Chapter Three

Interest Rates and

Security Valuation
Various Interest Rate Measures
 Coupon rate
 Determines the periodic cash flow received by the bond
investor (and paid by the bond issuer)
 Required rate of return (r)
 rates used by individual market participants to calculate
present values (PV)
 Expected rate of return or E(r)
 rates participants would earn by buying securities at current
market prices (P)
The required return and the expected return are the same if
market prices reflect present values
 Realized rate of return ( r )
 rate actually earned on investments

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Required Rate of Return

 The present value (PV) of a security is determined

using the required rate of return (r) as the discount
rate
CF1 CF2 CF3 CFn
PV     ... 
(1  r ) (1  r ) (1  r )
1 2 3
(1  r ) n
CFt = expected cash flow in period t (t = 1, …, n)
n = number of periods in the investment horizon

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Expected Rate of Return

 The current market price (P) of a security is

determined using the expected rate of return or
E(r) as the discount rate
CF1 CF2 CF3 CFn
P    ... 
(1  E (r )) (1  E (r )) (1  E (r ))
1 2 3
(1  E (r )) n

CFt = cash flow in period t (t = 1, …, n)

n = number of periods in the investment horizon

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Realized Rate of Return

 The realized rate of return ( r ) is the discount rate

that just equates the actual purchase price ( P) to
the present value of the realized cash flows (RCFt) t
(t = 1, …, n)
RCF1 RCF2 RCF3 RCFn
P    ... 
(1 r ) (1 r ) (1 r )
1 2 3
( 1  r )n

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 Bond Valuation

 The present value of a semi-annual bond (Vb) can be written

as:
INT
2T
M
Vb   2 
t 1 ( 1  r / 2 )t
( 1  r / 2 )2T

INT  1  1 (1  r 2 )2T   1 
    M  (1  r/2) 2T 
2  r 2   

M = the maturity (or par value or face value) of the bond, usually $1,000
INT = the annual interest (or coupon) payment
T = the number of years until the bond matures
r = the annual interest rate (often called yield to maturity (ytm))

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 Bond Valuation

 A premium (discount) bond has a coupon rate

(INT) greater (less) than the required rate of
return (r) and the price of the bond (Vb) is
greater (less) than the face or par value
 Par bond: if INT = r, then Vb = Par
 Premium bond: if INT > r; then Vb > Par
 Discount bond: if INT < r, then Vb < Par

3-7
Equity Valuation:
Constant Dividend Model

 The present value of a stock (Pt) assuming zero

growth in dividends can be written as:

Pt  D / rs
D = dividend paid at end of every year
Pt = the stock’s price at the end of year t
rs = the interest rate used to discount future cash flows

3-8
Equity Valuation:
Constant Growth Model

 The present value of a stock (Pt) assuming

constant growth in dividends can be written as:
D0 (1  g)t Dt 1
Pt  
rs  g rs  g

D0 = current value of dividends

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

3-9
Expected Return on Equity

 The return on a stock with zero dividend growth, if

purchased at current price P0, can be written as:
rs  D / P0
 The return on a stock with constant dividend growth,
if purchased at price P0, can be written as:

D (1  g) D
rs  0 g 1g
P0 P0

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Equity Valuation:
Supernormal or Non-Constant Growth Model

Three steps:
1. Find the PV of each dividend during the
supernormal growth period
2. Find the price of the stock at the end of the
supernormal growth period (using the constant
growth model)
3. Discount all the values from steps 1 and 2 and add
them together.

3-11
As Interest Rates Fall, Bond Prices
Increase

Interest FV 1000 1000 1000

Rate PMT 100/2 100/2 100/2
12% N 12 x 2 12 x 2 12 x 2
I/Yr 12/2 10/2 8/2
PV 874.50 1000.00 1152.47
10%

8%

874.50 1,000 1,152.47

Bond Value

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As Time to Maturity Increases, Price
Sensitivity Increases but at a Decreasing
Rate
Absolute value of change in price of a semi-annual
bond as required return changes from 8% to 12%
(10% coupon, $1000 par value)
29.00%
Percent change in bond price

28.00%

27.00%

26.00%

25.00%

24.00%

23.00%

22.00%
12 13 14 15 16

Time to Maturity (years)

