invs & port lec-03

8/4/2019 INVS & Port Lec-03

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Security AnalysisM. Jibran Sheikh

[email protected]

Office hours: Tuesday 16:00 to 18:00or by

appointment via e-mail.


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Outlook

Introduction to Securities

Bonds

Efficient Markets - Theory, Evidence & Alternatives

Valuation of Ordinary Shares

Wrap-up


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INTRODUCTION TO SECURITIES

Securities can be broadly defined as financial assets that offer a

claim on the issuers real assets and the cash that they produce.

Or more simply, they are a document that can be assigned a

value and sold, and in many cases traded in organised markets

such as a Stock Exchange.A more complex definition of a security is often needed for legal

and practical reasons, involving for instance the resolution of

disputes or assessment of tax implications. One such definition

is offered for the US in the Securities Exchange Act of 1934:


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Securities Exchange Act of 1934

The term 'security' means any note, stock, treasury stock, bond,debenture, certificate of interest or participation in any profit-sharingagreement or in any oil, gas, or other mineral royalty or lease, anycollateral-trust certificate, reorganisation certificate or subscription,transferable share, investment contract, voting-trust certificate,certificate of deposit, for a security, any put, call, straddle, option, or

privilege on any security, certificate of deposit, or group or index ofsecurities (including any interest therein or based on the valuethereof), or any put, call, straddle, option, or privilege entered into ona national securities exchange relating to foreign currency, or ingeneral, any instrument commonly known as a 'security'; or anycertificate of interest or participation in, temporary or interimcertificate for, receipt for, or warrant or right to subscribe to orpurchase, any of the foregoing; but shall not include currency or anynote, draft, bill of exchange, or banker's acceptance which has amaturity at the time of issuance of not exceeding nine months,exclusive of days of grace, or any renewal thereof the maturity ofwhich is likewise limited.


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Financial Securities

Debt / Fixed Income Securities

loans

leases commercial papers

bondsDerivatives

options

futures / forwards

Equity / Variable Income

Securities

ordinary shares preferred shares

warrants


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Fixed income securities:

They have a defined, limited, monetary claim. The receipts frominvesting in these securities will never exceed the promised claim,although it can be less in case of default.

Variable income securities:

They offer a residual claim on the earnings of an issuer. Holders ofthese securities are entitled to the remaining funds after all othersecurity holders have been paid their entitlements.

Primary securities:

They oblige the issuer to some form of payment from their income.The issuer is typically a government or a company.

Derivative securities:Derivative securities are issued by individual traders. These securitiesderive their value from another financial asset, hence their name. Foreach trader purchasing such a security there has to be another oneselling it, so the net-total of all outstanding positions is zero


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Bonds

A bond is a financial instrument that promises to make certain

fixed payments, usually in the form a periodic interest payments

and a redemption payment at the end of the bonds life.

However, bonds come in a variety of forms. Some simply make

the periodic interest payments, and do not provide acommitment to repay the bond's principal (such bonds are

generally referred to as irredeemable). Others, known as pure

discount bonds or zeros, offer no interest payments but a

commitment to redeem the bond at its par or face value at a

specified time in the future. Some are convertible into othersecurities on specified terms, and others are callable, giving the

issuer the right to redeem the bonds before the in maturity date

on certain terms.


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BONDS

bond covenants

embedded options

cash flow pattern

maturity

price

rating


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bond covenants

asset covenant

dividend covenant

financing covenant

bonding covenant


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embedded bond options

convertibility

callability

putability

exchangeability


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bond cash flow patterns

straight

deferred

zero

annuity

consol

variable coupon bonds


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Cash

flow

Cas

hflow

Year

T

Year

T

Cas

h

flow

Year T Year T

Cas

h

flow

Deferred Bond

Zero Coupon Bond

Annuity Bond

C

as

h

flo

w

Consol

T T+1 T+2 T+3

Principal

Interest

Straight Bond


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BOND PRICING

bond price = present value of the expected cash flows from the bond

cash flows from a straight bond:

periodic coupon interest payments

the face/par value at maturity


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formulae - straight bond

nn

c

nn

r

B

rrrCV

BrC

r

B

r

C

r

C

r

CV

)1()1(

11

)1()1(...

