' status: Tax is a""licable on somefnancial assets at di'erent rates in di'erent"eriods.


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1(. Return )redi"tability: )eturn is the rate oadditional beneft that can be earned rom a

fnancial asset and this return should be"redicted earlier.

11. Com)le'ity: #ome fnancial assets arecombinations o two or more sim"ler fnancial

assets. *onds attaching cou"on and callablebonds are com"lex in nature.


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Principles of pricing nancialassetsThe undamental "rinci"le o fnance is that thetrue or correct "rice o a fnancial asset is the

discounted "resent value o all uture cash &owsto be generated by that asset at desireddiscount rate. The ollowing ormula is a""liedor calculating "rice o a fnancial asset:

+o

-ere, +o "rice o the fnancial asset $t cash &ows in "eriod t /t0, 1, 222n3 n 4aturity o the fnancial asset

a""ro"riate discount rate

n

k

CFn

k

CF

k

CF

)1()1()1( 2

2

1

1

+++

++

+


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!"a#ple

50: 6x"ected dividends rom 4ega or"oration areT07, T.08.7, T.15, T19.7 and T5 in the nextfve years. I the required rate o return o thestocholder o the cor"oration is 00.7;.$orecasted reselling "rice is T.015.

51: 4ega ca"ital Inc. ?ust "aid a dividend T05.75

"er share and the dividends are ex"ected to growat a constant rate o 7; or next @ years.6x"ected selling "rice is T.075. I investorsrequire a 01; return, then what is the current

"rice>


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The a""ro"riate discount rate is the ex"ectedrate o return o the investor or su""lier or

lender based on real ris ree rate, in&ation"remium and ris "remium. 6x"ression o thisa""ro"riate discount rate is:

)) A I+ A D+ A 4+ A B+ A 6+

The appropriate discount rate


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)) rate o return can be earned in in&ation and ris reecondition.

I+ com"ensation or the ex"ected decline in the

"urchasing "ower o money

D+ reward or taing on the ris o deault in case o loani. e. ris o loss o "rinci"al

4+ the com"ensation or lending or long time "eriod

B+ reward or investing in an asset that may not bereadily converted to cash at a air maret value

6+ reward or investing in an asset that is denominated inoreign currency.

The appropriate discount rate


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!"a#ple 01:

There is an investment in T.05555,05;, 01 years bond. )eal risCree rate

in the economy is 9;. The investor=sex"ectation about di'erent ris andin&ation "remium are: I+ 1;, D+ 0.7;, 4+ 1.7;, B+ 0; 6+ 5;.


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#olution

+ $( )

+

+n

n

kk

k

)1(

1)1

( ) nk

Pn

+

+

1

( )

+

+12

12

)14.01(14.0

1)14.01 = 1000

= 7735.80

( )1214.0110000

++


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( )

+

+12

12

)14.01(14.0

1)14.01

( )1214.01

201510000

+

+

= Tk.7694.54

For charging transfer tax and brokerage commission of Tk.15 and

Tk.0 res!ecti"e#$ at the time of both b%$ing and se##ing the !rice

of the asset &i## be'

( = Tk.)*15*0 +1000


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!"a#ple % 02: There is an investmentin T.0555, 7;, @ years bond. )eal risC

ree rate in the economy is 1.7;. Theinvestor=s ex"ectation about di'erentris and in&ation "remium are: I+ ;,

D+ 1;, 4+ 5.7;, B+ 0; 6+ 5;.