3-13
Interest Rate Sensitivity is Lower for
Higher Coupon Rate Bonds
Required return 10% 12%
7.0% $1,240.88 $1,401.46
7.5% $1,195.56 $1,352.01
8.0% $1,152.47 $1,304.94
8.5% $1,111.48 $1,260.12
9.0% $1,072.48 $1,217.43
9.5% $1,035.35 $1,176.76
10.0% $1,000.00 $1,137.99
10.5% $966.33 $1,101.02
11.0% $934.24 $1,065.76
11.5% $903.66 $1,032.11
12.0% $874.50 $1,000.00
12.5% $846.68 $969.34
13.0% $820.14 $940.05
13.5% $794.80 $912.06
14.0% $770.61 $885.31

$ Price Δ 7% to 14% $470.26 $516.15

% Price Δ 7% to 14% -37.9% -36.8%

3-14
Duration

 Duration is the weighted-average time to maturity

(in years) on a financial security
 Duration measures the sensitivity of a fixed-income
security’s price to small interest rate changes

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Duration

 Duration (Dur) for a fixed-income security that pays interest

annually can be written as:
N
CF t t N

 ( 1  r )t  PV  t t
Dur  t 1  t 1
P0 P0
P0= Current price of the security
t = 1 to T, the period in which a cash flow is received
N = the number of years to maturity
CFt = cash flow received at end of period t
r = yield to maturity or required rate of return
PVt = present value of cash flow received at end of period t

3-16
Calculating Duration CF t t
N

 (1  r)t
Dur  t 1
P0

9% Coupon, 4 year maturity annual payment bond with a 8% YTM

Cash Flow PV @ 8% % of Total PV Duration

Year (t) (CFt) CFt/(1.08)t [CFt/(1.08)t]/P0 [CFt/(1.08)t]/P0 x t
1 $ 90 $ 83.33 8.06% 0.0806
2 90 77.16 7.47% 0.1494
3 90 71.45 6.92% 0.2076
4 $1,090 $ 801.18 77.55% 3.1020
Totals P0 = $1,033.12 100.00% 3.5396

Duration = 3.54 years

3-17
 CF t t
N

Calculating Duration  (1  r)t

Dur  t 1
P0
9% Coupon, 4 year maturity semi-annual payment bond with a 8%
YTM
Cash Flow PV = % of Total PV Duration
Year (t) (CFt) CFt/(1.04)2t [CFt/(1.08)2t]/P0 [CFt/(1.08)2t]/P0 x t
.5 $ 45 $ 43.27 4.19% 0.0209
1 45 41.61 4.03% 0.0403
1.5 45 40.00 3.87% 0.0581
2 45 38.47 3.72% 0.0744
2.5 45 36.99 3.58% 0.0895
3 45 35.56 3.44% 0.1032
3.5 45 34.20 3.31% 0.1158
4 1,045 763.57 73.87% 2.9548
Totals P0 = $1,033.66 100.00% 3.4569

Duration = 3.46 years

3-18
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 but at a decreasing rate

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Economic Meaning of Duration

 Given a small change in interest rates, the

estimated percentage change in a semi-annual
coupon bond’s price is approximately:

 
P  r 
  Dur  
P r
1  
 2

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Duration Based Prediction Errors

3-21
Convexity

 Convexity is good because it provides partial

insurance against interest rate movements
 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:

P  r  1
  Dur    CX ( r ) 2

P 1  r  2

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Convexity
Example: Consider an 8% semi-annual coupon
bond with 6 years to maturity and an 8% rate of
return. What is the change in price if rates rise by
2%?
1. The current price is $1000 because the coupon
rate equals the rate of return. Calculate what
the price will be if the rate of return is 0.01%
higher and 0.01% lower?
 PMT = 80, N = 6, FV =1000
 If I/Yr = 8.01 then PV = 999.53785
 If I/Yr = 7.99 then PV = 1000.46243

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Convexity
Example: Consider an 8% semi-annual coupon
bond with 6 years to maturity and an 8% rate of
return. What is the change in price if rates rise by
2%?
2. Calculate the convexity

 P  P  
CX  10 8
 
 P P 
 999.53785   1000.46243 
CX  10 
8
 1    1  28
 1000   1000 

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Convexity
Example: Consider an 8% semi-annual coupon
bond with 6 years to maturity and an 8% rate of
return. What is the change in price if rates rise by
2%?
3. Calculate the change in price

P  r  1
  Dur   CX ( r ) 2

P  1  r  2

P  .02  1
 4.993   28(. 02 )2
 .09246  .0056  8.69%
P  1.08  2

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Immunization

In order to eliminate risk of an obligation due in N

years:
1. Buy a zero coupon bond that matures in N years
2. Buy a coupon bond with a duration of N years

Example: Horizon is 5 years but you buy a 6 year

bond with a duration of 5 years.
Bond pays 8% annual coupon or $80 a year for 5
years.
What happens if rates are 8%? 7%? 9%?

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