)1(1

0

2

o


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formulae - straight bond

Where

The discount rate is given by the market determined rate ofreturn that can be expected on bonds of the same maturity,

coupon rate and risk. The valuation equation assumes that the

bond is being valued immediately following the receipt of an

interest payment.


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Example 1-A

A bond with nominal value of 100 issued 3 years ago has 5

years to run to maturity. It carries a coupon of 7%, but bonds

issued today with 5 years to maturity are offering an interest rate

of only 5%.

What is the current value of the bond?


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66.108

)05.01(

1100

)05.01(

1)10007.0(

)1(1

)1(1)(

0

5

5

1

0

1

0

V

V

rB

rBrV

tt

n

n

ttc


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The bond is selling above its par value as a result of the interest

rate having fallen since the bond was first issued, and there is an

inverse relationship between the present value of a series of

positive cash flows and the discount rate. A six year bond issued

today that offers a coupon rate of 5 per cent and thereby anannual interest payment of 5 will sell at its par value of 1 00:

clearly, another bond with six years to run to maturity that

offers an annual interest payment of 7 will be valued more

highly in the market. The market value of the 8 per cent bond is

given for a range of different interest rates in the following table,

and the relationship between the value of a bond and a range of

possible interest rates is illustrated in the Figure (in nest slide).

The table and diagram also consider the relationship between

the value of a bond and the interest rates for other bonds with

coupon rates of interest of eight per cent but maturities of one

year, ten years, and twenty years. The diagram reveals that the

sensitivity of value of a bond to the interest rate increases with

the length of a bond's remaining life.


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Figure


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BOND PRICES AND INTEREST RATES (8 PER CENT COUPON BOND 10 YEAR BONDS)


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Example 1-B

A bond issued last year has 10 years to run to maturity, it

offers a coupon of 5 % paid semi-annually.

What is the current bond value?


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100

)05.02

1

1(

1100

)05.02

1

1(

)10005.0(2

1

)2

11(

1

)2

11(

)(2

1

0

102

102

1

0

2

2

1

0

V

V

entscouponpaymannualsemi

r

B

r

C

V

t t

n

n

t t


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formulae - zero coupon bond

nOr

B

V )1(


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Solution

0250.0107.82

1000250.01

07.82

100

)1(

100

07.82

8

1

8

8

rorr

r


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dirty & clean prices

dirty price = bond price withaccrued interest

clean price = bond price withoutaccrued interest


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Yield

Internal rate of return

current yield = annual coupon interest / price

yield to maturity:

nnO

y

B

yyy

CV

)1()1(

11


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Example 3

What is the yield to maturity on a 6% coupon bond with

4 years to maturity which is currently selling for 97.05?


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3205.87)1.01(

1100

)1.01(1.0

1

1.0

16%10

100)06.01(

1

100)06.01(06.0

1

06.0

1

6%6

:

)1(

1100

)1(

11605.97

)1(

1100

)1(

11605.970

440

440

44

44

Vyf

Vyif

yforvakuesdifferenttrynow

yyyy

yyyyNPV


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spot & forward rates

1)1(

)1(

)1()1()1(

1

1,

,,

,

1

1,,

n

ns

n

nsnf

nf

n

ns

n

ns

rrr

rrr


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Example 4-A

The interest rate for the next year is 4% and the spot

rate of interest on a 2 year zero coupon bond is 5%.

What is the implied forward rate for year 2?


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060096.01)04.01(

)05.01(

)1()04.01()05.01(

)1()1()1(

)1()1()1(

2

2,

2,

2

2,

1

1,

2

2,

,11,,

f

f

fss

nfnnsnns

r

r

rrr

rrr


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Example 4-B

An 8 year zero coupon bond has a yield to maturity of

9.58% and a 9 year zero coupon bond offers a yield of

9.68%.

Determine the forward rate for year 9.


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)1()1()1(

)1()1()1(

9,

8

8,

9

9,

,

1

1,,

fss

nf

n

ns

n

ns

rrr

rrr


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Useful sources

Investors Chronicle:

http://www.investorschronicle.co.uk

Yahoo: http://uk.finance.yahoo.com

http://finance.yahoo.com (US)


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Assignment

Determine the yield to maturity of this 10 year, 7%

coupon bond.

The bond is currently selling for $950 and coupon

payments are made semi-annually.

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