Financial Markets

D. Sohair Thabet Ahmed

 Curriculum
Valuation of securities

- Chapter 4: time value of money

- Chapter 6: Interest rates and Bond valuation
- Chapter 7:Stock valuation
- Chapter 8:Risk and return
 Chapter 6

Interest rates and Bond valuation

 6.1 Interest rate and required return

• The term “Interest rate” is applied to debt instruments such as bank

loans or bonds; the compensation paid by the borrower of funds to
the lender.
• The term “ required return is applied to equity investments such as
common stock; the cost of funds obtained by selling an ownership
interest.
• Meaning of two terms is similar because, in both cases , the supplier
is compensated for providing funds to the demander.
 Equilibrium interest rate
Factors can influence the Equilibrium interest rate:
• Inflation: savers demand higher returns when inflation is high.
• Risk: when people perceive that a particular investment is risker, they
will expect a higher return on that investment.
• Liquidity preferences ( general tendency of investors to prefer short –
term securities). investors will hold short-term securities, despite the
relatively low return that they offer, because they meet investors’
preferences for liquidity.
 Real rate of interest
• The rate that creates equilibrium between supply and demand of
savings and the demand for investment funds in a perfect world,
without inflation, where suppliers and demanders of funds have no
liquidity preferences and there is no risk.
Real rate of interest
 Nominal or actual rate of interest
Nominal rate of interest is the actual rate of interest
charged by the supplier of funds and paid by the
demander.
Interest rates and required rates of return are nominal
rates.
Nominal rate of interest differs from real rate of
interest as a result of tow factors; inflation and risk.
 Nominal or actual rate of interest
• Investors will demand higher nominal rate of return if they expect
inflation. This higher rate of return is called the expected inflation
premium (IP).
• Similarly, investors generally demand higher rates of return on risky
investments as compared to safe ones. Therefore, investors demand a
higher rate of returns on risky investments. This additional rate of
return is called risk premium (RP)
r1 = r* + IP + RP
 Nominal or actual rate of interest(r1)
r1 = r* + IP + RP
Risk free rate Rf risk premium

r1 = Rf + RP
Rf = r* + IP
r* = Rf - IP
Real rate of return = Risk free rate - expected inflation premium
Deflation
 Impact of inflation
• The two rates tended to move in a similar fashion; T-bill rates were
slightly above the inflation rate most of time, meaning that T-bill
generally offered a small positive real return.
• The two rates tended to move in a similar fashion; T-bill rates were
slightly above the inflation rate most of time, meaning that T-bill
generally offered a small positive real return.
• Between 1978 and the early 1980, inflation and interest rates were
quite high, peaking at over 13 % in 1980-1981.
• Then, rates have gradually declined. To combat a severe recession,
the federal reserve pushed interest rates down to almost 0% in 2009,
and rate of inflation turned slightly negative (deflation)
 Term structure of interest rate
• It is relationship between the maturity and rate of return for bonds
with similar levels of risk
• A graph of this relationship is called “yield curve”.
• Usually, analysts examine the structure of interest rates, they focus on
treasury securities.
Yield curve
 Inverted yield curve
• Interest rates in May 1981 were high by historical standards.
• It is a downward-sloping yield curve. It occurs infrequently and often
a sign that the economy is weakening.
• Most recessions in the United States have been preceded by an
inverted yield curve.
• A downward-sloping yield curve indicates that short –term interest
rates are generally higher than long-term interest rates.
 Normal yield curve
• Interest rates in May 2010 were unusually low, largely
because at that time the economy was just beginning to
recover from a deep recession and inflation was very low.
• A upward-sloping yield curve indicates that long –term
interest rates are generally higher than short-term interest
rates.
 Flat yield curve