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*ased on above inormation the "rice o the asset isT.E95.@0. Fow the relationshi" between discount rate

and "rice o the asset is shown in the ollowing table:Discount rate, k (%) Price

4 1036.30

5 1000.00

6 965.357 932.26

8 900.64

9 870.41

10 841.51

11 813.85

12 787.39

13 762.04

14 737.77


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Price &olatilit' of Financial Assets: +ricevolatility o fnancial asset means the change in"resent value o discounted uture cash &ows o

the asset. It also termed as sensitivity o "ricewith res"ect to some inde"endent variables=change. +rice volatility mainly de"ends onmaturity "eriod o the asset, cou"on rate, level

o yields and interest rate changes i.e. duration.The level o "rice volatility or these variables isre"orted in di'erent tables below:


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1( Price of a )ond pa'ing *+(50 ann,all' and*+(1000 at #at,rit' for ario,s disco,nt rates

and #at,rities:

Discount rate, k

(%)

.at,rit' Period4 years 10 Years 15 Years 20 Years

Price Price Price Price

4 1036.30 1081.11 1111.18 1135.90

5 1000.00 1000.00 1000.00 1000.00

6 965.35 926.40 902.88 885.30

7 932.26 859.53 817.84 788.12

8 900.64 798.70 743.22 705.469 870.41 743.29 677.57 634.86

10 841.51 692.77 619.70 574.32

11 813.85 646.65 568.55 522.20

12 787.39 604.48 523.24 477.1413 762.04 565.90 483.01 438.02


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2. Price of a bond paying Tk.50

annually and Tk.1000 at maturity for

different coupon rates:

5% Coupon Bond 10% Coupon BondMaturity 15 Years Maturity 15 Years

Principal Tk.1000 Principal Tk.1000

e!uire" Yiel" 9# e!uire" Yiel" 9#

Price at 9#$ Tk.677.57 Price at 9#$ Tk.1081.61

Price at 10#$ Tk.619.70 Price at 10#$ Tk.1000

Price %all 57.87 i.e. 8.5# Price %all 80.61 i.e. 7.5#


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3. Price of a zerocoupon and bond

paying Tk.50 annually and Tk.1000 at

maturity for 15 years:

5% Coupon Bond Zero Coupon Bond

Maturity 15 Years Maturity 15 YearsPrincipal Tk.1000 Principal Tk.1000


Price at 9#$ Tk.677.57 Price at 9#$ Tk.274.54Price at 10#$ Tk.619.70 Price at 10#$ Tk.239.39



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!. Price of a bond paying Tk.50

annually and Tk.1000 at maturity for 15

years for different yields:

5% Coupon Bond 5% Coupon Bond

Maturity 15 Years Maturity 15 YearsPrincipal Tk.1000 Principal Tk.1000


Price at 5#$ Tk.1000 Price at 13#$ Tk.483.01Price at 6#$ Tk.902.88 Price at 14#$ Tk.447.20



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The technique o a""roximation an asset=s "ricesensitivity to interest rate changes is to examine howthe "rice changes i the yield changes by a small

number o basis "oints. This can be ex"ressedthrough the ollowing notations:

Gy change in yield

+o initial "rice o the asset

+C asset=s "rice i the yield is decreased by Gy

+A asset=s "rice i the yield is increased by Gy

"easuring Price #ensiti$ity to

%nterest &ate 'hanges: (uration


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The "rice o a 7; cou"on bond with a "rinci"al oT.0555, 07 years maturity at H; yield or discountrate is T.899.79. I the yield is increased by 75 basis

"oints rom H; to H.7;, the "rice would [email protected]. I the yield is decreased by 75 basis "ointsrom H; to E.7;, the "rice would be T.95H.7. Thenwe have these values:

Gy 5.557+o T.899.79

+C T.95H.7

+A [email protected]

)*ample of (uration calculation


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)*ample of (uration calculation

)y(2 +

oP

PP

005.0&57.677&2

73.64735.709

, =

, -,%ration =

9.09 -/ or =


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In order to be guided to set their rate or"ricing fnancial assets, I$Is use *ase

$inancing )ate /*$)3. It is the minimuminterest rate calculated by Islamic fnancialinstitutions based on a ormula which taesinto account the institutions cost o unds and

other administrative costs. sually it is similaramongst the ma?or Islamic *ans. #omead?ustments to the *$) are made by bans atthe almost same time, though not regularly.

Pricing of %slamic +inancial

%nstruments ,-enchmark to se/

8.properties and pricing of fin. assets

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