Chapter 3

Increase in bond issues will lead to drop in bond prices and increase yield

Required return on debt(not bonds)= Real Risk Free + Inflation premium + Default risk premium +
liquidity premium + maturity risk premium (interest rate fluctuation)

Changes with time

- Real Rf=same
- IP=depends
- DRP=depends
- LP=depends(unlikely to change)
- MRP=Increases

Term structure of ir show relationship between yield and maturity (not time)

Interest rate factors

- Risk
- Production opportunities
- Expected inflation
- Time preferences for consumption

Interest are paid off first (then principal)

TVM

When using NPV in multiple changes in conditions, imagine drawing out the money and putting it in
again in the bank  STANDARDISE USE “-“ for withdrawal and “+” deposit into a interest bearing
account

When the question has funny cash flow, break it down to EAR of FV of each year and analyse each
year’s cash flow

The difference in arears and advance, is the interest rate. Since default is arears, if transaction is in
advance, PV and FV will multiple by interest, PMT divide (arears ordinary annuity, advance is
annuity due)

1) Every payment has an interest rate occurrence thus when we need to calculate a annually
compounded, monthly paid scheme, we need to find the YTM and divide by 12 then you know
the effective interest rate. YTM can be divided and not rooted because there is no
compounding involved monthly but only annually
2) When there is annual compounding with monthly payment. Find the compoundable monthly
rate. i.e. the norminal interest rate for monthly, the interest rate should be able to be
compounded to the EAR of the annual compounding rate. Use that norminal interest rate as
periodical interest rate.
3) Nominal ratepayment EARcompounding

Bonds

TIPS( daily treasury real yield rate)

Callable bonds company call @ par value (if interest drops, price rise, company call to refinance at
cheaper price)

Debenture unsecured VS Mortgage  secured

Sinking fund  the issuer of the bond has to recall a percentage of bonds annually, be it recalling it at
face value or buying it at market value (it kinda protect the bondholders?)
Nominal interest ratenot effective, compounding follows coupon issue period unless otherwise
states

- Investment riskinterest rate risk and reinvestment risk

- Default risk

High coupon high reinvestment risk, low interest rate risk, the other way for low coupon

Shorter duration is like high coupon  high reinvestment risk, low interest rate risk

EAR of a bond is not over bond price but par value

YTM of bond is base on coupon payment

Call provision call premium to compensate the reinvestment risk that investors suffer

In recession  lower inflation, can lead to a lower required return

However, Low credit rating  DRP will increase much more than the inflation rate decreases 
nature of default risk premium is very different from inflation premium

High credit rating  DRP don’t drop that much  in fact when bear sterns’ hedge funds start to
implode, 10 yr bond yield drop from 5- 3.5%

Recession  people rush for safe havens

Portfolio

CV=s.d./ Ex return  is a better measurement of standalone risk

Whether to buy, use SML to see if the stock is under or overvalued

Required rate of return ri = rRF + (rM – rRF) bi stock risk premium

SML is different from regression of Rm and Ri because Regression of the curve  to find the beta of
the stock. SML is the universal line for the market at the moment
Total risk(stand alone risk) is standard deviation

Beta if the stock is in an portfolio

2 methods  weighted average beta(only if it is at equilibrium) or return  to find the expected return
of the portfolio

Equity

Stock price is expected to grow at dividend growth rate (cause of Gordon growth model and Cost of
Equity=Dividend yield+ capital yield)

To calculate if the stock is undervalue or overvalue (check the intrinsic value through Gordon growth
value)

When calculating the stock’s expected return RMB use capital gains(assume go back to next year’s
intrinsic value) + dividend gains

Capital gain=(1-payout ratio)*ROE

ROE =/= Cost of equity

Seasoned Equity issue  secondary equity offering

@Market equilibrium expected return = required return

Strong market efficiency  no abnormal returns  some times security has different value from
intinsic
TERMS

Nominal interest rate  Not effective, it’s the one that can be divisible to periodic