•A yield curve that indicates that interest

rates do not vary much at different
maturities.
Yield curve affect the firm’s financing decision
Yield curve affect the firm’s financing decision:
• A financial manger who faces a downward-sloping yield curve may be
tempted to rely more heavily on cheaper, long-term financing
• A risk in following this strategy is that interest rates may fall in the
future, so long-term rates that seem cheap today may be relatively
expensive tomorrow.
Yield curve affect the firm’s financing decision
Yield curve affect the firm’s financing decision:
• A financial manger who faces a upward-sloping yield curve may be
tempted to rely more heavily on cheaper, short-term financing.
• A variety of factors influence the choice of loan maturity, but the
shape of yield curve is something that managers must consider when
making decisions about borrowing short-term versus long-term.
 Theories of term structure
Three theories explain the general shape of yield curve:
• Expectation theory,
• The liquidity preference theory,
• The market segmentation theory.
 Expectation theory
• The theory that the yield curve reflect investors expectations about
future interest rates; an expectation of rising interest rates results in
an upward-sloping curve, and an expectation of declining rates
results in a downward-sloping yield curve.
 Liquidity preference theory
• Theory suggesting that long-term rates are generally higher than
short-term rates(hence, the yield curve is upward sloping) because
investors perceive short-term investments to be more liquid and less
risky than long-term investments.
• Borrowers must over higher rates on long-term bonds to entice
investors away from their preferred short-term securities.
 Market segmentation theory
• Theory suggesting that the market for loans is segmented on the basis
of maturity and that supply of and demand for loans within each
segment determine its prevailing interest rate; the slope of the yield
curve is determined by the general relationship between the
prevailing rates in each segment.
 Risk premiums

r1 = r* + IP + RP
Nominal interest rates = Risk free rate Rf + risk premium

• The risk premium varies with specific issue and issue characteristics.
 Risk premiums
Nominal interest rates
U.S. Treasury bonds represent the risk free

Security Risk premium

Security Nominal interest rate
U.S. Treasury bonds 3.3% Corporate bonds (by risk rating)
Corporate bonds (by risk rating)
High quality (Aaa-Aa) 3.95 High quality (Aaa-Aa) 3.95% - 3.30% = 0.65%
Medium quality (A-Baa) 4.98 Medium quality (A-Baa) 4.98 - 3.30 = 1.68
Speculative (Ba-C) 8.97 Speculative (Ba-C) 8.97 - 3.30 = 5.67
 Corporate bonds

Long –term debt instrument indicating that a corporation has

borrowed a certain amount of money and promises to repay it
in the future under clearly defined terms.
• Most bonds are issued with maturities of 10 to 30 years and
with par value, or face value, of $1000. the coupon interest
rate on a bond represents percentage of the bond’s par value
that will be paid annually, typically in two equal semiannual
payments.
 Legal aspects of corporate bonds
• Certain legal arrangements are required to protect purchasers of
bonds.
• Bondholders are protected primarily through the indenture and
trustee.
 Bond indenture
• It is legal document that specifies both the rights of
the bond holders and duties of the issuing
corporation.
• It has description of the amount and timing of all
interest and principal payments, standard and
restrictive provisions.
 restrictive provisions (restrictive covenants)
1. Require a minimum level of liquidity to ensure against loan
default.
2. Prohibit the sale of account receivables to generate cash.
3. Impose fixed-asset restrictions to maintain a specified level
of fixed assets to guarantee its ability to repay the bonds.
4. Constrain subsequent borrowing. Additional long-term debt
may be prohibited or subordinated (subsequent creditors
agree to wait until all claims of the senior debt are
satisfied).
restrictive provisions (restrictive covenants)
5. Limit the firm’s annual cash dividend payments to a
specified percentage or amount.
6. Sinking –fund requirements: its objective is to provide for
the systematic retirement of bonds prior to their maturity. The
corporation makes semiannual or annual payment that are
used to retire bonds by purchasing them in the marketplace.
7. Security interest: the bond indenture identifies any
collateral pledged against the bond and specify how it is to be
maintained.
 trustee
• Third party to a bond indenture.
• The trustee can be an individual, corporation, most
often a commercial bank trust department.
• The trustee is paid to act as a “watchdog” on behalf of
the bondholders and can take specified actions on
behalf of the bondholders if the terms of the
indenture are violated.
 Cost of bonds to the issuer
The major factors that affect the cost:
• bond’s maturity,
• The size of the offering,
• Issuer’s risk,
• Cost of money
 General features of a bond issue

• Conversion feature,
• Call feature
• Stock purchase warrants
 Conversion feature
• Convertible bond that allows bondholders to change
each bond into a stated number of shares of common
stock.
• Bondholder convert their bonds into stocks only when
the market price of the stock is such that conversion
will provide a profit for the bond holder.
• Conversion feature lowers the interest cost.
 Call feature
• It gives the issuer the opportunity to repurchase bonds prior to
maturity.
• Call price is stated price at which bonds may be repurchased prior to
maturity.
• Sometimes the call feature can be exercised only during a certain
period.
• As a rule, call price exceeds the par value by an amount equal to
year’s interest (call premium).
• The issuer must pay a higher interest rate for callable bond.
 Stock purchase warrants

• Bonds occasionally have stock purchase warrants

attached as “sweeteners”
• They are instruments that give their holders the right
to purchase a certain number of shares of the issuer’s
common stock at a specified price over a certain
period of time.
• Their inclusion enables the issuer to pay lower interest
rate.
 Bond yield
It is used to assess a bond’s performance over a giver
period of time (1 year).
There are 3 popular yield measures:
• Current yield,
• Yield to maturity,
• Yield to call
 Current yield

• The it indicates the cash return for the year from the bond
Example
Par value = $1000
Coupon interest rate = 8%
price = $970
Current yield = {(1000 × 0.08 ) ÷ 970 = 8.25%
 Yield to maturity (YTM)
It is the compound annual rate of return earned
on a debt security purchased on a given day and
held to maturity.
Bond prices
Bond Ratings
 Bond Ratings
• There are inverse relationship between the
quality of the bond the rate of return
 Common types of bonds
• Debenture: unsecured bonds that only creditworthy firms can issue.
Convertible bond are normally debentures. claims are the same as
those any general creditors.
• Mortgage bonds: secured by real state or buildings. Claims is on
proceeds from sale of mortgaged assets. If not fully satisfied, the
lender becomes a general creditor.
• Zero coupon bonds: issued with zero or very low coupon and sold at a
large discount from par (treasury bills).
 International bond issue
Companies and governments borrow
internationally by issuing bonds in two capital
markets:
• Eurobond market,
• Foreign market.
 Eurobond market
• Issued by international borrower and sold to investors
in countries with currencies other than the currency in
which the bond is denominated.
Example
A dollar-denominated bond issued by a U.S.
corporation and sold to Belgian investors
 Foreign market

• A bond that is issued by a foreign corporation or

government and is denominated in the investor’s
home currency and sold in the investor’s home market
Example
A Swiss-franc-denominated bond issued in Switzerland
by a U.S. company
 Valuation fundamentals
• Valuation is the process that links risk and return to determine the
worth of an asset.
Three key inputs to valuation process:
1. Cash flows (returns),
2. Timing,
3. A measure of risk which determines the required return.
 example
Celia wishes to estimate the value of three assets:
• Common stock in Michaels Enterprises,
• Interest in an oil well,
• An original painting by a well-known artist.
 example
Cash flows
• Common stock in Michaels Enterprises: expect to receive cash
dividends of $300 per year indefinitely.
• Interest in an oil well, expect to receive cash flow $2000 at the end of
year 1, $4000 at the end of year 2, $10000 at the end of year 4, when
the well is to be sold.
• An original painting by a well-known artist. Expect to be able to sell it
in 5 years for $85000
 example
Timing
We must know the timing of the cash flow

Risk and required return

The level of risk associated with a given cash flow can affect its
value. The greater the risk of a cash flow, the lower its value.
Greater risk can be incorporated into a valuation analysis by
using a higher required return or discount rate.
 Risk and required return

Placing a value on the original painting

• Scenario 1 (certainty): a major art gallery has contracted to buy the
painting for $85000 at the end of 5 years. Because this is considered a
certain situation, Celia views this asset as “money in the bank”. She
would use risk free rate of 3% as a required return.
• Scenario 2 (high risk) the values of original paintings by this artist
have fluctuated widely over the past 10 years between $30000 and$
140000. because of high uncertainly, Celia believes that a 15% is
appropriate.
 Basic valuation model

V0 = CF1 + CF2 +………….+ CFn

(1+r)1 (1+r)2 (1+r)n

V0 = value of the asset at time zero

CH = cash flow expected at the end of year t
r =appropriate required return
n = relative time period
 example
The value of Michaels Enterprises stock
$300 / 0.12 = $2500

The value of Oil well investment

$2000 + $4000 + $ 10000 = $ 9266.98

(1+ 0.20)1 (1+0.20)2 (1+0.20)4

Value of the painting

$85000 / (1+0.15)5 = $42260.0

Bond value behavior
 Self test problems
ST6-1 Bond valuation: Lahey Industries has outstanding a $1000 par-
value bond with an 8% coupon interest rate. The bond has 12 years
remaining to its maturity date.
a- If interest is paid annually, find the value of the bond when the
required return is (1) 7%, (2) 8%, (3) 10%.
b-Indicate for each in part a whether the bond is selling at a discount,
at a premium, or at its par value.
c. Using the 10% required return, find the bond’s value when interest is
paid semi-annually.
Value of the bond
 Value of the bond
1080

80 80 80 80 80 80 80 80 80 80 80

0 1 2 3 4 5 6 7 8 9 10 11 12

= σ $80 + $1000 = 80 × 7.943 + 1000 × 0.444 =

(1+ 0.07)12 (1+0.07)12
= 635.44 + 444
=1079.44
The bond is selling at premium
= σ $80 + $1000 = 80 × 7.536 + 1000 × 0.397 =
(1+ 0.08)12 (1+0.08)12
= 602.88 + 397
=999.88 ≈ 1000
The bond is selling at its par value
= σ $80 + $1000 = 80 × 6.814 + 1000 × 0.319 =
(1+ 0.10)12 (1+0.10)12
= 545.12 + 319
=864.12
The bond is selling at discount
 1040

40 40 40 40 40 40 40 40 40 40 40 40 40 40 40 40 40 40 40 40 40 40 40

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

σ $40 + $1000 = 1080.29

(1+ 0.035)24 (1+0.035)24
= σ $40 + $1000 = 40 × 15.247 + 1000 × 0.390 =
(1+ 0.04)24 (1+0.04)24
= 609.88 + 390
=999.88 ≈ 1000
σ $40 + $1000 = 40 × 13.799 + 1000 × 0.310 =
(1+ 0.05)24 (1+0.05)24
= 551.96 + 310
= 861.96
ST6-2 Bond yields Elliot Enterprises’ bonds currently sell for $1150
have an 11% coupon interest rate and a $1000 par value, pay interest
annually, and have 18 years to maturity.
a. Calculate the bonds’ current yield.
b. Calculate the bonds’ yield to maturity (YTM).
c. Compare the YTM calculate in part b to the bonds’ coupon interest
rate and current yield (calculate in part a). Use a comparison of the
bonds’ current price and par value to explain these differences.
a. Current Yield

1150 1110

110 110 110 110 110 110 110 110 110 110 110 110 110 110 110 110 110

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

a. Current Yield
Coupon = 1000 × 0.11 = 110
Bond value = 1150
Current yield = coupon / bond value = 110 / 1150 = 0.10
Yield to maturity (YTM)

= σ $110 + $1000 = 1150

(1+ Y)18 (1+Y)18
Y = 9.26
YTM < bonds’ coupon interest rate
9.26 < 11
Bond’ current price > par value
1150 > 1000
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‫‪ 3-‬اكتب نسبة من عندى وبعدين =‬
‫‪ 4-‬لو طلعت هي سعر السهم اذا هي النسبة الصحيحة او اجرب نسبة ثانية‬
E6-1
The risk-free rate on T-bills recently was 1.23%. If the real rate of
interest is estimated to be 0.80%, what was the expected level of
inflation?
 Nominal or actual rate of interest(r1)
r1 = r* + IP + RP
Risk free rate Rf risk premium

r1 = Rf + RP
Rf = r* + IP = real rate of return + expected inflation premium
r* = Rf - IP
Real rate of return = Risk free rate - inflation premium
 r* = Rf - IP
Real rate of return = Risk free rate - inflation premium
0.8 = 1.23 - IP
IP = 1.23 - 0.8
= 0.43
E6-2
Maturity Yield
The yields for treasuries with
differing maturities on a recent 3 months 1.41%
day were as shown in the table 6 months 1.71
a. Use the information to plot a 2 years 2.68
yield curve for this date.
3 years 3.01
b. If the expectations hypothesis
is true, approximately what 5 years 3.70
rate of return do investors 10 years 4.51
expect a 5-year treasury note
30 years 5.25
to pay 5 years from now?
Yield curve
Yield curve
600.00%
5.25

500.00% 4.51

400.00% 3.7

3.01
300.00% 2.68

200.00% 1.71

100.00%

1.41%
0.00%
3 months 6 months 2 years 3 years 5 years 10 years 30 years

• It is Upward-sloping curve. Rate of return of 5-year treasury note

3.7
 Expectation theory
• The theory that the yield curve reflect investors expectations about
future interest rates; an expectation of rising interest rates results in
an upward-sloping curve, and an expectation of declining rates
results in a downward-sloping yield curve.

• It is Upward-sloping curve. Rate of return of 5-year treasury note = 3.7

 Chapter 7
stock valuation
Differences between debt and equity

Debt Equity
Although Debt and equity capital Debt financing is Equity financing is
are both sources of financing used obtained from creditors obtained from investors
by firms, they are very different. (part owners of the firm.
Creditors have a legal Investors have only an
right to be repaid. expectation of being
repaid.
Debt is repaid according Equity consists of funds
to a fixed schedule of repaid to the firm
payment performance
A firm can obtain debt A firm can obtain equity
only externally either internally or
externally
 Common stock
• Common stockholder expect to be compensated with adequate dividends
and capital gains.
• They cannot lose any more than they have invested in the firm.
• Common stock holder are sometimes referred to as residual owners because
they receive what is left “the residual” after all other claims on the firm’s
income and assets have been satisfied.
 Ownership
• The common stock of a firm can be owned by:
1. Private investors ( small group of private investors such as a family),
2. Public investors ( many unrelated individual or institutional investors)
 Par value
• The market value of common stock is completely unrelated to its par value.
• The par value of the shared sold is recorded in the capital section of the
balance sheet as apart of common stock.
• Setting a low par value is advantageous in states where certain corporate
taxes are based on the par value of stock and is also beneficial in states that
have laws against selling stock at a discount to par.
 Preemptive rights
• It allows common stockholders to maintain their proportionate ownership in
the corporation when new shares are issued, thus protecting them from
dilution of their ownership.
• Preemptive rights allow preexisting shareholders to maintain their
preissuance voting control and protects them against the dilution of
earnings.
 Dilution of ownership
• It is a reduction in each previous shareholder’s fractional ownership resulting
from the issuance of additional shares of common stock
 Dilution of earnings
• It is a reduction in each previous shareholder’s fractional claim on the firm’s
earnings resulting from the issuance of additional shares of common stock.
 Right offering
• Financial instruments that allow stockholders to purchase additional shares at
a price below the market price, in direct proportion to their number of
owned shares
Authorized. Outstanding and issued shares
• A firm’s corporate charter indicates how many authorized shares it can issue. The
firm cannot sell more shares than the charter authorized without obtaining approval
through a shareholder vote.
• Authorized shares become outstanding shares when they are issued or sold to
investors. If the firm repurchases any of its outstanding shares, these shares are
recorded as treasury stock and are no longer considered to be outstanding shares.
• Issued shares are the shares of common stock that have been put into circulation;
they represent the sum of outstanding shares and treasury stock.